The world of cryptocurrencies can be overwhelming for a beginner. There are a lot of new concepts and subtle differences to learn, including the difference between utility tokens vs security tokens. These two asset types form the base for the economy of most crypto projects. Read on to understand what they are and how they differ from one another.
First and foremost we need to understand the general concept of tokens. In the most global scope, the definition of a token is an imaginary or a real unit that represents some form of value or right within its environment. Tokens as economy units are used by companies to power loyalty programsю while in programming they are used to indicate a right to perform an action.
So are tokens the same as cryptocurrency coins? Well, not exactly.
Like crypto, tokens have value and they can be exchanged and sent. But unlike coins, they represent a utility or security of a company that issued them and can be used in their native project. Cryptocurrency coins, on the other hand, are used strictly for value exchange over a decentralized network.
If you want more about cryptocurrency, check out our comprehensive cryptocurrency guide.
So why do companies even bother to create tokens?
The answer is universal in almost all cases — to exchange them for other valuables during a crowdfunding stage and subsequently provide an incentive for certain actions on their platform, creating a mini-economy bound to the constraints of one project.
These kinds of crowd fundings are called ICOs.
ICOs are essentially instances of crowdfunding in the cryptocurrency world that allow investors to fund projects with crypto coins.
A company promises to use the funds it gains from investors to launch or develop it’s idea and investors obtain the chance to profit from the value growth of received coins.
ICOs became a world-wide phenomenon in 2017 when 30% of seed-stage funding worldwide was completed via Initial Coin Offerings. Some projects actually raised thousands of millions. For example, Filecoin raised $257 Million in the largest ICO of 2017.
Due to the fact that most tokens, just like any crypto, are quite unstable and dynamic by nature, some ICOs brought investors hundreds of thousands of percents of profit like Spectrecoin ICO which was held from November 18th, 2016 to January 6th, 2017 and generated 149,806 percent profit of for investors!
Interested to learn more about ICOs? Consider reading our comprehensive ICO guide.
Now that we understand why Initial Coin Offerings became such a large phenomenon in the crypto world let’s talk about some of the processes behind them.
Firstly, a company issues a limited amount of coins and sets goals. Most ICOs have a soft cap and a hard cap. Upon reaching a soft cap indicated by a certain amount of sold coins, ICO is considered a success, but it continues until a set date. If ICO reaches a hard cap it means that all supply of coins was sold and the sale ends right there.
So why limit the number the coin supply?
It allows a company to create value. The initial value of a coin is set by the company and it can be fixed or dynamic. After the end of the ICO, the market value is determined and this is where the price can either freeze, skyrocket or completely diminish.
You may ask, but how do I participate in an ICO? Is there some kind of a contract?
The answer is yes, there is. A smart contract, in fact. Investors send their cryptocurrency to a specific address and receive coins in exchange automatically. These coins are created by a smart contract which is just a program designed to issue coins when certain conditions are meant.
If ICO does not reach a soft cap then all funds are automatically distributed back to investors, so the process is entirely trustless.
STOs or Security Token Offerings work largely the same as ICOs, however, as evident from their name, investors purchase securities rather than utilities.
Although STOs are very similar to ICOs, governments heavily regulate STOs and they aren’t accessible to all companies and investors.
Before we look at the actual differences between security and utility tokens, let’s understand why do they even become valuable in the first place? In summary, utilities gain value because they give privileges to the holder.
These privileges contribute to the growth of the demand. Remember that companies create only a limited number of coins during an ICO? Where demand is greater than supply value is created. This is the same rule that allows companies like Supreme to sell relatively inexpensive to produce items for thousands of dollars.
There are specific factors that contribute to higher demand. Let’s look at them in more detail.
When it comes to securities the mechanism is very different.
Unlike utilities, they must be backed by real assets that directly correlate with the price. As such, if a company does well and makes a profit, the price of the coins will go up. If a company that issued the security coins is doing bad, the price will go down.
Now that we understand the mechanics behind tokens in general and the reasons for their creation, let’s talk about the actual token classes and their differences.
All tokens that exist on the market fall into two major groups: utility and security. SEC and FINMA define use those groups to tell whether purchasing a coin can be considered an investment or not.
In essence, these assets represent a right to use a service or product created by the company. They play a certain role in the ecosystem of a company that issued the token and have practical applications. For example, paying a fee for transactions in a network. They also play a vital role in creating an economy within a company’s product.
There is no doubt that utility tokens are the most popular asset class in the cryptocurrency world and we have the 2017 ICO boom to thank for it. Most of the utility tokens exist on the Ethereum blockchain and use an ERC20 standard. This enables the developers to create compatibility with most major exchanges and wallets as well as issue tokens using almost a pre-made smart contract.
Multiple reasons make utility tokens so widely adopted by companies and teams of all sizes and backgrounds. They have several distinct advantages.
Unfortunately, as much as we would like to say that utility tokens are a perfect asset class — they are not. They have some very serious disadvantages. Let’s take a look at the flip side of the coin. Pun intended.
Now that we understand utility tokens in more depth, let’s take a look at some famous examples in this asset type.
Finally, we’ve made it to the section about the security tokens. These are indeed a very special asset class with a lot of potentials. This is what we’ve learned so far.
Security is an asset that promises to deliver profit to investors by the means of work or advertising done exclusively by a third party.
Also, security tokens are usually backed by assets, so they derive their value from the real world rather than from the supply vs demand equation, which makes them more stable than utility tokens.
Companies that sell securities must adhere to SEC regulations very strictly and have to operate under a lot of scrutinies. If they fail to comply they can be subject to penalties and can even be shut down for good.
This is because a security token is, in essence, an investment contract and has legal power. However, it is one that must be confirmed by the blockchain.
It is the “confirmation in the blockchain” part that makes security tokens so special. Let’s take a look at the following example: imagine that 100 people decide to buy a house together. In theory, it is possible to issue any number of coins that represent shares of ownership for this house. Each person can then own a number of these shares, freely trade them, store them in digital wallets or even exchange them!
Imagine that you could go to a Starbucks and buy coffee with a part of your house! It sounds crazy, but in the future, it might be possible.
In summary, security tokens have the power to transform the economy and the concept of ownership as we understand it today.
This asset class has several distinct advantages over utility tokens that makes securities a better investment option in a lot of cases.
However, despite being such a transformative asset class that is rising in popularity with more and more Security Token Offerings appearing on the market, they do have some distinct disadvantages.
Now that we understand what a security token is, let’s take a look at the list of tokens that are currently available on the market.
Regulators commonly use something called the Howey Test to determine whether they are dealing with a utility or a security. The test is based on a Supreme Court case SEC vs Howey which created the basis for establishing if an arrangement involves an investment contract. You too can use this case to classify a token.
According to the Howey test, to classify as a security an asset must:
Since utility tokens pretty much fall under the first two parameters anyway, most ICO companies nowadays will try to avoid mentioning anything even remotely related to future profits.
We hope that this article helped you to understand the differences between the two asset classes. As always, there are multiple sides to the argument. Some will say that security coins are better because they strike a good balance between regulation and innovative potential. Others will argue that utilities are the way to go because they stay true to the original idea of cryptocurrency and give owners more freedom and anonymity.
And others will even add that neither securities nor utilities should exist. After all, in their opinion, the real future is behind original cryptocurrencies such as Bitcoin.
In any case, it is safe to say that we are living in very exciting times! Don’t know about you, but we can’t wait to find out what awaits us!