Security Tokens vs. Utility Tokens : A Concise Guide [UPDATED]

Summary

There is no doubt that Blockchain is causing significant disruptions across almost all industry verticals that are in existence. Blockchain technology makes it possible to create a wide array of new business models. Blockchain is credited with being the sole technology since the invention of the internet brought about valuable innovations such as decentralization and trustless networks. Using tokens is one of the significant factors, out of the many, which have contributed to the success of Blockchain technology. This article will delve deeper into the concept of tokens and help you gain a clear picture of security tokens, and utility tokens. Also, you will be learning about the difference between these tokens. So, let’s begin!



Overview

The term “Blockchain” can be confusing itself, and so are its terminologies. Talking about tokens, coins, and cryptocurrency, they all are considered one thing by most people. However, they all have their own functionality, which differs from each other. Tokens are of a few types. Here we will be discussing security tokens, utility tokens, and NFT. Security tokens are a form of investment, and anyone can utilize utility tokens for a particular service or  product. On the other hand, a Non-fungible Token is a unique type of token and a collectible token. It is a form of art where artists can monetize their work. The prices of NFT are significant and can have extraordinary value.

Here, we are going to discuss all these tokens in detail and what is the use of tokens in the Blockchain industry.

Understanding Tokens

A token may simply refer to any given cryptocurrency token or a token that exists on another cryptocurrency’s Blockchain in computer security and cryptocurrency. A token is an asset, utility, or unit of value that a company issues. Tokens represent programmable assets or access rights which are managed through a smart contract and an underlying distributed ledger.

These are issued when a company launches an Initial Coin Offering (ICO), which is more or less the same as the Initial Public Offering (IPO). The main difference between an IPO and an ICO is that in an IPO, you receive stock in exchange for the investment you will make, whereas in an ICO, you will receive a token in exchange for your investment. Tokens can be redeemed to access the product or service of a company in the future.

What Are Security Tokens?

Security tokens are digital assets that derive their value from an external asset that can be traded. These are subject to Federal laws that govern security. It is mandatory for the security tokens to comply with these regulations. Failure to comply would lead to severe consequences such as penalties and potential derailment of the development of the project.

These depict assets such as participation in real physical underlyings earnings streams, companies, or entitlement to interest payments or dividends. In terms of economic function, these are the same as bonds, derivatives, and equities. If the startup abides by the regulatory requirements, security tokens offer a wide array of applications. These are also known as securitized tokens. Security Token Offering (STO) is built to increase the trust of the investor to invest in various projects.

  • Security tokens authenticate identities electronically by storing personal information.
  • They are issued by Security Token Services (STS), which authenticate the person’s identity.
  • They may be used in place of or in addition to a password to prove the owner’s identity.
  • Security tokens are not always secure—they may be lost, stolen, or hacked.

How does Security Token Work?

Security tokens are created as investments. Dividends in the form of additional coins are given to token holders each time the issuing company of the tokens earns a profit in the market. Users who hold the security token will also gain ownership of the company. Blockchain provides a platform that can be used to create a voting system that allows investors to exercise control over the decision-making process of the company. In short, a cryptocurrency token that passes the Howey Test is deemed a security token. They derive value from an external tradeable asset. As these tokens are deemed a security, they are subjected to federal securities and regulations. The Howey Test was determined by the Supreme Court to determine whether certain transactions qualify as “investment contracts.” If so, those transactions are considered securities under the Securities Act of 1933 and the Securities Exchange Act of 1934 and are subject to certain disclosure and registration requirements. In the USA, Security Tokens are subjected to regulations such as:

Regulation D

This will allow a particular offering to avoid being registered by the SEC-provided “Form D” that has been filled by the creators after the sale of the securities. The individual who offers this security may solicit offerings from investors in compliance with Section 506C. This section needs

verification stating that the investors are accredited and that the information provided during the solicitation is free from misleading or false statements.

Regulation A+

This allows the creator to offer SEC-approved security to non-accredited investors through a general solicitation of up to $50 million in investment. When compared to other options, this regulation may take more time compared to other options for the requirement to register the security. Due to this reason, this regulation will be more expensive than any other option.

Regulation S

This regulation is for any security offering which is executed in any country apart from the US and is not subjected to the registration requirement under section 5 of the 1993 Act. The creators will still need to follow the security regulations of the country where they will be executed.

On the other hand, utility tokens are not intended to give their holders the ability to control the decision-making process of a company. They aid users in interacting with a company’s services. Utility tokens are also not subjected to any regulations.

Having differentiated security tokens and utility tokens based on regulations, intended use, and functionality, let us now learn the three other crucial areas of distinction.

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Role of Security Tokens

The role of security tokens revolves around providing a digital representation of ownership or investment in real-world assets while adhering to securities regulations. Here’s a straightforward breakdown:

  • Asset Tokenization: Security tokens tokenize real-world assets, such as real estate, company shares, or other traditional financial instruments. This involves converting the rights to these assets into digital tokens on a Blockchain.
  • Legal Compliance: One of the primary roles of security tokens is to comply with securities regulations. By adhering to these laws, security tokens ensure that the issuance, sale, and transfer of ownership are done in a legally compliant manner, protecting both issuers and investors.
  • Ownership Representation: Security tokens represent ownership or a stake in an underlying asset. Holders of these tokens have legal rights tied to the asset, such as dividends, voting rights, or a share in profits.
  • Efficient Transfer of Ownership: Blockchain technology enables efficient and transparent transfer of ownership. Security tokens streamline the process of buying and selling assets, reducing paperwork and administrative hurdles associated with traditional securities transactions.
  • Increased Liquidity: By enabling secondary trading on compliant security token exchanges, security tokens contribute to increased liquidity for traditionally illiquid assets. Investors can buy and sell these tokens more easily than the physical assets they represent.
  • Global Accessibility: Security tokens can be traded globally, providing access to a broader investor base. This global accessibility is facilitated by the decentralized nature of Blockchain technology, allowing for cross-border transactions.
  • Automated Compliance: Smart contracts embedded in security tokens automate compliance with contractual and legal obligations. This can include the automatic distribution of dividends, execution of voting rights, and other functions, reducing the need for intermediaries.
  • Fractional Ownership: Security tokens enable fractional ownership of high-value assets. Investors can own a fraction of an asset, making it more accessible to a wider range of investors who might not have the means to purchase the entire asset.
  • Innovation in Fundraising: Security tokens offer new possibilities for fundraising, such as Security Token Offerings (STOs). These regulated fundraising methods provide companies with a way to raise capital by offering security tokens to investors.

Security Tokens Issues and Challenges

Security tokens, despite offering advantages in terms of digitizing ownership and complying with securities regulations, also face certain issues and challenges. Here’s an overview of some common challenges associated with security tokens:

  • Regulatory Compliance: Ensuring compliance with securities regulations is a significant challenge for security tokens. Regulatory frameworks can vary globally, and navigating these complexities requires substantial legal expertise and resources.
  • Legal and Regulatory Clarity: The regulatory landscape for security tokens is still evolving, and there may be uncertainties regarding how existing laws apply to these digital assets. A lack of clear and consistent regulations can create challenges for issuers and investors.
  • High Initial Costs: The process of tokenizing securities and conducting regulated offerings, such as Security Token Offerings (STOs), involves significant legal and compliance costs. These high initial costs can be a barrier for smaller companies or startups looking to tokenize assets.
  • Liquidity Concerns: While security tokens aim to enhance liquidity for traditionally illiquid assets, achieving this goal can be challenging. The success of secondary markets for security tokens depends on factors like market infrastructure, investor interest, and regulatory support.
  • Educational Barriers: Investors and market participants may lack understanding of security tokens and how they differ from traditional securities. Educational efforts are needed to increase awareness and facilitate broader adoption of security tokens.
  • Custody and Security: Safeguarding digital assets is crucial. Security tokens rely on secure Blockchain technology, but concerns about cybersecurity, hacks, and secure custody solutions remain important considerations for both issuers and investors.
  • Market Fragmentation: The security token market may face fragmentation due to different Blockchain platforms and standards. The lack of interoperability among different security token protocols can hinder the seamless transfer of tokens across platforms.
  • Token Standardization: The absence of standardized tokenization frameworks and protocols can complicate the integration of security tokens across different platforms and exchanges. Standardization efforts are essential for promoting consistency and compatibility.
  • Slow Adoption: The traditional financial industry has been slow to adopt security tokens due to concerns, skepticism, and regulatory uncertainties. Overcoming resistance and encouraging institutional participation are ongoing challenges.
  • Market Perception: Security tokens may face challenges in terms of perception, as some investors may associate them with a higher degree of risk or complexity compared to traditional securities. Building trust and credibility is crucial for wider acceptance.

What Are Utility Tokens?

Utility tokens are user tokens or app coins. This is a token that is given out during crowd sales as a project executes an ICO. When a company creates a utility token, it means that it is essentially creating a form of a digital coupon that can be redeemed in the future for discounted fees or special access to a product or service. Unlike security tokens, utility tokens are not used as investments as they can be exempted from the federal laws governing securities if they are properly set up. Examples of utility tokens are Filecoin, Siacoin, Civic, etc.

How Does a Utility Token Work?

A utility token is a type of cryptocurrency that has a specific purpose within a Blockchain ecosystem. It’s called a “utility” token because its primary function is to provide access to a particular product or service on a Blockchain platform.

Here’s a breakdown of how it works:

  • Token Creation: The utility token is created through a process called an Initial Coin Offering (ICO) or Token Generation Event (TGE). During this event, people can buy these tokens using other cryptocurrencies like Bitcoin or Ethereum.
  • Smart Contracts: Utility tokens often operate on Blockchain platforms that support smart contracts (self-executing contracts with the terms of the agreement directly written into code). These smart contracts define the rules and conditions of the utility token.
  • Access to Services: The main purpose of a utility token is to provide access to a specific service or product within the Blockchain platform. For example, it could grant access to use a particular software, participate in a decentralized application (DApp), or get special privileges within a network.
  • Limited Functionality: Unlike other types of cryptocurrencies