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How is Security Token Different From Utility Token?

The initial coin offering (ICO) or the Token Generation Events (TGEs)is an innovative crowdfunding model that enables new businesses to sidestep traditional early seed investment.

In 2017, ICOs raised over $4 billion in capital and massively disrupted conventional finance. Through the ICO fundraising model, new companies can raise capital by issuing crypto tokens on a blockchain — most commonly Ethereum — and circulating them to token purchasers in return for making a money related commitment to the task.

These tokens then can be used for various functions. Some grant access to company’s dividends (sharing profit for holders) and some can used to access a certain service on the platform. Depending on such functions, they can be assessed as Utility token or a security token. However, it isn’t that simple in the eyes of the regulators. 

In July 2017, the Securities and Exchange Commission (SEC) discharged a report which inferred that specific tokens could be delegated securities and subject to control. According to the report, almost EVERY SINGLE ICO to date has been an unregistered securities offering, posing under the guise of utility tokens. Also SEC Chairman Jay Clayton said:

“I believe every ICO I’ve seen is a security.”

Jay Clayton, SEC chairman

Chairman Clayton warned against using the phrase utility token. ICOs that violate securities laws could soon confront punishments or graver consequences.

However, as I said earlier, depending on their function, crypto tokens might be classified as Utility tokens or Security tokens.

Utility Tokens

Utility tokens represent a unit of account for the network. The bigger the network grows, the more utility in the token, because the number of tokens is fixed. As the size of the network and transaction volumes within it grows, this will create demand for the tokens.

It is important to note that “utility token” is an organisational distinction–not a legal one. The SEC has not given official guidance on utility tokens, so the industry does not with certainty whether they are subject to securities regulations.

Bloomberg’s Matt Levine compares utility tokens to the Starbucks card:

“A Starbucks gift card is probably not a security, even though you pay money to a corporation for the card and expect to get back something in the future, because you are not investing the money in the expectation of profit: You’re investing it in the expectation of coffee.”

Bloomberg

Utility tokens have a use case and are not designed as investments, but that doesn’t mean that they don’t bring any profit. They have a certain use case inside the project and don’t represent company’s share. Utility tokens may grow in price, if the demand for service or product increases. So buying such tokens of a project, that solves real problems of users and is constantly being developed and improved, may give great profit in future.

Golem is a pertinent example, allowing users to lend their own PC’s power to the network which collectively employs it to run a remote supercomputer. Users earn GNT for connecting to the network, but they can also buy them via an exchange. Basic Attention Token is similar, with users rewarded in BAT for using the BRAVE browser and viewing ads.

Also Filecoin –which raised an ICO-record $257 million–plans to provide a decentralised cloud storage service that will take advantage of unused computer hard drive space. ICO contributors received tokens that they will be able to use to purchase storage space from Filecoin once the service has launched.

Security Tokens

One of the major topics of discussion in cryptocurrency right now is around the development of security tokens.

Security tokens gives their holders to ownership rights of a company. A security token’s value is derived from a tradable asset; subsequently, it is liable to government laws controlling traditional securities. Security tokens can be utilised to change conventional IPOs(initial public offerings) and issue company shares, profits, and voting rights over the blockchain frameworks.

Joshua Stein, the CEO of tokenised securities startup Harbor said,

“A security token represents traditional, private security interest. It could represent a share in a company, an LP interest in a fund or a trust, a member share in an LLC. Essentially, you’re taking something that today you have on paper and you’re putting an electronic wrapper around it.”

Joshua Stein, CEO, Harbor

Polymath is doing for securities tokens what Ethereum did for utility tokens. Polymath’s ST20 security token protocol embeds regulatory requirements into the tradable tokens themselves, which are only available to verified and authorised participants.

“The next mega trend in crypto will be assets migrating to the blockchain in the form of tokens. pretty much any security is better denominated as a token than traditional forms of ownership. This is the future, not share certificates in filing cabinets.”

Trevor Koverko, CEO, Polymath Inc.

Online retailer Overstock recently announced that tZERO, one of its portfolio companies, will hold an ICO to fund the development of a licensed security token trading platform.The tZERO tokens that are issued from this ICO will be in accordance with SEC regulations. tZERO token holders will be entitled to quarterly dividends from the profits generated by the tZERO platform.

The first major wave of security token offerings has already begun; starting with the launch of Nexo, a crypto-backed instant loan platform by Credissimo; a leading European FinTech Group that has been a key player in Online Consumer Lending and E-commerce Financing for over 10 years. The company generates operating revenues from crypto-backed loans. The  positive bottom line, called Net Profit, when achieved, 70% from it will be reinvested back into the company to fund more crypto-backed loans, and a fixed 30% from the Net Profit is paid out as dividends to NEXO Token holders in the given accounting period.

How Do We Actually Distinguish Security and Utility Token?

In the US, with a specific end goal to decide if a digital token is a security, we can apply the Howey Test. This is used to confirm regardless of whether or not a transaction qualifies as an ‘investment contract’. If it meets the criteria, at that point it will be considered as a security and will be subject to additional disclosure and regulation requirements.

So as to be named a investment contract under the Howey Test, a token must meet the following prerequisites:

  • There is an investment of money.
  • The user expects to profit from the investment.
  • The investment of money is in a common enterprise.
  • Any profit comes from the efforts of a third-party or promoter.

In India however, due to the absence of regulatory guidelines and old laws around securities offering, it becomes difficult for Blockchain projects to register and offer ICOs or TGEs. Most ICOs, led by Indians are registered in regulatory friendly countries like Estonia or Singapore. 

Disclaimer: This is a guest post. All opinions in the article are of the author and may or may not reflect the opinions of Coin Crunch India. 

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