The initial coin offering (ICO) is an innovative crowdfunding model. It enables new businesses to raise capital by issuing crypto tokens on a blockchain and it acts as an early seed investment. ICOs in 2017 alone raised over $4 billion and disrupted the conventional finance. This article will cover what are utility tokens & security tokens, what are security tokens offerings, Howey test and much more.
Startups launching token sales generally claim that they are issuing a utility token, to escape from the realm of securities law in most jurisdictions. However, many of these tokens issued under the banner of utilities actually have the majority characteristics of securities, which is why financial regulators nowadays are taking a closer look. Depending on their function, crypto tokens are mostly classified as utility tokens or security tokens.
What are Utility Tokens
Utility tokens are basically used to get access to the company’s platform or service. The bigger the platform becomes the more utility the token gives. As the total supply is fixed, utility tokens may appreciate over time if demand for the product or service increases.
The utility token “Basic Attention Toke (BAT)” is a very good example. The BAT tokens act as a medium of exchange between the users, publishers and advertisers who interact with the Brave Browser. BAT tokens are used by advertisers to purchase ads and the BAT tokens are then distributed among the users and publishers on the Brave Browser as a reward for using and viewing the ads on the platform.
Utility tokens are not designed as investments. However, tokens may grow in price, if the demand for service or product increases. In the above example of BAT token, if more and more people start using the Brave Browser the value of coin will appreciate. So, buying the utility tokens of a project which is solving real problems of users, might earn you great profit in future.
The Securities and Exchange Commission (SEC) does not have any official guidance on utility tokens. So, the industry members do not know with certainty whether utility tokens are subject to securities regulations or not. The Chairman of SEC, Jay Clayton has previously said “I believe every ICO I’ve seen is a security.”
What are Security Tokens
One of the hot topics to be discussed in cryptocurrency word right now is the future of security tokens. Having security tokens give you the ownership rights of a company. Security token offerings (STOs) combine the features of ICOs with IPOs in order to provide a perfect balance between gaining access to capital at a low-cost and also remaining compliant to securities laws side by side.
A security token can represent shares in the company or a member share in LLC. So, in simple words you can say while issuing shares of a company in form of digital tokens the companies have more potential to attract more investors at lower cost than if they were to list on a stock exchange.
Also Read: Five benefits of Security Tokens
A great example is the launch of Nexo, a crypto backed instant loan platform. The company generates operating revenues from the crypto loans which people take. The company has declared that a fixed 30% of the net profit generated will be paid as dividends to the people who hold NEXO tokens.
Another example is the tZERO exchange, a trading platform for security tokens. It launched an ICO to fund the development of its platform. The tZERO tokens that will be issued to the investors will be in accordance with SEC regulations. In addition, the token holders will be given share of quarterly dividends from the profit earned by the tZERO platform.
According to Howey test a token will be deemed as a security if it meets the following prerequisites:
- There is investment of money
- User is expecting profit from the investment
- The profit comes from a third party
- Investment of money is in a common enterprise
The word common enterprise in the test meant a horizontal enterprise where the investors pool in their money and assets to invest in a project.
If we run this Howey test on the utility tokens that exist today, half of them will come out as securities!
The Future of Security Tokens
Security tokens have the potential to become an easy funding mode for established startups and companies. The firms which want to tokenize their security offerings instead of listing their shares on a stock exchange. The introduction of much awaited security token exchanges like tZERO will enable a new breed of token issuer to come to the market.
It is quite unlikely that security tokens will replace ICOs completely. As many small startups or companies might still want to run in a regulatory free environment. As a normal token sale can be completed with little upfront capital but security token offerings require more capital.
Security ICOs are all set to become a real competitor of traditional IPOs. As more and more investors will move to realize the advantages of digital tokens over “real shares”.