Security Tokens vs Utility Tokens: Learn the Difference
Tokens are deemed an essential part of the crypto ecosystem. They serve a myriad of functions that include powering a blockchain and granting their owners access to certain products or services. Some can even give their holders a part of the stake in a blockchain-based company.
According to their objectives, crypto tokens can be categorised into two types: security tokens and utility tokens. In this article, we define the two tokens and help you learn their difference.
To kick us off, we have:
Utility tokens are simply user tokens. As a holder, they give you access to future products or services offered by a company. They are issued to help finance a crypto project. They are not a form of an investment asset.
Utility tokens play a vital role in building an internal economy within a company's product. These tokens give you the right to use a particular network and participate in the network's activities like voting.
They are also used to create a unique incentive scheme. For example, some models reward people who use renewable energy with tokens.
Utility tokens are the most popular form of tokens in the crypto space, mainly because of the 2017 ICO boom. These tokens have helped many startups and companies raise millions of dollars in funding.
Advantage of utility tokens
Besides powering a platform, utility tokens can also be used as incentives. People can be rewarded with tokens every time they participate in the platforms or bring in new users—platforms like Steemit award users with tokens for posting, commenting, and upvoting other peoples' content.
Disadvantages of utility tokens
The ease of making utility tokens has made it easy for thieves and scammers to take advantage. Currently, anyone can issue utility tokens. Plus, considering the crypto market is highly unregulated, people who lose their money to scammers have no recourse.
Examples of utility tokens
Filecoin: Filecoin is a decentralised data storage protocol that allows anyone across the globe to rent out their spare hard drive storage space. Filecoin pays anyone who rents out their digital storage space. The project managed to raise $257 million through the sale of its tokens back in 2017.
Civic: Civic is a personal identity verification protocol that utilises blockchain to manage digital identities better. Civic pays its users to verify identities and create attestation within their blockchain.
The most popular utility token is the ERC20 Ethereum standard, which has been used by many blockchain-based companies to build tokens for their DApps.
Security tokens are digital assets that derive their value from an external, tradable asset. This makes them subject to federal laws that govern securities. Failure to comply with the set regulations can result in legal punishments or termination of the whole project.
A security token is, in essence, an investment contract that represents legal ownership of a physical or digital asset, which has been verified on the blockchain.
As a security token holder you can;
- trade your tokens for other assets,
- use your tokens as collateral for a loan,
- or fractionalise your tokens to store in different digital wallets.
While security tokens are a recent invention, crypto advocates believe they will go a long way in overcoming scalability problems in the crypto ecosystem. This is because they make it possible to tokenise digital and non-digital assets.
Advantages of security tokens
- They provide access to multiple asset classes.
Security tokens promote the tokenisation of different asset classes. From real estate to artwork, as an investor, you have the option to invest in any product or company that produces value.
- They provide access to illiquid assets.
Security tokens make it possible to invest in traditionally illiquid assets like real estate, collectables, and art. You can easily sell your house or art in token-form anywhere across the globe and get the funds almost instantly.
- They Eliminate scams and other illegal dealings.
Unlike utility tokens, security tokens fall under strict regulations that scare aware scammers and thieves. Companies that release security tokens have to satisfy set regulations before they can be accessible to the public.
Disadvantages of security tokens
- Strict regulations
To many crypto enthusiasts, regulations may cripple a decentralised system. With regulations, third parties start dictating how operations should be conducted. Trustless transactions go out the window.
Rules also make it harder to enter the market as a company. The strict sets of laws that have been put in place are costly and time consuming for any business. The cost also locks out many potentially productive companies.
- Restriction for investors
In the US, under current regulations, you cannot invest in security tokens if you are not an accredited investor. To be one, your net worth should be over $1 million or have a yearly income that exceeds $200,000. Obviously, this locks out many people looking to invest in security tokens.
Examples of security tokens
Siafund: Siafund is a security token generated by Sia, a blockchain-based decentralised cloud storage platform. As a Siafund holder, you are entitled to a portion of the network's fee that is paid by renters and hosts on the Sia platform.
SPiCE: SPiCE is a tokenised venture capital fund that offers immediate liquidity for venture capital investments. The SPiCE token is a tradable asset and a piece of the investment made by the VC fund. One hundred thirty million SPiCE tokens were created, 85 per cent of which were offered to the public.
The Difference Between Security Tokens and Utility Tokens
The significant difference between security tokens and utility tokens is functionality. While utility tokens enable their holders to interact with a company's product and services, security tokens offer an investment opportunity. Security tokens are simply an investment contract.
With security tokens, you have more direct participation with the company's day to day dealings. You can even get ownership of the company you invested in.
With Utility tokens, you are more of an outside player when it comes to the decision-making process of a company.
Note that you can make money from both utility tokens and security tokens if the prices of the tokens appreciate in value. It is this one factor (they both can earn a profit) that sometimes makes it hard for people to differentiate between the two tokens.
How to Distinguish Between Security Tokens and Utility Tokens
The easiest way to separate the two tokens is by using the Howey Test. The test is comprised of two simple questions;
- Does the token allow its holder to contribute to the funding of a company's capital and receive a portion of its profits?
- Does the ICO's fundraising procedure entail investment in a project whose profits are entirely generated from the efforts of individuals other than the creators or founders of the project?
If the answer to both questions is yes, then the token is a security token and is subject to laws regulating securities.
Hopefully, you now have an idea of how to differentiate between security tokens vs utility tokens. While one is an investment contract, another merely enables you to interact on a blockchain-based platform. Yes, they both can earn a profit, but they are not the same.
About the author:
Jay Jackson is a blockchain enthusiast and a freelance writer at topcryptowriter.com. He works closely with brands (people, businesses and startups) in the crypto sphere. He currently writes Blog posts, Guides, Press releases, ICO reviews, eBooks & Whitepapers. You can find him on LinkedIn.
The above references an opinion and is for informational purposes only. Do not take this as personalised financial advice or investment advice. The views expressed by the author do not necessarily represent the opinion of BitPrime.
Last updated: 27/08/2020