There is a lot of different terminology associated with the world of cryptocurrency. It can be confusing for those who are new to the sector and there is even a lot of debate from experienced people in the cryptocurrency space about the exact definition of certain terminology.
One of the areas of confusion is in relation to tokens. You will hear a lot about utility tokens and security tokens, however you may not really know what they mean.
This article aims to bring you more clarity on the subject.
What is a token?
A token represents something in a given ecosystem. It might represent some form of value, the right to a vote or a stake in a given project. There is no strict definition of what a token can be.
In terms of cryptocurrency, there is a key difference between a token and a cryptocurrency coin.
Cryptocurrency Coin
This is a coin such as Bitcoin which can be used independently of the given platform. You are able to use these coins like currency without needing to use it as part of its native platform. This is what most people refer to as cryptocurrencies.
Token
Tokens exist solely on a given platform, such as Golem on the Ethereum platform. This token is a representative of the utility or security of a given platform/company. The origination of utility tokens is mostly through initial coin offerings (ICOs).
ICOs are akin to initial public offerings (IPOs) where a company going public issues their company stock for the public to purchase in return for a stake in their company. It is through a Security Token Offering (STO) that a security token originates.
Types of Tokens
In order to get a grasp on the nascent sector that is the cryptocurrency space, the likes of the United States Securities Exchange and Commission have given two broad categories to tokens. These are security tokens and utility tokens.
Utility tokens
Partaking in ICOs is usually seen as an investment in the given company. Therefore, the majority of tokens issued through these offerings will be security tokens. However, there is a test known as the Howey test that determines if a given ICO token qualifies as a security token or not.
If it does not qualify as per this test, then it is a utility token. Such tokens give the holder some service or product.
Usually utility tokens will give the holder the ability to use an associated network. Otherwise, the token provides them with a share to place a vote in a given network.
Utility tokens have been very popular since the explosion in popularity in ICOs during 2017. Firms behind these ICOs were issuing these utility tokens in order to raise funds for their operations.
As well as raising money, they can also be used for creating an economy within a given system. Some utility tokens also allow you to vote on certain key issues that dictate the future direction of a given network or platform.
The most well-known utility token is the Ethereum ERC20 standard. This has been the basis for the creation of countless tokens, which in turn often end up holding their own ICO.
Security tokens
Those tokens which are approved through the Howey test are known as security tokens. Usually, these tokens have value because of some underlying asset that can be traded. As a security, these tokens need to adhere to securities rules and regulations like traditional investments.
Essentially, if there exists a profit expectation from holding the token, it is a security. It is an investment contract which represents your state in some asset, such as a share of a company or in real estate for example.
The blockchain is used to verify who owns security tokens. After the verification process is complete, you can trade these tokens, use them as loan collateral or keep them in storage in an external wallet.
Howey Test
The Howey Test has been in existence since 1946. This test was developed following a Supreme Court Case involving a corporate defendant and the SEC. The basis of this case was about the creation of some form of test that could determine if a given arrangement is deemed to be an investment contract.
Therefore, a transaction is seen to be an investment contract if it is a monetary investment, it is a common enterprise investment, and there is a profit expectation. A common enterprise is usually defined as being something in which investors will put their assets together (such as money) in order to make an investment.
Therefore, if a token adheres to those three criteria, then you need to deal with it as a security.
Debate about token classification
With the cryptocurrency space still being so new, there have been a lot of teething problems both the authorities and stakeholders have to deal with. One of the big issues is deciding whether a token is a utility token or a security token.
A lot of ICOs see their offering as being a utility token, but for the most part, the authorities class ICO tokens as being security tokens. Therefore, if a company fails to adhere to the relevant securities laws, they will be hit with stiff penalties and other measures which could jeopardize their project.
While there are too many ICOs out there to properly check if each one can be classified as a security token, the SEC has pinpointed a number of high-profile ICOs and come down hard on them. As per the SEC Chairman Jay Clayton: “I believe every ICO I’ve seen is a security.”
The difference between a utility token and a security token is still a debate that is raging on across the world.
Regulatory bodies are trying to keep up with this nascent sector and implement a sturdy framework, but they need to fundamentally answer this question, as it is at the core of the sector.