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Security Tokens vs. Utility Tokens : A Concise Guide

There is no doubt that blockchain is causing major 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 to bring about useful 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. In this article, we will delve deeper into the concept of tokens and help you gain a clear picture of security tokens andutility tokens.

Understanding Tokens

In computer security and cryptocurrency, a token may simply refer to any given cryptocurrency token or a token that exists on another cryptocurrency’s blockchain. A token is an asset, utility, or a unit of value that is issued by a company. 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 participations 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.

What Are Utility Tokens?

Utility tokens are user tokens or app coins. This is a token that is given out during crowdsales 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.

Security Tokens Vs. Utility Tokens

Security tokens and utility tokens can be distinguished based on the intended use and functionality of the tokens. 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 on the decision-making process of the company. In short, a cryptocurrency token which passes the Howey Test is deemed as 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 for determining whether certain transactions qualify as “investment contracts.” If so, those transactions are considered securities under the Securities Act of 1933 and 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:

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

2. 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.

3. 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 andutility tokens based on regulations, intended use, and functionality, let us now learn the three other crucial areas of distinction.

1. Purpose

A security token is an investment contract representing the legal ownership of a physical or digital asset that has been verified within the blockchain. Utility tokens help fund ICOs and create an internal economy within the project’s blockchain. The user who holds a utility token will also have certain voting rights within the ecosystem.

2. Expectations

In a security token, the value of the company is directly tied to the company’s valuation. More valuable the company, more valuable the token. In a utility token, there is no relation between the current state of the company’s valuation and the value of the token.

3. Scam Potential

The chances of a scam are infinitesimal in a security token as it is highly regulated. Utility tokens are highly unregulated, and hence, scammers are known to create bogus ICOs and tokens to make quick money.

Conclusion

Hope this article helped you understand the basic differences between a security token and a utility token. We have now learned that one helps incentivize holders to act in a certain way while the other is a contract that represents the legal ownership of an asset. But out of these two,security tokens are considered safer than utility tokens due to the strict regulations imposed upon them.

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