Security or Utility? That is the question
The ICO craze has swallowed the planet. This new blockchain-based method of crowdfunding has become the hot news in the business, economy, and financial circles. Each day brings a new ICO launched by an aspiring startup and a new token issued.
Both young and established companies appreciate the simple requirements of initial coin offerings and use this method to finance their new projects. On the other hand, millions of crypto enthusiasts all over the world are willing to support a promising project by purchasing its token.
The concept of tokens is important both for startup launching it and for the investor. The startup needs to choose the type of token they are going to issue, and the investor needs to know what they are going to get when they contribute their money.
Before we dive deeper into the types of tokens, let’s see what it is, in fact.
What is a token?
Crypto tokens, crypto coins, cryptocurrencies – you are sure to come across all these terms in the context of ICOs. Sometimes they are mixed up and sometimes they seem to mean the same thing. However, there are differences.
What is the difference between a token and a coin? Both of them fall into the broad category of cryptocurrency, however, their nature is different. A token is always associated with a particular application or service and represents a unit of value directly connected to such app or service. Both the token and the related application are hosted on another blockchain, usually the Ethereum blockchain, and cannot exist outside it. Moreover, the token is a necessary attribute in accessing the application,
At the same time, crypto coins, such as Bitcoin or Ether, can exist independently and act like money in the traditional meaning of the word – they store and transfer value. All of them have their own native blockchain which is used to process transactions with such coins.
Tokens use other blockchains which makes them relatively easy to launch. This feature is appreciated by the startups creating ICOs, as there is no need to write a new blockchain to launch a custom token. Most often, the Ethereum infrastructure is used.
We are coming closer to the question in the title of this post. There are several types of tokens that can be created for an initial coin offering. In most cases, you will hear the comparison of security and utility tokens, while, in fact, there are other types, as well.
However, we will also deal with the two major types, as the choice between them has recently become the key matter for all ICOs. Since the US SEC issued its token-related regulation in 2017, both the startups and investors became rather concerned about the types of tokens.
In the Wall Street terminology, a security is a tradable financial instrument that has a certain monetary value and represents ownership. Some tokens issued during ICOs possess exactly the same features – they represent ownership providing voting rights in the business and can be traded at the exchange by their value.
The recent definitions by the Securities and Exchange Commission of the US confirmed that some tokens can be considered as securities. In its analysis, the SEC applied the Howey test used to determine whether an asset is a security or not. According to this test, if an asset is an investment with the expected profit to come solely from the effort of others, it is a security.
The tokens issued during an ICO can fall under this classification, as the investors expect to gain profit by trading them at the exchange when the company grows. If this is the only purpose of the token, they are subject to the SEC regulation. This regulation demands that, on the one hand, the issuers of tokens must be properly registered or licensed. On the other hand, it requires that all investors in tokens must be “accredited investors”. Obviously, for the startup, the cost of registration may exceed any capital raised via the ICO.
This effectively prevents US-based startups from using this crowdfunding method and US residents from investing in ICOs. While the declared purpose of this SEC move was to protect potential investors from ICO frauds, as the Commission states in its bulletin on initial coin offerings, it has caused a confusion on the crypto market.
One of the well-known examples of a security token is Digix where the value of one token is equal to the value of one gram of gold.
The other major token type has a definite advantage – it is not subject to the SEC regulation and is, therefore, not required to comply with the federal laws. Tokens of this type are also issued during the token sale and sold to the investors, however, the benefits they give are different.
Utility tokens represent access to the product or service that the startup is going to generate. In other words, a utility token can be seen as a coupon, certificate or pre-order for the future product. All investors who purchase the tokens will be able to use the service when it becomes available. The amount of service directly depends on the number of tokens each investor purchases.
Here, we should note that while we use the term “investor”, utility tokens do not count as investments from the technical point of view.
For the investor, the value of a utility token is in the growing amount of service that it represents. Here we come to another feature of utility tokens that is important in their understanding – the fungibility.
Fungible tokens can be exchanged for other tokens of the similar value, regardless of their origin. When you exchange fungible tokens, you get back exactly the same asset that you gave.
Non-fungible tokens are unique and cannot be exchanged. Thus, non-fungible tokens can never be considered as cryptocurrencies, as they are not interchangeable. The typical use cases of non-fungible tokens are game assets and collectibles, such as the famous CryptoKitties.
A good example of a fungible utility token is the WOLF coin of the WiseWolf Fund. The startup is building an AI-based investment platform where the capacities of artificial intelligence will be used to analyze multiple market trends and generate investment recommendations. Only those who purchase the WOLF coin will be able to use the platform, with the largest token holders getting the profitable investment advice ahead of others.
We will briefly touch upon the third type of tokens, although it is not that widely used as the major two. A debt token represents the interest accrued on the amount loaned to the company.
The best-known debt token is the STEEM coin that is launched by the Steemit blogging platform. The coins are used to pay for the highest-rated content published on the platform. Users can exchange STEEM coins for Steem Dollars on which a 10% interest is accrued.
How to choose the token type for your ICO?
With the new regulations in effect, most ICOs tend to choose utility tokens to offer during their crowdsales. True, utility tokens are not subject to the SEC regulations and federal laws, thus the startup can launch its initial coin offering without a complicated registration procedure and fully within the legal bounds.
However, the reality is a bit more complex. Merely calling your token a utility token does not automatically exempt your business from the SEC rules and makes you invisible to its all-seeing eye. We recommend getting legal advice on launching a token and the consequences it may have.
Another point you should keep in mind is that once the token is promoted as an investment, it can be considered a security with all the legal implications. Thus, be careful in your promotional campaigns.
A more practical aspect of the token choice is the nature of the product you are developing. It must have a utility to qualify for a utility token. In other words, the product must represent a value that users will be willing to purchase. Buying tokens is an additional transaction involving a certain degree of commitment to your company. Once you have rolled out the product, users should be able to pay for it with Bitcoin or Ether, why would they need an additional dedicated coin?
The answer to this dilemma may be the assignment of voting rights to your utility tokens. This way, your users will have the opportunity of voicing their opinion on the company’s plans and prospects.
In any case, planning an ICO, choosing the token type, and organizing the marketing campaign requires professional advice. The cost of an incorrect strategy may be too high, as it involves legal compliance and high fines when you do not comply. To launch a successful ICO, you need the assistance of professional blockchain developers, crypto economists, marketing experts and, of course, lawyers. We can provide the ICO development services and assist in selecting the type of token that corresponds to your project. Contact us to discuss your startup idea and, maybe, further cooperation on your project.