Grasping the Distinction Between Utility Tokens, Security Tokens, and Cryptocurrencies

Blockchain technology has substantially changed how we think of finance, ownership, and value transfer. Since the establishment of Bitcoin in 2009, the blockchain ecosystem has evolved rapidly and given birth to a multitude of digital assets. Utility tokens, security tokens and cryptocurrencies have been some of the most talked about—and confused—forms of blockchain-based assets.

While used interchangeably in the popular media, these are actually different types of blockchain-based assets. Each of them serves different purposes and is subject to different regulatory treatments, which is important to understand for investors, developers, regulators, and everyone else engaged with decentralized technologies.

This article will now take a deeper look at these three asset types, comparing how they work, their legal significance, and their respective roles in the blockchain ecosystem.

1. Cryptocurrencies: Blockchain, and More

What Are Cryptocurrencies?

Cryptocurrencies are digital or virtual currencies that function as a means of exchange and use cryptographic techniques for security. All cryptocurrencies are decentralized and operate on a network based on blockchain technology. The most widely recognized example of cryptocurrency is Bitcoin (BTC), which was introduced as a peer-to-peer electronic cash system.

It’s necessary to point out the difference between native cryptocurrencies and the various tokens that are developed on blockchains. Cryptocurrencies are the native, core assets and lifeblood of any blockchain network.  For example, on the Bitcoin blockchain there is Bitcoin (BTC) and on the Ethereum blockchain there is Ether (ETH). When looking at cryptocurrencies in a traditional way, they act as both a store of value and a medium of exchange. Additionally, they operate the functions that are established or determined by the network such as gas fees (the transaction fee that miners receive for validating transactions) or security incentives (the fees that miners or stakers receive for validating transactions and “securing” the network).

While other digital assets – examples include Tether (USDT), DAI (embedded token), Shiba-Inu (SHIB), and Uniswap (UNI) – have some utility or reason for value, they are tokens under a technical definition. They are designed to operate on decentralized apps or platforms that are built on top of a blockchain protocol.

Key Features:

• Decentralized – Cryptocurrencies are created and utilized on a distributed network maintained and managed by network participants, without any central authority or agency overseeing circulation.
• Means of Exchange – Cryptocurrencies were created and are used primarily to exchange
• Store of Value – Bitcoin has been commonly referred to as “digital gold.”
• Mining/Staking – Mining (Proof of Work) and staking (Proof of Stake) are some of the ways cryptocurrencies are created.
• Native to Network: Native cryptocurrencies like BTC and ETH are on their own blockchains. The creation, validation, and transfer of these native cryptocurrencies are part of the protocol of the blockchain. Thus, they function as the primary means of verification, integrity, and functionality of the network.

Examples:

• Bitcoin (BTC) – Bitcoin was developed and offered as a decentralized digital currency.
• Ethereum (ETH) – Ethereum was originally created as a smart contract platform but is also used as a cryptocurrency.

Use Cases:

• Payment for goods and services
• Cross-border remittance
• Wealth storage in countries where the local currency has fluctuated significantly
• Portfolio diversification

Legal and Regulatory Issues:

Cryptocurrencies exist in a regulatory grey area. Some countries treat them as property (the U.S.); others handle them as currency or don’t allow them at all. Unlike security tokens, most cryptocurrencies are not regulatory investment contracts, but regulators have begun to treat them as such – this is changing as well.

2. Utility Tokens: Access to Services

What Is a Utility Token?

Utility tokens provide users access to a blockchain-based product or service, rather than being intended as investments, utility tokens should be used in an ecosystem.

Key Features:

• Investment-Usually not established to generate profits or dividends
• Platform-Specific Tokens-Usually developed for a specific distributed app or service in a blockchain platform
• Functional Access-Utility tokens are digital tokens that allow users access to different functions or services

Example Utility Tokens:

• Filecoin (FIL) – used to acquire decentralized storage space
• Basic Attention Token (BAT) – allows users to make micropayments on the Brave browser
• Golem (GLM) – used to acquire access to decentralized computing power

Use Cases:

• Access to dApps – (decentralized applications)
• Access to any service in a blockchain ecosystem
• Fuel our smart contract execution – (e.g., gas on the Ethereum Network)

Regulatory Challenges:

Utility tokens are generally not recognized as securities; however, utility tokens’ legal status has come under scrutiny based on their initial distribution (via ICO) and the manner in which they are promoted and marketed to the public. If utility tokens were marketed as investments or if purchasers anticipated a future profit potential or profit from the reselling of a utility token, such as an ICO, then regulators may classify the utility token as a security based on the legal analysis (Howey Test) of whether the utility token is a security in the United States.

3. Security Tokens: Digital Investment Contracts

What are Security Tokens?

Security tokens are a reflection of ownership of an asset (like equity, real estate, or debt) that is meant to be regulated as securities. They are akin to traditional financial instruments but they are issued and traded on a blockchain.

The three key characteristics of Security Tokens are:

• Investment: They generally provide rights to dividends, shares of revenue, or interest payments.
• Regulated: No securities are unregulated, general need to comply with securities laws; however, they often require registration or particular exemptions.
• Asset-backed: They usually have an issuer backed by actual assets or shares of a company.

Example of Security Tokens:

• tZERO – A marketplace that authorized trading of security tokens in accordance with U.S. securities laws, policies and regulations.
• SPiCE VC – A venture capital fund that is a token on the blockchain.
• INX Token – ownership represents equity in the INX trading platform for digital assets.

Use Cases:

• Tokenized equity and debt issues.
• Shares of ownership in real estate.
• Fractionalized ownership of commodities or collectibles.
• Revenue-sharing investment models.

Regulatory Considerations:

Security tokens must be compliant with existing securities laws. In the United States, depending on the amount of money being offered, registration must be made with the SEC or one of the exemptions, like Regulation D, Regulation A+, or Regulation S. This clearly communicates that compliance implementation has made the process legally more complicated, but moreover, it adds a legal layer of investor protection as security tokens offer more investor protection than utilities or cryptocurrencies.

Real World Implications

For Investors:

It is beneficial to understand the difference between these tokens when it comes to risk and compliance. Typically, an investment in a cryptocurrency like bitcoin has market risk and few legal restrictions. On the other hand, when investing in a security token, the investor must account for accredited investors and restricted markets, knowing that they are getting dividend-like returns from an equity stake in the project, most likely portability of that investment, and a clear exit plan when it is time to divest.

For Projects:

Blockchain projects need to properly choose their token model. If offering a utility token, it is important to strongly advise participants that the token is not an investment vehicle. Otherwise, it will be risk complicated legal consequences. Security token offerings (STOs) are generally additional work and expense to the project, but they represent a compliant way to raise capital from investors.

For Regulators:

Governments and regulators are still figuring out how to deal with the rapidly expanding crypto space. Being able to tell these token types apart will assist in drafting appropriate rules and regulations that achieve safeguarding investors to an appropriate level (without excessive burdens) while still promoting innovation. Recognizing the case for securities tokens provides an avenue to modernize capital markets without having to sacrifice oversight.

Regulatory Case Study: The Howey Test

In the United States, the determination of whether a token is a security or not is often based upon the Howey Test, which is a legal standard that arose from a 1946 Supreme Court Case. The test has 4 prongs:

• An investment of money,
• In a common enterprise,
• With a reasonable expectation of profits,
• Derived from the efforts of others.

Many utility tokens issued in an ICO context have not passed this test, resulting in enforcement actions for the SEC. For example, Telegram’s TON and Kik’s Kin token were fined or terminated, respectively, after selling what was considered unregistered securities.

The Future of Digital Assets

The lines between these types of tokens may continue to blur as blockchain technology develops further. Ethereum 2.0 and other scalable platforms have made it easier than ever to create tokens, while we are also seeing emerging hybrid models – tokens that possess qualities of both utility tokens and security tokens.

Central bank digital currencies (CBDCs) and stablecoins also add a layer here, giving us the opportunity to consider government-backed or price-stable digital assets that differ from the other three categories,  but can very well interact with them.

Security tokens are likely to grow as institutions begin adopting blockchain. Tokenized securities can promise liquidity, fractional ownership, and access to global investors – advantages that often exist with traditional financial markets.

Utility tokens, security tokens, and cryptocurrencies all exist under the system of blockchain, yet they are unique in their design, purpose, and treatment under the law. The ability to differentiate between these tokens is not only a helpful academic idea – it is also important for understanding the opportunities and risks for everyone within the world of digital assets.

Whether you are a developer working to create the next decentralized application, an investor deploying capital into crypto markets, or a regulator ensuring everyone plays nice, understanding these classifications gives you a useful foundation.

As the world of regulations develops and blockchain adoption increases, it seems the best investment anyone can make is in what they understand – those are the things that bring comfort and excitement.