To Be or Not to Be a Utility or a Security Token: That is the Question

Navigating the Token Minefield

2017 was a crazy year in cryptocurrency with digital tokens raising an estimated 5.6 billion dollars. The majority of tokens released in 2017 claimed to be utility tokens to avoid any friction with the SEC but in fact were actually security tokens.

What is the difference between the two tokens plus what are the other variations of the two?

“Implementation bar is higher for Utility tokens than Security tokens. You can hire lawyers and go the Security route, but you can’t hire users to get to Utility. You need to earn them and keep them. The Security token test is a legal one. The Utility token test is market-driven.” William Mougayar, @wmougayar

Token Types

The SEC, the U.S. Securities and Exchange Commission, classifies cryptocurrency tokens into two categories — utility tokens and security tokens.

Utility Tokens

Utility tokens are also named as app tokens or user tokens. These tokens are majorly issued by the companies to fund the development of their project, against the services or product they are offering. The value of a utility token is measured against the future utilization value of their concept. Utility tokens are more specific to the platform/ecosystem for which they are developed for. Value of these tokens is directly proportional to the activity of the participants inside the platform/ecosystem. These tokens are further decomposed in two types: Use of Product and Reward Tokens.

Use of Product or Service

Utility tokens can be offered against the use of product or service. In general terms these token generation events are used somewhat like pre-orders of any upcoming product or service. Once the project is completed, token holders can use their tokens to make purchases of that product or service.

For example early participation discounts offered by several mobile or web applications.

Reward Token

These types of utility tokens are issued when a token holder or a user maintains the relationship with the company for a specific period of time. The reputation he or she builds with the respective organization (over blockchain network) could be rewarded as reward tokens. The loyalty points could allow customers special access to new products and services, used to get discounts on future purchases or even receive free merchandise.

For example reward gamers for being influencers — building large followings and bringing more customers to gaming companies.

Pros and Cons of Utility Tokens:

Pros

· The fixed no of tokens may lead to growth in the value over time as the demand for product/service increases[1]

· These tokens can easily traded on exchange and hence are based on the law of supply and demand[2]

· It gives the user an access to a product or a service provided by a company

· Users may get voting and participation rights[3]

Cons

· Not under any federal/state law or regulations

· SEC has not given official guidance on utility tokens

· Fraud, cyber-attacks, price volatility are the major risks[4]

Security Tokens

Security tokens are generally backed by a real asset such as equity, shares of a limited partnership company, or commodities. Security tokens holders can be granted ownership rights or shares of the company. Security tokens have been evolved to empower traditional initial public offerings (IPOs) on top of blockchain technology. Security tokens are also subject to federal regulation.

Security tokens are used to pay dividends, share profits, pay interest or invest in other tokens or assets to generate profits for the token holders. These are tradable financial instruments with monetary value. Public Equity, Private Equity, Real Estate, Managed Funds, Exchange Traded Funds, Bonds are the common examples of security tokens. These tokens are further decomposed in two types: Equity tokens and Asset tokens.

Equity Tokens

Equity tokens are currently the most prominent example of security tokens — it represents ownership an asset, such as debt or company stock. Equity tokens enable the startup to raise funds using a token generation event (TGE) over a traditional initial public offering (IPO). It removes the barrier for an average investor or a startup entering into financial markets.

Asset Tokens

Asset baked tokens are another type of security tokens. These tokens are typically linked with a real-world assets for example - real estate property or gold. Through the mechanism of tokenization the investors can invest in a small part of the asset rather than investing in it as a whole.

Pros and Cons of Security Tokens

Pros

· Federal law compliant security tokens are cheaper to run than IPOs[5]

· Bridge between the traditional finance sector and blockchain[6]

· Reduced legal risk

· Barrier to entry into the financial markets is much lower

· Potential to deliver better returns

Cons

· Non Compliance of federal regulations can result in penalties and could even derail the project

· Trading restrictions

· Marketing limitations due to target market is to certified investors

Is 2018 the Year of the Security Token?

As many startups try to navigate the security/utility token Labyrinth many industry people believe the security token route is the safest and clearest way to go.

Generally, security tokens are issued under Regulation D, Regulation S, Regulation A+, and Regulation Crowdfunding. These regulations make the security tokens, much faster and cheaper then conducting an Initial Coin Offerings (ICO); moreover, these regulations provide some legal protection as well as a level of security to the investors.

Security tokens, registered with the Securities and Exchange Commission (SEC), obtain a wealth of legal precedents that highlights token buyer rights, protections and expectations. The issuing organizations are bound by federal law to make it more transparent with buyers about token economics and how they intend to increase token value.

There is a lot of benefit in merging current stock/financial markets with the crypto world via security tokens including increased liquidity as tokens can be sold and traded internationally and projects can attract a larger pool of investors globally.

Marketing Differences — Utility & Security Tokens

If your token is truly a ‘utility’; your marketing strategy would focus on targeting the end user for your product or service. You would be targeting a large group of purchasers (for the most part) with a low barrier to entry (lower minimum purchase).

The marketing strategy for a ‘security’ token looks quite different from a strategy for a ‘utility’ token. If you are offering a security token you would be targeting accredited investors that can demonstrate an annual income of $200,000 or $300,000 over the last two years and have a net worth exceeding $1,000,000 (not including the worth of his or her primary residence). This person is a very different demographic than perhaps, a gamer that is willing to purchase your token for use of your gaming platform (utility token).

If you are planning to launch an ICO/Crowdsale campaign your token structure and the legal issues surrounding that structure are important to have figured out right from the beginning. Your marketing strategy, the countries you can sell in, the country you register the company in, etc, are all affected by your token structure. I have seen a lot of hard work go down the drain due to legal issues that company founders thought would work themselves out. They didn’t.

Side note: The Swiss Financial Market Supervisory Authority (FINMA) divides tokens into three classifications: utility tokens, payment tokens, and asset tokens.

Payment Tokens

Payment tokens refer to cryptocurrencies that are solely used now, or in the future, as a means of payment for goods or services, or as a means of money or value transfer (like Bitcoin).
 
 The SEC Securities and Exchange Commission has publicly stated that Ether and Bitcoin should not be regulated as securities as they are payment systems.

Payment tokens refer to cryptocurrencies that are solely used now, or in the future, as a means of payment for goods or services, or as a means of money or value transfer (like Bitcoin).
 
 The SEC Securities and Exchange Commission has publicly stated that Ether and Bitcoin should not be regulated as securities as they are payment systems.

Audrey Nesbitt

SpinSpirational Marketing & PR

Audrey Nesbitt on Linkedin

@AudreyNesbitt11 on Twitter

[1] https://medium.com/monetizr/security-tokens-advantages-of-the-investment-132053e3f27d

[2] https://medium.com/@straightofftheledger/cryptocurrency-icos-utility-tokens-vs-security-tokens-2d16041717f0

[3] https://decent.ch/blog/Utility-vs-security-what-you-need-to-know/

https://www.ccn.com/fundamental-principles-utility-tokens-blockchain-ecosystem/

[4] https://medium.com/monetizr/security-tokens-advantages-of-the-investment-132053e3f27d

[5] https://medium.com/@argongroup/8-important-things-to-know-about-security-tokens-token-regulation-3d548a1a6367

[6] https://www.investopedia.com/tech/2018-year-security-token/