Everything you need to know about Utility Tokens in blockchain


Utility Tokens is a popular topic in the blockchain world, but there’s still a lot of people that are confused on what Utility Tokens are and how they differ from Security Tokens. No worries, we’re here to break down every piece of it in an easy to understand way for everyone!

Quick Summary:

  • ICOs – to explain where tokens come from.
  • Types of token – to differentiate kinds of token.
  • Difference – to solidify the differences between security and utility tokens.
  • Regulation – to highlight the role of the SEC within the crypto sphere.
  • Benefits – to underline the purpose of utility tokens.
  • Industry disruption – to discuss their potential as monopoly breaking game changers.

In summary, this article gives a background on utility tokens in a logical manner.  It develops from a statement of their beginning and goes along a journey that details their place within the crypto world, concluding with commentary on how utility tokens can benefit the people.

Everything You Need to Know About Utility Tokens

Have you ever wondered about utility tokens?  Well, if knowledge is power, then you’ve come to the right place to level up.  Read on to find out more about what they are, why they differ to security tokens, and how they fit into the crypto space.

Money, Money, Money

Money makes the world go around, and the crypto space is no different.  All crypto projects need money in order to accomplish their purpose – which is where Initial Coin Offerings (ICOs) come in.

In exchange for money or an existing cryptocurrency such as Bitcoin or Ethereum, ICOs allow investors to back a project, giving it the capital needed for development.  In return, the investor receives a non-physical token specific to the ICO.

Types of Token

You’ll likely come across two types of token:

Security Tokens – are digital assets that represent shares in a crypto project.  They are classed as a securities product and so fall under the jurisdiction of federal laws.

Non-compliance with regulation could result in penalties and the threat of project termination.

Utility Tokens – are not created to be an investment.  Their purpose is to enable access to the products/services offered by the crypto project. 

A good example is the decentralized cloud storage service Storj, whose utility tokens allow holders access to storage space on the Storj network.

What’s the Difference?

The main difference lies in their intended use.

Security tokens are investments, the holders have ownership rights, a say in how the company is run, and they also receive dividends, in the form of additional coins, if a profit is made. 

On the other hand, utility tokens are not classed as investments, the holders don’t have any ownership rights or a say in how the company is run, they merely enable access to the issuing company’s products/services.

Both security and utility tokens are traded on crypto exchanges, and both can increase in value, which is why many people find it hard to differentiate them.  However, the Securities and Exchanges Commission (SEC) have devised a test to determine whether a cryptocurrency token is either a security token or utility token.

The Howey Test

The Howey Test is used to differentiate between security tokens and utility tokens.  It can be summarised by asking two questions:

  • Does the project offer an opportunity to contribute money and share in the profits?
  • Are profits generated from the efforts of people other than the creator/founder of the project?

A token is likely a security if the answer to both questions is yes.

The Law

The Securities Act of 1933 was set up as a result of the 1929 stock market crash.  It has two main objectives:

  • To prevent fraudulent activities, such as misrepresentations and deceit.
  • To ensure transparency so that investors can make better-informed decisions.

Any organization that issues securities must register their investment contracts with the SEC.  Failure to do so can result in fines, lawsuits, penalties or imprisonment.

There is also a requirement to disclose:

  • How shareholders will have their voices heard.
  • How reports on company activities and financial performance will be compiled.
  • How money laundering will be dealt with.

All in all, these are costly and time-consuming obligations.

Why Does This Matter?

With ICOs raising $6.8billion for blockchain start-ups in 2018; there’s no denying they represent a significant form of investment.  But that’s not to say everything is rosy. 

In fact, most ICOs actually issue security tokens but pass them off as utility tokens in order to sidestep legal requirements. 

Scammers also exploit the lack of regulation around utility tokens.  ICO exit scams totaled approximately $100million over the last two years.  Of which, a single company, Shenzhen Puyin Blockchain Group, is alleged to be responsible for $60million of that figure.  They reportedly ran three ICO scams in PuyinCoin, BioLifeChain, and AAChain – none of which materialized.   

As such, correctly classifying a token matters on the basis of protecting investors, and as a way of legitimizing the crypto space.

Regulation

With so much money flowing into the crypto space, it’s evitable that regulators will act.  But this is easier said than done.  To begin with, securities laws were passed before the internet existed, with that in mind, is it fair to apply these rules to blockchain companies?  In addition, how do we reconcile the varying international laws when cryptocurrencies, by their very nature, transcend geographical boundaries?

All too often, many in the crypto space see regulation as something that’s spoiling the party.  But in truth, without legitimizing the crypto space, cryptocurrencies will never achieve mass adoption, and nor will they shake their scam reputation amongst the uninitiated.

The SEC is not against ICOs as such, its main goal, as far as cryptocurrencies are concerned, is to ensure all ICOs follow the rules.  Earlier this year, they set up a cryptocurrency task force and started investigating non-compliant ICOs, of which Tezos is perhaps the biggest company they’ve brought to task.  The SEC claimed their ICO utility tokens were, in fact, security tokens, meaning they should have registered their ICO proposal before selling to investors.

Start-ups now realize that non-compliance will lead to consequences.  And things are headed in the right direction, as far as cleaning up the crypto space is concerned.  Already this year, there have been several SEC-compliant ICOs, including Polymath, Corl, and tZERO.

What’s the Point of Utility Tokens Then?

Moving on from token classification and crypto regulation, we now know that utility tokens lack investor protection, and holders have no say in the running of the project.  So why bother with utility tokens?

The answer lies in community building, after all, a crypto project with a solid community behind it is more likely to succeed.  With a utility token, there are no guarantees or expectations of dividends, meaning people tend to invest because they believe in what the project is trying to achieve.

By removing the expectation of short-term monetary gains, a crypto project will accrue a following that cares about what is happening at the project.  And being this market focused, more often than not, leads to crypto stardom.

Unfair Platforms

As utility tokens prioritize community over short-term profit, their ideology is one of social harmony, which is something that is often forgotten in the pursuit of gains.  This can be further demonstrated through their potential effect on platforms.

Examples of platforms include Airbnb, eBay, and Uber.  These companies provide a platform ecosystem that connects buyers with sellers in a convenient way.  However, not every stakeholder benefits to the same degree. 

Let’s take the example of eBay.  As the platform provider, eBay earns the majority of the money and gets to be a major player in online retail.  Buyers also benefit from having access to millions of products.  But sellers have to:

  • Bear the cost of fraud.
  • Pay hefty PayPal fees.
  • Share part of their revenue with eBay.

Under this system, the power of the platform owner creates an imbalance in the market.    

Times Are Changing

The current platform system is unfair; however, utility tokens have the potential to change that.

We already know that utility tokens give access to participate within a crypto ecosystem, and when this concept is tied to a fairer set of rules under a smart contract, all stakeholders can be incentivized to behave in a way that benefits themselves and the market.

Let’s break this down with the example of concert tickets.  The problem with concert tickets is that hot artists sell out fast, and ticket prices in the secondary market get massively inflated.  But imagine if ticketing ran through a blockchain system.

The Aventus project is working on doing just that.  Their utility token is called AVT, and it operates under smart contracts that outline every ticket transaction. 

Under their system, buyers would know how much the seller paid for the ticket.  So, if someone tried to sell you a ticket, but you knew they paid a third of the asking price, would you go ahead and purchase?  Chances are, you wouldn’t. 

Price transparency is one thing, but what will really drive change is the use of immutable pre-determined fair rules. 

Smart Contracts

Smart contracts add a dimension of fairness by acting as a referee.  If you play to the rules then everything is fine, but if you break the rules, you’ll suffer a consequence.

To participate, ticket sellers need to contribute, or “stake”, AVT to the system.  In the process of buyers and sellers interacting, if the system recognizes that a seller has sold a ticket at an unfair price, all, or part of their staking tokens are taken away.

This is better than the current system because the confiscated tokens go to the stakeholder who raising the problem, and not the platform provider, Aventus.

Projects that use utility tokens can re-create the rules of the game, and because authority is built into the system through smart contracts, execution of the rules is swift and automatic. 

Should enough people agree that the rules are fair, then the makings of a revolution are in place.


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Samuel Tan

Samuel Wan has been an analyst and cryptocurrency evangelist for the last few years. Previously he worked as a consultant for a Big 4 consulting firm and is passionate about how blockchain will make an impact in the world. You can contact Sam at s@cryptomenow.com

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