EXPLAINED!: The differences between Utility and Security Tokens

The Smartblocks Agency’s deep dive into Security Tokens continues. This time, we’re going back to basics to explain how Security Tokens differ from the ubiquitous Utility Token. Of late, the world’s attention seems to drawn the Security Token asset class. To understand why this is happening, it’s important to define them and understand the risks and potential benefits associated with each.

Crypto has emerged as a popular way to invest and make transactions, but not all cryptocurrencies are created equal. There are three main types of tokens: Utility, Governance, and Security tokens. We will not go into Governance Tokens here, but for reference, they usually give you voting rights within a DAO or other kind of organization. Let’s talk about the other two, Utility and Security Tokens.

The following is based on my Cryptonized episode titled “What's the Difference? Utility Tokens vs Security Tokens.”  Be sure to check out the video if you’d like to learn more.

‍

What’s so useful about Utility Tokens?

In a nutshell, Utility Tokens are the native currency of specific projects. I liken them to Frequent Flyer Miles, in that they are rewards designed to be used within a particular platform or ecosystem. Theoretically, Utility Tokens gain value if the project is successful, but do not provide ownership rights.

At the moment, most Utility Tokens are released in the Ethereum Blockchain and use the ERC20 standard. When Ethereum introduced Utility Tokens in 2014, their flexibility and ease-of-use were hard to resist. Despite 90% of ICOs failing, Utility Tokens dominated until Terra collapsed in 2022 and the resulting contagion left many people holding the bag.

It’s important to note that Utility Tokens are not subject to the same regulatory requirements as Security Tokens. And they’re so easy to create and replicate that the risk of fraudulent or misleading Utility Token offerings will always be there. There’s also the possibility of great success, just ask the first holders of UniSwap’s $UNI. The token started as a free airdrop and it’s now worth $6.38, with a market cap of nearly $5 billion.

However, due diligence and extreme caution are the order of business when dealing with Utility Tokens.

‍

Security Tokens are here to stay

Organizations issuing Security Tokens (STOs) acknowledge from the get go they’re offering Securities and need to comply with Securities Laws to the best of their ability. Security Tokens or STOs are investments that provide their holders with ownership rights in a company, or claims to a debt instrument, or part of a real estate project, or even a valuable painting.

In Smarblock’s article about RavenCoin, we quote the project’s lead developer Tron Black saying:

“An STO is a legal issuance of securities on the blockchain. STOs are like the ICOs of 2017, but they are issued under the legal framework of — and compliant with — the securities laws. In the U.S., specifically the Securities Act of 1933.”

When you invest in a Security Token, you are essentially buying a piece of the asset or company that issued it. This means that as the asset grows in value, the value of the Security Token increases. But it’s also possible that both the asset and the token will decrease in value. Always take that into account. As with traditional investments, risk is inevitable. Be suspicious of offerings advertised as “risk-free.”

The other key characteristic of STOs is that if the underlying asset produces revenue, the system can automatically distribute a proportional share to Security Token holders. This could be compared to a dividend or interest payment. Additionally, like NFTs before them, STOs can unlock access to special events or meetings. And that’s just what has been done already. The field is constantly evolving, as programmers create new features and implement them all the time.

‍

Security Tokens and the law

These vehicles are similar to traditional Investments, such as stocks or bonds, because they are regulated by Security Law. However, living on the blockchain, they’re unbounded from the limitations of the real world. STOs flood traditionally illiquid assets with new customers by giving the global market access to a previously unavailable investment vehicle. WIth great power comes great responsibility, though.

We couldn’t stress this enough, but Security Tokens provide ownership rights and potential return on investment. So, they come with greater regulatory scrutiny and compliance requirements. Issuers must comply with their jurisdiction’s specific checklist, and this probably includes registering with regulatory bodies and providing ongoing reporting to investors.

The reporting is not as strict as it is with the stock market, but you still need to issue ongoing correspondence with investors. The good news is, developers are creating the systems with these characteristics in mind, and communicating with STO holders is easier and more convenient than ever. On the other hand, issuers will have to register a Security, and that process can be draining and neverending.  Every quarter, they’ll have to provide the authorities with financial records, and of course, there are no guarantees of success. 

It’s as we concluded in Smartblock’s step-by-step guide for Security Token beginners, “Security Tokens are just the digital version of what the traditional financial system has to offer. And like TradFi, these digital versions are not perfect.” However, there’s no denying that STOs can “democratize the sector and open access for retail investors at a lower price point.”

Whatever you decide, always remember that by doing your due diligence and staying informed, you’ll be able to make informed decisions and minimize your risk.