Security vs. Utility Tokens

TAGS: , , DATE: 11/05/2018

Our previous post defined security tokens and explored several uses cases for “securitizing” various investments. We explained that security tokens are backed by real-world assets that are tangibly valuable. This makes the asset more liquid because it provides a building owner, art dealer, or classic car purveyor with access to capital while still retaining ownership of the tangible “thing.” While utility tokens are typically offered with an ICO and might grow in value, but can become worthless. But the differences between these two types of tokens is a little more complex.

 

Before digging deeper into a security vs. utility comparison, it’s helpful to first define a “token” to provide some needed context. In the simplest form, a token is an asset or some unit of value that is offered/issued by a company. This issuance is usually done through an initial coin offering (ICO), similar to the familiar initial public offering, or IPO. Instead of stock received in an IPO, an investor receives a token that corresponds to a set monetary value. Security tokens are offered as security token offerings (STOs), another category of investing where security tokens are exchanged for fractional asset ownership. So why are tokens not considered “coins?” Coins have a payment-related use case and their own blockchain, while tokens are secondary assets that do not run on their own blockchain.

 

Consider a utility token as offering access to products or services at a later date. Many firms offer an ICO that’s built on the promise of a future delivery. A newsworthy example is the ICO of Filecoin which raised just over a quarter billion and allows participants to rent out their unused computing storage power for tokens.

 

 

Regulatory Standing

 

Security tokens have value that’s based on a tangible and tradable asset. This dynamic means security token-based transactions are “securities” in the legal regulatory sense. Therefore, according to the SEC and other country’s agencies, these tokens must be offered, sold, traded, and held in ways that conform to stringent financial regulations. Not complying with these rules leads to penalties or worse.

 

Despite the claims of many in the industry that ICO-produced utility tokens are not “securities”, the SEC thinks otherwise in certain cases. Companies offering ICOs and investors should both carefully review the SEC’s guidelines (or their country-specific regulations). For example, the SEC’s page on ICOs says, “ICOs, or more specifically tokens, can be called a variety of names, but merely calling a token a “utility” token or structuring it to provide some utility does not prevent the token from being a security.” This is a very important point, as it doesn’t matter what a company calls their token, it’s the SEC’s guidelines that could be the difference between penalties and a damaged brand and a successful business. The SEC and other regulatory bodies are looking closer at ICOs because some are pyramid schemes, with members who own tokens pushed to enroll new members for more tokens, and so forth. Whether or not a token is under SEC regulations isn’t just a semantics issue, it brings with it a set of rules, disclosures, and reporting documents.

 

 

Key Differences and Similarities

 

A core difference between the two types of tokens is their intended use. Security tokens are offered as investments, with the token holders buying a fraction of an asset that will hopefully increase over time. Or the holder receives more coins when the company makes money. As an individual gets more and more coins, the security tokens give them an increasing number of voting rights which then enables them to have some control over the firm’s direction.

 

Utility tokens are not based on equity, they instead offer a way for the holder to have some interaction with the offering capacity. They function as a type of currency that’s specific to a platform or service, where the owners of the tokens are able to use their supply to get something in return. It’s a similar dynamic to a gaming company that allows people to pre-order the latest first-person-shooter game that might not be live for a few months.

 

A similarity between the two is price appreciation. Both types can increase in value over time, so they can create some profits. This potential for profit confuses the characterization of tokens as “securities.” Determining the type of token is often done with the Howey Test, a series of questions that guides the issuer on what type of token they’re offering. The two main questions of the test ask if the token holder is providing funding and expecting profits from the company, and if the ICOs fundraising depends on profits generated from individuals more so than the actual creators of the endeavor. If either question is “yes”, then the company has a security token on their hands.

 

There is a line of differences between security and utility tokens, but it’s very blurry. Many ICOs are presenting tokens that are disguised as utility tokens but are in fact security tokens. The lack of related regulation means many ICOs are failing and are very risky investments that do not offer investors any kind of legal recourse.

 

Blockchain, cryptocurrencies, and tokens are transforming the digital economy, by creating entirely new transparent ecosystems. Companies are rapidly entering this space, and are finding a pressing need for blockchain and token strategies. Sphere’s staff members have the knowledge base necessary to guide companies on best practices, including how to develop strategies for both security and utility tokens.