Even if you are new to the world of cryptocurrency, you may have heard of the various tokens - utility tokens, security tokens, governance tokens, etc. When you don’t know the differences, it can feel like opening a mysterious door that dumps you into a parallel universe where people speak the same language as you, but nothing makes sense.
The purpose of the tokenization series is to chop the knowledge into bite size nuggets. This article focuses on utility tokens and security tokens in crypto. If you don’t know the difference between crypto coins (cryptocurrencies) and tokens, please check out this article.
To understand what a security token is, it is important to understand what a security is.
Security refers to any representation of an ownership position in a publicly traded corporation, or the ownership rights in terms of options. When a security is issued to digitally represent a real tradable asset, it becomes a security token.
Therefore, a security token reflects a stake of business issuing the token, rather than providing a direct value to the investors. It is like holding a share of public company. Most investment in security tokens are profit driven.
Also known as user tokens or app tokens, utility tokens serve a particular purpose. For example, these tokens could be used on an app to gain preferential benefits. Utility tokens don’t provide owners with actual stake, so they are not really meant to be used to gain profit, like security tokens. The investment value of a utility token is proportional to the utility token’s actual demand.
If a utility token is linked to a decentralized application (dApp), the value of the token can increase as the network grows. For example, utility tokens can be used to enable voting rights to token holders, enable token holders to connect the network, or assist in the development of a system-wide internal economy. In some cases, token holders, by staking their tokens in a network, can ensure the right to vote on different decisions regarding the network.
Security tokens vs. utility tokens
The purpose of a token creation can be used to differentiate security tokens from utility tokens. Security tokens are created as profit-driven investments, and represent a stake in a corporation, while utility tokens are created to create an internal economy within the project’s blockchain, and they don’t represent ownership of the project or company.
Another way to differentiate security and utility tokens is to use the Howey Test. If a token qualifies as a security based on the Howey Test, then it classifies as a security token. Otherwise, it is a utility token. Utility tokens simply provide access to a product and/or service.
Determining the value: security token vs. utility token
The value of a security token is directly related to the value of the company issuing it, just like how it works with stocks. The more valuable the company, the more valuable the security token. For utility tokens, on the other hand, there is no direct relationship between the company value and token value. The value of utility tokens is primarily decided by supply and demand.
Who regulates them?
A security token is regulated by law as a security, and the Securities and Exchange Commission (SEC) oversees how securities are regulated. The SEC also has rules on how firms should report their share offerings which also apply to cryptocurrencies and blockchain platforms. On the other hand, utility tokens are largely unregulated. They don’t fall under existing laws and regulations.
With the popular rise of blockchain technology and cryptocurrencies, both utility and security tokens are projected to grow in value over time. With that said, a token can develop over time, which makes it difficult to differentiate between them.
Keep in mind that a security token is a contract that represents the ownership over a legitimate asset, while a utility token is a tool for incentivizing holders to contribute to governance and decision-making within the network.
Read more of our Tokenization 101 series.
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