Security Tokens vs. Utility Tokens

Stefan Perlebach
Stefan Perlebach

Aug 23, 2018

Will Security Tokens create the next big Hype in Crypto?
If so - what does that mean for Utility Tokens? Will they survive?

In order to find answers to these questions, the following text shall help you to understand the differences between Security & Utility Tokens and provide you with knowledge about the advantages and shortcomings both token types represent.

1. The difference between Security Tokens & Utility Tokens

What is an Utility Token?

Utility Tokens are comparable with vouchers. Holding one entitles the owner to access a company’s product or service. Utility Tokens are not supposed to be investments and are therefore theoretically exempted from federal laws governing securities.

What is a Security Token?

Security Tokens represent the ownership to an underlying asset that has a tangible value, such as real estate, funds, stocks or a piece of art. Often Security Tokens provide different financial rights to the owner, e.g. voting rights, profit share rights, redemption rights, equity, dividends. Security Tokens are subject to federal security regulations (e.g SEC in the U.S., Bafin in Germany etc.)

2. Current State of Security Tokens & Utility Tokens

The State of Utility Tokens

2017 was undoubtedly a great year for Utility Tokens - raising more than $5 billion through ICOs. 2018 performed even better when looking at the amounts raised. However, slowly the hype around ICOs and Utility Tokens seems to slow down. One reason for that might be that 78% projects conducting an ICO in 2017 turned out to be scams and another 7% failed or went out of business - according to a study done by the Satisgroup. The remaining 15% that are still out there now need to deliver. All of them pitched great utopias, promising new or better services. However, for the vast majority, these still remain promises until today, as not many of them have usable products yet. Those who have a running product mostly lack of good user experience or simply a strong enough added value compared to centralized services.

The State of Security Tokens

Whereas many projects conducting an ICO in 2017 have been desperately trying to avoid having their tokens classified as securities, we can now see a shift into the opposite direction.

In 2017, it seemed very unattractive for projects to label their tokens as securities for mainly two reasons: First, they thought by simply calling it a Utility Token they can exempt it from the securities laws. Second, promoting anything as an ICO and Utility Token seemed to work quite well to raise money in 2017. Those two arguments don't work anymore. These days, we see more projects looking for certainty being compliant with the regulators. The SEC, which is enforcing the federal securities laws in the US, clearly states to this subject:

“Merely calling a token a “utility” token or structuring it to provide some utility does not prevent the token from being a security. Tokens and offerings that incorporate features and marketing efforts that emphasize the potential for profits based on the entrepreneurial or managerial efforts of others continue to contain the hallmarks of a security under U.S. law.”

As we can see, not messing around with the regulators is crucial if your company doesn't want to take the risk to be fined or shut down. Also the second argument becomes invalid: In order to attract investors, calling your offering a STO (Security Token Offering) instead of an ICO can be an strong USP these days. As so many ICOs turned out to be scams, investors becoming much more cautious, starting to more appreciate legally compliant companies.

On top of the legal safety and guaranteed rights both coming with Security Tokens, they also offer an already existing underlying value. Whereas Utility Tokens mostly promise a service with prospects for a rise in value once more people will demand this service in the future, a Security Token is backed by an asset which already exists.

But there is also a downside to Security Tokens: Additional regulations come along with limitations and restrictions on who can invest in Security Tokens and how they can be exchanged. As I am writing this article, no Security Token ist tradable yet and therefore still misses one of its supposedly biggest advantages.

3. Benefits of Security Tokens & Utility Tokens

Benefits of Utility Tokens

The value and benefit an Utility Token can deliver is defined by - surprise - its underlying utility. As many projects did not focus to much on the actual utility their token is providing but more on the promotion as an investment opportunity during their ICO, those projects and its investors might face a difficult time. In order to be a successful Utility Token it needs to be adopted by a strong user base rather than just being hodled or traded by investors. To attract users you either need to offer them a service which is new and innovative or add value to existing ones.

Good examples for replacing existing services with a Utility Token could be decentralized versions of Uber or Airbnb. Whereas today such infrastructures are owned by the companies themselves, with blockchain no centralized authority is required anymore. Service providers and consumers could connect directly and by cutting out the middleman prices can be reduced and ultimately transforming this industry into a fairer sharing economy. Another good use case for Utility Tokens is the gambling industry. Due to the new capabilities smart contracts are enabling, gambling sites can be decentralized allowing automated payouts and therefore raising the level of trust among users (due to guarantee of execution). And again - cutting the costs for the middleman.

Any sort of market places that connect buyers and sellers is another playground Utility Tokens are targeting. Steemit - a social media platform where people can get paid for creating content is one example. The Golem Project is another one, doing to computing time what AirBnB does to flats. Users can rent out their spare computing power in exchange for Golem’ s Utility Tokens while others can use this power to get highly demanding computational task done (e.g. rendering files). You can learn more about how to use Golem here.

An ultimate challenge for disrupting a centralized service would be the replacement of a centralized social network. Instead of Facebook owning your shared data and making business with it, you can do so. Whereas today only Facebook knows how much money your data is worth, in a decentralized version you will know. Anybody who wants to access your data or show you advertising will first have to ask for your consent and once confirmed pay you directly with the embedded Utility Token. You will have more data security, as every single set of data is encrypted, making hacks where huge amounts of data gets stolen nearly impossible. And due to the transparent and immutable characteristics of the blockchain technology, events like Cambridge Analytica can not be hidden anymore.

Many examples for new services Utility Tokens will enable we will see within the online gaming industry. Projects such as GamerToken are working on a global marketplace for buying and selling unique in-game items on the blockchain. So playing games all day long finally becomes economically feasible :)

Benefits of Security Tokens

Security Tokens will have their biggest impact on the financial industry. They will allow investors to trade tokenized stocks, funds, bonds, real estate and even commodities such as art works.

By putting these assets onto the blockchain, much more people will gain access to various investment opportunities. At the same time, those who tokenize their assets can access a global pool of capital and reach out to a larger potential investor base. Smaller companies will be able to raise capital in a similar way to crowdfunding, just in exchange for equity.

Another advantage Security Tokens will bring is a higher liquidity in the markets by allowing fractional ownership and thereby lower minimum investments. Exchanges will be open 24/7 globally, making trading more accessible, faster and cheaper.

For investors who buy Security Tokens, the assurance of regulatory compliance gives them more certainty not to be scammed and provides them with a set of rights such as for voting or dividends.

For further information on the advantages of Security Tokens feel free to read this article

4. The Future of Security Tokens & Utility Tokens

The Future of Utility Tokens

What happened during the dot-com bubble to companies 18 years ago will also happen to Utility Tokens. During bearish markets just a few will survive and most of them will disappear. As long as the reason to buy a Utility Token is entirely driven by the motivation to sell it at a higher price, there is no fundament for a sustainable business and currently we rarely see people purchasing Tokens in order to access any provided services.

Accordingly, examples of Dapps having a high, permanent user base are rare. But this will change. Existing projects and upcoming ICOs will not be able to attract capital or customers without some sort of product/service in place as investors will expect this when doing their due diligence. How many of the Utility Tokens will survive is also dependent on how good they can compete against the existing centralized services and what kind of added value they can provide to achieve mainstream adoption. On top of this, in order to succeed, most projects will have to solve the puzzle of being decentralized, secure, scalable and user friendly at the same time.

The Future of Security Tokens

The Tokenization of securities is still at the very beginning but offers a huge potential to disrupt the traditional financial market as we know it. Blockchain technology allows opportunities for creating a more open, inclusive, transparent, liquid and efficient marketplace for financial products. Some evangelists believe that Security Tokens will even replace traditional stock exchanges and OTC markets over the next decade. And industry experts estimate a $10 trillion market volume for Security Tokens.

Compared with Utility Tokens, Security Tokens will give investors more clarity and safety due to legal compliance, ownership rights and less volatility in the markets since they are backed by tangible assets. To get there, we still have to overcome many legal and technical barriers for building this entire new infrastructure Security Tokens will live on.

The first actors who will lay the foundation for Security Tokens by building its playground will be trading platforms that are compliant with Securities law. Once Security Tokens can be traded, legal and technical service providers will help existing financial products  and assets to be digitized into Security Tokens. Afterwards, more and more new companies will enter the game using Security Tokens for their fundraising.

Conclusion

The majority of tokens we will see in the future are going to be Security Tokens as they deliver more obvious and tangible benefits for investors compared to Utility Tokens. Only those Utility Tokens which can deliver a significant added value to an existing service or identify new areas of application will survive.

Most likely we will also see projects offering Utility Tokens and Security Tokens existing side by side serving complementary functionalities (see Siafunds & Siacoins). And there will be those projects issuing Security Tokens that feature significant utility attributes and therefore unifying the strengths of both token types in one.

Things certainly remain exciting & we'll keep you updated!

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