Security Tokens vs Utility Tokens
It is unlikely that Bitcoin will ever be classed as a security as no project team has ever promised investor profits. Though Ethereum’s case is more complex, ether has utility, and ETH holders don’t expect Vitalik Buterin to generate a profit for them. However, a haze rolls over the landscape when one tries to separate other tokens listed on CoinMarketCap into two neat piles of ‘utility’ and ‘security’ tokens. There is a blurred line drawn in shifting sands between tokens that provide access to product or service vs those that bestow a vested interest in an enterprise or asset set.
How are they the same?
- Both types of tokens can increase or decrease in value depending on market demand.
- Both ICOs and STOs are the crowdfunding successors to Kickstarter, Indiegogo, GoFundMe, and similar platforms.
- Many utility tokens are stealthily promoted as an investment that likely increases markedly in value, whereas security tokens promoted unambiguously as the same thing.
- Utility and security tokens are not cryptocurrencies. Cryptocurrencies can be used to buy or sell almost anything, as proven by the defunct Silk Road website and many sites now on the Dark Web. Neither utility nor security tokens are designed primarily for use in commerce in any direct sort of manner like buying and selling of external products and services.
How are they different?
- “Wild West” investment token offering and trading environments that are prone to extreme price volatility, cyber-attacks, and outright fraud.
- Token grants its holder access to the ICO issuing company’s products or services, i.e., access to a “utility” that is a tangible benefit in the form of a product or service distributed on the blockchain. For example, access to cloud storage now or in the future.
- ICO often act as a launchpad for an idea or the expansion of a business with no MVP (minimally viable product) or substantively demonstrated user acquisition trajectory, often with moving goalposts that require recalibration of business plan strategy and tactics.
- Unregulated crowdfunding model and mechanism vulnerable to speculative bubble formation, cyber-attacks, and pump & dump schemes.
- ICO raises funds which will be partially converted to fiat cash to be subsequently spent on project development.
- Tokens move as quickly as possible to a public exchange.
- 4 out of 5 ICOs now fail to reach soft cap.
- Most utility tokens are built on the Ethereum ERC-20 technical standard, while some special case projects use a purpose-built or custom blockchain platform.
- “Button-down and staid” investment environment.
- Recognition by investors that a security token buy is an investment in the company issuing it, chiefly one that will pay off at some point in the future on a public or private security token exchange, OTC, brokerage, peer-to-peer trading platform, or token issuer buyback.
- Crowd long-term-investing model and mechanism resistant to token value volatility, speculative bubble formation, cyber-attacks, and pump & dump schemes.
- Project stability with clearly-defined and unwavering mission goals built around a business modeling focused on scalability.
- A security token need not grant access to utility functionality as it can be offered purely as an investment.
- Enhanced potential for high success rate as defined by achievement of soft cap goal.
- May act as an equity funding vehicle for a startup that owns an MVP and has a strong business plan for scaling the MVP to the maximum potential provided by the associated marketplace.
- May act as an equity-derived funding vehicle or asset liquidation mechanism for any of several types of assets held by an established enterprise, be it equity held by a VC fund in early-stage companies, real estate equity held by a REIT, equity in a company’s holdings of precious metals or other commodities, or a tokenized stake in a company’s illiquid asset holdings such as art or fine wine. So the token represents a unit of ownership or stock in the company that issued it, in which case it may be termed an “equity token”.
- Freshly minted tokens are available for purchase only to accredited and institutional investors.
- Regulated with strict KYC/AML compliance and vesting period requirements.
- Security tokens are built on the Ethereum ERC-20, Polymath, Hyperledger, Harbor, or another technical standard or proprietary platform.
Someone with a background in cryptocurrency and utility token investing may see security tokens as an investment vehicle with enhanced protection against fraud and hacks. A traditional private equity investment firm may see security tokens as a fast, cost-efficient, and KYC/AML-compliant investment vehicle by which to liquidate and sell units of equity that it owns in various early to mid-stage enterprises.
Up until 2016, governing and regulatory bodies around the world mostly ignored ICOs. That changed with the collapse of the value of the Ethereum token (ether or ETH) that same year. The $150 million raised by the Ethereum-based DAO (Decentralized Autonomous Organization) ICO made it the largest crowdfunded project in history. Hackers then stole $50 million worth of ether from DAO token holders, precipitating an ETH price drop of almost 50%. This event caught the attention of securities regulators around the world. None of them had any idea of how to go about regulating this seemingly new form of security innocuously called a ‘utility token’. However, many securities regulators endeavoured to examine how to apply the fundamental principles of securities law to at least some of the paradigm-shifting utility tokens and cryptocurrencies.
The U.S Security and Exchange Commission (SEC) categorises a contract as an investment contract, and, therefore a security, when it meets these four conditions:
- There is an investment of money.
- There is an expectation of profits.
- The money raised is used to fund a common enterprise among all participant in the arrangement.
- Any profit paid out to those participants providing the funding comes from the efforts of the enterprise’s owner, or its promoter or other third party.
It is immaterial whether there is a sale of property with or without intrinsic value, or if the funded enterprise is speculative or non-speculative. If participants who are providing the funding plan to profit from the efforts of someone else, they are buying a security.
The SEC released a statement saying that some ICOs appeared to be ‘virtual organizations or capital raising entities that use distributed ledger or blockchain technology to facilitate capital raising and/or investment and the related offer and sale of securities’. The statement continues, ‘the automation of certain functions through this technology, “smart contracts,” or computer code, does not remove conduct from the purview of the U.S. federal securities laws’. From that point on, cryptocurrencies no longer existed in some unregulated never-never land, but, instead, in a legal grey area no longer outside the purview of governing bodies and securities regulators.
Some tokens, namely those offering investors the benefits of access to a service or product augmented with profits in some way generated from the work of others, are much more apt to being classed as securities than others. For example, a utility token ICO issuer that promises space on a forthcoming or nascent cloud storage platform, and, oh, by the way, a share of profits from that cloud storage platform as it scales, has likely crossed the line over to the issuance of a security token. The work of the project’s developers is essential to the full benefits to be derived from the purchase of the token. This scenario meets the conditions of the famous SEC Howey Test for determining a business arrangement to be an investment contract, and, therefore, a security offering. The astute observer will quickly draw a direct line between the work of a token project’s developers and the activity of the Howey Company in tending and harvesting the orange groves.
Hardship or Opportunity – Is Regulation Bad for Crypto?
ICOs still want to dodge regulatory scrutiny. There are now consultants that specialise in advising companies on how to elude or fend off regulatory oversight. This intent is, of course, driven by a desire to avoid security classification and the inherent risk of legal consequences, including fines or prosecution stemming from the many ways that a security may be deemed as non-compliant. Moreover, for some crypto purists, there is an even larger issue at stake: government regulation, they contend, runs counter to the economic theory and philosophy that underpins the genesis of the first cryptocurrencies and utility token projects. Beyond that, there are many utility token nouveau riche with a vested interest in maintaining the status quo as a means of capitalising on speculative bubbles, whale-trading market manipulation, and pump & dump.
Whilst some less-than-honest players in the ICO space try to circumnavigate regulatory oversight, there is a counterbalancing shift occurring amongst players in the more traditional investment space. Yes, there are still ways to dodge regulatory compliance, but ICO Malta is entirely onboard with full transparency and regulation in alliance with all applicable EU regulatory oversight. After all, equity distribution via smart contracts on the blockchain, instead of via traditional VC limited partnership contracts, may likely increase the value of an underlying portfolio and pay back more profit to investors due to these factors and others:
- unlocking of illiquidity that actualises liquidity premiums in place of illiquidity discounts
- correlated increase in market depth via the opening up of new capital to global assets markets
- 24/7 trading with asset interoperability
- automated external compliance and internal governance processes that are less costly and more easily implemented cross-border
Corporate giants are moving into the space with sandbox trialing of security token trading platforms. Once these live-launch, they will offer institutional investors a relatively familiar and comfortable regulated walled garden in which to invest in STOs and other DLT ventures. These platforms should be hack-resistant if for no other reason than stolen tokens will be recoverable, though regulatorily-accredited blacklisting and regulatorily-sanctioned audit reporting will also help a lot. These new token trading platforms may attract a vast amount of institutional capital with the promise of the processing speed and high returns commonly associated with utility tokens and cryptocurrencies, sans the risk and uncertainty.
Companies have been selling shares of stock for hundreds of years. Traditional stock exchanges around the world typically require 2-4 days to clear purchases. The application of blockchain technology to stock trading could reduce wait time to an hour or less.
For some, the crowd mentality dynamics and the ability to complete transactions in minutes may be a synergistically pivotal operational development, whereas for others it may have little impact on the viability of investment strategies that typically take years to develop, although hedge and venture capital funds seem to be a strong presence among STO early-adopters.
The tokenisation of equity appears to be the next far-reaching permutation in blockchain technology use case evolution. There may be a gravy train awaiting boarding by whoever builds the dominant system for the exchange of security tokens. There is something akin to $25 trillion in tangible assets in the world. Providing liquidity and ease of commerce to these assets, and, thus, connecting much of the world’s previously illiquid equity to consumer investors through the blockchain could transform financial markets around the world.
While at present no one knows where the future of security tokens lies, those who are bullish on the security token phenomenon believe that STOs combine the best aspects of ICOs and traditional investment vehicles and mechanisms. The functionalities and operational efficiencies native to security tokens are motivating more and more smart money to bet on securities tokenisation and the phenomena developing around it. Security tokens are here to stay and the future that does appear very bright indeed.