What is a security token and what can you do with it?

What is a security token?

A security token is a digital asset (also referred to as a cryptocurrency) that legally represents an enforceable financial right. It can, for example, represent ownership rights, but also other rights such as a claim or a right to profit distributions. As a result, assets labeled as security tokens generally fall under securities law. The function of security tokens largely corresponds to traditional assets, such as shares and bonds, namely the ability to create value appreciation and make profit distributions or dividends possible, or for example voting rights. All of this is set out in legal documentation (such as terms or a contract), making a legal claim possible.

The main difference from other tokens, such as utility tokens, is the purpose. Utility tokens are primarily intended for use within a network or service, for example to pay transaction costs (such as Ether and Solana) or to access certain functionality. A security token does not need to have such a functional role. The classification mainly depends on the rights the token represents.

Security tokens are, in principle, digitally tokenized rights and are presented as tokens on a blockchain or other distributed ledger technology (DLT). The economic value of a security token usually relates to the underlying rights (such as cashflows, profit distributions or other proceeds) and expectations about them, and like traditional securities is also influenced by supply and demand in the market. Unlike many utility tokens, where value often depends more strongly on the use and adoption of the network, supply and demand also play an important role there.

Key Takeaways

• A security token is a digital token that legally represents a financial right, such as ownership, a claim, profit or dividend rights, interest or voting rights, and therefore functions similarly to traditional securities such as shares and bonds.
• The rights behind a security token are set out in legal documentation (such as terms or a contract); the blockchain is mainly the carrier on which those rights are issued and managed as tokens.
• The value of security tokens usually relates to the underlying rights and expected cashflows (such as profit distributions or interest) and to supply and demand in the market, just like traditional securities.
• Issuance and trading often involve extra compliance: KYC and AML, rules on who may hold or receive the token, and sometimes restrictions such as whitelists, lock-ups and restrictions by country or investor type.
• In the EU, security tokens can fall under MiFID II if they qualify as a financial instrument; then they generally fall outside MiCAR, while utility tokens often qualify as crypto-assets under MiCAR because they are primarily intended for use or access within a network or service.

How does a security token work?

A security token effectively works as a digital financial right, set out in legal documentation (such as contractual terms). The issuer first legally defines which right the token holder receives (for example the right to profit distributions, interest, voting rights or a claim). That right is then issued on a blockchain or another form of distributed ledger technology (DLT). Compliance checks are often set up, such as KYC and AML and rules on who may hold or transfer the token. These checks can be enforced in different ways, for example via a platform's systems, but also directly on-chain through a smart contract.

The tokens are then issued to investors via a private placement or via an STO (Security Token Offering). An STO is essentially a public offering of securities, but in token form. In execution it can resemble an ICO, but it falls under securities rules because it is a security. Trading of security tokens can then take place via trading platforms that comply with securities laws and regulations. This can differ by country, for example in how strict rules are and how strictly they are enforced.

During the term of the contract, the rights linked to the token are carried out, such as dividend or interest payments and voting. This can be partially supported or automated technically (for example via smart contracts), but is often also partially handled off-chain through the issuer's processes.

Why do security tokens exist?

Security tokens are often mentioned as a solution to three problems in the traditional securities market: transaction settlement is often slow and expensive, participating often requires a lot of capital, and compliance with rules runs through many intermediaries.

• More efficient and potentially cheaper: Transaction settlement and ownership transfer can partially be digitized and automatically recorded via DLT systems such as a blockchain, for example using smart contracts. This often means less manual back-office work than with traditional securities, where multiple parties are involved in registration and settlement. That can save time and costs.
• More accessible through fractional ownership: Thanks to tokenization, it can be easier to participate with smaller amounts, for example because you can buy a small part of an asset. In some structures you do not need to purchase the entire underlying instrument, but can obtain a fraction via tokens. At the same time, investor protection remains a hard requirement: clear information, appropriate distribution and attention to risks.
• Rules and transfer: Where compliance in traditional markets often runs through multiple parties and systems, with security tokens certain rules can be integrated directly into the process of holding and transferring (for example via whitelists or restrictions by country). This is especially relevant because in Europe there is close scrutiny of when a crypto-asset qualifies as a financial instrument (MiFID II) and therefore falls outside MiCA.

What are the characteristics of security tokens?

Security tokens have recurring characteristics that can help you identify that it is a security token rather than another type of crypto-asset. These are the main characteristics:

1. The legal nature of a security token

A security token often legally falls within securities law. Within Europe, this means they can fall under MiFID II, because they can grant rights comparable to traditional securities, such as economic ownership rights, the right to profit or dividends, interest or other distributions, or rights that strongly resemble shares or bonds. In that case, they generally do not fall under the European MiCAR, because MiCAR in principle applies to crypto-assets that are not a financial instrument under MiFID II. This means that trading platforms that do not have the correct MiFID II license may not offer security tokens.

2. Economic rights and cashflow linkage

Security tokens are generally linked to economic rights that resemble those of traditional securities. Holding them can legally give you rights to, for example, dividends, interest payments, profit participation or voting rights. There is therefore often a financial reward associated with holding security tokens, while the token does not necessarily have a functional role within the network it runs on, as is often the case with utility tokens.

3. Investor protection and disclosure obligations

Security tokens are generally seen as investments, and such investment instruments come with additional rules for providers to protect investors. For example, the provider must give clear information about what you are buying, what risks are involved and how the product works. In many countries a prospectus requirement can therefore apply, a kind of leaflet containing the risks and conditions. The idea is simple: investors must receive sufficient, understandable and consistent information so they can make a well-informed decision.

4. Restrictions on transferability and identity

Many types of tokens are permissionless tokens, meaning tokens you can send without conditions to other wallet addresses. With security tokens this is different, because these tokens often have restrictions that are set out contractually. Due to the legal nature, these restrictions must comply with securities laws and regulations, such as investor protection, KYC and AML and sales restrictions by country. As a result, a security token is often less freely tradable than a standard utility token. Common conditions include:

• Whitelisting: specific or KYC-verified wallet addresses may receive or hold the tokens. A transfer to a non-approved address can be technically blocked.
• Lock-up periods: there may be a lock-up period after purchase or receipt of the token, during which you cannot sell or transfer it. This period often starts immediately after issuance and may apply to certain groups of investors. Many of these conditions are legally required and will be stated in the issuance terms, for example via a prospectus requirement.
• Restrictions by country or investor type: different rules for security tokens apply per country. This can also mean that you can hold and trade a security token in one country but not in another. In addition, a security token may only be allowed to be held by a specific category of investors, such as investors classified as professional investors.
• Transfer-agent-like functions: sometimes there is a party or mechanism that oversees the official ownership registration and transfers, comparable to a transfer agent for traditional securities. This can mean transfers must be approved, a register is maintained or procedures exist for, for example, recovery after loss, corporate actions or changes in rights.

What is the difference between a security token and a utility token?

The big difference between security tokens and utility tokens is, simply put, that the token was developed with a different purpose: a security token is often seen as an investment, while a utility token is intended to have a useful function within a blockchain ecosystem, such as access to a product or service. So it is not about why you as a user buy a token, but about what rights and function the token provides. This means that both digital asset classes are also viewed differently from a regulatory perspective.

Security token

A security token often has the character of an investment:

• The buyer expects a return, such as dividends, interest, profit participation or value appreciation.
• That return often depends on the performance or efforts of an issuing party or third party, such as management, and not only on the use of the network itself.
• This can be set out legally in the terms, for example in contracts and or via the token structure.

Utility token

A utility token is primarily designed to provide access to a product or service and or to play a functional role within a decentralized network, such as paying transaction costs, governance or staking.

The EU distinction (MiCAR vs MiFID II)

Legally, security tokens and utility tokens are also treated differently. Utility tokens are often classified as crypto-assets and then fall under MiCAR. Security tokens can, if they qualify as a financial instrument, fall under MiFID II and are then treated within securities and investment law. Which rules exactly apply ultimately depends on the concrete characteristics and rights of the token.

Final thoughts

Security tokens are, at their core, a digital wrapper of rights we already know from the traditional financial world: ownership, a claim, interest, dividends, profit participation or voting rights. The crypto element mainly lies in the way these rights are issued and managed via tokens on a blockchain or other DLT, not necessarily in the purpose or operation of the product itself. Precisely because these are investment-like rights, security tokens often sit closer to securities law than to the rules for ordinary crypto-assets. You can see this in stricter requirements around information, investor protection and restrictions on who may buy, hold or trade the tokens.

This makes security tokens an interesting bridge between traditional markets and tokenization: they can make processes more efficient and participation more accessible, but only within clear legal frameworks. Unlike utility tokens, the value of security tokens usually revolves around the underlying economic rights and cashflows, not the functional role of the token within a network. Ultimately, classification is therefore not a question of what people want to do with it, but of the concrete rights and terms linked to the token.