The Difference Between Utility and Security Tokens

The line between a security token and a utility token is generally not clear. We look at the underline concepts of utility and security tokens.

By Julia Cook
Published Jan 9, 2021 and updated Jan 15th, 2022
The Difference Between Utility and Security Tokens

As the world becomes more familiar with blockchain technology and cryptocurrencies, the question that many countries are struggling to address is whether a token can and should be classified as a security. The line between a security token and a utility token is generally not clear. To determine whether a token is a utility token it is necessary to understand the concept of utility and security tokens.

What are the Differences Between a Utility Token and a Security Token?

In basic terms, a Utility Token is a token that has some sort of use or utility either within a particular platform or across various platforms. ‘Utility’ encompasses many possibilities, including purchasing power, platform access, and much more.  All tokens therefore have a Utility Token component. The issue is whether they qualify as being Security Tokens as well. The question therefore should be: ‘is there such a thing as a non-security token?’

Henceforth, for the purposes of expedience, we’ll use the term ‘Utility Token’ to refer to non-security tokens, as that is what people generally mean.

Factors That Determine if a Token is A Security

The factors determining whether a token is a security lies in its functionality. The legal guidelines issued by the securities commission or equivalent governmental body within a given country in many cases are very clear about the functions of a security.  The US and Canada are probably the most salient cases. In both, this serves to determine what characterizes a security and that serves as a guideline to understand whether a token is indeed a security.

For instance, according to the SEC, a token would be classified as a security when it represents a degree of ownership in a business. In traditional markets, stock shares, which could potentially allow the shareholder to earn dividends from work done by a third party, would be defined as a security. Some Token holders argue that in the case of tokens, earning interest does not necessarily make the token a security. It is rather a function of inflation if the token is inflationary.

Similarly, certain initial coin offerings (ICOs) that are offering investors interest or dividends on their investments could be equated with bonds and would therefore also be considered equities. There is a small technical difference between them though, as interest rates on tokens, theoretically speaking, would be paid out in tokens as inflation increases and would result in a net gain of 0% for the individual. In the case of traditional markets, bonds (and other types of loans) pay out actual interests. The latter is the approach that many ICOs go with, since they are generally only looking to raise funds.

However, whether the SEC would choose to recognize these nuances is doubtful. It also seems more likely that the SEC will choose to categorize tokens based on their assessment of an investor’s intent in purchasing a specific token, rather than figuring out what the intention of the ICO was.

Other Assets are Also Securities

It is also important to note that according to the SEC’s Howey Test, there are a number of other assets that could qualify as a security. These are generally divided into three sub-categories, namely Equity securities, Derivative securities and Debt securities. Without going into too much detail, a Shares security would be a type of Equity security, Futures contracts would be a type of Derivative security, and a promissory note would be a type of Debt security. These concepts will be expanded upon shortly.

Is there a Positive Side to Registering Tokens with the SEC?

At first glance it would seem not, especially on the side of the ICOs. After all, registering with the SEC is expensive and time-consuming. It could arguably consume so much of both resources as to render the venture either bankrupt before it begins, or to give their competitors a large head-start. However there might be some advantages if the ICO wants to be able to sell its token in the US, which is the biggest market in the world.

There are also a few other ways in which this could benefit ICOs:

  • They wouldn’t have to worry about being caught out and fined or subpoenaed by the SEC or similar body at a later date, and
  • Potential investors would feel more secure in investing in an ICO that has been registered and assessed as being authentic by a trusted governing body than in an ICO that requires personal validation on the part of the investor.

Nevertheless, securities can only be sold to or through accredited investors, killing the crowdfunding component. That is a disadvantage, since tokens that are properly designed, should be creating a new “micro-economy” in which a wide number of participants is necessary. The other disadvantage is that a securitized token cannot be sold on every exchange. Only licensed brokers and platforms can sell them.

How Does this Affect ICO Marketing Strategies?

As the US SEC continues to crack down on ICOs, new ICOs generally opt to bar the US market from participating in their projects, while very few try to comply with the SEC. Those that do attempt to do so are often cryptocurrency exchanges, investment or financial services that specifically want to appeal to the US market with their claims of aligning with the SEC’s guidelines. Some even offer to only host SEC-approved tokens, thereby making it that much easier for potential US investors to find new projects. As complicated as that may seem, the US still has it better than other countries such China, Nepal and Macedonia that have completely banned ICO launches and participation.

It is also important to realize that, compliance with the Howey Test only applies in the US and to a large extent in Canada, which has a similar test. Other countries have other regulatory requirements., Therefore, ICOs will have to do their due diligence before launching a token sale in any country. This is also why investors should be wary of ICOs claiming that they will be ‘fully compliant with the legal requirements of every country,’ as this alone would require millions of dollars of additional investment and thousands of hours to ensure.

Tokens Could be Debt Securities

Another category that tokens could fall into is a debt security. These might not apply to the original ICOA debt security is where a loan is made to another party in exchange for interest over a fixed period of time. This can include the borrower having to place collateral against the loan, so that if the loan is not repaid, the lender can liquidate the collateral and collect the amount owed from the amount generated by the sale.

Blockchain platforms that offer similar services include lending platforms such as Lendingblock and Fusion, as well as mortgage or property-investment blockchain platforms like Reidao. However, as with the laws governing equity tokens, the laws differ from state to state and country to country. Therefore, many ICOs opt to launch in a country that has either flexible case by case regulation or loose laws regarding ICOs and cryptocurrencies.

How Can You Test Whether a Token is a Security?

After reading how tokens could end up being classified as securities, it is important to know how you can do a quick assessment to see if there are some red flags that you should check with a lawyer. Since SEC regulation is among the most stringent in the world, it may serve as a litmus test for any given project. According to this test, there are four terms that need to be met for an investment to qualify as a security:

  1. The transaction is an investment of money – cryptocurrencies can be viewed as money, and later interpretations include assets other than money.
  2. There is an expectation of profits from the investment.
  3. Investors invest in a “common enterprise.”
  4. Profit comes from the efforts of a third party or a promoter.

When are Tokens Defined as Utility Tokens?

Based on the above illustration, it seems that a Utility Token is meant to be different, as it does not offer the token holder any kind of share in the company, but rather offers the user access to a platform or to specific services within platforms. Furthermore, the majority of new ICO platforms claim that all activity will be decentralized and many also provide access to their open-source code on github. This is meant to  allow for direct transactions, such as peer-to-peer, business-to-business and business-to-person structures. This eliminates the involvement of an external party investing in the token holder’s behalf.

Tokens often are used for platform-specific functions beyond payments.These tokens are supposed to be utility tokens.

Utility Tokens Might Never Classify as Such

Nevertheless, whether a token can be classified as a Utility token is challenging. There are those who will say that a Utility token refers to a token that is sold to provide the user with future access to the platform. If this were true, it would be difficult to prove. After all, why would an individual want to purchase 500 ETH worth of tokens for ‘personal use?’ It is arguably more likely that said individual would be stock-piling tokens in the hope that they would increase in value over time, thereby providing them with a return on their investment upon the reselling of their tokens at a later stage. In this case, the token could be considered a Derivative Security, rather than a Utility Token. On the other hand, there are collectors who purchase way more stamps – for instance – than the amount they need, expecting them to go up in price in the future.

Furthermore, ICOs are known as a form of crowdfunding. Crowdfunding is the process of appealing to a wide range of individuals to raise small amounts of funds from a diverse range of companies and individuals, to increase their chances of obtaining at least the minimum capital that they require to launch their venture, while acquiring users in the processAs intention is difficult to determine, it is tricky for an ICO to prove that these buyers are simply participating in the ICO, hoping to broaden their portfolio. This is especially true when ICOs launch a ‘private sale’ for major companies and wealthy individuals, who could qualify as accredited investors.

ICOs Crowdfund

Some might wonder how this differs from other crowdfunding platforms such as Kickstarter and Indiegogo, but there is a distinct difference. In the case of a platform such as Kickstarter, entrepreneurs are only permitted to offer products or services, not shares or concepts, and they can only do so if they can provide real-world proof of existing prototypes. This means that entrepreneurs cannot supply a rendering of the prototype, but rather an actual sample produced in the real-world.

Platform users will then have two options, to either invest in order to receive the product when it is produced, generally with some added perk, or they can opt to donate simply because they believe in the usefulness of the invention in general. A perk can include promotional extras, such as extra playable promo-cards or minis for a board game, or perhaps an interesting cork-stop with an innovative bottle-opener set.

Therefore, buyers are not able to receive any financial benefits that are immediately obvious in their purchases. The only thing that they are purchasing is the right to early access to products, as well as exclusive early-buyer only content. Entrepreneurs on the other hand will need to fork over a total about 8 – 10% of their earnings to Kickstarter and to their payment processor Stripe. With an ICO sale, the fees are charged according to the payment method, meaning that if someone were to pay in ETH, they would also be charged gas, and so on. There are generally no further fees charged beyond those.

ICOs, they generally set a soft-cap and a hard-cap, meaning that they will retain funds if the minimum amount is raised. This means that the buyer will not know in advance whether they will get what they are paying for or they will get their money back because the project failed to raise the minimum amount.

So, Can Tokens be Just Utility Tokens?

The similarities between ICOs and Crowdfunding is striking. Nevertheless, the decentralized component, the expectation of wild returns and a general lack of suitable regulation around the world, are putting these projects in limbo. Some countries are drafting sound regulatory frameworks, but this might not be enough to bring these projects under the guise of the law. There will always be a jurisdiction that would allow them to raise funds without subjecting themselves to any type of regulatory framework, or a loophole to launch from a jurisdiction in which there are regulatory frameworks in place.