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Security and Utility Tokens: Where Is the Dividing Line?

Blog • 5min read
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Written by

Hunain Naseer
Published on September 11, 2018

We explain the difference between security and utility tokens from an investor’s point of view.

Initial coin offerings (ICOs) have been the talk of the town for quite some time. This ingenious crowdfunding model is popular among tech startups and businesses looking for a quick and easy way to secure money for their projects while bypassing the complexity of traditional seed investments or initial public offerings (IPOs).

Despite numerous exit scams and hair-raising stories about still-born or outright fraudulent schemes, the trend has kept growing: over 1,000 ICOs have been launched so far in 2018 and about $6.8 billion collected, according to ICO Data statistics. The amount raised exceeds the total figure for 2017 and represents a 6,600% increase from 2016.

To reduce risks and avoid regulatory or legal issues, investors should know the basics before they part with their money to support another promising project with a revolutionary idea.

In ICOs, companies raise funds by selling cryptographic blockchain-based coins or tokens that can be traded on cryptocurrency platforms, exchanged between users, or utilized in payment for certain products and services supplied by the project. These assets fall into two groups: security tokens and utility tokens. They differ in their functions and specifications and knowing the difference might save investors from mistakes and disappointment.

Let’s dig deeper into these token categories to understand better how they function and what the difference between them is.

Utility Tokens

Definition

Utility tokens are units of account within a project's ecosystem. They provide their holders with access to certain products and services developed by the startup, but they do not represent a share in the project and do not entitle holders to future profits.

Functioning

A company launches an ICO to finance the development of its products and services, so selling utility tokens amounts to offering pre-order coupons for goods or services that are still under construction and may take a few months to hit the market.

Consider them a form of credit that can be exchanged in the future for what the company has to offer. Once the project is live, token holders can often get the company's products at a discounted price.

Investor considerations and regulatory aspects

Utility tokens are not designed as investment instruments, but it does not mean they cannot appreciate and bring some profit to their holders.  If the project is successful, they will grow in price as demand for the service or product increases.

Consider buying utility tokens which have solid use cases or solve real-life problems. Investments in projects that are continually developed and improved may eventually pay off in spades.

Since utility tokens are considered a non-investment asset, they are exempt from securities legislation. This detail deprives investors of regulatory protection but, at the same time, spares ICO startups the trouble of complying with a myriad of requirements and obtaining heaps of approvals. As a result, most ICOs claim they have a utility token while in reality many of them are not structured as such or have little to no practical use.


Warning!

Be careful with utility tokens that have a vague structure or a dubious use case as some regulators may classify them as a security. A potential investor should understand the economics of the project and the utility of the token before investing in an ICO.


Security Tokens

Definition

Security tokens are more like traditional investment instruments. Backed by real assets, they can represent equity, debt, or a derivative, depending on their economic function.

Such tokens give their holders ownership rights in a company and entitle them to dividends or a share of future profits. In this case, an ICO (or STO - Security Token Offering) is very similar to an IPO, the difference being that the former uses a blockchain platform and smart contracts.

Also, investors can buy tokens on a secondary market during or after the STO.

Functioning

The important thing about security tokens is that they serve primarily as an investment tool, allowing holders to benefit from a company's success or trade the assets on the market to generate speculative profits.

Investor considerations and regulatory aspects

A security token is a tradable asset with a value defined by the market, which makes it liable to applicable securities laws and regulations.

Currently, utility tokens are the predominant type in ICOs, but some crypto experts expect security tokens to gradually replace them as companies will tend to issue stock, profits, and voting rights in digitalized form on a blockchain.

A security token is considered the safest option for investors as their rights are protected by law. It makes things more comfortable and more straightforward, but it also requires compliance with KYC/AML procedures and other regulations applicable to equities and bonds.


Warning!

Security tokens are prohibited in some countries (including the USA) unless their issuers obtain permission from the relevant regulator and ensure full compliance with existing securities laws. The US Securities and Exchange Commission (SEC) employs the Howey Test to determine whether a token is a security.

However, many startups ignore this limitation and sell security tokens to US residents, which makes both the companies and their investors vulnerable to a regulatory crackdown.


Conclusion

There are two types of tokens within the ICO space: security and utility tokens. However, the line between them is blurred as many projects try to avoid regulatory supervision and issue utility tokens with no real use cases.

Considering that investments have some form of risk (whether they are ICOs or STOs), investors should always do their homework and analyze the token and its fundamentals before making investment decisions. Token prices follow the laws of economics (supply and demand, for example), which means it is useful to understand the fair value of a token and the forces behind its price dynamics.

Published on September 11, 2018