Different types of crypto tokens: Security versus utility

Different cryptos deliver different returns, and levels of risk, for investors

An imagined security token offering graphic                                 
Security and utility tokens are not the same as cryptocurrencies – Photo: Shutterstock
                                

There are many different types of crypto tokens out in the marketplace, making it even harder to navigate this complicated industry. Here we explain what distinguishes a security token from a utility token and offer clear, simple definitions of other types of tokens you might come across.

What is a security token?

The humble security token has been getting a lot of good press recently and some believe it has the potential to propel the financial world into the future.

Security tokens can be compared to shares, given how they often reflect an ownership stake in the company that issued them via a security token offering (STO). Some investors have greater levels of confidence in security tokens because they are subject to stricter regulations in countries like the US.

Security tokens can also be used to denote ownership of other assets in practically everything from bonds to real estate and artwork to fine wines.

Supporters believe that in the coming years, financial institutions are going to embark on a tokenisation spree. That would mean anything with value can be represented digitally and traded on blockchain.

As well as delivering immediacy and reducing paperwork, this could help democratise investments and open up opportunities to more people. Advocates also say this technology could make listing on the stockmarket a lot less expensive.

How does a security token work?

It all starts with the company issuing the security tokens. To ensure they remain compliant with regulatory requirements, they will need to create a ‘white list’ to ensure that investors are accredited, verified and not running foul of anti-money laundering laws. These restrictions help reduce the chance that a token will be deemed illegal in most jurisdictions.

If you’re ever unsure about how to distinguish between types of tokens, it’s worth remembering the good old ‘Howey test’, which is named after a notorious 1946 case in the US. This offers a simple four-point checklist. If the answer is “yes” to each, it should be classified as a security token. The four-step test is whether: the token is a financial investment; the investment is going to a company; the investor expecting to make a profit by purchasing it; and any profit is being generated by third parties.

Security token: Advantages and disadvantages

So, what are their pros and cons when compared with different types of tokens? Well, security token offerings have the potential to add a sheen of credibility to crypto projects after countless investors were burned by initial coin offerings (ICO).

The removal of intermediaries during the process of buying and selling these assets also helps drive down transaction fees. However, it is worth noting that some regulatory uncertainty still lingers – and those who wish to sell a security token on the secondary market may find it’s a rather illiquid asset because the buyer will also need to be white-listed.

What is a utility token?

Many crypto start-ups have turned to utility tokens to generate the funds they need to get their businesses off the ground. However, there are some crucial distinctions that set them apart from a security token. Buying these through an ICO doesn’t necessarily entitle the investor to an ownership stake in the company or dividends.

How does a utility token work?

Companies tend to offer a utility token when they have an idea and they are yet to launch a product or service or even develop a prototype. These tokens almost serve as an ‘IOU’, meaning the investor will be entitled to redeem them for the product or service when it becomes available at a later date.

Unlike security tokens, these assets can be easier to sell on a secondary market, provided they have been listed on an exchange. Generally, those investing in these types of tokens are motivated by the prospect of their value rising substantially in the future, meaning they can make a healthy profit in any sale.

However, research suggests that this could be a highly risky strategy, as more than 50% of projects that release utility tokens in an ICO fail to survive for more than four months.

Utility token: Advantages and disadvantages

Some argue that utility tokens face a far greater challenge than security tokens – resulting in an opportunity for bigger returns – because they are subject to supply and demand.

If consumers or the crypto community hate a project, it simply won’t gain any traction. High demand can result in healthy price growth, especially if the start-up has limited the number of tokens in circulation.

The obvious downside is the regulatory uncertainty associated with these assets. Investors have very few protections in the event that something goes wrong, prices can be volatile, and fraudsters have been known to woo unsuspecting victims through sham tokens.

What about cryptocurrencies?

It is worth stressing that tokens and cryptocurrencies are an entirely different ball game. The likes of bitcoin are not connected to a development project, meaning that their only purpose is to facilitate payments. This makes them more comparable to cash or gold, rather than stocks or bonds.

Further reading

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