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Utility Tokens vs Security Tokens: What’s the Difference?

BCA Solutions 17 Jul 2019

Blockchain technology, being dubbed as “the new internet,” is continuing to cause major disruptions across all industries by opening up the possibility of creating a wide variety of new business models. One of the major reasons it has become so successful is the use of tokens.

What is a Token?

Generally speaking, a token is a representation of something in a particular system. It could be anything – a voting right, stake, or a unit of value. A token, dependent on its design, can fulfil many roles in its system and is not limited to a particular role only.

Tokens vs. Cryptocurrency Coins

A cryptocurrency coin such as Bitcoin, for example, can be independent of a platform. Cryptocurrency coins can be used as a type of currency outside of their original system. On the other hand, tokens such as DAI and LINK exist on a particular platform – Ethereum, in this case. They are implemented with the help of smart contracts, and make use of a common infrastructure.

Tokens represent a utility or security belonging to a company and they are oftentimes distributed to investors during a public sale known as an Initial Coin Offering (ICO) in the case of utility tokens, and Security Token Offerings (STO) in the case of security tokens.

What are Utility Tokens?

Also known as a user token or app coin, utility tokens are hands down the most popular type of tokens and give users future access to the company’s products or services. Utility tokens are not meant to be investment vehicles, and investors are discouraged from participating in public sales if their main purpose merely is the generation of profit.

How do Utility Tokens Work?

A company can decide to issue utility tokens and sell digital coupons for the products or services it is developing.

Utility tokens can also:

  • Grant token holders a right to use the network
  • Assist in building an internal economy within the system
  • Permit token holders to take advantage of the network by voting. For example, token holders can lock their tokens (staking) in a network, thereby securing the right to vote on the overall well-being of the network.

Ethereum’s ERC20 standard is what most utility tokens are built on. However, many other platforms have emerged since its inception, and serve as the underlying infrastructure framework to issue tokens, such as Binance Chain or EOS. A specific example of a utility token is Filecoin. Through the sale of tokens, the project team managed to raise $257 million. Holders of said tokens are granted access to Filecoins’ decentralized cloud storage platform.

Usually, there is an upper cap on token availability which can result in the value of tokens going up due to the simple rules of supply-demand: An increase in demand with all else being constant will lead to a higher token price. So even though utility tokens were not created for investment purposes, people may still invest in them in the hope that the token value increases over time. Projects also opt for inflationary token models, emitting tokens on a continuous basis, and some do not cap their supply at all, for whatever reason. The design of a company’s token economics does therefore play an important role and has the power to influence investment decisions.

Security Tokens

These are tokens distributed to investors through a Security Token Offering (STO).. Crypto tokens that share profits, pay interest, pay dividends or invest in assets or other tokens to generate profits for the token holders are considered security tokens. Since they grant rights similar to those of financial instruments, , they are subject to financial and capital markets regulations.

Simply put, a token is deemed a security when there is an expectation of profit from the efforts of others. It is an investment contract which represents legal ownership of a digital or physical asset or right, that would resemble any financial instrument right. If certain regulations are not followed by the STO this could result in penalties being incurred and even the development of the project being stopped.

What are the benefits of Security Tokens?

However, when all rules and regulations are followed, startups can benefit greatly. One such benefit is that the company is able to offer tokens as a digital representation of shares in its stock. Benefits for security token holders include:

  • Being able to store them in different wallets
  • Using them as collateral for a loan
  • Trading their tokens for other assets

Redefining Ownership

Security tokens bring a new meaning to the term “ownership.” Because of these tokens, assets, such as wine yards or real estate, can be divided into fractions and subsequently sold off to investors. In detail, instead of investing in and owning a complex real estate project, which may be too expensive for a lot of people, 100 people could own a fraction of it and receive pro-rata returns.

What are the Similarities Between Security and Utility Tokens?

  • Both are subject to increase or decrease in value depending on market demand;
  • They are not cryptocurrencies in the sense that neither one is created for direct commercial use such as buying or selling of external services and products. Simply put, they are not comparable to fiat money since they are not standalone means of payments;
  • Utility tokens are often incorrectly promoted as an investment, whereas security tokens could mistakenly be taken forutility tokens.

 

Conclusion - Utility Token vs Security Token Differences

Utility Tokens Security Tokens
Access to utility or protocols Asset ownership
Buyers, no guarantee of profits Investors with an expectation of profit
Token sales are rarely regulated (in recent years, this has changed and countries such as Malta and Liechtenstein have introduced laws specifically aimed at ICOs) Offerings are regulated

 

Which is Better? Security Token or Utility Token?

Both have their risks, pros, and cons. That said, care should be taken to differentiate between the two, especially if retail investors are considering an investment in an unregulated token sale. In such a case, funds could be stuck or lost should the project be abandoned or simply fail. In addition, both tokens usually serve different purposes, which is why their usefulness cannot be directly compared and needs to be individually assessed.

While every token issuer will probably have various reasons to believe that its token does not have any potential legal repercussions, there is a vast difference between belief and confirmation. Our expert legal team has ample experience in the determination and classification of tokens under several legal regimes, and can guide you in the best possible way should your token have semblances of securities or financial instruments.

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