Brought to you by the Liquid team to help you make sense of crypto.
In crypto, there are two primary tokens: utility tokens and security tokens. What are they and what's the difference?
To get to the bottom of the matter, we first need to understand ICOs.
What is an ICO?
Initial Coin Offerings (ICOs) take their name from Initial Public Offerings (IPOs), the first offering of a company’s stock shares to public owners.
ICOs have the same goal as IPOs: allowing individuals to have ownership of a small portion of an asset – in the case of an ICO, a coin rather than a stock share.
ICOs are often made by new cryptocurrencies offering ownership in the currency to investors.
But they can also be made by non-cryptocurrency companies that are simply offering coins – or tokens – as a form of ownership in a commodity: a piece of real estate, a company and so on.
ICOs allow the owners of those assets to offer a digital token as a small, fractional piece of ownership in the asset. What form that ownership takes – tangible financial ownership or access to service – is the primary difference between utility tokens and security tokens.
- Utility tokens = utility on a platform
- Security tokens = ownership of a commodity or stake in a commodity
Another key difference between utility and security tokens is how they’re regulated.
Because cryptocurrency traditionally has had a decentralized financial model, ownership in coins and currencies hasn’t fallen under the same regulation as, say, owning stock would.
But when a token represents ownership in an asset – crypto or non-crypto – it becomes a regulated asset.
What are utility tokens?
Most ICOs are not selling coins for the purpose of ownership in a commodity. Instead, they want people to show interest in a company without offering monetary ownership in that company.
To do this, they can provide investors utility tokens.
Utility tokens represent access to a service or opportunity a company can provide. Essentially, a utility token is like a voucher. Utility tokens are usually given away in events called TGEs (token generation events) or TDEs (token distribution events).
These are basically ICOs.
Examples of utility token distribution include Golem, which allows users to connect their computer to a specific network, enabling the energy from their combined machines to power a remote supercomputer, Golem.
In exchange for supplying computer power, people earn access to the Golem Network (GNT) – a service, not a currency.
Another example is Filecoin, which raised $257M by selling tokens that allow users access to a cloud storage platform.
Because utility tokens don’t have a specific monetary value outside of speculation and do not represent a specific monetary investment, they are not regulated – particularly in the United States.
Thus they continue the decentralized market model that is a hallmark of cryptocurrency.
What are security tokens?
In contrast to utility tokens, security tokens represent ownership of a digital or liquid contract that is a fraction of an asset that already has value.
That asset could be a piece of real estate, a home a company or something else.
Whatever the asset is, the security token represents a real ownership of the asset – even a non-cryptocurrency asset.
Many companies selling a new cryptocurrency will execute an ICO to disperse coins for the currency and raise its value. But ICOs are not limited to cryptocurrencies. In fact, many security tokens are sold for ownership of non-crypto assets.
Basically, they represent a way that companies call sell stock in a digital form on the cryptocurrency market. An ICO allows for broad ownership of a commodity, and because coins can represent very small monetary value, it makes the investment entry point low – and coin ownership accessible to a wide population.
Security tokens also represent the convergence of the cryptocurrency market with the more traditional financial industry. They provide a bridge for owners of non-cryptocurrency commodities to sell fractions of those assets to people who want to diversify their cryptocurrency portfolio.
Security coins represent a specific investment, so they are regulated in the United States by the SEC.
What are equity tokens?
A third type of token is the equity token.
Equity tokens are an application of Ethereum-based smart contracts, which allow startups to offer stock in their companies in the form of tokens. Like security tokens, equity tokens divide an asset up into small parts, so they can be beneficial to investors, as they allow investing in a specific company for far less than an individual stock.
Equity tokens have the added benefit of creating community oversight over the start-up, as holders of equity tokens can conduct transparent voting through the blockchain.
For the most part, there is a lack of regulation around equity tokens, so many start-ups are reluctant to issue stock in this form.
Recently, though, Delaware updated its law to allow reporting shareholders’ names on a blockchain, thus creating transparency of ownership and increasing the likelihood that these emerging tokens can take a more prominent role in the crypto community.
So there we have it. Three different types of token.
The choice to use utility tokens, security tokens or equity tokens is dependent on how a company wants to disperse equity in their organization or asset, or offer access to a valuable service, but the decision also depends on their desire to manage regulations.
In the United States, cryptocurrencies are regulated by the SEC. The laws that control them go all the way back to a 1946 in a case called SEC v. Howey, which led to the creation of the Howey test
The Howey test is:
a series of questions that define criteria for whether the investment contract is subject to regulations.
A transaction is considered a security if all of the following requirements are met:
1. There is an investment of money
2. There is expectation of profit
3. The investment of money is in a common enterprise
4. Profit comes from the efforts of a promoter or third party
Because utility tokens provide access to a service rather than a specific investment in an asset, they are generally not regulated.
On the other hand, equity tokens are regulated because they represent a clear investment in a tangible commodity.
The fact that they usually represent an ownership stake in a non-crypto asset is an additional requirement for why they need to be regulated.
As the number of cryptocurrencies grow and investors, business owners and others in possession of commodities want to allow people who own cryptocurrencies to buy their assets, tokens will likely play an increasingly important role in the crypto marketplace.
It is also likely that other forms of tokens representing new ownership opportunities or service access will evolve.
In the meantime, utility, security and equity tokens offer a variety of ways for individuals in the crypto marketplace to own assets, diversify their portfolio and access valuable services.
WRITTEN BYMatt Crook
Marketing Operations Manager for Liquid. Still holding QASH.