You might be thinking that a security token sounds a lot like a utility token. But from a legal standpoint, security tokens offer investors a lot more protection than a utility token does, and there are also several differences regarding how each of these tokens is intended to be used.
Utility tokens operate in a somewhat grey area when it comes to legality, that is why utility tokens do their best not to be labeled as securities. If a token is deemed to be a security, then it falls under the jurisdiction of the Securities and Exchange Commission (SEC) and must abide by the SEC’s regulatory frameworks; this has a domino effect in the blockchain and cryptocurrency industry. Not only do companies selling securities have to register their securities with the SEC beforehand, but cryptocurrency exchanges also have to register to be securities brokers; otherwise, they will be considered unregistered broker-dealers and could face severe consequences like some crypto-exchanges already have.
And for those reasons–mainly the potential legal issues–most companies who have a token offering insist that they are not selling securities, but instead, are selling utility tokens.
Utility tokens grant their holders access to a product, service, or discount being offered by the company sometime in the future. When you buy a utility token, you are not purchasing ownership of the company like you are when you buy a security token.
On the other hand, security tokens do not need to tiptoe through the markets to avoid any potential legal issues. Securities tokens represent shares of ownership in a company, are registered securities, and are in accordance with the regulations the SEC has created. For that reason, security tokens are considered safer investments because they adhere to stricter regulations and offer protections for investors.
The Howey Test: is your token a security?
There can sometimes be a thin line between a security token and a utility token. Although this line is thin, the categorization that the token falls into is significant. If it turns out a token is a utility, then you are relieved of a lot of regulatory pressure and potential legal troubles. If your token is a security, then you have to register with the SEC, and cryptocurrency exchanges will be wary about listing your token unless they have registered with the SEC as licensed securities dealers–which a lot of exchanges have not done yet.
For those wondering how to determine whether their token is really a utility token or is actually a security, you can apply the Howey Test to the token and see if it fits the bill of being a security.
The Howey test comes from supreme court case–SEC v. W.J. Howey Co.––where it was determined that Howey Co was selling unregistered securities. To come to the conclusion that Howey Co. was selling securities, the SEC looked to see if the investors in Howey Co. and the activities of Howey CO fit the following four criteria:
- An investment of money took place
- The investment was in a common enterprise
- Investors invested in the common enterprise with an expectation of profit, and
- The investors expected profit from the activities of a promoter or third party.
Long story short, what the Howey Test is asking is if the expectation of profit that an investor is expecting to receive from their investment is dependent on the work of another entity. If the answer to this question (really if the answer to all four criteria) is yes, then the token is a security and must be registered with the SEC.
The future of security tokens
We live in the age of the internet and are experiencing a digital revolution. Consumers are finding it more efficient when processes and operations are digitized and can be completed through the internet or via electronic devices. That being said, the current banking and finance industry can save a lot of time and money by switching to a blockchain and adopting a security token-esque system for securities trading. And on the crypto front, a security token offering can be a safer route than a utility token offering; and a security token can be a great addition to a portfolio, especially if you want to contribute to a company’s growth via investment. There are already several security tokens in the cryptocurrency market–raven coin, tzero, polymath, StellarX, and many more; and there are likely to be even more security tokens as the utility token ICO continues to lose steam as it has trouble navigating a tricky legal field where their legal status is uncertain in many countries.
But as more crypto projects figure out how to navigate their complex legal world, it is likely you are going to see more security token offerings in the future. And as banks and financial institutions realize they need to stay ahead of the curve or they will get left behind or lose business to competition, it is likely you will see them incorporate blockchain technologies and cryptocurrencies into their business models.