Understanding Tokens: Security Vs Utility Tokens

by | Apr 13, 2021

Understanding Tokens & Security Vs Utility Tokens

It’s a well-established fact that blockchain technology is here to stay. Not only that, the underlying tech is causing major upheavals in almost all industry verticals that are in existence around the world. Not just in the crypto segment, blockchain technology is solving the issue of trust in various arrays of business models. 

Bitcoin being its first use-case, blockchain technology has been credited with reimagining the concept of money, building an ambitious new world of decentralized finance, decentralized data storage, digital identity and what not. 

However, the concept cryptocurrency still remains one of the major use-cases of blockchain. So today, we’ll understand the concept of tokens in respect to blockchain technology as well as two distinct categories of tokens – security and utility tokens.

The Concept of Tokens

A token is basically a representation of anything in a given ecosystem. If you go to a Chai shop, pay your bill at the counter and get a token that you can exchange for a cup of Chai. In this given scenario, a single token represents a cup of Chai. 

However, if that Chai shop shuts down and you’re left with a bunch of Chai tokens, these tokens serve absolutely no value anymore. Starbucks reward is one good example of tokens. You can accumulate these rewards to exchange them for consumable goods at any Starbucks outlet. However, these rewards are worthless in case all the Starbucks outlets close down.

Cryptocurreny Tokens

Similarly, in the world of cryptocurrency, a token represents an abstract value in a given blockchain ecosystem. In more technical perspective, a token is simply an asset or unit of value representing programmable assets that are managed through a smart contract and an underlying distributed ledger. 

For example, ChainLink has LINK token, MakerDAO has MKR, Augur has REP, you get the point. These tokens serve a necessary function in their respective ecosystem and without these tokens or their value, the given application would cease to exist. 

Well, if you’re talking about tokens, it’s hard to not discuss the ICO-mania of 2017-18. For those not familiar with the term, ICO stands for Initial Coin Offering. Much like IPO (Initial Public Offering), ICOs are basically new means of getting crowdfunding. Usually these tokens are sold with a capped-supply and a pre-determined price. In some cases, a company or project can leverage a bonding curve mechanism to establish the price of to-be-issued tokens depending upon the demand and supply. 

Bonding Curve

Basically, a token model achieves three things for funders and project owners:

  1. Give access to funds required for developing or scaling a project
  2. Allowing funders to participate in project governance
  3. Aligning incentives between funders and project owners.

However, the ICO-mania ended badly with many projects either failing to take off, burning all the funds or even outright disappearing with public funds. Even though the ICO-mania ended badly, it’s worth noting that it unlocked new innovative techniques for crowdfunding. (or getting scammed)

Regulatory Concerns

For that precise reason, regulators jumped into the ICO-mania trying to regulate the market and serve the investors’ interest. In January to March 2018, ICOs had raised an estimated amount of about $5 billion. With such large amounts of money pouring in, regulators were bound to act. 

Subsequently, the United States’ Security Exchange Commission (SEC) started acting against ICOs with a basic objective to ensure that all ICOs comply with the regulations. Thus, making sure that companies and projects attempting to shy away or undermine the law in any situation would present investors a serious risk and all forms of cryptocurrency projects in the future. Although it’s up for debate whether the SEC is actually working in the interest of investors or putting barriers against innovation in the crypto ecosystem. 

Now that we’ve covered the concept of token in general as well as in the crypto ecosystem, let’s delve into two distinct categories – security and utility tokens.

What are Utility Tokens?

Utility tokens basically enable the holders with a right to use the service and participate in the project’s governance. These tokens are initially given out during crowd sales as a said project implements an ICO. When a company distributes utility tokens, it simply means that it’s essentially making a form of digital coupon that can be redeemed in the future for a discounted fee or special access to a service or product. 

What are Security Tokens? 

Security tokens, on the other hand, are digital assets that derive their value from an external asset and can be traded. They are also known to be subject to federal laws which govern security. It is important for security tokens to comply with such regulations. 

Failure to comply would lead to grave consequences such as penalties and potential derailment of the project’s development. They are known to depict assets such as earning streams, participation in physical endeavours, companies, interest payments, etc.

Applying the Howey Test to Differentiate Between Tokens 

As per Wikipedia, Howey test is a measure to determine whether an instrument qualifies as an “investment contract” for the purposes of the Securities Act: “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” In the context of crypto ecosystem, this test is said to apply two simple questions to differentiate between utility tokens and security tokens, and the questions are; 

  1. Are the token holders permitted to provide funding for the company’s capital and receive a portion of the profits? 
  2. Does fundraising efforts of the ICO entail investment in projects where profits are generated entirely from persons other than the founders of the projects? 

Such a token is likely to be a security token if any of these two questions’ answers are yes. 

Conclusion 

I earnestly hope that this article gives you an understanding of the concept of tokens, ICOs as well as the difference between a security and a utility token. We have now learned that one helps encourage holders to act in a particular way while the other is a contract representing the legal ownership of such assets. 

However, out of these tokens, security tokens can be considered safer than utility tokens due to the tight regulations imposed upon them.

Written By Narender Charan

Head of Content Marketing @ HyperLinq. His love for Chai and mountains precedes everything. Often wonders about things like, "why $1 earned through leverage feels 100x better than $1 earned selling your time?"
Disclaimer

Posts on the HyperTrader blog and associated HyperLinq websites are for educational and informational purposes only. These posts should not be taken as financial advice, nor are they meant to be viewed as trading advice. HyperLinq Inc. or the authors take no responsibility for any damages or losses.

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