Security Tokens vs Utility Tokens
The difference between security tokens and utility tokens is fairly clear-cut, though the distinction can seem murky and nuanced since both types of tokens can increase or decrease in value depending on market demand. Moreover, many utility tokens are promoted covertly as an investment likely to increase markedly in value in parallel with how security tokens are promoted overtly as the same thing. So the line between each type of token may appear to be blurred at present but is becoming more evident over time.
Essentially, utility tokens bestow future access to the ICO issuing company’s products or services, whereas a security token offering serves as an investment vehicle for the buyer in the STO (Security Token Offering) issuing company. An STO can be thought of as a securities law compliant ICO.
Arnold Spencer, lead attorney for Coinsource, the world’s largest Bitcoin ATM network, made an astute observation that can aid one in dichotomizing utility tokens and security tokens when he said, “If you join a golf club to play golf, it is not a financial investment and not a security. If you buy an interest in a golf course to make money from the business, it is a financial investment and therefore a security.”
The target markets for utility tokens and security tokens are markedly different from one another. An online gamer purchasing utility tokens for use on a gaming platform is a far cry from an accredited security token investor who must authenticate an annual income of $200,000 over the last two years and a cash position exceeding $1,000,000.
Utility tokens are issued by companies seeking to fund the development of their project. They represent access to a company’s product or service. In other words, utility tokens are issued against the issuing entity’s existing service or product, or, more frequently, as a pre-order for a forthcoming service or product.
Utility tokens are ostensibly not designed as investments, though most ICOs are, on the sly and in one way or another, promoted as an investment that will yield high returns, i.e., “buy low, sell high” speculation.
Utility token value is chiefly determined by market demand even though the value should ideally be measured against the viability of the tokenomic ecosystem for which it is developed. Utility token value should be more or less proportional to the activity of the participants on the blockchain. So, though demand for a utility token should be driven by the current or potential future utilisation of the foundational concept and platform, many bubbles have grown from utility token speculative zeal.
To date, the disguising of utility tokens as something other than an investment has enabled issuing companies to evade securities regulations. So utility tokens have existed mostly outside the purview of regulatory agencies. That is changing as governments start scrutinizing in earnest the exemption of utility tokens from laws governing securities.
There is a type of utility token known as a reward token where token holders who maintain a relationship with the issuing company for a set period of time are rewarded with more tokens. A reward token holder may alternatively be incentivized to build a reputation on the platform, perhaps by building a “following” or bringing in more customers, and, when a “good” reputation is established, the token holder is rewarded with more tokens or discounts on future purchases in a way similar to a loyalty points program.
Utility tokens are not sanctioned or regulated under the security laws of most countries and jurisdictions, and are thus prone to cyber-attacks, price volatility, and outright fraud.
If a token draws value from an external, tradable asset, it is a security token. The external asset can be shares of a limited partnership company, public or private equity, a liquid commodity like gold, or an illiquid asset such as a share of ownership in an office building, resort, or other real estate, or things like artwork and fine wines. A security token can also represent ownership of a particular category of a company’s assets or a subsidiary’s revenue stream, an exchange-traded or managed fund, or any of a broad range of other tokenizable assets.
So the asset tokenisation mechanism provides a liquidity bridge between blockchain innovation and traditional investment sectors, and also between the blockchain and less traditional investment sectors.
Security tokens provide, in theory, the potential to deliver better returns, a lower barrier to entry into an investment market once they are tradeable on an exchange, and, in some cases, reduced legal risk. Also, the fusing of blockchain technology with investment markets via security tokens may increase the potential investor pool and improve cross-border liquidity.
Security token investors can receive quarterly dividends paid out of the profits made from the asset they own, issued in the form of additional coins. So security token buyers own part of the issuing company’s assets and expect future returns on those assets. However, though a security token may be similar to a share of stock in a company, it need not have the same rights assigned to it as a share of stock would have. A security token may or may not grant dividends, a percentage of ownership, voting rights, or profits. It is up the STO issuing company to assign specific attributes to a security token.
Smart contracts eliminate intermediaries and thus cut down security token delivery of services costs. Administrative costs of buying and selling security tokens are negligible. KYC and AML checks can be partially automated so that selling tokenized assets to accredited investors is fast and easy.
There are many token offering regulations and limitations on who can invest in security tokens during the STO. For a certain period after the conclusion of the STO, security tokens are typically subject to trading restrictions that affect liquidity. However, security tokens are essentially global once they are listed on an exchange and are then transactable in any country or jurisdiction where they are legal for trade. With a compatible wallet, one can trade security tokens from anywhere in world 24/7.
The Howey Test
The Howey Test is a standard methodology used by the U.S. Securities and Exchange Commission (SEC) to determine if a transaction or business arrangement will be classified as the sale of a security. An agreement that qualifies as an investment contract is considered a security, subject to disclosure and registration requirements, if one of its participants is dependent upon the other’s work. A crypto token is a security if sold with the promise of an expectation of profits primarily from the efforts of others in a common enterprise.
The future is indeed looking very bright for STO’s and security tokens. Security token offerings are demonstrating themselves to be a compelling way of raising large amounts of capital in a relatively short time frame. An STO is often a more economical and clear-cut alternative to shopping for a venture capital raise.
There are trillions of dollars of assets around the world that may, sooner or later, be tokenized on a blockchain into investments in the form of security tokens, creating liquidity for the token issuer for new investments and ventures. Funds, institutions, and private and public equity groups excluded from the ICO market are now able to liquidate and sell interest in their assets via a security token offering.