Differences Between Cryptocurrency Utility Tokens And Security Tokens
Utility Tokens and Security Tokens –What the Difference?
Cryptocurrency’s rise in popularity has resulted in higher scrutiny particularly from tax agencies in most countries. This is not surprising seeing as cryptos provided the highest ROI in 2017 than any other asset class since the beginning of recorded history.
As a result of this sudden explosion of wealth and income, tax and regulatory agencies everywhere in the world have taken regulation seriously. To this end, we’ve seen institutions like the SEC and the US Congress scrutinize the asset class to the point of inviting financial experts to congressional hearings.
So, even though cryptos have been declared a complicated area, the good news is the regulation still looks like something that won’t happen anytime soon. However, this doesn’t mean they aren’t seriously considering it, and trying to determine if cryptos –bitcoin in particular- are securities.
The conclusion so far, is that bitcoin isn’t a security, which means the SEC cannot regulate it… for now. The case is different for tokens launched via initial coin offerings. These are generally considered as securities, considering that most of them are purchased by investors in the hopes that they will gain something in return from the company.
Therefore, the SEC is looking to actively regulate tokens that fall under this category. This is why you need to be able to differentiate between utility and security tokens as an investor.
So, even though regulation is still in the distant future, you want to make sure that your tokens do not become subject to regulations when they begin, as the regulation may be on a case by case basis.
With that in mind, let’s quickly examine the two token types and see how they differ from each other.
These are tokens that are released by companies that have an actual use within the company or around it. These tokens provide direct benefits to both its users and the company.
The company often releases them with the intention of claiming them back later –with a decent ROI for the investors of course- or converting them to equities. Utility tokens are generally not considered as investment tokens.
However, investors can decide to buy them and hold on to them for the value appreciation. It’s their personal call. But, from the government’s standpoint, these aren’t considered securities, and will not be subject to regulatory effects.
The best way to really think about utility tokens is to see them as “digital coupons” that investors can trade in later when the company or project becomes profitable. Admittedly, this makes it look like an investment opportunity to investors.
But, the SEC sees them differently, thanks to the Howey Test. This test outlines a yardstick that clearly defines what a security is. According to the test, all instruments that meet the following requirements are considered securities:
- Fiat currency must be used to buy the asset
- Has to be connected to an established business entity
- Must promise some sort of return on investment to investors without requiring them to work for it.
Based on these parameters, you can clearly see that utility tokens don’t fall under the same purview. Sure, you’ll have to spend some fiat currency, but the company never actually promises returns.
This is often implied and dependent on the company to make it a reality. The returns from the purchase and holding of the tokens are actively tied to the token’s growth in value.
Growth in value is often tied to increased demand for the token. So, how much profits investors make will be tied to the company’s efforts in making their token more popular.
While there are many utility tokens in circulation, many of them are actually from ICOs. Some of the more popular ones include Siacoin and Filecoin, both utility tokens for decentralized cloud storage projects, Aworker for an artificial intelligence powered recruitment platform, and Bonpay for a trading platform.
Tokens that pass the Howey Test are categorized as securities and will be subject to the SEC’s regulatory processes. Tokens like this are meant to be traded and strictly designed with the clear intention of making money for the investor.
Companies that issue these tokens often outline decent ROIs as part of its sales and marketing. Whatever the case, if your token falls under this category, then you’ll need to company with all regulations including the paying of taxes.
Security tokens are created by companies across multiple industries, and designed to look like traditional shares declared in IPOs. When the company releases these tokens for sale, they inform the investor of the potential for returns.
This makes them a financial instrument that falls under the purview of traditional financial regulations. A good example of this is Overstock’s upcoming tZERO tokens. Investors in this token can expect to receive dividends from the profits made by the platform.
With Overstock starting this trend, it is believed that companies may soon start doing more ICOs and issue real world shares, while boycotting traditional IPOs. This is not surprising seeing as ICOs are incredibly easy to set up, compared to IPOs that can take months and cost a bit of money.
Even though, ICOs for security tokens are carried out on crypto platforms, companies are advised to do so with government compliance. Some companies that tried that without government compliance have lost their credibility and reputation.
With this clear distinction between these two tokens, investors should not find it as hard clearly differentiating between them and choosing those that suit their needs. And if you’re worried about government crackdowns, don’t.
The government is actually in support of these tokens, although they’d prefer they were regulated. They understand the income potential of these tokens, even if cryptocurrencies as a whole stands against everything the government is.
Investors though, are advised to do their due diligence before investing in any tokens. Make sure they’re run by legitimate hands, experienced teams and individuals who know what they are doing.
Always lookout for transparency, the proof of concept –no matter how small, and an active community. This will help you separate the duds from the real deal.