Security Tokens Vs Utility Tokens: What are the Key Differences?
Main differences between security tokens and utility tokens. Image courtesy Tecsynt Solutions on Medium
In the context of cryptocurrency investments, a token represents value, right, stake, or anything else that an investor would treasure holding. The token is known to exist in a particular platform such as a cryptocurrency coin. OmiseGO and Golem are examples of tokens existing in the Ethereum blockchain platform.
A token is a representation of a company’s security or utility, and is often issued to investors during crowd sales. Coins that companies issue during an Initial Coin Offering (ICO) are utility tokens, while security tokens are given out a security token offering (STO). A basic distinction between these two types of tokens is brought forth the Howey Test.
The Howey Test
The Howey Test is a creation of the Supreme Court following the Securities and Exchange Commission Vs W. J. Howey Co of 1946. The key aim was to have a legal framework that will help categorise investment contracts from other usual business transactions. The mentioned test asks the following two critical questions:
1. Are the bearers of the tokens permitted to fund the company and share in the profits?
2. Do the efforts to raise funds through Initial Coin Offering (ICO) involve investing in a project that generates profits entirely from the efforts of persons who are not the creators or promoters of the project?
Where the answer to these two questions is a “YES,” then the type of token in question may be a security token.
Key differences between security tokens and utility tokens
Image courtesy The Money Mongers
Security tokens are cryptocurrency coins that pass the Howey Test. Their value comes from a tradable external asset.
In USA, federal securities and regulations control the issuance and operations of such tokens. The applicable regulations include Regulation D, Regulation A+, and Regulation S. This type of token is classified as such because should be profitable. If the provision complies with all relevant regulations, then security tokens have great impact.
Such a token is an investment contract representing lawful ownership of an asset. However, this ownership is only verifiable within the blockchain. Upon verification, holders of security tokens have a right:
· to exchange their tokens for other valuable assets;
· or, offer them as collateral security for a credit facility;
· and, keep them safe in various wallets
Since companies use ICOs as investment opportunities, most of the tokens qualify as securities. In case the token does not qualify due to Howey Test, they become utility token.
The implication is that it provides users with a product or service. A utility token is more or less like a digital coupon for a product or service that the issuing company is developing in the future. Due to an upper cap that exists on the maximum token available, there is a possibility that the value of tokens will go up because of the market forces of supply and demand.
ERC20 Ethereum standard utility token is one of the most popular. Other examples of utility tokens are Filecoin, Siacoin, and Civic.
Other key variables that distinguish security tokens from utility tokens follow the following variables:
The purpose of security tokens is to serve as an investment contract representing lawful ownership of both physical and digital assets that have been verified inside the blockchain.
The purpose of utility tokens on the other hand is to fund Initial Coin Offerings (ICOs) and to create an economy within the blockchain of a project. The bearer of the tokens acquires the rights to vote within the ecosystem, among other rights.
Expectedly, the value of a security token is directly related to the valuation of the company. The higher the value of the company, the higher the value of its security tokens. Utility tokens do not quite enjoy this stature. They, on the other hand, do not present any relationship between their value and the past, present, or future value state of the company.
3. Scam potential
Given that security tokens are subject to strictly regulation; the possibility of scamming is almost nil or very minimal.
Utility tokens are fairly unregulated. Therefore, scammers capitalize on this situation to create fake ICOs and tokens.
4. Regulation status
To execute a security token, including the distribution exercise, the company and investors must comply with the Howey Test, and other related regulations as asset out by the SEC. Since it is not easy to come up with regulations for ICOs; utility tokens will for a long time remain as they are; largely unregulated.
From this narrative, it is apparent that the design of utility tokens serves to help motivate the bearer to behave in a particular way, whereas security tokens act as an investment contract representing legal ownership of assets.
Utility tokens were designed to avoid government regulation that exists in security tokens, and to make it easy to raise seed capital for cryptocurrency and blockchain projects. Although investors would be glad to experience far less regulation because of the fear of tax burden, common sense dictates that some modicum regulation is not only necessary but also very wise.