Utility Tokens vs Security Tokens Guide…
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If you are new to the crypto space then you must be overwhelmed by the sheer volume of terminology. For the uninitiated, terms like “cryptocurrency”, “tokens”, “securities”, “utility tokens” etc. must get extremely overwhelming.
In this guide, we are going to tackle all those terms and make life much simpler for you. We are especially going to put the last terms, i.e. security tokens and utility tokens under the microscope, to help you clearly understand the differences between the two. After all, utility tokens and tokenized securities are million dollar concepts that are funding startups around the world.
So, let’s begin with some basics.
Utility Tokens vs Security Tokens
What are Tokens?
It can be a little complicated to pinpoint on an exact definition of a “token”. To give you a very wide, non-generalized definition, a token is a representation of something in its particular ecosystem. It could value, stake, voting right, or anything. A token is not limited to one particular role; it can fulfill a lot of roles in its native ecosystem.
Before we go any further, however, we must make one more difference clear. The difference between a cryptocurrency coin and a token.
A cryptocurrency coin, like BTC, Ether etc. can be is independent of a platform. They can be used as a form of currency outside their native environment. Basically, these are the “cryptocurrencies” that we are all familiar with.
However, on the other hand, OmiseGO, Golem etc. are examples of tokens which exist on a particular platform, in this case, Ethereum.
A token represents a security or utility that a company has and they usually give it away to their investors during a public sale called ICO (Initial Coin Offering), in the case of utility tokens, and STO (Security Token Offerings), in the case of security tokens.
What Are ICOs?
ICOs or Initial Coin Offerings are basically crowd sales, the cryptocurrency version of crowdfunding. The ICOs have been truly revolutionary and have managed to accomplish amazing tasks:
- They have provided the simplest path by which DAPP developers can get the required funding for their project.
- Anyone can become invested in a project they are interested in by purchasing the tokens of that particular DAPP and become a part of the project themselves. (We are talking about Work Tokens here).
So, how does an ICO work?
Firstly, the developer issues a limited amount of tokens. By keeping a limited amount of tokens they are ensuring that the tokens itself have a value and the ICO has a goal to aim for. The tokens can either have a static pre-determined price or it may increase or decrease depending on how the crowd sale is going.
The transaction is a pretty simple one. If someone wants to buy the tokens they send a particular amount of ether to the crowd-sale address. When the contract acknowledges that this transaction is done, they receive their corresponding amount of tokens. Since everything on ethereum is decentralized, an ICO is considered a success if it is properly well-distributed and a majority of its chunk is not owned by one entity.
The recently concluded EOS ICO which raised a whopping 4 billion dollars in a year is till date the biggest ICO ever.
Also, as TechCrunch points out, ICOs delivered at least 3.5x more capital to blockchain startups than Venture Capitals since 2017
How Does a Token Gain Value?
So, before we continue and classify our tokens, let’s look at what functions a token can serve in order to gain value.
As William Mougayar points out in his Medium article, there are three tenets to token value and they are:
These three are locked up in a triangle and they look like this:
Each token role has its own set of features and purpose which are detailed in the following table:
Let’s examine each of the roles that a token can take up:
By taking possession of a particular token, the holder gets a certain amount of rights within the ecosystem. Eg. by having DAO coins in your possession, you could have had voting rights inside the DAO to decide which projects get funding and which don’t.
The tokens create an internal economic system within the confines of the project itself. The tokens can help the buyers and sellers trade value within the ecosystem. This helps people gain rewards upon completion of particular tasks. This creation and maintenance of individual, internal economies are one of the most important tasks of Tokens.
It can also act as a toll gateway in order for you to use certain functionalities of a particular system. Eg. in Golem, you need to have GNT (golem tokens) to gain access to the benefits of the Golem supercomputer.
The token can also enable the holders to enrich the user experience inside the confines of the particular environment. Eg. In Brave (a web browser), holders of BAT (tokens used in Brave) will get the rights to enrich customer experience by using their tokens to add advertisements or other attention based services on the Brave platform.
Can be used as a store of value which can be used to conduct transactions both inside and outside the given ecosystem.
Helps in the equitable distribution of profits or other related financial benefits among investors in a particular project.
So, how does this all help in token valuation?
In order to become more valuable, a token must fulfill more than one of these properties. In fact, more properties that a token can have, higher its valuation.
Alright, so now we know what a token is, how a company distributes token and where a token can gain value from.
Before we go any further, it is important to know what the Howey test is.
The Howey Test
In 1946, the Supreme Court handled a monumental case. The case was SEC vs Howey which would lay down the foundation for the, now infamous Howey Test. The case was about establishing a test of whether a particular arrangement involves an investment contract or not.
To keep a long story short, two Florida-based corporate defendants offered real estate contracts for tracts of land with citrus groves. The defendants offered buyers the option of leasing any purchased land back to the defendants, who would then tend to the land, and harvest, pool, and market the citrus. As most of the buyers were not farmers and did not have agricultural expertise, they were happy to lease the land back to the defendants.
However, this was deemed illegal by the U.S. Securities and Exchange Commission (SEC) and the defendants were promptly sued.
According to the SEC, the defendants broke the law by not filing a securities registration statement. Upon investigating the defendant’s leaseback and finding that it was indeed security, the Supreme Court made a true landmark decision.
They developed a test which will be used to determine whether a certain transaction is an investment contract or not. If it is, then it will be subject to the securities registration requirement.
The said transaction will be called an investment contract if it fulfills the following criteria:
- It is an investment of money
- The investment is in a common enterprise
- There is an expectation of profit from the work of the promoters or the third party.
The term “common enterprise” is open to interpretation. However, many federal courts have defined a common enterprise as a horizontal enterprise where the investors pool in their money and assets to invest in a project.
Even though the original Howey Tests used the term “money”, later cases expanded that to include other investments and assets other than money.
Plus, there is another important thing to consider while determining securities. The profits that come from the investment, is it in the investor’s control or is it completely out of it? If it is not in the investor’s control, then the asset is declared a security.
So, how is this relevant for ICO and tokens? If the token meets all the three aforementioned criteria, then it is regarded as security.
All these three elements have to be met for a coin to classify as security.
Other Alternative Tests
Turns out that the Howey Test is not the only test that courts can use to find out whether a given investment is a security or not.
In 1990, the Supreme Court developed a family resemblance test which provided a way for contract creators to show that their contract has a “family resemblance” to other investments and hence cannot be called securities.
Certain states have their own securities registration requirements which are sometimes called “Blue Sky” laws.
According to Wikipedia, “The first blue sky law was enacted in Kansas in 1911 at the urging of its banking commissioner, Joseph Norman Dolley, and served as a model for similar statutes in other states. Between 1911 and 1933, 47 states adopted blue-sky statutes (Nevada was the lone holdout). Today, the blue sky laws of 40 of the 50 states are patterned after the Uniform Securities Act of 1956. Historically, the federal securities laws and the state blue sky laws complemented and often duplicated one another.”
The DAO and SEC
The Howey Test and securities have become a source of intense debate in the crypto-community after the DAO tokens failed to pass the Howey Test and were deemed securities by the SEC.
This article by Ash Bennington for Coindesk breaks down why the DAO was deemed security in the form of a tale:
“Not so long ago, a group of developers started a DAO.
The DAO developers said: “There are all these decentralized projects and there’s no way for them to get funding – because they need money to make money.”
Tell you what. We’re going to write code and sell a token and, in exchange, people who buy the token will get whatever profits are made from those projects.
We’ll work the code. They’ll pick the projects. The projects will flourish and everyone will profit.
The SEC said: “That’s a security.”
The DAO developers said: “No, no. That’s just selling tokens.”
Ultimately, the SEC said: “That’s a security” – because of the application of the Howey Test: There was an investment of money. A common enterprise. With the expectation of profit, primarily from the efforts of others.”
So, why was this investigation and ruling done in the first place?
Well, it was because of the infamous DAO hack. We have covered this in detail before, but just to give you an overview:
- There was a flaw in the Dao smart contract
- The hacker exploited that flaw to execute a re-entrancy attack.
- Over $50 million worth of ether was siphoned away.
Because a lot of people invested and got back nothing in return, the SEC intervened to “protect” the interest of the investors and deemed the tokens a security.
As SEC CEO Jay Clayton puts it, “The SEC is studying the effects of a distributed ledger and other innovative technologies and encourages market participants to engage with us. We seek to foster innovative and beneficial ways to raise capital, while ensuring – first and foremost – that investors and our markets are protected.”
This decision was met with a mixed reception in the Crypto community:
Brad Garlinghouse, Ripple Ceo, said, “Regulators aren’t going away – and shouldn’t. For generations, they have protected from fraud (some is happening w/ the ICO market).”
Roger Ver, Bitcoin.com founder, however, disagreed with the decision, “Call this what it is: A bunch of strangers in a far-off land threatening peaceful people all over the world with violence if they don’t obey.”
Ok, so till now we know what tokens are and what the Howey Test is. So, now let’s get into the two major classifications of tokens.
Types of Tokens
The SEC and FINMA have broken down tokens into two broad categories:
- Utility Tokens
- Security Tokens
Because most of the ICOs are investment opportunities in the company itself, most tokens qualify as securities. However, if the token doesn’t qualify according to the Howey test, then it classifies as utility tokens. These tokens simply provide users with a product and/or service. Think of them like gateway tokens.
Since there is an upper cap on the maximum token availability, the value of the tokens may go up because of the supply-demand equation. Supply-demand is pretty easy to understand. The idea is that more the demand for an asset, lesser will be its supply and that is going to shoot up its price.
The sweet spot where both the curves intersect is the equilibrium.
How Utility Tokens Work
As Jeremy Epstein, the CEO of Never Stop Marketing, explains, Utility tokens can:
- Give holders a right to use the network
- Give holders a right to take advantage of the network by voting
Utility tokens are hand down the most popular form of tokens out there, mainly because of 2017’s ICO boom. Companies have used these utility tokens to raise millions of dollars in funding. However, that’s just one of the roles that they fulfill.
- They help in building an internal economy within the system. Eg. Civic pays its users to verify identities and create attestations within their blockchain
- They can give the holders to take advantage of a network by voting in it. Think of any blockchain that has a proof of stake model. Once you have locked up a stake in the network, you have the power to vote on the network’s overall well-being.
The most popular example of utility token is the ERC20 ethereum standard. To know more about the ERC20 standard, read our guide here. The ERC20 standard has been used by companies to build tokens for their DApps and launch their ICOs.
Examples of utility tokens:
Finally, we come to security tokens.
So what exactly are they?
A crypto token that passes the Howey Test is deemed a security token. These usually derive their value from an external, tradable asset. Because the tokens are deemed as security, they are subject to federal securities and regulations.
In simpler terms, a token is classified as security when there is an expectation of profit from the effort of others. If the ICO doesn’t follow certain regulations, then they could be subject to penalties. However, if all the regulations are properly met, then these tokens have immensely powerful use-cases.
Security Token = Investment Contract
At its very essence, a security token is an investment contract which represents legal ownership of a physical or digital asset like real estate, ETFs etc.. This ownership must be verified within the blockchain.
After the ownership is verified, security token holders can:
- Trade away their tokens for other assets
- Use them as collateral for a loan
- Store them in different wallets
Having said that, the true value in security tokens lies in how they can completely redefine the meaning of “ownership”. They can democratize assets and distribute them among people all over the world. To give a very crude example, instead of owning a gold coin, which may be out of a lot of people’s budget, it is now possible for 100 people to own fractions of that gold coin.
What Regulations Are Security Tokens Subjected to?
Anthony Pompliano does an admirable job of explaining the kind of regulations that security tokens will be subjected to in this article.
According to him, because Security Tokens are subject to federal security regulations, they are compliant from the first day itself. So, in the USA, security tokens need to follow these regulations:
- Regulation D
- Regulation A+
- Regulation S
Regulation D will allow a particular offering to avoid being registered by the SEC provided “Form D” has been filled by the creators after the securities have been sold. The individual who is offering this security may solicit offerings from investors in compliance with Section 506C.
So what does Section 506C require?
It requires a verification that the investors are indeed accredited and the information which has been provided during the solicitation is “free from false or misleading statements.
This exemption will allow the creator to offer SEC-approved security to non-accredited investors through a general solicitation for up to $50 million in investment.
In order for the requirement to register the security, the issuance of Regulation A+ can take a lot more time compared to other options. For the same reason, Regulation A+ issuance will be more expensive than any other option.
This happens when a security offering is executed in a country apart from the US and is therefore not subjected to the registration requirement under section 5 of the 1993 Act. The creators are still required to follow the security regulations of the country where they are supposed to be executed.
NOTE: As Anthony Pompliano notes in his article, the above summaries are merely his interpretation. They should not be construed as legal or investment advice and you should consult a lawyer for any and all questions you have.
Examples of security tokens are:
- Sia Funds (Sia has two tokens, Sia coins which is a utility token and Sia Funds)
- Bcap (Blockchain Capital)
- Science Blockchain
Utility Tokens vs Security Tokens
Alright, so let’s see how these two tokens do head-to-head.
Utility Tokens vs Security Tokens: Conclusion
We hope that this article has helped you understand the differences between utility tokens and security tokens. While one helps in incentivizing the holders to act in a certain way, the other is a contract that represents legal ownership of an asset. Did we miss out on some important points? Let us know in the comment section below.