Utility tokens: definition, difference from security tokens, and why this matters to regulators like the SEC

Token or coin: learn the difference

Utility token vs. security token

What is a utility token?

  • access to the platform and its services;
  • the right to vote on technical improvements and upgrades;
  • access to member-only features;
  • possibility to pay for items and services on the platform;
  • loyalty rewards, etc.

What is a security token?

  • a right to a share in the project’s profits;
  • an ownership stake in the project or an asset;
  • a right to receive dividends or fixed income.

The Howey Test

  1. an investment of money (can also mean ‘assets’, such as cryptocurrency)
  2. in a common enterprise
  3. with an expectation of earning a profit
  4. the profit being a result of the efforts of a third party.

Applying the Howey Test to blockchain tokens

  • an IDO participant invests digital currency (USDT, ETH, etc.)
  • in a common enterprise — a blockchain platform that hasn’t been built yet;
  • expecting that the price of the token will go up in the future, so that they can sell higher than the IDO price;
  • and that price increase will result from the project team’s hard work (development, marketing, partnerships etc.).

Possible courses of action for projects

1) Exclude US investors from the token sale

Case in point: Polkastarter

Some of the projects featured on Polkastarter

2) Build a platform first, distribute tokens later

Case in Point: TON

3) Design a real utility token

Case in point: Turnkey Jet

4) Issue a stablecoin instead of a regular token

Case in point: Diem

5) Register the token with the SEC

  • Reg D only allows projects to raise funds from accredited US investors, and it’s the issuer’s job to verify that each investor is accredited; by contrast, Reg A+ gives the right to attract money from both qualified and unqualified investors;
  • A Reg D offering is not capped, while Reg A+ allows one to raise up to $50M;
  • With Reg A+,the tokens can be immediately resold in the secondary market; Reg D has a lock-up period of one year;
  • Reg A+ security can be listed on NASDAQ or NYSE, while those registered under Reg D are considered private securities.

Case in point: YouNow

Summary

  • A coin runs on its own blockchain, while a token is launched on an existing chain; some coins and tokens are designed primarily to act as currencies, while others offer utility of other types;
  • Utility tokens provide value within their specific ecosystem: access to services, voting, loyalty rewards, etc.
  • Security tokens are investment contracts that entitle holders to a stake in the project, a share in the profits, dividend income, etc.
  • Most popular tokens (DOT, MATIC, UNI, LINK etc.) can be considered utility tokens under this classification
  • The Howie Test defines a security contract as investment of money into a common enterprise with the goal of extracting profit, and that profit should result from the efforts of others;
  • Under the criteria of the Howie Test, most tokens sold at IEOs and IDOs can be seen as securities, since many people buy them in order to re-sell later for a profit;
  • The SEC (Securities and Exchange Commission) often attacks initial token offerings on these grounds and even managed to block some major ones, including Telegram’s TON;
  • There is no bulletproof way to avoid issues with the SEC, apart from registering a token as a security.

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