Utility Tokens Versus Security Tokens

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Utility Tokens Versus Security Tokens

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Tokenatomy 101- Utility tokens Versus Security Tokens

For the past year, the ecosystem of tokens was built on blockchains integrated into decentralized applications (DApps), which have been rapidly expanding. One of the most contentious subjects surrounding tokens has been the difference between Utility Tokens and Security Tokens.

The ramifications of any individual token being considered a utility token or a security token are enormous. Security tokens are subject to regulations which, in many cases, can make their project unfeasible to execute. Utility tokens avoid regulatory oversight but can have their own risks.

What are tokens typically used for?

The major use case for tokens so far has been fundraising. In the public equity markets, when a company needs to raise funds, they issue shares of the business to the public in the form of securities. These are subject to regulation and oversight. In the United States, the Securities and Exchange Commission (SEC) is responsible for regulating the public equity markets.

When cryptocurrency projects raise funds, they issue a token which is often incorporated with the proposed project in some way. The token is issued and the funds are raised via an event called an initial coin offering (ICO). The tokens issued in this kind of event are typically considered utility tokens.

These tokens derive utility from their function within a blockchain. The most popular method for conducting an ICO is on the Ethereum blockchain, the second-largest cryptocurrency network by market cap currently. ICO events have mostly avoided regulation despite a few projects being shut down when conducting an ICO in the U.S.

While this method of fundraising gained huge popularity over the past two years, a new type of fundraising for crypto projects is now being executed, known as a Security Token Offering (STO). Security tokens are linked to a real-world or digital asset and differ in significant ways from utility tokens.

We will be delving into each separately, to present the key similarities and differences and also discuss the role each may play going forward. We will also be shedding light on some cryptocurrency projects which are addressing this space specifically.

ICOs & Utility Tokens

crypto ico court

ICOs exploded over the past two years. Over $6.5 billion was raised in 2017 via ICOs and over $20 Billion in 2018. Most projects conducting an ICO would release a whitepaper outlining the technical details and how the ICO will be structured.

Oftentimes, in the small print of the whitepaper, there is text detailing that the token being issued is a utility token and is not subject to regulation. This means that the team does not have any responsibilities towards investors. This should always be considered carefully.

When investors participate in an ICO, it is completely different from participating in a publicly regulated market. Institutions providing a service in a publicly regulated market have a duty of responsibility towards their clients and investors and will suffer consequences for not respecting such duty. With little consequences for ICO teams not respecting their clients, many projects have pulled what is known as an “exit scam” where the team disappears once the funds have been raised.

The most common type of utility token has been issued using the ERC20 smart contract standard on the Ethereum blockchain. This is a Fungible Token, which means every token will be priced equally against USD, Ether, or otherwise, and each token is equivalent to any other token. For example, if the token was not fungible, tokens issued first may be more valuable than others.

Many major cryptocurrency projects have used ERC20 smart contracts to issue tokens during an ICO. Examples of major cryptocurrencies which have completed ICOs through this method include EOS, Icon, and Tron. The ERC20 tokens essentially act as a placeholder until the projects launched their own mainnet.

Utility tokens derive their value from their function within the specific blockchain system they operate in. They essentially act as digital assets and should be carefully designed to manage the incentives of users of the blockchain system, those who maintain the network, and should also serve a key use case and function within the blockchain system that they are operating in.

One example of a utility token is Basic Attention Token (BAT). BAT is a token which operates in the Brave browser, a competitor to major browsers such as Google and Firefox. Instead of companies such as Google being paid to publish advertisements which target the browser users, Brave browser and BAT reward the user of the browser for choosing to view advertisements. The Brave browser has over 4 million users making it one of the most active projects which have incorporated a utility token.

STOs & Security Tokens

Security tokens serve to tokenize both physical and digital assets. They are more similar to equity instruments in the manner that holders may receive dividends from holding the tokenized asset. Tokenizing real-world physical assets may increase their liquidity. Transferring ownership of a token which represents ownership in property could be completed far more efficiently than transferring ownership of the actual property.

One of the key differences with security tokens is that they are subject to regulatory oversight which is another aspect of making them similar to equity instruments. This makes it more difficult for teams which are issuing security tokens but provide more protection to the investor. In some cases, this will also restrict the number of potential investors.

In the US, only accredited investors will be able to invest in security tokens meaning that the investor needs to have, as a minimum, either $1 million in net worth or $200 thousand in annual income.

One example of a security token is the tethering of assets. This is where the value of the token is backed by a real-world physical asset and the token can be traded as if it were the real-world asset. One of the biggest examples of this is USD Tether which is a cryptocurrency claimed to be backed by USD in a 1:1 ratio. Others are issued to investors in exchange for funds via an STO.

One example of a security token would be Aspen Coins. Each token represents a common share in St. Regis Aspen Resort, a high-end hotel and luxury resort. The token can be purchased through Templum Markets which is an SEC-registered broker-dealer. Token holders benefit from all the rights they would have if they held a normal security. They are entitled to profit sharing, voting rights, and hold equity in the company.

Utility Tokens Versus Security Tokens

security vs utility token
Image source: Crypto Potato

There are benefits and drawbacks to both utility tokens and security tokens. When issued correctly, utility tokens can serve a valuable purpose within a blockchain ecosystem. They are also available to a wide array of potential investors and provide those with even small amounts of cryptocurrency holdings a means to invest their holdings.

On the other hand, security tokens are typically more restricted but represent less risk for the investor. There are also the benefits of regulatory oversight which acts to ensure that projects conducting STOs act in the best interest of investors.

While a utility token operates within a blockchain ecosystem, a security token can be linked to a real-world asset and can make the asset more liquid and also divisible. Instead of purchasing a whole property, users can purchase tokens which represent a share in the property.

Distinguishing between Utility Tokens and Security Tokens

There are cases where utility tokens seem to have all the properties of a security token but still claim to be a utility token. In these cases, it is better for the investor to distinguish for themselves whether the token more closely represents a utility or a security token. Many tokens which have claimed to be utility tokens may be deemed by regulators to be security tokens down the line.

The Howey Test

One method for distinguishing between utility and security tokens is to match the token up to the criteria of the Howey Test. The Howey Test was established in 1946 and has since been used to determine what is considered a security. This test assesses an instrument against four criteria and if the instrument meets all of the criteria, it is deemed a security. The criteria are the following:

  • It involves an investment of money
  • The investment of money involves an expectation of profit
  • The investment is in a common enterprise
  • The profit will be generated by a third party

When the Howey Test criteria are applied, it becomes clear that many projects which claim to be issuing a utility token are in fact issuing a security token. The ICO process clearly involves an investment of money, and investors are mainly enticed to invest from the prospects of profit.

The proposed project acts as the common enterprise and the team building or operating the project generates the profit. Not all cases of ICOs are clearly issuing security tokens, but many are better categorised as such, rather than utility tokens.

While most governments have refrained from commenting on their position in relation to tokens, the US SEC made a public statement in July 2017 which clarified that they would consider many tokens issued to be securities. The statement did not classify all token issuings as security issuings but it has had a big impact on the state of ICOs in the US. Many projects raising funds from a token issuing now exclude investors from the US.

Key Security Versus Utility Token Debates

Distinguishing between a utility token and a security token is important for those who are issuing tokens to raise funds. It also has ramifications for projects which are currently in existence. Many projects which are currently considered utility tokens could find themselves in precarious situations if it is later deemed that their token is a security by regulators.

Ethereum

ethereum token

Ethereum has been one which has been hotly debated whether it should be classified as a security or not. With a huge ecosystem being built on top of the Ethereum blockchain, a decision by regulators to classify Ether as a security could have catastrophic consequences.

It would potentially call into question the legitimacy of every project built on top of Ethereum. Although there has not been an official statement regarding whether ether is a security, unofficial comments make it seem that the SEC does not consider Ether to be a security.

The DAO

The Decentralized Autonomous Organization (DAO) was launched upon the Ethereum network in 2016. The DAO was programmed to function solely from smart contracts where everything was preprogrammed. Investors would be issued DAO tokens which could be used to vote on projects to invest in and also when to receive dividends from the invested projects.

A major hack took place in the DAO due to a flaw in the code which resulted in Ethereum reversing its transaction history to return the funds to the original investors. This sparked significant controversy in the Ethereum community. The DAO also sparked controversy in cryptocurrency regulation. The SEC considered the DAO tokens securities and it was the motivation for the public statement released in July 2017.

XRP

XRP, the popular digital cryptocurrency issued by Ripple Labs, is another currency which has witnessed intense debates regarding its status. XRP is a token which provides a low-cost liquidity to emerging markets. It provides a similar service to those that Western Union and TransferWise perform but via their digital currency. XRP has recently been onboarding users but there is speculation that the token could be considered a security in the future potentially causing issues for the customers and Ripple itself.

Projects Specifically Focused on Security Tokens

With security tokens becoming more popular and offering some advantages over utility tokens, some projects have been developed to specifically focus on facilitating the creation of security tokens. While the market is well-established for utility tokens, with some selling out within seconds (the Gibraltar Blockchain Exchange ICO sold out in nine seconds earlier this year), the market is not well established for security tokens.

This provides an opportunity for platforms to come and provide a market and liquidity for security tokens along with providing services so that the security tokens comply with regulations.

Polymath

polymath securities token

Polymath is striving to be the Ethereum of security tokens. They have created their own smart contract standard, the ST20, which enables projects to deploy security tokens on their platform. The ST20 token has know-your-customer (KYC) built into its code to account for the KYC compliance aspect of issuing security tokens. Polymath also applies measures to provide liquidity for private entities seeking to invest in liquidity tokens.

Swarm

Swarm is a project which provides a protocol which enables users to tokenize real-world assets. The protocol has rules which must be complied with prior to launching a token on the protocol. Assets such as real estate and companies can be tokenized through the protocol.

Tokeny

Tokeny is another platform which allows users to tokenize assets. The platform applies bank-grade KYC procedures on issued tokens. The key goals of Tokeny are to provide liquidity to the market for security tokens and to provide institutional measures to ensure compliance.

Key Tokenatomy Takeaways

Utility tokens versus security tokens is a topic which is currently meshed out in the cryptocurrency community and among regulators. Some government bodies such as the SEC have made their stance more clear but most governments have made no official statements regarding the matter.

Security tokens are rising in popularity and offer some key advantages over utility tokens. Some projects are being developed to specifically focus on facilitating the creation of security tokens. Other projects are taking the initiative to issue security tokens and may benefit from providing their investors with the assurance that the project complies with regulation.

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