A deep dive into the functionality of security tokens and utility tokens

Security tokens and utility tokens both play different roles, though both are enabled and maintained on blockchain technology.

As interest in such tokens – and tokenization in general – increases, we explain the key differences between the functionality and characteristics of security and utility tokens, to help you understand how each of them work.

Tokenization, blockchain, and new ways to invest

A digital token can refer to lots of things, ranging from a cryptocurrency to a stablecoin that is built on a blockchain. A blockchain is an immutable ledger that can hold numerous tokens, which themselves have self-executing smart-contracts to facilitate instant and transparent trades.

The process of “tokenization” – which is essentially the creation of digital iterations of real-world currencies, securities, utilities, and even minerals and precious metals – is taking the crypto world by storm, offering people new ways to trade and invest. 

Two prominent types of tokens have captured the attention in recent times – security tokens and utility tokens. Understanding the functionality of each and the differences between them is key, as they both play different roles in Web3.

What are security tokens?

Security tokens are digital assets that can be traded, much like real-world assets such as stocks and bonds. Securities are subject to strict federal laws and regulations that must be adhered to by everyone involved in the trade.

Security tokens are digital representations of things like stocks, bonds, debentures, and derivatives, and they can be openly traded on digital exchanges for profit.

This type of digital token exists to serve as an investment vehicle for traders. Dividends are issued in the form of coins when the issuing company earns a profit, and holders of these tokens gain a share of the company’s ownership. In other words, it’s very similar to owning real-world stock in a publicly listed company.

To be legally regarded as a security token, a crypto asset must pass the Howey Test, which was determined by the Supreme Court to provide protection following the Securities Act (1933) and the Securities Exchange Act (1934).

Learn more about the Howey Test here.

As a result, security tokens in the United States are regulated by the following:

• Regulation D enables coin offerings to avoid being registered by the SEC, as long as a form has been filled and specific requirements are met.
• Regulation A+ allows the creator to offer SEC-approved security for investments that can reach up to $50 million.
• Regulation S is the regulation required for any non US-based security token.

The different functions & characteristics of security tokens

As a digital representation of ownership or investment in real-world assets, security tokens are valuable. They have the following characteristics:

• Ownership: Essentially, security tokens represent ownership or fractional ownership in an underlying asset, giving owners options like voting rights and profit shares.
• Compliance: As outlined above, security tokens must comply with industry regulations. This protects both issuers and investors.
• Liquidity: Security tokens can be traded on digital exchanges, increasing the liquidity for investors, making it easier to trade.
• Fundraising: Security tokens also offer viable fundraising opportunities for crypto project owners. Security Token Offerings (STOs) are regulated fundraising methods that can help to raise capital for a broad range of Web3 projects.
• Accessibility: One of the best things about security tokens is that they can be traded all around the world. Cross-border transactions are facilitated by blockchain and digital exchanges, removing traditional barriers to entry.

What about utility tokens?

Utility tokens play a different role to security tokens. Primarily, they are used as tokens or coins to access services, products, or features within a blockchain ecosystem.

When a utility token is created by a company, it serves as a digital coupon that can be redeemed in the future for a specific purpose. They are usually created via an Initial Coin Offering (ICO) or a Token Generation Event (TGE) and they have smart contracts that define their roles and characteristics.

As a result, utility tokens are not seen as a viable way to invest in the DeFi space, rather they are a means to access discounts, special features, or certain products and services.

Filecoin is a great example of a utility token and the one that most crypto investors are aware of.

The different functions and characteristics of utility tokens

Utility tokens take their name from the fact that they typically provide access to a product, service, or “utility” within a blockchain ecosystem. Here are some of the main functions and characteristics of utility tokens to be aware of:

• Service access: Utility tokens provide owners with access to a specific product or service within a blockchain platform. These tokens can be redeemed for the product or service in question.
• Token creation: Available via ICOs and TGEs, utility tokens can be purchased by coins like Litecoin, Ethereum, Bitcoin, and others.
• Exchange: Utility tokens are freely traded on token exchanges and their prices fluctuate depending on market prices.
• Community: Some blockchain systems involve utility token holders in polls and community decision making as an extension of their community ownership structure.
• No regulation: Unlike securities, utility tokens are not regulated and they are not tied to real-world assets like stocks and bonds.

The key differences between security tokens and utility tokens

The table below presents the key differences between the functionality of each type of token:

Function/Characteristic	Security Token	Utility Token
Purpose	Provides digital ownership in a real-world asset like stock or bonds	Provides the opportunity to access services, products, or features within a blockchain ecosystem
Reason	Purchased to be traded for profit	Purchased to gain access to something
Regulation	Subject to strict regulation in the United States and other jurisdictions	Not regulated (a gray area does exist, depending on the definition of the token)
Assets	Its value is derived from the real-world asset it represents	Its value is derived from what it grants access to within the ecosystem
Issuance/creation	STOs via regulated processes	ICOs and TGEs

The main challenges facing security & utility tokens

Security tokens face strict regulatory compliance, which isn’t something that crypto investors typically like to see. What’s more, the absence of standardized token frameworks means that the integration of security tokens can be problematic, particularly when numerous platforms take up the token.

As for utility tokens, one of the most significant challenges is that they lack intrinsic value, in that they are specifically for an intended purpose within a blockchain community. What’s more, the regulatory uncertainty can be problematic, and it can often be difficult for creators and investors to acutely define what a utility token actually is.

Final thoughts

Both security and utility tokens play important roles in Web3. Security tokens – like cryptocurrencies and tokenized minerals – offer investment opportunities and typically form part of investors’ diversified portfolios.

On the other hand, utility tokens enable users to access services, products, and features within a blockchain ecosystem, and are not regarded as a viable investment option.

While there are challenges attached to both types of tokens, they are both important and play distinct roles for crypto users and traders.

References

https://www.blockchain-council.org/blockchain/security-tokens-vs-utility-tokens-a-concise-guide