Security Tokens v/s Utility Tokens – A Closer Look.
Since everyone has been gushing about Security Tokens in the recent months, another common discussion which has sparked debates across the world is the comparison, “Security Tokens v/s Utility Tokens”. In our last blog, we addressed the very basic question, “What are Security Tokens?”. Give it a read: The Security Token Thesis – “What are Security Tokens?”
It comes as no surprise that the term ‘security tokens’ has been the buzzword for much of the ICO-related talk in the past year. With the SEC stepping in after the DAO incident, regulations and rules have made it just a little bit trickier to raise money through ICOs. Tokens being sold as securities, but being branded as utilities have now been cracked down upon, with the term ‘security tokens’ being used for such coins being offered. Security tokens resemble shares and stocks in the blockchain world, but this isn’t all. There are far more intricacies to this topic than what can be written in two or three lines. Read on.
ICO performances in the past year or two deserve closer inspection than what has been done. According to statistics, over USD 2 billion were raised by ICOs in 2017 alone, but it wasn’t all rosy. Over 140 projects did not survive due to a variety of reasons, either due to poor ideas or lackluster planning. The 54% of ICOs that did become a success managed to conjure up an ROI of 500%. Looking at the different types of tokens that ICOs issue, they can be classified into two types, security tokens, and utility tokens. Both have their benefits and drawbacks, with security tokens arguably being the better ICO model of the two. Here, we shall discuss both these tokens at length, how to differentiate them, and the regulations that govern these tokens.
These are by far the most used ICO models. Issuing utility tokens is the most widespread ICO funding method. Utility tokens are formally defined as tools which allow the holder future access to a company’s product or service. They are by no means designed as investments, and, if structured correctly, can be exempt from all federal laws governing securities. They can be best understood by the analogy of video game pre-orders for titles which haven’t been released at the time of ordering. Similarly, utility tokens are issued at the time of the ICO, promising access to the company’s service sometime in the future. One of the most popular utility tokens is the filecoin, which allows users access to file storage space on filecoin’s servers in the future. Another example is the SRN token issued by Sirin Labs, which would allow users to order their blockchain-based smartphone FINNEY at a reduced price.
The reason why issuing utility tokens is the most popular ICO funding technique is that they are exempt from federal laws governing securities. The thing is that companies want to work their way around these laws, and call their tokens as utilities, even if they represent securities in the true sense. These “false” claims are usually made by companies in order to justify that they’re selling utilities, not securities. What happens is, if a project becomes successful, the price of the tokens is driven up, and as a result of very few tokens being released initially, the cost skyrockets. This hidden potential for investment is mentioned nowhere in the whitepapers, and thus companies can claim that they’re not selling securities, which in a way, is wrong. It is believed that only about 10% of the tokens offered by different ICOs are utility tokens, even though the rest may claim otherwise. If these aren’t utility tokens, what are they? Let’s discuss.
SEC, regulatory body in the USA last year dropped a bombshell on the blockchain and ICO community, by announcing that tokens issued by ICOs could be classified as securities and hence, will be subject to federal laws. Hence, the term “security tokens” was coined. Initially, security tokens were not intended to be a concept, but on further investigation by the SEC, especially on the DAO tokens from 2016, it noted that every token that it examined fell under the category of a security. The chairman of the SEC, Jay Clayton, stated that companies could keep calling their tokens coins, but if the value of the token keeps increasing over time with the performance of the company, it would be considered a security. Security tokens are designed as investments, which investors buy in the hope of future profits. They are analogous to stocks and shares in the traditional financial markets; due to their nature, they fall under government regulations. It is very clear to see why most tokens fall under this category, even though they are called otherwise.
Tokens generally offered by ICOs are sold as potential for an increase in value, with these tokens then being traded on exchanges for profit. These are the key features of securities, and hence tokens exhibiting these features are called security tokens. Failure to adhere to federal laws governing securities can lead to potential termination of the project, and legal punishment for the people involved. Although it is somewhat of a tough nut to crack, some ICOs have the necessary resources to comply with all regulations governing securities, and hence have the opportunity for a multitude of new applications. Some of these include representation of a company’s shares via blockchain-based tokens.
Differentiating between the two – “Security Tokens v/s Utility Tokens”
Although on first sight it may seem that a majority of the tokens can be blindly classified as securities, it is not the case. The SEC of USA uses the Howey test to determine whether a token under consideration is a utility or a security. The test comprises of two simple questions-
1- Does the token offer its holders an opportunity to contribute to the startup’s capital and to have a share in its profits?
2- Does the ICO’s fundraising procedure involve investment in a project whose profits are solely generated from the efforts of individuals other than the creators or founders of the project?
If the answer to either of these questions is positive, then the given token classifies as a security, and hence falls under the federal regulations governing securities. The main difference between the two types of tokens is that security tokens represent stake/ownership rights, while utility tokens represent access to products and services. This difference is becoming more and more crucial in the ICO scene, as we are seeing entrepreneurs call their ICOs token generation events in order to dodge the regulatory eye of the federal laws.
Utility over security?…
It is easy to see why most companies would want their tokens to be classified as utility and not security. In such an ICO model, companies can accept money without offering any concrete returns, without any possibility or potential for future dividends. As for the promises of access to future services and products, who has seen the future?
Most of the times, it happens that there is no real need for a utility token in the project, but money hogging companies still introduce the concept to maximize every cent that they can squeeze out of their investors. Besides the monetary factor, choosing utility tokens has another good reason, and that is to escape the regulations and federal laws governing securities. Some projects just don’t have the resources to comply with these laws, in order to save their blushes, they stray away from the securities concept. Restrictions and regulations slow down startups because they have to do things they simply don’t want to do. There’s more to this comparison of “Security tokens v/s Utility Tokens”.
To further make the case, utility tokens have been divided further into fungible and non-fungible tokens. Fungible means that these tokens are simply interchangeable with other assets of similar value, for example, gold. This helps in more categorization in the token scene. Non-fungible tokens are used to determine ownership of digital assets. This classification is much needed for companies which do not want to navigate the minefield that is regulations.
…or is security the way to go?
Even though security tokens represent labor and resource usage in terms of compliance with rules, ultimately they only succeed in helping out the company. It is actually cheaper to issue security tokens in compliance with the current regulations, which is unexpected but logical. Reducing legal risk is another benefit of going with security tokens as opposed to utility. Looking at the long run, security tokens and regulations go a long way in proving that the crypto and blockchain scene is truly upon us, and is here to stay. It is just in its initial stages as of now, but the potential is unparalleled. Even for investors, investing in security tokens is more beneficial. If, for instance, you invest in a utility token project, and it turns out to be a security one, and the SEC terminates it, your funds are going to go to the dogs. Therefore, security tokens, when done right, can be the true way to go in today’s ICO scene.
This was a closer look at the comparison, “Security Tokens v/s Utility Tokens”
Rules and regulations are something that is a part of every innovative and groundbreaking concept. Lawmakers need a reason to make new laws, and innovations give them many. In the ICO world, the SEC is the main regulatory body when it comes to security tokens. Any form of advertisements, promises or suspicious behavior by companies usually means that the SEC is going to crack down on them. If startups promise their investors of high returns on investment, they become easy prey to the SEC. All is not dark and bleak, though. Correct compliance with the regulations means a host of benefits, as discussed above.
When it comes to utility tokens, the SEC and other federal bodies cannot regulate these assets. Because they give access to company services and not returns on investment, they do not need to comply with federal laws governing securities. Companies must be wary of their actions, though. If their tokens function as security rather than utility, they could be in a host of trouble.
The security tokens v/s utility tokens is a debate that is meant to continue for a long time coming. What the future holds for ICOs and the blockchain is certainly interesting, to say the least. Let us hope for the best!