Security Tokens Defined

How to use the Howey Test to Determine a Security Token

The Breakdown

Security tokens are any blockchain asset that meets the SEC’s standard for a securitized asset as defined by the Howey test.

Seems like a mouthful, but we are here to break it down for you. In more basic terms, security tokens are the cryptocurrency equivalent of buying stocks or shares of a company. For example, if you buy a Tesla stock, you are the owner of a small piece of Tesla. So when you buy a security token for X company, you become a partial owner of that company and are protected by specific federal laws and regulations.

How to use the Howey test to determine a security token:

The SEC developed a test that is used to determine whether a certain transaction is an investment contract (aka security token) or not. If it is, then it will be subject to the securities registration requirement.

A coin is considered a security token if it fulfills the following criteria:

• It is an investment of money
• The investment is a common enterprise
• There is an expectation of profit from the work of the promoters or the third party.

The term “common enterprise” can be interpreted in many different ways. In several federal courts, it has been defined as a “horizontal enterprise where the investors pool in their money and assets to invest in a project.”

The Difference Between Security Tokens vs Utility Tokens

There seems to be a common misconception that a security token is the same as a utility token. Although security tokens may seem very similar to utility tokens, they are actually quite different.

The big difference between security tokens and utility tokens is that security is defined as an investment in someone else’s effort, while a utility token merely gives you access to a company’s platform or services. Typically these security tokens are released at the end of a company’s ICO or initial coin offering.

Security Tokens vs ICOs
Security tokens have become increasingly popular over the last 3 years. They make up most of the tokens in circulation and unlike an ICO, they are restricted by federal laws and rules of stock trading. Read more here for specific questions regarding some of the US Token regulations.

Security tokens developed as the market’s response to the ICO boom of 2017. With the explosive entrance of crypto into the mainstream, and easy tools to DIY your own ICO, shady actors and scammers flooded the market.

Now, ICOs have fallen out of favor for most investors who are (understandably) wary of unregulated coins. Security tokens have become incredibly popular as they allow investors to invest in transparent, regulated projects. With a registered STO, investors can purchase with confidence that the operators are legitimate and that they’re not giving their money to someone who will run off with their money and dump the project. Before designated security tokens, there was no way to monitor or protect your investment against these individuals. The token protects your investment in the form of encrypted security already attached, so you never have to think twice after purchasing.

Here’s an example:

Let’s talk about it as an analogy in the “real world” based on the Howey test. If you invest $20 for your child to start a lemonade stand, is your $20 considered a security token/investment contract? There are 3 questions to ask yourself:

1) Did I invest money? (yes)

2) Did my spouse or others also give them money to make this a “common enterprise” with two or more partners? (maybe)

3) Do I expect any money in return? (maybe)

If the answer isn’t yes to all of those, there is nothing stopping that child from choosing to buy a new toy at the store over lemonade products or spend that money however they see fit.

However, if the answer is yes to all three, then you and your money are legally protected. The issuers are bound by securities law. This is the function of a security token. The security token protects the investor via predetermined rules and regulations. The Howey test is the only true way to determine what can or cannot be considered a security token.

Final Word

If you take anything away from this, here are the 3 things that truly define a security coin.

• It is an investment of money
• The investment is a common enterprise
• There is an expectation of profit from the work of the promoters or the third party.

We hope that you have found this article helpful and are always here to dive deeper into all things crypto for yourself and for your business.

Reach out to us today to discuss our security token creation or issuance offerings with one of our professionals.