By Nathan Ferguson
Just after Bitcoin paved the way in the digital financial revolution, hundreds of other cryptocurrencies (coins and tokens alike) have appeared on the scene to represent the native currencies of different blockchain projects and ecosystems, which are designed and developed to meet different needs and solve different problems across all ramifications of life.
As you can point out in any industry, there are various categories created in the crypto space to identify and differentiate the types of tokens and coins in the space. Some are created to represent payment systems that are expected to be accessible for everyday spending, while some are created to represent the utility currencies of a particular crypto project or ecosystem.
In this guide, we will look into the two primary categories of tokens in the crypto space namely security tokens and utility tokens. Also, this guide will compare them to reveal the similarities and peculiarities of each category.
What are Utility Tokens?
In today’s cryptocurrency ecosystem, the most popular category of tokens is the Utility tokens, and it is majorly because of the massive wave of new blockchain startups emerging since last year. Beyond their emergence, most of the startups have been able to raised enough money through their ICO – Initial Coin Offering, which basically requires that they develop their native tokens which will be for sale to the interested members of the crypto community, mostly in exchange for Ethereum or whatever native currency of the blockchain the token was hosted.
The truth is the primary essence of the token is beyond fundraising for the project. This category of tokens is digital assets created for spending and for facilitating transactions within a certain blockchain ecosystem. Depending on the service offered or the problem being solved by the crypto project, utility tokens are created to help progress the project or to incentivize users to encourage them to interact with the project more.
Also, utility tokens can be a reward for fulfilling some tasks on some blockchain ecosystem or projects. For instance, Filecoin reward users who offer data storage space for others with its native token. Another one is Civic which pays its users to create attestations and verify identities on its blockchain.
As mentioned earlier, most [utility] tokens are created to function as an incentive scheme that will reward people for performing some functions on the blockchain with the prior knowledge that they will get a reward for them. For example, a token incentive model was created to encourage the transition of people to renewable energy. The blockchain was developed in a way that the blockchain network can report and track data regarding their energy use through IoT (Internet of Things) devices, which will in turn compensate users based on the data.
Currently, the most common utility tokens in the crypto space are the ones built to Ethereum’s ERC-20 standard. Different companies have been able to establish their dApps – decentralized applications – on the Ethereum network while also launching their Initial Coin Offerings (ICOs) on the network using ERC-20 tokens.
What are ICOs?
The meaning of ICO is Initial Coin Offering. It is like IPO (Initial Public Offering) in the stock market, but this time around for the crypto space. Startup owners, product creators, and investors use ICOs for crowdfunding. So ICO helps creators and owners to raise funds to develop their projects or to create new projects which will be handled by the developers. These projects can be decentralized applications (dApps).
Basically, in ICO, tokens will be offered to the investors at a certain price that is believed to be the lowest price the project can be valued and the purpose of the investment in such projects is that investors (after their research or considerations) believe that someday in the future, the value of the project will increase tremendously and that will automatically translate to a huge profit for them. The situation is a win-win situation for the two parties involved.
How does ICO Work?
In this section, this guide will attempt to demystify ICO as much as possible. There are various types of tokens that are released by the developers for a specific period of time. Within that period, those tokens have a certain value, which is compared to some other crypto assets like Ether.
This means any investor interested in buying the token of a particular project will have to pay with the crypto initially compared with the token. So, if the new token is compared with ETH, that means investors can only purchase with ETH alone. By the way, most of these new projects, including decentralized applications (dApps), are built on the Ethereum network to ensure fast and smooth transactions.
Also, the success rate of a certain ICO is dependent on the security involved. As soon as the transactions passed through the required security guidelines, a specific amount of the token is shared among the pool of investors involved in the project. For ICOs, the tokens can be utility tokens, collectible tokens, reward tokens, asset tokens, security tokens, currency tokens, etc. However, the type of token you will receive depends on the kind of project you invest in.
While investors are taking advantage of the token at its earliest price range, the creators and developers are getting funding to develop the project, so it is a win-win situation, as mentioned above. But the truth is investing in digital tokens can be a rollercoaster, so it is essential that investors carry out extensive research on the project they want to invest in, and they should understand the type of tokens to be distributed in exchange for their investment. Hence, the basic objective of this guide – helping investors to understand the difference between the two major types of tokens that we have.
What are Security Tokens?
This kind of tokens are considered a recent innovation in the crypto ecosystem. Experts considered them as the major path that leads to the adoption of cryptocurrencies in the mainstream. This sentiment is because of their emphasis on asset tokenization including the non-digital and the digital ones, which increases their applicability in almost every application and industry.
Essentially, security tokens are investment contracts representing the legal ownership of assets both digital and physical assets, including EFTs, real estate, and artworks, according to the standard of the Security and Exchange Commission (SEC) of the United States of America. These tokens are considered verified on whatever blockchain they are hosted, and people can invest their fiat money or even any kind of cryptocurrencies for them through an innovation called Smart Contract.
Through this system of ownership which is considered legal and verifiable, people holding the security tokens can now trade their assets easily, fractionalize them for easy storage in various digital wallets, or even use them as collateral for obtaining loans.
However, the original value of all security tokens is inherent in their capacity to revolutionize how we define and perceive asset ownership completely, making assets that were originally and traditionally attributed to wealthy and influential people in developed nations more accessible to the common and regular people across the globe. In addition, they can own these assets in fractions and even collect dividends for owning them.
In wrapping this section up, when we recognize and consider the fact that almost every asset that holds value in the world both digital and physical (including personal brands, company equities, rewards, and so on) can be tokenized, and distributed as securities through the blockchain technology, we will understand that the possibilities attached to this category of tokens are unlimited.
The Pros and Cons of Utility Tokens
- The Pros of Utility Tokens
Basically, utility tokens are used as an instrument to drive human behavior in a certain direction using the reward scheme within a particular blockchain ecosystem. In today’s economic system, there are many problems arising from the lack of incentives on some tasks required from people.
For example, everyone will agree that the responsibility of transiting to the usage of cleaner energy sources for the sake of the environment has been saddled on people, but with the current system, any company that is on the mission of ensuring this through public advocacy will most likely be a not-for-profit institution because such initiative has no express business model attached to it.
But through blockchain technology, startups like Swytch now have the ability to run their own ecosystems and mint their own currency, which will be targeted at rewarding people for using renewable energy. Also, tokens like this can be exchanged for other crypto assets like Bitcoin and Ethereum, which can, in turn, be traded for fiat currencies. This process of exchange makes them as valuable as any fiat money you can think of.
- The Cons of Utility Tokens
Because of the ease attached to the creation of utility tokens, there are a huge number of them out there, and it has become significantly challenging to have proper and quality regulatory assurance in the crypto space. Even though the intention of most companies is good when raising funds for their token launch through ICOs, there have been huge scams in the space, and the fraudulent companies will also present their ecosystem as a value-driven organization.
Most of them are ultimately concerned with raising money as much as possible and then exiting the space without releasing the product or offering the value they promised their investors. To combat this, there have been propositions that self-regulation will be a better alternative that will allow people to see the utility in a better perspective.
The Pros and Cons of Security Tokens
- The Pros of Security Tokens
The first thing about security tokens is the elimination of scams of different forms in the crypto space. investment in these tokens is considered trustworthy because companies offering them have been extremely checked and regulated before they are licensed to distribute them to the public.
Another advantage of security tokens is dividend payouts. Just like stocks, most investors of security tokens can get dividends on the returns from the assets they invested in depending on the time chosen by the company. This can be considered another source of a reliable and steady stream of income for the investor.
The third on the list of advantages of investing in security tokens is the access to multiple asset classes. This category of tokens gives investors access to different kind of products, companies, structures, and funds that produces massive value. Depending on any amount of money with you, you can get expanded options of investments through security tokens.
Another one on the list is the access to more liquidity for assets that are traditionally illiquid. Investment in a security token represents owning a stake in a building. You can always close your position faster and get paid almost instantly.
The last but not the least of the advantages of security tokens is the access to a wider pool of investors. Just by organizing what is called a Security Token Offering (STO), product creators and startup founders can access an expanded pool of investors across the globe without any need to deploy a blockchain-based business model.
- The Cons of Security Tokens
On top of the list of disadvantages of security, tokens are complicated legal requirements. According to the SEC, securities are classified under Howey Test. This Howey Test has used some criteria to evaluate if an asset is security-based. The criteria are as follows:
- It involves money investment
- The money invested is in a common enterprise
- The investment gives an expectation of profits
- Any profit comes from the efforts of a third-party promoter.
According to the test, for an asset to be considered a security, it must have passed all the four criteria listed above.
However, registering a security is not an easy task because companies are required to abide by some set of strict laws and rules which require the disclosure of financial records frequently among many other things, in bid to ensure investors’ protection. These requirements can be time-consuming and laborious for businesses.
Another disadvantage of security tokens is the limited investor base. Currently, under the regulations in the United States, security tokens are accessible to only accredited investors, and the requirement is to have a total of $1 million as net worth or have an annual income of $200k.
To wrap up this section, the last disadvantage but not the least of them is the reliability of the connection of assets in the real world to the blockchain. Over time it has been realized that there are various logistical challenges attributed to the tokenization of assets majorly in the aspect of ensuring the movement of data from the traditional setup to the blockchain is updated and reliable.
The value of security tokens represents trillion dollars’ worth of real-world assets which will require accurate and timely sourcing for data to replicate the conditions and also, adjust the valuations if need be.
Difference between Utility Tokens and Security Tokens
This section will discuss the basic difference between the two categories of tokens under discussion under various topics.
- Essence: The essence of utility tokens is to drive human behavior through incentives within a certain blockchain ecosystem. While security tokens are investment contracts that represent the legal ownership of assets (either digital or physical) which has been verified on the blockchain.
- The Connection Between Company and Token: For the Utility token, the value of the token is not necessarily connected with the success and value of the company but for the security tokens, the tokens represent the true ownership of the company or products as the case may be, and their growth is directly proportional to the growth of the company.
- Scam Potential: Within the Utility token ecosystem, there are many scammers who are looking for opportunities to scoop funds from investors without delivering the values and products they promised them. But companies involved with security tokens are monitored by the regulatory bodies depending on the jurisdictions they are operating from. This is believed to be a natural killer of potential scams within the security tokens ecosystem.
- Regulations: Up to date, there are huge difficulties attached to the establishment of proper regulations for the initial coin offerings (ICOs) of utility tokens, but the company offering security tokens (including the investors that will invest in them) must meet a certain set of strict regulations and considered by the SEC which is often called the Howey test.
Conclusion
The objective of this guide is to help you understand the basic differences between a utility token and a security token. And we have learned that one of them helps in incentivizing holders for certain tasks they undertook while the other is simply a contract that represents the ownership of an asset. Based on this guide, the safest of these categories to invest in is security tokens simply because of the strict regulations imposed by the SEC and other regulatory bodies responsible for that assignment in their jurisdiction of operation.