When talking of security tokens, it makes sense to start ab ovo and define securities in the first place. Here’s the definition from the US Securities & Exchange Commission: “an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.” Simply put, anything invested from outside with the objective to gain profits is deemed a security. The same applies to security tokens: external investors acquire the tokens expecting to reap the dividends.
Can we call any crypto a security token and what are the key criteria? The best way to check is to conduct a litmus test, aka the ‘Howey Test‘. What is it all about? The ‘Howey Test’ was conceived by the Supreme Court to determine which transactions qualify as ‘investment contracts.’ According to the Securities Act of 1933 and the Securities Exchange Act of 1934, there are four factors that help tell apart the securities and:
- Investment of money
- In a common enterprise
- With an expectation of profits
- From the efforts of others.
All four criteria match? Bingo, you are dealing with security tokens, and therefore facing the relevant disclosure and registration requirements.
Now, how are they better than or different from utility tokens? In fact, it’s much easier to issue security tokens in accordance with the clear rules. That’s how you mitigate legal risks and, at the end of the day, render the entire process more cost-effective. The bottleneck here is strict regulations on who can be an investor and how the tokens are distributed. Security tokens have no liquidity which may limit your opportunities. Chance are you’ll scare off the network and slow down the product development.
Security tokens may represent different financial tools such as may represent different financial tools such as the company’s shares whereas utility tokens unlock access to this company’s products or services and have a ‘utilitarian’ function. It’s worth noting that ‘utility token’ is not a legal designation. SEC has no official guidelines on these tokens so the question whether securities regulations apply to them remains an open question.
Utilities have their specific use cases and they are not designed as an investment, however, they do yield profits. They may grow in price should the demand for the product or service increase. As the solution starts bringing more value to the customers and the company’s services improve over time, token holders may benefit greatly in the mid-term perspective.
Matt Levine at Bloomberg compares utility tokens to a Starbucks card: “A Starbucks gift card is probably not a security, even though you pay money to a corporation for the card and expect to get back something in the future, because you are not investing the money in the expectation of profit: You’re investing it in the expectation of coffee.”
Consider all the pros and cons before issuing — or investing into — either type of coin. Look deeper into the legal aspects and define your ultimate goal, listen to your hunch and enjoy the beauty of the global tokenization.