Cryptocurrencies and blockchains have ushered in an era of Initial Coin Offerings (ICOs) for blockchain startups. Such events have successfully raised billions of dollars, far surpassing the amounts procured through traditional ventures. ICOs offer a fundraising model whereby digital tokens are distributed to various buyers, in exchange for their financial contributions to the project.
These tokens can be commonly classified as Utility Tokens and Security Tokens. In addition to being tradeable on cryptocurrency exchanges, these tokens may have a variety of functions depending on the issuing company. For instance, a token may identify itself as a currency, a share in the company, or even a user’s reputation.
Also referred to as app coin or user tokens, a Utility Token is simply a future access to an upcoming service or product, sometimes even at a discount. Think of is as a ‘digital coupon’, or a ‘pre-order’ for a video game. Utility tokens have a specified function in the company’s platform, and fuel the running of the network. For instance, Ether is a utility token that enables execution of task on the Ethereum blockchain. Filecoin is another good example, and it successfully raised around 250 million dollars by distributing tokens to users for an access to a decentralized cloud storage.
Characteristically, utility tokens are not a means of an investment (The emphasis of this point shall be explained later on).
Nevertheless, the price of utility tokens may still function as regard to the demand of the service or product. Utility tokens have an automatic stabilization system; if the price increases, the demand may fall. If the demand declines, the price will also follow. Utility tokens may also be fungible or non-fungible, and this basically implies whether an asset or good is interchangeable with another or not.
A security token represents a share of the company, and so provides the holder with certain ownership rights. It represents a value derived from an external, tradable asset that can be owned without actual possession. A security token may be used as a venture capital in a new project, or to offer a share from the profits a company might make in the future.
In essence, security tokens are inherently designed to be an investment, i.e. future expectations of profit and dividends resulting from the performance of the company, and an increase in the value of investment over a period of time.
But, why is it is of paramount importance to identify and differentiate tokens as either utility or a security?
The reason is simple: U.S Federal securities law.
The onset of a number of scam ICOs due to lack of regulation and questionable practices has prompted the Securities and Exchange Commission (SEC) to scrutinize the fundraising frameworks to ensure compliancy with federal rules and regulations. It is expected that many other countries will follow suit.
After the investigation of the DAO tokens back in 2016, SEC conclusively described the key hallmarks of a security offering- If the token in question has a potential for investors to make a profit down the line based on the efforts of others, it is a security token. The Howey Test is an effective tool used to stipulate whether a token is either a utility or security by evaluating this attribute.
Hence, security tokens are subject to the federal securities law. Such tokens are to be registered first, a violation of which may lead to costly penalties. As disadvantageous as it may sound, however, regulations do lead to greater credibility and lessen the legal risk of ICOs.
From a perspective of securities law, utility tokens are exempted from regulation, even though a buyer may purchase items as part of a purpose for an investment. This is particularly why many may wish to explicitly describe their tokens as utility to avoid the expensive and complicated licensing procedures needed for securities. This may also be another reason why crowdsales offering utility tokens are often termed as Token Generating Events (TGEs) or Token Distribution Events (TDEs) to evade undue attention from regulators.
To conclude, utility tokens have a practical functionality within the company’s system, while security tokens constitute investment contracts or ownership stakes in respect to the issuing company. The involvement of legal and regulatory bodies only provides further evidence to the importance of navigating the ICO waters safely with your own due diligence.