Security Tokens vs. Utility Tokens: What is the Difference?

Written by Jay Jackson - Reviewed by Coin Review Team

Published: Oct 2, 2018 | Last Updated: Feb 14, 2019

Understanding the difference between Security Tokens & Utility Tokens. What the Future of ICOs Will Look Like.

2024-10-11T02:49:50+00:00

It’s no secret that tokenization has revolutionized the global investment landscape. As the world gradually embraces Blockchain technology and cryptocurrencies, it has become much easier for business to crowdfund from various sources with the help of ICOs.

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Companies can raise funds by issuing crypto tokens as an alternative to ownership of shares.

To bring to perspective, this year more than $20 billion^[1] has been collectively raised by hundreds of start-ups through Initial Coin offerings (ICOs).

Perhaps you may ask: as an investor how will you use these tokens?

You can use these tokens to trade and exchange across different cryptocurrency exchanges. Tokens serve several functions; this includes granting access to services offered as well as entitlement to company dividends. Therefore, tokens can be classified as either utility tokens or security tokens depending on their objectives.

However, there is a thin line between the two, and as a potential investor or start-up founder, it’s important you know how to distinguish a utility token from a security token.

If you have been struggling with these million dollar concepts, this is your article.

So let’s delve and explore:

What is a token?

A token is a virtual representation of a particular asset or utility that operates on top of another Blockchain. It’s a representation of an asset that is both tradable and fungible.

Tokens are mostly issued to the public when a company launches an initial coin offering (ICO), which works almost like an IPO. The only thing that sets them apart is: in an IPO you will receive stock in exchange for your investments while in an ICO it’s the tokens that are exchanged for every investment.

Now that we know what tokens are, let’s dive deeper into utility and security tokens.

Utility tokens

They are also referred to as user tokens. They represent future access to a company’s product or services for users. They have a use case and are not designed as investments, and this frees them from the federal law governing securities.

Nevertheless, they are profitable. They may grow in price depending on the increase in demand for services or products. Therefore purchasing utility tokens, especially of a project that is solving problems for users and is constantly under improvement and development is likely to be lucrative into the future.

An example of utility tokens

1. Civic
2. Filecoin

Civic

According to Vinny Lingham (CEO and co-founder), Civic has already produced one billion tokens that will offer access to identity verification-related services in its decentralized, token-based ecosystem. The tokens will represent a unit of account for the network.

The utility of the token is expected to increase with an increase in the growth of the network. This is because of the fixed number of tokens in the network. It is also expected that an increase in both the size of the network and transaction volumes will amount to a rise in demand for tokens.

Filecoin

Start-ups that create utility tokens can sell them as digital coupons for the services they are developing, just like retailers who accept pre-orders of video games yet to be released.

For example, Filecoin was able to raise $52 million^[2] through selling tokens that will enable users to access its decentralized cloud storage platform.

Security tokens

Security tokens enable their holders to acquire specified ownership rights of a company. They acquire their value from tradable assets. Security tokens can be used to issue out dividends, company shares, and voting rights over blockchain-based networks.

According to the US Securities and Exchange Commission (SEC), security tokens are under the federal legislation that regulates conventional securities. This is a tough call for the current bunch of ICOs because only a few of them have capacity offer security tokens that meet SEC’s security regulations.

Here is an example of pure security token.

tZERO

Recently, Overstock, an online retailer, announced that tZERO will be holding an ICO to fund the development of a security token trading platform. The tZERO tokens, comply with SEC regulations, and token holders will be eligible for quarterly dividends.

Compliance with the set federal regulations can open up security tokens to a multitude of applications that include representation of companies’ shares or stock through blockchain-based tokens.

However, non-compliance with the set federal regulations could amount to legal punishments to the start-up’s founder and even termination of the whole project. Already SEC has launched a crackdown on non-compliant companies such as Tezos^[3] and Centra^[4].

Utility Tokens or Security Tokens?

Utility tokens and security tokens mainly differ from each other depending on their intended use and functionality.

Security tokens, through proof of staking, enable their holders to benefit from an investment angle every time the project owners earn a profit. Also, they enable their holders to acquire ownership rights in the company they invested in. On the other hand, utility tokens are used for the daily running of the platform services.

Nonetheless, there exist similarities between security tokens and utility tokens that make it difficult to distinguish between the two tokens. For instance, appreciations of the token price in the market increase the value of both the utility and security tokens.

Therefore, both tokens can earn profits.

With such similarities, the best way of distinguishing between the two tokens is through the Howey test, which was created in 1946 and has been mandated by the US Supreme Court.

Howey test

According to the Howey test, a token is an investment contract if it meets the following criteria:

If the token is offered to the public as an investment
If individual investors expect profits from their investment
If the investment of money is in a common enterprise
If profits are generated from the efforts of a third-party or work of the promoters

If a token meets the above prerequisites, then it’s categorized under security tokens. That said, perhaps you may have come across ICOs that try to disguise themselves as utility tokens.

A token presenting itself as a utility token while it’s a security token will soon or later fall in the hands of the SEC crackdown, and your investment may go down the drain.

Final word

In conclusion, if you are looking to take advantage of the rewarding opportunities that ICOs present, it makes sense to do your due diligence before investing in any token.

Distinguishing utility tokens from security tokens can go a long way in enabling you to make good investment decisions.

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References

[1] https://www.coinschedule.com/stats
[2] https://cointelegraph.com/news/is-there-such-a-thing-as-a-sec-compliant-ico-filecoin-thinks-so-raises-52-mln
[3] https://www.coindesk.com/tezos-founders-sued-securities-fraud-potential-class-action/
[4] https://www.sec.gov/news/press-release/2018-53

Disclaimer

The writer’s views are expressed as a personal opinion and are for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.