Ambo Learn: Utility tokens and securities
A deep dive into utility tokens versus securities.
*All legal language is meant for the United States. Prior to making an investment, make sure to do your own research*
Digital tokens in the Ethereum ecosystem fall into two main categories: utility and security. These two types have extremely different use cases, and the projects behind them are subject to different governmental regulations.
Utility Tokens must meet the following criteria:
- Uniformity, as all tokens can be swapped with other ERC20 tokens
- They must give token holders the right to use the protocol.
Utility Tokens can also:
- Provide voting power to token holders
- Build an internal economy built on Ethereum
Essentially utility tokens are the easiest to develop and require less regulatory approval since they are meant to be used to interact with a decentralized protocol and not for investment purposes. For example, the 0x token, ZRX, can be used to vote for future developments of the protocol by staking a portion of tokens you may own.
Security tokens can allow:
- Trading with other types of assets
- Collateral for loans
- Investments for turning a profit
Security tokens are fully regulated and provide investors with a tool very similar to traditional financial products, such as loans and tradable assets.
Utility tokens became prevalent during the ICO mania, which we briefly discussed here and will cover more in-depth in a later article. This period began in 2017 when developers began releasing tokens to the public as a method of crowdsourcing capital. Instead of going through the traditional fundraising process, companies conducting an ICO release shares of their project in the form of digital tokens (ERC20 tokens) that can be held or traded across the Ethereum blockchain. ICOs are intended to work seamlessly. For example: Jack sends ETH to a crowd-sale address and then, if it is valid, the project will send Jack the equivalent amount in their tokens.
How is a token deemed either a utility or security token?
The United States Supreme Court developed a test to determine how securities are recognized. This is called the Howey Test, and it is used to determine whether a token was being used for speculative purposes or for fundraising and supporting the project. If a token is deemed a security, it then has to follow many regulatory guidelines in order to not be considered illegal, while a utility token does not require these extra steps and can be bought by anyone.
If you are still confused about tokens, make sure to read the Ambo Learn article that took a deep dive on tokens and how they power the Ethereum economy.
