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Crypto Terminology// 5 min read

Explained: Security Tokens vs Utility Tokens

Explained: Security Tokens vs Utility Tokens

In March of 1602 the Dutch East India Trading Company offered to sell shares in order to raise capital, thus pioneering the first modern IPO. Shares were listed on a public stock exchange and later produced a fully fledged capital market.

Since then IPOs have become the industry standard for established corporations looking to raise money. Alibaba, Facebook, Google and many others have used an IPO to raise capital in the past.

For smaller companies however, IPOs are typically too expensive and time intensive to make sense. As a result, startups and smaller corporations needed to innovate and find a cheaper, faster way to raise funds.

With the emergence of blockchain technology, entrepreneurs have sought to leverage its power to fuel innovative ideas. In January 2012, a Seattle-based Software Engineer called JR Willett published The Second Bitcoin Whitepaper. Here Willett claimed that a new currency layer with new rules could be built on top of the bitcoin protocol, heralding the arrival of ICOs.

These are a means of fundraising whereby cryptocurrency is sold in the form of tokens. The appeal for investors is either:

  1. To speculate on the token returning profits in the future, either by simply increasing in value or paying out dividends. OR
  2. To acquire a token which promises to provide a function sometime in the future.

This distinction is crucial to understanding the current legislative landscape surrounding ICOs. In 2012 however, the motivation for investors to crowdfund a project was hardly relevant, as barely any ICOs existed and regulation was seemingly non-existent.

This changed in 2016, when the power of Ethereum’s ERC20 token became apparent. 43 ICOs were completed, raising a total of $95 million dollars. Although the amounts were starting to turn heads and now prominent actors like Lisk, Waves and Iconomi launched that year, it wasn’t until 2017 when ICOs became mainstream.

Bancor, EOS and Filecoin each raised over $100 million, bringing the total for 2017 to over $3 billion. With such significant amounts now in play, regulators began to pay close attention, throwing a sceptical eye on this new form of fundraising.

In July 2017, the red hot ICO market was thrown into turmoil when the Securities & Exchange Commission (SEC) ruled, that some ICOs were in fact securities. As a consequence they would have to abide by securities law, something no ICO was doing at the time.

As is to be expected this turned the crypto world on its head. The lack of regulation had been a major advantage for smaller companies without the resources to pay expensive lawyer fees or buy licenses.

The question of what constitutes a security token is therefore crucial, as it determines not only the legislative landscape in which the token operates, but also the expectations of investors.

Understanding Securities

Now that we’ve taken a brief look at the history of fundraising, and where ICOs stand today, we need to discuss how the SEC defines a security.

The key to understanding this matter is the Howey Test. The Howey test originates from a legal dispute in 1946, in which the California-based Howey Company leased parts of its property in order to raise funds.

The problem arose when the SEC realised that the signing of a decade-long service contract essentially turned the new property owners into speculators. The speculators invested with the expectation of earning profits based on the work of the Howey Company. As such the agreement constituted a security, fell under the Securities Act of 1933, and consequently meant that the Howey Company had violated federal law by not reporting it to the SEC.

Understanding Security Tokens

With regards to crypto, we can state that any token purchased with the sole intent of providing a profit can be deemed a security in the eyes of US regulators. As such it will be expected to abide by US securities law. Failure to do so results in hefty penalties and even shutting down the project.

On the flipside however, being a securities token also brings benefits, like offering quarterly dividends to token holders, and allowing investors to benefit from the growth of the company.

Additionally, regulators outside of the US, like BaFin in Germany, have proven to be receptive to ICOs issuing security tokens (also known as STOs). Unfortunately, working with regulators around the world is still a lengthy and costly endeavor, making it uneconomical for many startups.

That being said the ecosystem for security tokens is being built as we speak. TZero, for example, is in the process of building a security token trading platform which is SEC compliant. Bancor have just completed their decentralized exchange service for security tokens, enabling almost instant liquidity for any ERC 20 security token.

Another service to watch is Polymath, a blockchain protocol which enables the creation of legally compliant security tokens. If Polymath is successful, it will become the Ethereum of STOs, providing a platform on which to create tokens and issue them to investors.

That being said, US-based retail investors cannot currently participate in STOs which are not registered with the SEC. Instead only accredited investors, who are expected to be aware of the risks, can invest in such opportunities. In order to be recognized as accredited, the investor must prove either:

  1. An annual income of $200,000 over the last two years, with the expectation being to receive the same in the years ahead.
  2. Possession of net assets in excess of $1 million, excluding the primary residence.

In terms of planned and regulated STOs, Bitbond is worth mentioning. Regulated and licensed by BaFin in Germany, the blockchain startup plans to provide quarterly or bi-annual payouts to token holders over a 10 year period. When the maturity is reached, Bitbond offers to buy back the tokens at the original price. Listen to the podcast episode where we interview Bitbond’s CEO here.

Understanding Utility Tokens

The easiest way of thinking about utility tokens is as digital coupons that allow holders to participate in the running of the blockchain, or give them rights to future services. Unlike security tokens therefore, investors do not participate in order to gain profits. Instead, they receive a token which provides functionality or participation either now or in the future.

A prominent example of this would be EOS, the ambitious operating-system like protocol, which raised over $4 billion in a year long ICO. As CEO Brendan Blumer points out:

Instead, the EOS token is designed to let holders participate in the running of the platform. More specifically, token holders are able to vote for block producers which validate transactions in a Delegated Proof of Stake consensus system.

In the case of Sia, the token is a utility because it gives holders access to a specific service, namely cloud storage. This differs from EOS because it does not represent a right, but instead a service, however it is still classified as a utility token, because investors’ primary objective is not to make a profit.

Comparing Security and Utility Tokens

FeatureSecurity TokenUtility Token
Investor’s objectiveTo profit from the work of others.To participate in the blockchain or gain access to a service.
Regulated by the SEC?Yes.No.
Who can participate in the US?Accredited investors only.Everyone (Up to the discretion of the ICO).
Does the token represent a share of the company?Yes.No.
KYC requirements?Yes.No.
State of the ecosystemWeak.Strong.

Conclusion

This is a fascinating time for everyone in the cryptocurrency space. The SECs ruling in July 2017, sent shock waves throughout the industry. Before the ruling, ICOs were seen as the best way for smaller companies to raise capital.

Now, with most tokens seemingly classified as securities, the mounting legal fees, licences and administrative tasks run the average cost up to between $300,000-600,000 dollars – an impossible sum for most.

Additionally, SEC Chief Clayton has said Every ICO I’ve seen is a Security, foreshadowing punitive measures being taken retroactively against past ICOs.

Nevertheless, the number of ICOs keeps growing. According to CoinSchedule, over 570 ICOs have already occurred this year. As of June, an eye-watering $1 billion a month has been raised in 2018 (so far).

These staggering figures suggest that the ICO market is in great shape and that regulatory pressures around securities have had little impact. This is only part of the story, however, as anyone who has participated in an ICO will tell you.

As this article from Coincentral points out, 46% of ICOs listed on Tokendata in 2017 have failed. Indeed most never even reach their soft-cap. In more troubling cases, the project is funded but shortly collapses, leaving investors out of pocket.

The startling regularity of such failures is an indication that regulation needs to catch up. The SEC and other regulators need to act swiftly to remove the murkiness of current legislation and allow the market to prosper.

It can be argued that most tokens are purchased with the hope of future profits, but that should not ring the death knell for an industry with so much potential for good.

Written by:

Chris Grundy is an avid tech enthusiast and the Head of Marketing at Bitbond. He's been writing about the Bitcoin space since 2015 and has enjoyed every minute of it.

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