Utility Tokens and Security Tokens – A concise guide

Understanding Utility Tokens

Utility tokens are digital assets built on existing blockchains to provide access to a specific product or service within those blockchain ecosystems. Consequently, their value is derived from the utility or functionality they offer.

1. Functionality and Use Cases

The development of Ethereum Virtual Machine (EVM) has opened the door to a range of new blockchain-based applications. Dapps such as decentralised finance (DeFi) platforms, gaming systems, and artificial intelligence (AI) applications leverage smart contracts to issue tokens which give their holders privileges while using these apps. 

In some cases, the core functionalities of an app are accessible only to token holders. These tokens are known as utility tokens. For example, some metaverse platforms and NFTs can only be purchased using a designated token only. 

• Non-Investment Nature

Utility tokens are non-investment tokens. Businesses and projects issue utility tokens to offer users exclusive functionalities offered by the associated blockchain project. When a token is launched into the market, authorities often scrutinise the nature of token sales to determine whether the token falls under the category of a utility token. 

• Regulatory Considerations

Issuers must be careful not to inadvertently categorise their tokens as securities as this could lead to legal complications. 

Roles of Utility Tokens

Utility tokens are created primarily to grant access to functions on Dapps or projects within a blockchain system. However, there are different implications of those tokens that benefit users significantly. Let’s delve into this role summary together:

• Access to Services: The primary function of utility tokens is to grant access to specific services or products within a blockchain platform. 
• Token Creation: These tokens are created through Initial Coin Offerings (ICOs) or Token Generation Events (TGEs), where users can buy them using other cryptocurrencies like Bitcoin or Ether.
• Limited Functionality: Unlike security tokens, utility tokens do not represent ownership in a company or profit shares. Their value is tied to their specific use within the platform, and they are designed primarily for accessing services. 
• Token Exchange: Similar to any other normal tokens, utility tokens can be traded on cryptocurrency exchanges. Their value may fluctuate based on supply and demand dynamics, as well as the success and popularity of the associated platform.
• Redeemable for Services: Users can use utility tokens to pay for services or products on the platform, and holding a certain number of tokens may provide additional benefits or privileges. 
• Promoting Ecosystem Growth: Utility tokens incentivise active participation, promoting the growth and sustainability of the blockchain ecosystem. 

What are the challenges?

Utility tokens are a good option for gaining profits, yet they contain high risks. The utility tokens became popular with the ICO boom in 2017 due to the excessive use of their mechanisms. This was also the reason that dragged them down, causing several project failures and token depreciations. People began to question and constantly audited new projects. New—born projects must have real utility and specific, practical goals to gain trust among supporters and increase their tokens’ value. 

However, this is not the only issue that utility tokens face. Market volatility or regulatory uncertainty could also put investors at risk. Here we list ‘big challenges’ that a utility token might encounter: 

• Regulatory uncertainty: The regulatory landscape for utility tokens is sometimes considered ‘grey area’ and can vary across jurisdictions. Determining whether a utility token qualifies as a security or not is challenging. If you inadvertently make mistakes, this could lead to legal risks for both issuers and investors. 
• Investor Protection: Several scams and fraudulent activities in utility token sales were recorded, especially during Initial Coin Offerings (ICOs). Investors must be wise to unerringly distinguish between legitimate projects and fraudulent ones to avoid financial losses. 
• Market volatility: The value of utility tokens can be highly volatile, influenced by market sentiment, demand for the associated services, and overall market conditions, leading to significant price fluctuations.
• Lack of Intrinsic Value: These tokens’ value is directly tied to the success and adoption of the associated platform. In fact, unlike crypto coins, they often lack intrinsic value, and this makes them more susceptible to market sentiment.
• Market Saturation: The market has been packed with, and new projects need to indeed offer practical and novel utility to gain appreciation. Investors are now much more careful with their money and more educated about the crypto industry. 
• Cyber risks: Tokens are built based on existing blockchains. Therefore, they can inherit most of the blockchain’ features, as well as its existing limitations. Issues such as scalability and security vulnerability.  
• Limited Adoption: The success of utility tokens relies on the widespread adoption of the associated platform. If the platform fails to gain traction or faces strong competition, the utility token’s value and usefulness may decline.
• Lack of Interoperability: This can be considered as the drawback of a utility token that offers exclusive functions. In some cases, utility tokens are limited to use within a specific platform, hindering interoperability with tokens from other projects. 
• Tech Barriers for Users: Many users face challenges understanding and using utility tokens. Issuers must deeply understand their supporters’ needs or difficulties to improve user interfaces and education for broader adoption. 

Understanding Security Tokens

Security tokens represent ownership or a stake in a real-world asset or in any revenue-generating enterprise. These tokens derive their value from the underlying assets to which they are linked. These tokens are typically subject to strict regulatory oversight. Failure to comply with regulations would lead to severe penalties and potential derailment of the project’s development. 

• Asset-backed value

Security tokens are backed by real-world assets such as equities, bonds, debt, real estate, or profit-sharing agreements. This nature makes security tokens more closely related to traditional financial instruments and subject to securities regulations. 

• Investment Nature

Security tokens are particularly designed as investment instruments. This is why businesses offer security tokens and leverage security token development services. Investors would expect potential appreciation in the token’s value over time. 

• Regulatory Compliance

Security tokens must adhere to securities laws in the regions where they are issued. This could include registration with regulatory authorities, disclosures of financial information, and adherence to investor protection measures. The regulations for security tokens vary around the world, and projects must comply with these legal frameworks to remain compliant. 

Role of Security Tokens

Security Tokens’ use cases derive from its inherent investment and legal binding nature. Still, there’s a bunch of different utilities that a security token offers. Here’s a breakdown on their roles: 

• • Asset Tokenisation: Security tokens tokenise real-world assets.  Basically, this means converting the rights to these assets into digital tokens on a Blockchain.

• Legal Compliance: These tokens ensure legal compliance with securities regulations for the issuance, sale, and transfer of ownership, protecting both issuers and investors. 

• Ownership Representation: Security tokens represent ownership or a stake in an underlying asset, granting holders legal rights such as dividends, voting rights, or profit shares. 
• Efficient Transfer of Ownership: Blockchain technology facilitates efficient and transparent ownership transfers. Security tokens simplify the process of buying and selling assets, reducing paperwork and administrative burdens of traditional securities transactions.
• Increased Liquidity: By enabling secondary trading on compliant security token exchanges, security tokens enhance liquidity for traditionally illiquid assets, making it easier for investors to trade these tokens. 
• Global Accessibility: Security tokens can be traded globally due to the decentralised nature of blockchain technology, allowing for cross-border transactions.
• Automated Compliance: Smart contracts embedded in security tokens automate compliance with contractual and legal obligations, such as the dividend distribution and voting rights execution. There is no need for intermediaries.
• Fractional Ownership: Investors who might not afford the entire high-value assets can adopt fractional ownership through security tokens. 
• Innovation in Fundraising: Security tokens introduce new fundraising methods, like Security Token Offerings (STOs) which are regulated ways for companies to raise capital by offering security tokens to investors. 

What are the challenges? 

• Regulatory Compliance: Ensuring compliance with securities regulations poses a significant challenge for security tokens. Regulatory frameworks are different globally, and navigating these complexities requires substantial legal expertise and resources. 

• Regulatory Uncertainty: The regulatory landscape for security tokens is still evolving, and there are still disputes and uncertainties regarding how existing laws apply to these digital assets. Issuers and investors therefore will have to constantly keep up with regulation updates, which is a big hurdle. 
• High Initial Costs: Tokenizing securities and conducting regulated offerings like Security Token Offerings (STOs) involve substantial legal and compliance costs. These expenses can be prohibitive for smaller companies or startups.
• Liquidity Concerns: While security tokens aim to improve liquidity for traditionally illiquid assets, achieving this can be difficult. Success depends on market infrastructure, investor interest, and regulatory support.
• Educational Barriers: Education efforts are essential to increase awareness of market participants about the intrinsic value of security tokens and how they differ from traditional securities. Many potential clients may not yet understand the tokens, and if issuers want to facilitate broader adoption, they must educate the market. 
• Custody and Security: Just like utility tokens, security ones can be exposed to cyber breaches, custodial issues, or limitations created by their blockchain ecosystem. Safeguarding those digital assets is crucial for both issuers and investors. 
• Market Fragmentation: The security token market may experience fragmentation due to different blockchain platforms and standards, which can hinder seamless token transfers across platforms.
• Token Standardisation: The lack of standardised tokenization frameworks and protocols complicates the integration of security tokens across different platforms and exchanges. Standardisation is necessary for consistency and compatibility.
• Slow Adoption: The traditional financial industry has been slow to adopt security tokens due to concerns, scepticism, and regulatory uncertainties. Overcoming resistance and encouraging institutional participation remain ongoing challenges.

Key Distinctions between Utility Tokens and Security Tokens

• Purpose of Tokens

Utility Tokens: Serve a specific function within a blockchain ecosystem, offering exclusive access to features of Dapps or blockchain projects. 

Security Tokens: Represent ownership or investment in physical underlying assets or enterprises with hope for financial returns. 

• Source of Value

Utility Tokens: Derive from their utilities within specific Dapps or projects. 

Security Tokens: Derive from underlying assets or revenue streams they represent. 

• Investment Nature

Utility Tokens: Boast non-investment nature. 

Security Tokens: Particularly designed as investment instruments, subject to securities regulations. 

• Regulatory Implications

Utility Tokens: Subject to less stringent regulatory scrutiny. However, projects must clearly communicate the non-investment nature of the token. 

Security Tokens: Subject to securities regulations, must comply with strict legal requirements.