The world of cryptocurrencies can be overwhelming for a beginner. There are a lot of new concepts and subtle differences to learn, including the difference between utility tokens vs security tokens. These two asset types form the base for the economy of most crypto projects. Read on to understand what they are and how they differ from one another.
TABLE OF CONTENTS
What Are Tokens
First and foremost we need to understand the general concept of tokens. In the most global scope, the definition of a token is an imaginary or a real unit that represents some form of value or right within its environment. Tokens as economy units are used by companies to power loyalty programsю while in programming they are used to indicate a right to perform an action.
So are tokens the same as cryptocurrency coins? Well, not exactly.
Like crypto, tokens have value and they can be exchanged and sent. But unlike coins, they represent a utility or security of a company that issued them and can be used in their native project. Cryptocurrency coins, on the other hand, are used strictly for value exchange over a decentralized network.
If you want more about cryptocurrency, check out our comprehensive cryptocurrency guide.
So why do companies even bother to create tokens?
The answer is universal in almost all cases — to exchange them for other valuables during a crowdfunding stage and subsequently provide an incentive for certain actions on their platform, creating a mini-economy bound to the constraints of one project.
These kinds of crowd fundings are called ICOs.
Why Tokens Are Created — ICOs
ICOs are essentially instances of crowdfunding in the cryptocurrency world that allow investors to fund projects with crypto coins.
A company promises to use the funds it gains from investors to launch or develop it’s idea and investors obtain the chance to profit from the value growth of received coins.
ICOs became a world-wide phenomenon in 2017 when 30% of seed-stage funding worldwide was completed via Initial Coin Offerings. Some projects actually raised thousands of millions. For example, Filecoin raised $257 Million in the largest ICO of 2017.
Due to the fact that most tokens, just like any crypto, are quite unstable and dynamic by nature, some ICOs brought investors hundreds of thousands of percents of profit like Spectrecoin ICO which was held from November 18th, 2016 to January 6th, 2017 and generated 149,806 percent profit of for investors!
Interested to learn more about ICOs? Consider reading our comprehensive ICO guide
How Tokens Are Created
Now that we understand why Initial Coin Offerings became such a large phenomenon in the crypto world let’s talk about some of the processes behind them.
Firstly, a company issues a limited amount of coins and sets goals. Most ICOs have a soft cap and a hard cap. Upon reaching a soft cap indicated by a certain amount of sold coins, ICO is considered a success, but it continues until a set date. If ICO reaches a hard cap it means that all supply of coins was sold and the sale ends right there.
So why limit the number the coin supply?
It allows a company to create value. The initial value of a coin is set by the company and it can be fixed or dynamic. After the end of the ICO, the market value is determined and this is where the price can either freeze, skyrocket or completely diminish.
You may ask, but how do I participate in an ICO? Is there some kind of a contract?
The answer is yes, there is. A smart contract, in fact. Investors send their cryptocurrency to a specific address and receive coins in exchange automatically. These coins are created by a smart contract which is just a program designed to issue coins when certain conditions are meant.
If ICO does not reach a soft cap then all funds are automatically distributed back to investors, so the process is entirely trustless.
A Few Words About STOs
STOs or Security Token Offerings work largely the same as ICOs, however, as evident from their name, investors purchase securities rather than utilities.
Although STOs are very similar to ICOs, governments heavily regulate STOs and they aren’t accessible to all companies and investors.
What Gives Tokens Value
Before we look at the actual differences between security and utility tokens, let’s understand why do they even become valuable in the first place? In summary, utilities gain value because they give privileges to the holder.
These privileges contribute to the growth of the demand. Remember that companies create only a limited number of coins during an ICO? Where demand is greater than supply value is created. This is the same rule that allows companies like Supreme to sell relatively inexpensive to produce items for thousands of dollars.
Factors That Give Tokens Value
There are specific factors that contribute to higher demand. Let’s look at them in more detail.
- Rights: this could be the right to vote on the next business moves done by the team or influence certain aspects of the project ecosystem. For example, the more Steemit tokens a user has the more they can influence which content gets featured on the website.
- Value: tokens are often used as a medium of value within an ecosystem. Think of them as currencies such as USD or EURO but designed to function in an ecosystem of a project. Like Starbucks’ loyalty points which users can freely trade.
- Fees: sometimes one can only use the service of a company if they pay a little fee in native coins. Thus, if you want to benefit from the useful service you need to own the token.
- Addition of functionally: users can buy tokens to enhance the user experience and gain access to additional functions. For example, in our very own upcoming product, TEAMSHOP users can spend coins to obtain advertising and acquire customers.
- Profitability: users can store tokens as potentially profitable value exchange units. Since most projects will allow exchanging their tokens for cryptocurrency like Bitcoin and directly for fiat money (like USD), tokens can serve as value holding mediums with the potential to skyrocket in price.
When it comes to securities the mechanism is very different.
Unlike utilities, they must be backed by real assets that directly correlate with the price. As such, if a company does well and makes a profit, the price of the coins will go up. If a company that issued the security coins is doing bad, the price will go down.
Utility Tokens vs. Security Tokens — What Are The Differences
Now that we understand the mechanics behind tokens in general and the reasons for their creation, let’s talk about the actual token classes and their differences.
All tokens that exist on the market fall into two major groups: utility and security. SEC and FINMA define use those groups to tell whether purchasing a coin can be considered an investment or not.
Utility Tokens Definition
In essence, these assets represent a right to use a service or product created by the company. They play a certain role in the ecosystem of a company that issued the token and have practical applications. For example, paying a fee for transactions in a network. They also play a vital role in creating an economy within a company’s product.
There is no doubt that utility tokens are the most popular asset class in the cryptocurrency world and we have the 2017 ICO boom to thank for it. Most of the utility tokens exist on the Ethereum blockchain and use an ERC20 standard. This enables the developers to create compatibility with most major exchanges and wallets as well as issue tokens using almost a pre-made smart contract.
Utility Tokens Advantages
Multiple reasons make utility tokens so widely adopted by companies and teams of all sizes and backgrounds. They have several distinct advantages.
- Lack of regulation: this can be viewed as an advantage and a disadvantage at the same time. On the bright side, it is much easier for a company to hold crowdfunding and collect development funds without adhering to SEC regulations.
- Ease of production: with already existing platforms and popular standards like ERC-20, ICOs can issue their coins and not worry about integration with exchanges and wallets. There are hundreds of solid options on the market to form an ecosystem and provide opportunities for secure storage and liquidity.
- An abundance of options for practical applications: utility tokens are the ones that started the boom of decentralized application development. They give incentives to people for creating different actions and power a new generation of products. We already mentioned Steemit. It’s a platform where users curate content and determine which articles will get to the top of their categories. Curators make real money on Steemit and it is the economy that allows a product like this to flourish.
Utility Tokens Disadvantages
Unfortunately, as much as we would like to say that utility tokens are a perfect asset class — they are not. They have some very serious disadvantages. Let’s take a look at the flip side of the coin. Pun intended.
- Lack of regulation: it means that it is easier to make and sell coins. But it also means that investors are less protected. While investors give real money in exchange for coins and essentially, well, invest in a project, on paper they don’t. In reality, purchasing a utility token is not much different from buying a coin at an arcade to play video games.
- Ease of production: nowadays almost anybody can issue utility tokens. That’s right, you can issue your tokens in a matter of a couple of hours. It’s not certain whether anybody would buy them, but you still can do it. This ease of production leads to a lot of shady companies and people entering the market during the 2017 ICO boom.
- High risk of fraud: combine the two disadvantages above and you get a very dangerous result. Unfortunately, fraud was and still is very common in the ICO market. This study shows that a staggering 80% of ICOs in 2017 were scams!
Utility Tokens Examples
Now that we understand utility tokens in more depth, let’s take a look at some famous examples in this asset type.
- Basic Attention Token (BAT)
- Aragon (ANT)
- Golem (GNT)
- Storj (STORJ)
- Funfair (FUN)
- Decentraland (MANA)
Security Tokens Definition
Finally, we’ve made it to the section about the security tokens. These are indeed a very special asset class with a lot of potentials. This is what we’ve learned so far.
Security is an asset that promises to deliver profit to investors by the means of work or advertising done exclusively by a third party.
Also, security tokens are usually backed by assets, so they derive their value from the real world rather than from the supply vs demand equation, which makes them more stable than utility tokens.
Companies that sell securities must adhere to SEC regulations very strictly and have to operate under a lot of scrutinies. If they fail to comply they can be subject to penalties and can even be shut down for good.
This is because a security token is, in essence, an investment contract and has legal power. However, it is one that must be confirmed by the blockchain.
It is the “confirmation in the blockchain” part that makes security tokens so special. Let’s take a look at the following example: imagine that 100 people decide to buy a house together. In theory, it is possible to issue any number of coins that represent shares of ownership for this house. Each person can then own a number of these shares, freely trade them, store them in digital wallets or even exchange them!
Imagine that you could go to a Starbucks and buy coffee with a part of your house! It sounds crazy, but in the future, it might be possible.
In summary, security tokens have the power to transform the economy and the concept of ownership as we understand it today.
Security Token Advantages
This asset class has several distinct advantages over utility tokens that makes securities a better investment option in a lot of cases.
- Regulation: because SEC regulates these assets, it is very very unlikely that a company issuing security tokens will try to scam their investors. In essence, a business must be transparent and legitimate to even get into this market. This greatly reduces the investment risk for anybody willing to participate in an STO, or a Security Token Offering.
- A real investment: when you buy security tokens according to the contract you may be eligible to receive dividend payments from the company’s profit. You may even become a board member. It depends on the rights that a particular token provides. On the contrary, whey buying utility tokens you don’t have any right to participate in profit distribution. Even if you own 50% of all utility tokens, you don’t get any more rights than if you own a single token.
- High liquidity: security tokens provide access to liquid markets. They guarantee that it will be much easier to sell those tokens that are backed by real assets with stable real-world value. For companies, they provide access to investment institutions that work with businesses outside of the highly speculative blockchain market.
Security Tokens Disadvantages
However, despite being such a transformative asset class that is rising in popularity with more and more Security Token Offerings appearing on the market, they do have some distinct disadvantages.
- Regulation: some will argue that security tokens betray the core ideas of cryptocurrency. People created crypto to provide anonymity and a self-regulated environment. Furthermore, while governments don’t regulate utility tokens in many jurisdictions, they do regulate securities and you will probably have to pay taxes. It is also much harder to get into the market as a company since business must comply with strict regulations.
- Restrictions for investors: according to US regulations only accredited investors can buy securities. It means that right now you may not be able to acquire security tokens unless your net-worth is over 1 million USD or your yearly income exceeds 200,000 USD.
- Technical complexity: previously we looked at an example that had us buy coffee with a share of house ownership. But how do you make a connection between a physical house and a digital token? This is a very complex process and some companies out there are currently tackling this issue.
Security Tokens Examples
Now that we understand what a security token is, let’s take a look at the list of tokens that are currently available on the market.
- Swarm (SWM)
- Neufund (NEU)
- BlueShare (BST)
- PO8 (SPO8)
- BlockState (BKN)
- Kriptomat (KRTEX)
How To Tell a Utility From a Security. The Howey Test.
Regulators commonly use something called the Howey Test to determine whether they are dealing with a utility or a security. The test is based on a Supreme Court case SEC vs Howey which created the basis for establishing if an arrangement involves an investment contract. You too can use this case to classify a token.
According to the Howey test, to classify as a security an asset must:
- Be an investment of money
- Be a common enterprise
- Provide an expectation of profit from the work of the promoters or the third party
- Provide an expectation of profit that is completely out of the investor’s control.
Since utility tokens pretty much fall under the first two parameters anyway, most ICO companies nowadays will try to avoid mentioning anything even remotely related to future profits.
Utility Tokens Vs Security Tokens — a Short Summary
We hope that this article helped you to understand the differences between the two asset classes. As always, there are multiple sides to the argument. Some will say that security coins are better because they strike a good balance between regulation and innovative potential. Others will argue that utilities are the way to go because they stay true to the original idea of cryptocurrency and give owners more freedom and anonymity.
And others will even add that neither securities nor utilities should exist. After all, in their opinion, the real future is behind original cryptocurrencies such as Bitcoin.
In any case, it is safe to say that we are living in very exciting times! Don’t know about you, but we can’t wait to find out what awaits us!
Want to read more? How about learning how to trade crypto and tokens on the Exscudo Exchange?