Security Tokens vs. Utility Tokens: A Comprehensive Guide

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Introduction

Many people know about cryptocurrencies through the internet. However, without knowing the basics of blockchain and digital ledger technology new investors can’t understand different classifications and variants. Based on their underlying functions and their origin several types of cryptocurrencies serve a varied variety of uses. This article is focusing on exploring the important points of distinctions between tokens and coins that originate from the blockchain.

What is a Token?

It is best to start from the very beginning to create a better understanding of the topic. Most people know that a cryptocurrency is a digital representation of a monetary entity that is used for the exchange of value and it is generated from a blockchain. However, there are two most fundamental types of cryptocurrencies. The first type is coins. Coins are the core or the central cryptocurrency issued by a blockchain. For example, ETH is a coin by nature native to the Ethereum blockchain.

On the other hand, there are also tokens. Tokens are the cryptocurrencies that belong to one blockchain source but they originate from secondary DeFi applications. For example, the Basic Attention Token is also hosted on the Ethereum blockchain but it is not the main cryptocurrency on the blockchain. The users need to understand that tokens are also issued by one blockchain that is sourced from them but does not operate as the primary cryptocurrency.

What is a Security Token?

Security tokens are the type of cryptocurrencies that enable the issuer to transfer the rights of the project alongside some value to the purchaser. Security tokens are created using the tokenization process that allows the developers to set investment criteria for the buyers.

Once a term and condition protocol is added to the blockchain or dApp, it can create security tokens. The security tokens also need to fulfill the 1st condition of the Howey test to qualify. Sia Funds, Bcap, and Science Blockchain are some examples of security tokens.

What is a Utility Token?

A Utility token is a type of digital asset that is created for performing a specified task. If a cryptocurrency investor purchases a Utility Token, they will be able to get access to the products or services that are provided by the issuers.

Siacoin is a type of Utility token that allows access and space to the holders on the Cloud storage of the Sia Network. It is worth noting that Investors do not purchase Utility Tokens to get massive returns later. On the contrary, the primary function of the tokens is to grant special access to products, services, or any other privileges offered by the issuing enterprise.

What are ICOs?

ICO is an abbreviation for Initial Coin Offering. ICOs are like launch events for a blockchain or a new DeFi project that is going to issue new tokens. The ICO is equivalent to IPOs or Initial Public Offerings for tech or blockchain organizations. The main purpose of such events is to allow the developers to present their products to potential investors and collect funds for continuing or expanding their operations.

Blockchain startups often opt for ICOs to invite the members of the public to invest in their company against a token purchase. At the same time, ICOs are also used for selling a set amount of tokens among potential investors. The investors, who have accumulated tokens from ICOs as a result of their investment, can show their ownership in the project but they do not have the authority to make any decisions or participate in any governance role for the blockchain.

The Role of Utility and Security Tokens in ICOs

The main reason for mentioning ICOs and how they operate before was to allow the reader to grasp the importance of Utility and Security tokens in them. ICOs are events where blockchain startups are issuing tokens to their users with the promise to make profits. This feature fulfills the first condition of the Howey test. On the other hand, ICOs that are issuing utility tokens during their fundraising event are only granting access to the buyers of their products or services and not any promise of future returns. At the same time, the investors also don’t get to have any governance rights in the project.

The issuance of Utility tokens grants some level of ownership to their investors meaning that it fulfills the second condition of the Howey test.  If an investor is the ability to distinguish between security and utility tokens, they might end up getting in trouble later since their expectations of future profits are not met. There are several cases, where ICOs were found guilty of pushing Utility tokens on the investors while marketing them as security tokens.

Why are ICOs Gaining Popularity Among Investors?

In the USA, only a person with $1 million in semi-liquid assets or net worth is qualified to become an accredited investor. On the contrary, any person with a yearly income of $200K that has remained consistent for two years can get the same status. For the families, the requirement is set at $300K. Such regulation is created to ensure that the smaller investors are safe from the risks of massive financial investments. With such a restriction, small-scale investors can only put their savings into secondary markets or mutual funds that offer a small risk.

Therefore, ICOs grant small investors participation in some of the biggest investment opportunities in the world. Blockchains are permissioned networks that operate on an international scale. It means that investors can make a good amount of profit if their investment is successful. At the same time, ICOs do not have to get approval or registration from a centralized financial agency since they are based on blockchain or are advertised as decentralized entities.

How ICOs can be Harmful to Investors?

In most cases, the people who are living below a certain income level are prone to have limited knowledge surrounding the financial and investment infrastructures. However, ICOs allow anyone hailing from any part of the world to start investing with the smallest amount of money. The small-scale investors who have not conducted any research about the ICOs do not have any idea about what they are getting into. They rely on the claims of the ICO organizers and put their investments based on their word of mouth or virtual presentation.

The point of pain in the ordeal is that regulators have not issued any criteria for these ICO organizers. On the other hand, ICOs have become a guise for Pyramid Schemes. Where old investors make profits by luring in new investors. The small-scale investors are unable to discriminate between Utility or Security tokens. They are also unable to afford legal or technical assistance that can provide them with the correct answers and provide them with a solid basis for their investment commitments.

What are Securities?

Securities outside and within the purview of the blockchain sector are a type of loan undertaken by an organization that fulfills all the conditions of the Howey Test. When an investor is purchasing stock, it means that they are getting ownership of the business. At the same time, the investors who have purchased the stock or security are liable to receive a proportionate share in the profits of the company.

It is important to mention that securities and stocks are heavily regulated to safeguard the interests of investors. Financial agencies like the Securities and Exchange Commission monitor all the listed companies with a stock offering and ensure compliance with the law of the land. Security is offered with the view of gaining future profits and it belongs to a single enterprise rather than a democratically governed network according to the specifications of the Howey Test.

What is Howey Test?

Howey Test is a judgment issued by the Supreme Court of the USA. The test is used for determining whether a transaction can or cannot be qualified as an investment contract. The registration and disclosure requirements present in the Howey Test are referenced from the Securities Act of 1933 and 1934. Lawmakers use Howey Test to examine whether an asset class can be classified as a security or not. A cryptocurrency transaction can be classified as an investment contract if they fulfill the following conditions of the Howey Test:

  • The investment is made in the form of money.
  • The investors are expecting profit revenue or shares from the sellers.
  • The investment is taking place for a common enterprise in the form of money.
  • The profits are created as a result of third-party collaborators or the primary promoters.
  • The latest amendment has expanded money for the above conditions with assets such as cryptocurrencies etc.

Many people and investors are excited about getting financial inclusion offered by Blockchain, DeFi, and ICOs. The current age of knowledge is a good and ideal time that can warrant safety for investors at a smaller scale to get the appropriate knowledge and place their bets while equipped with the right information.

However, there are still a considerable number of cryptocurrency investors who treat cryptocurrencies like gambling. Anyone who is not willing to take their time to conduct research and gain proper and qualified the right information is certainly doing an enormous disservice to them. Some scammers sell Utility tokens with a promise of future profits for their investors. While Utility tokens do not qualify the investors to get a share of the company’s profits, they are also unable to grant any stakes or ownership rights.

These enterprises are not registered with SEC or any authorized financial regulator. Such fake ICOs do not have any registration, certification, qualification, or approval to host such an event. At the same time, they are not fulfilling the reporting and disclosure requirements to the regulatory agencies that will make them trustworthy. Furthermore, the liquidity for these Utility tokens that are presented as Security tokens is offered on exchanges, which is another flagrant violation of securities laws.

Regulators are Trying to Curb Fake ICOs?

The financial regulators have started to wake up to the matter of unruly ICOs. Such ICOs are pushing Utility Tokens as Security tokens and openly fooling unsuspecting investors. In recent times, financial regulators have started to take the following steps to discourage and mitigate such fraudulent activities:

  • Securities and Exchange Commission has issued subpoenas to more than 80 Blockchain startups that are suspected of organizing such scam fundraising events.
  • Some of the non-complaint blockchain projects like Tezos and Centra have received prosecution notice from SEC.
  • SEC prosecutors and commissioners are investigating the ongoing ICOs events such as ICONOMI among others. It means that blockchain startups have become more careful.

While these blockchain enterprises are under the scrutiny of SEC inspectors, the funds of the investors are frozen. At the same time, the blockchain enterprises that are marked for investigation or facing non-compliance actions from SEC can face a negative reputation and lose their goodwill among the investors. That can create issues for them to restart their business operations in the blockchain sector.

On one end, where scammers are ruining the reputation of the legitimate Blockchain startups, they are also harming the investors financially and psychologically. Therefore, ICOs must ensure that they are compliant with the regulatory requirements of the SEC.

At the same time, first-time investors should make sure that they work with the ICOs that have SEC approval and verification. Blockchain startups like tZero, Polymath, and Corl are some of the companies that have taken the first step toward becoming compliant with SEC guidelines. On the other hand, the media and articles like this are also ensuring that more cryptocurrency investors are educated about the differences between Utility and Security tokens to make responsible investment decisions.

Differences Between Utility and Security Tokens

Function

The most important difference between utility and security tokens is their underlying purposes. The main objective of a Security token is to grant ownership to the investors in addition to a promise of profit share in the future. On the other hand, the main function of a Utility token is to allow investors to get access to products or services offered by an enterprise. Utility tokens can grant voting options to their holders but they are not an indicator of ownership.

Investment Interest

The underlying value of a security token is directly attached to the value of a company. It means if a company grows and gathers more traction among the investors, the value of the Security token will appreciate accordingly. On the other hand, the Utility token value is not connected with the company evaluation or performance. The powers that are tied to a Utility Token remain the same regardless of the condition of the connected company.

Scam Probability

Both Security and Utility tokens are widely used for collecting funds. However, securities tokens tend to offer the investors what they are promised. It means that they carry a smaller percentage of investment fraud or risk. On the other hand, in many cases, Utility tokens are falsely represented as Security Tokens, which means that they offer a greater chance of fraud for investors.

Regulations

Since Utility tokens are more frequently used for disillusioning investors, they are also not regulated or verified by financial agencies such as SEC. On the other hand, for ICOs security tokens are offering the same things that they present which means that they are more likely to be compliant with the regulatory guidelines and also pass the Howey Test conditions.

Issues with Utility Tokens

  • Utility Tokens can suffer from the following limitations:
  • Utility tokens are fixed in quantity and there are no protocols to increase their supply if needed.
  • Utility tokens become useless and without any value, if the issuer organization suffers from losses or does not takes off.
  • Utility tokens are not suited for adoption as a cryptocurrency.
  • If the Utility Token native project fails, the investors can face a loss of liquidity that will result in an inability to sell them swiftly.
  • The holders of Utility tokens may not have any power to take part in the decision-making process. Meanwhile, the company owners and the developers manage all the governance procedures.

Regulatory Requirements for Security Tokens

A+ Regulation

This regulation enables the ICO promoter to offer funding opportunities to the non-accredited users after submitting a $50 million solicitation fee to SEC. It means that the startup needs to have a seed capital big enough to fulfill this condition and it also makes the procedure more time-consuming and expensive for Blockchain startups.

D Regulation

The D Form is filled and filed with SEC by the Blockchain startup after they have concluded their ICO event. In the lieu of the form, the ICO testify that all the investors taking part in the event are accredited and in compliance with Section 506C of the Securities Act.

Furthermore, the Section dictates that all the primary promoters of the ICO have issued authentic and honest representations of the investment contracts to the accredited investors.

S Regulation

S regulation stands for securities-related legislative requirements that are necessary for companies operating outside of the USA. The S regulation does not fall under the purview of the 1993 Securities Act, section 5. However, the ICO organizers need to comply with this criterion if they are planning to offer their services to investors in the USA.

Conclusion

Many things in blockchain and investment sector can seem straightforward. However, the truth of the matter is that the smallest of technical details can make a huge difference in the outcome. In the same manner, the ICO prospect investors need to understand the difference between Utility and Security tokens to make sure that they can get the most out of their investments.


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