Security Tokens vs. Utility Tokens — How different are they?

Security Tokens Series (5 part series — Part 2)

You can also watch our video about security tokens, its advantages and how to identify them here.

There is no doubt that Blockchain technology is poised to cause major disruptions in almost all industries in existence by making it possible to create a vast array of new business models. It has brought forth useful innovations such as decentralization and trustless networks. One of the significant factors that has contributed to the success of this technology is the use of tokens.

Today, utility tokens and tokenized securities are million dollar concepts that startups across the globe are grabbing onto as they crowdfund. But what do these terminologies mean? How different is a utility token from a security token? Let’s dive in and explore the details:

What is a Token?

A token is a utility, an asset or a unit of value issued by a company. In most cases, tokens are issued when a company launches an initial coin offering (ICO) — that works more or less like an initial public offering (IPO). The difference between an ICO and an IPO is that in an IPO you receive stock in exchange for the investment you make while in an ICO you receive a token in exchange for your investment.

Image: Worldspectrum

As we mentioned earlier, there are two primary types of tokens that you are likely to meet in the ICO space:

• Utility tokens
• Security tokens

Confusion often arises in differentiating between security tokens and utility tokens. Even though they may seem complicated at first, they are in fact very easy to understand as you will see in the subsequent sections.

What is a Utility Token?

Utility tokens are simply app coins or user tokens. They enable future access to the products or services offered by a company. Therefore, utility tokens are not created to be an investment.

Just like an electronics dealer might accept orders for a video game that will be released several months later, a startup can create utility tokens and sell digital coupons for the services or products it is developing.

A good example is Filecoin, which raised $257 million through the sale of tokens. These tokens will allow users access to its decentralized cloud storage platform.

What is a Security Token?

A security token is a digital asset that derives its value from an external asset that can be traded. Therefore, these tokens are subject to federal laws that govern securities. Failure to comply with these regulations could result in severe consequences including penalties and potential derailment of the development of a project.

On the other hand, security tokens can offer a vast array of applications if the startup abides by all the regulatory requirements. The most promising of these features is the ability to offer tokens as a digital representation of shares of a company’s stock.

For instance, Overstock recently announced that tZERO, one of its portfolio companies, would hold an ICO to fund the creation of a licensed security token trading platform. The tZERO tokens will be issued according to SEC regulations.

Security Tokens or Utility Tokens?

The major difference between security tokens and utility tokens is in the intended use and functionality of the tokens. Security tokens are created as investments. Token holders are given dividends in the form of additional coins every time the company issuing the tokens earns a profit in the market.

Users holding the security token also get ownership of the company. Blockchain offers a platform that can be used to create a voting system that allows investors to exercise control on the company’s decision-making process.

Utility tokens, on the other hand, are not intended to give their holders the ability to control how decisions are made in a company. They merely enable users to interact with a company’s services.

Both security and utility tokens can increase in value if the prices of the tokens appreciate in the market. And since they can both earn some profit, many people may still find it difficult to differentiate them. Here is the Howey test formulated by SEC to enable you to classify a cryptocurrency token as either a security or utility token.

The Howey Test

This test uses two simple questions to differentiate between security tokens and utility tokens:

Are the token holders allowed to provide funding for the company’s capital and receive a portion of the profits?

Does the fundraising effort of the ICO entail investment in the project where profits are generated entirely from the effort of individuals other than the creators or founders of the project?

The token is likely to be a security token if the answer to any of these two questions is yes.

How does the fundamental difference between utility and security tokens affect ICOs?

The securities act of 1933 governs securities in the US. The law has two primary objectives which include the prevention of fraudulent activities such as misrepresentations and deceit and ensuring that those issuing the securities provide financial and other relevant information to the investors.

Anyone issuing any form of securities must register their investment contracts with the SEC. Failure to make appropriate registration when dealing with securities can result in fines, lawsuits, penalties or even imprisonment.

Some of the important disclosure requirements include disclosures related to proxy solicitations and corporate reporting among others. SEC also oversees the security market to prevent unlawful activities such as insider trading. Companies issuing securities have to abide by essential anti-money laundering (AML) and know-your-customer (KYC) requirements, which are not only costly but also time-consuming.

Let us examine the current happenings in ICOs

First, startups create their whitepapers, tokens, websites and other marketing materials and then launch their ICO. Most ICOs are actually security tokens disguised as utility tokens through the citing of a number of primary use cases. They do this to evade the regulations governing security tokens.

They then employ aggressive marketing strategies that promise investors huge profits. Keep in mind that any security sold with the expectation of future profit qualifies as a security. Yet, some startups often fail to abide by the reporting and disclosure rules and they do not register their ICOs with SEC. Such companies are at risk of facing prosecution.

Why the regulators step in

The cryptocurrency market cap is currently around 300 billion dollars. From January to March 2018, ICOs raised an estimated amount of about $5 billion. With such vast amounts of money pouring in, regulators were bound to act.

SEC is not against ICOs in general. Its primary objective is to ensure that all ICOs comply with the regulations. Attempting to undermine the law presents serious risks for the investors and also for future Blockchain based cryptocurrency projects. In case things go wrong investors have no legal recourse against the malpractices.

Earlier this year, they stepped in and officially set up a cryptocurrency task force. By now, the task force has already sent notices to noncompliant ICOs such as Centra and Tezos.

Nonetheless, most upcoming Blockchain startups have now realized the importance of complying with the regulations, and several SEC-compliant tokens have been issued. Examples of such tokens include; Polymath, Corl, and tZERO.

Final word

We hope this article was helpful in enabling you to distinguish security tokens from utility tokens, and their impact in the crypto world. What your opinion on how the fundamental differences between utility and security tokens affect ICOs? Do you believe adhering to SEC rules will go a long way in ensuring the growth of the ICO industry for many years to come?

Security Tokens Series (Part 1): 10 Important Things to Know About Security Tokens

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Security Tokens vs. Utility Tokens — How different are they? was originally published in Hacker Noon on Medium, where people are continuing the conversation by highlighting and responding to this story.