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Security vs. Utility Tokens: A Detailed Guide For Crypto Traders

Published: Tuesday, 19th July, 2022 - 21:17

Bitcoin was the first digital currency, but hundreds of other cryptocurrencies have since emerged on blockchains that offer specific solutions and solve problems for people across the globe. The coin type is classified according to different categories, just like any other industry.

As one of many factors contributing to blockchain technology’s success, using tokens is essential. We’ll examine tokens in more detail in this article. To learn how each token differs from the other, please read on.

Overview

A term such as “Blockchain” and its terminologies can be confusing. In most people’s eyes, there is no difference between tokens, coins, and cryptocurrencies; they all belong to the same family. However, they all have unique features that make them different from one another. Several different types exist for tokens. In this section, we will discuss NFT, utility tokens, and security tokens.

Utility tokens can be used to pay for a service or a product, and security tokens are used to invest. An alternative to fungible tokens, a Non-Fungible Token is a rare and collectible token made from one piece of metal. Art that allows creators to monetize their creations is called a work of art. NFT has an extremely high price and can be exceptionally valuable. We will go through all these tokens in detail and examine how they are used in the blockchain industry.

Understanding Tokens

Cryptocurrency and computer security define tokens as anything that appears on another cryptocurrency’s blockchain. Tokens are assets that a company issues to their customers, as well as utilities, services, or units of value. A token is a programmable asset or access right controlled by a smart contract through a distributed ledger, which is underlying the contract.

An Initial Coin Offering (ICO) is an effort on a company’s part to raise funds by offering one or more coins. Many strategies are similar to those used in creating the Initial Public Offering (IPO). It is important to note that an IPO will provide you with stock in exchange for your investment, whereas an ICO will give you a digital token. The company’s customers can access its future services and products using their tokens.

Coins and tokens are not the same, although they both fall under the generic term “cryptocurrency.” Tokens represent non-cash assets, such as an ownership stake, voting rights within a blockchain, or early access to upcoming products from the company that issued the token.

On the other hand, a coin is simply a currency representation. The value of a coin always has a cash equivalent, based on market pressures and demand. Tokens can be valuable, but they don’t exist solely to transfer that value. They are often used for more complicated transactions than just monetary transactions.

What are security tokens?

Tokens that are traded are security tokens. As the name implies, securities are derived from a financial term of the same name, which is used to describe a fungible, tradeable asset with some monetary value.

Besides representing a share in a company, security tokens can also represent voting rights and a unit of value. The difference between a security token and security is that a security token is managed and organized automatically using smart contracts.

Security tokens are highly esteemed in the financial world because they eliminate mediators from the transaction process, reduce the cost of creating and maintaining securities, and boost transparency by storing all transactions on a decentralized ledger.

Security tokens are a type of token that must be compliant with financial regulators. It represents the most significant concept of security tokens. These token offerings have thus been dubbed Security Token Offerings (STOs) and are primarily aimed at institutional investors.

How does Security Token Works?

Securities tokens are tokens created for investment purposes. Each time the issuing company earns a profit in the market, dividends are distributed to token holders as additional coins. By purchasing security tokens, holders own a portion of the company.

As a result of blockchain technology, an investor can use it to create a voting system to influence a company’s decision-making process. If the Howey Test is passed, the cryptocurrency token is deemed a security token. A tradable asset provides the token’s value. Federal regulations govern the regulation of these tokens.

In determining whether certain transactions qualify as investment contracts, the Supreme Court developed the Howey Test. Securities Act of 1933 and Securities Exchange Act of 1934, disclosure and registration requirements apply if these transactions are classified as securities. Several regulations apply to Security Tokens in the USA, including:

  • Regulation A+

It allows the creator to offer securities with SEC approval to non-accredited investors as part of a general solicitation of investment up to $50 million. If this regulation is followed, it may take more time to register the security than if another option is used. The cost of this regulation is, therefore, higher than any alternative.

  • Regulation D

Thereby, it will be possible to avoid filling out the SEC-provided “Form D” following the sale of securities to avoid being registered as part of a particular offering. Those who offer this security may solicit investments from investors according to Section 506C. During the solicitation, investors need to verify that they are accredited and that the information provided is accurate.

  • Regulation S

Section 5 of the 1993 Act does not regulate securities offerings outside the United States. Therefore, these offerings are not subject to section 5 registration requirements. There will still be security regulations to follow in the country where the creators will be executed.

Utility tokens do not allow the holder to direct the company’s operations and decisions. They facilitate interaction with a company’s services.

Furthermore, utility tokens do not fall under any regulations. The three essential differences between security and utility tokens have been discussed regarding regulation, intended use, and functionality. Let’s examine the three other differences.

Advantages of security tokens

While meeting the regulatory requirements for this industry, security tokens provide tokenization for traditional business transactions. An element (underlying asset) is transferred to the blockchain by tokenizing.

Regulatory requirements must be met by each party involved in the transfer of real estate ownership. Those rules are incorporated directly into the protocol with security tokens. Polymath and BlockEstate tokenized real estate in September as part of their partnership.

  • Reduction of investment thresholds

Companies can reduce investment requirements to almost nothing by using security tokens, an effective fundraising tool. Campaigns require investors to contribute a certain amount through investment in the past.

Failure to meet the minimum requirements led to a ban on stakeholders. Therefore, millions of investors could not invest since the costs of processing their data were prohibitive.

By using blockchain technology, this process can be automated to a great extent. Security tokens use intelligent contracts to expand the concept and remove regulatory burdens.

  • Increasing the liquidity of the underlying asset

By investing in security tokens, investors benefit from liquidity. Thousands of investors cannot access their funds because they have committed to long-term investments. As a result, investors may not get access to their money for years because many of these investments are long-term.

By using security tokens, these issues are eliminated. A tokenized fund can be bought and sold by an investor at his discretion after it has been tokenized. As a result, asset flows are more efficient, and market opportunities are created for secondary trading platforms.

  • Output costs

IPO placement is much more expensive than STO placement. In a traditional IPO, over 7% of the capital is spent on issue and transaction costs. These costs are simple to understand. Many verification companies are involved in IPOs. They all charge commissions.

Crowdfunding costs are significantly lowered with STOs than with IPOs. Companies can automate their most costly transactions using blockchain technology. Smart contracts can also track and distribute investment funds proactively without requiring intervention.

  • Improved Market Efficiency

With blockchain technology, the current market system is significantly improved due to its transparency. With security tokens, you can monitor the market instantly. Users can easily monitor their investments and tokens using a blockchain monitoring app. Fundraising progress for investments can be tracked without restriction by investors.

Drawbacks of Security Tokens

Every token, including security tokens, has its imperfections. These tokens give investors access to traditional investments and provide a bridge to the blockchain space. However, they also come with limitations.

  • Investor Accreditation Limitations

One of the most significant disadvantages of non-accredited investors is their inability to own security tokens. It means that, as a requirement of SEC compliance, more US STOs will require accredited investors. The minimum income requirement to become an accredited investor is $1 million in your bank account or $200,000 a year.

  • More Expensive than Utility Tokens

STOs, unlike ICOs, are required to include other organizations as part of their crowdfunding campaign. Participants in STOs must pay an additional cost to underwriting firms. Regulations are expensive, and hosting an STO is more costly than an ICO.

  • Secondary Market Trading Restrictions

Secondary trading restrictions are another drawback for security token investors. You can only trade security tokens on licensed exchanges.

The platforms must hold a license for trading securities in the country where they operate. Security tokens are also equipped with time-lock mechanisms. Only qualified investors can trade these tokens for a predetermined period after the ICO.

What are utility tokens?

At the moment, utility tokens reign supreme. Blockchain startups have multiplied like crazy over the past year because of the mass wave. To raise money, these startups used initial coin offerings in exchange for ETH, in which they created their tokens and sold them to the public.

Utility tokens such as Siacoin are a good example. The primary objective of this token is to let people utilize the cloud storage network called Sia. As payment for service consumption, tokens are transferred within the network. Tokens indeed appreciate as a network becomes more popular, but this is not their primary use case.

The Sia network issues Siacoin. Because of this, the token fails the Howey Test in this aspect. Also, since Siacoin is primarily used to access a service, it is not considered a security or a security token. These tokens serve a greater purpose than raising funds; they also serve a primary goal. A utility token is a piece of digital currency intended for use within a specific blockchain ecosystem. In the case of Filecoin, its token is used to pay users who provide data storage space. In the case of Civic, its token is used to pay users to verify their identity on their blockchain.

By creating unique incentive schemes, tokens also help motivate people to take action within ecosystems since they know they will receive rewards. An example is allowing token incentives to encourage people to switch to renewable energy. With the use of IoT devices, they can track, report, and receive tokens as compensation for their energy use through the blockchain network.

The security token represents symbolically the stake of the company. In contrast, a utility token does not represent any stake in the company—a security token is expected to be appreciated steadily due to an investor’s investment. There is a constant correction in the price of any given utility token due to the demand-supply equation.

Increasing the value of a utility token can lead to the product or service being perceived as too expensive, and the demand will decline. Lowering the price will increase demand. The prices of user tokens are constantly fluctuating due to this cycle. After the Bitcoin crash of late December/early January, if you were one of those Bitcoin investors who predicted the price would rise again, you will know that is often not the case.

Utility Tokens Advantages

In a blockchain ecosystem, utility tokens can be used to drive human behavior through incentives. Many challenges exist in the current economic environment that our financial system does not incentivize people to address. Most people agree that people should use cleaner energy sources and clean up the atmosphere.

The problem is that, under our current system, an organization that wants to clean the environment would have to operate as a non-profit, as no transparent business model exists for such a venture.

Switch, a blockchain-based company uses this technology to build its ecosystem, create its own ‘money,’ and use this money to encourage people to use renewable energy. Using utility tokens in exchange for Bitcoin or Ethereum, exchangeable for fiat money, makes them as valuable as any fiat currency.

Utility Tokens Disadvantages

Regulatory and quality assurance challenges have arisen in the crypto space, with many utility tokens available. Many companies seeking funding through ICOs have good intentions when launching tokens.

There have also been scams presented as valuable companies seeking to raise as much money as possible by offering themselves as valuable companies but failing to deliver on what they promise. Better self-regulation is needed in crypto to foster a more positive perception of utility tokens.

Security Tokens Vs. Utility Tokens

A Security Token differs from a Utility Token by the following factors:

  • Scam Potential

A security token has a minimal chance of being scammed since it is highly regulated. Due to the unregulated nature of utility tokens, fraudsters use them to make quick money.

  • Regulation Status

Creating regulations for ICOs is difficult since Utility Tokens are relatively unregulated. The company and investor must pass a Howey test in the case of Security Tokens.

Security tokens are investment contracts representing legitimate ownership positions in physical or digital assets that are verifiable on the blockchain. By creating an internal economy within a blockchain project, utility tokens facilitate ICOs. Those who hold utility tokens will also be entitled to vote within the ecosystem.

  • Expectations

The company’s value is directly linked to its valuation by utilizing a security token. A more excellent company’s value means a higher token’s value. In utility tokens, the token’s value is independent of the company’s value.

Conclusion

Now, you should be able to differentiate between security tokens and utility tokens. In our experience, we have learned that one motivates holders to behave in a particular manner, while the other represents the official ownership of an asset.

Because of the strict legislative regulations imposed on them, security tokens are considered more secure than utilities. Security tokens are characterized as unique collectible digital items.

This post first appeared on: CryptoCy News

Author: Jay Howell
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