- March 7, 2019
- Posted by: admin
- Category: Uncategorized
With many startups turning to ICOs to generate capital for their businesses, the SEC has had to determine if any of the tokens issued by these companies should come under their regulations. As a result, there are currently two different categories that cryptocurrency tokens fall into: utility tokens and security tokens.
The main distinction between utility and security tokens is that one is created to provide users with access to products or services while the other provides an investment opportunity. One way to differentiate between them is through the “Howey Test”.
The Howey Test
This test was the result of a Supreme Court case in 1946 known as SEC vs Howey. This test is designed to test whether a transaction involves an investment contract by asking the following questions:
- Is it an investment of money?
- Is a profit on investment expected?
- Is the investment in a common enterprise?
- Is there an expectation of profit from the work of a third party?
If all answers point to yes, then the transaction is considered to include an investment contract and it would then be subject to securities regulations.
Security tokens are any cryptocurrency tokens that pass the Howey Test, or in other words, tokens created primarily as a way for investors to make a profit or speculate on projects. As such, they are subject to federal regulation like any other securities. It can be thought of as digital tokens that combine the traditional model of raising money through IPOs with being built through blockchain technology.
While most cryptocurrency tokens are currently considered utility tokens (SEC has ruled Bitcoinand Ethereum to not be securities), security tokens have a potential to be large players in the cryptocurrency market as it can bridge the gap between traditional financial markets and the current blockchain space.
Why are security tokens important?
- Removing the Middlemen: Traditionally, getting investors involved in a business necessitates the participation of multiple players like banks and legal firms. With smart contract technology and the use of security tokens, the middlemen in this process can be eliminated which can reduce fees, inefficiencies and time.
- Global Investment Pool: While they will be regulated, security tokens can be marketed to anyone with an internet connection, meaning companies will be able to receive funding from investors all over the world.
- Decentralisation: Using a decentralised model that employs smart contracts, this type of fund procurement process will be less susceptible to manipulation and corruption.
Utility tokens are cryptocurrency tokens that provide token holders access to products or services from the company in the future. For example, tokens can provide access to using a startup’s network or give them voting rights. Utility tokens are sold specifically to be used for the services or products a company is developing – they are not designed to be investments.
Similar to security tokens, the value of utility tokens can go up or down based on the supply and demand of the ecosystem. Usually, they are sold in crowdsales known as token generation events (TGEs) or token distribution events (TDEs) to differentiate them from security tokens.
Since utility tokens are not designed to be an investment, with proper structuring, they do not have to follow federal laws that govern securities.