A utility token can have several functions

Security token

Security tokens are tokenized investments that are intended to comply with applicable regulations for securities. So they are officially approved securities in token form.

Tokens are built on an existing blockchain; they represent a kind of benefit and only apply to it. Outside of their token environment, neither security tokens nor utility tokens are particularly suitable. However, the uses of tokens can be varied.

Three dominant fields of application have emerged for tokens: security tokens, utility tokens and payment tokens. What are the differences?

What is the difference between security tokens, utility tokens and payment tokens?

Utility token

Utility tokens are digital vouchers that entitle their owner to some type of access on a platform. Most companies link utility tokens to specific services, such as the activation of functions within an app. According to the US Securities and Exchange Commission, utility tokens may not have any financial incentives. This means that the issuer may not promise investors any kind of return.

However, the debate about the legal classification of utility tokens in the USA persists. According to SEC Chairman Jay Clayton, all tokens issued through ICOs are securities.

Security token

The situation is different with security tokens. Security tokens are token-based assets and are clearly advertised as such. The regulatory authorities therefore treat them in regulatory terms like traditional securities. For example, companies are obliged to prepare a so-called securities prospectus. Before they can issue security tokens, the supervisory authorities must agree to this. The issuance of security tokens is then called Security Token Offerings or STO.

The big difference between security tokens and utility tokens is the following: While utility tokens mostly serve a blockchain use case, security tokens are regulated investments like company shares. The main difference to conventional assets is their token structure.
This results in decisive advantages: Issuers do not have to certify tokens, they are therefore independent of settlement centers such as Clearstream and Co. Every existing security, regardless of whether it is a share, bond or certificate, can be issued as a security token. The decisive difference to a traditional share is the change of medium, from certificate to token and the change to the settlement infrastructure from electronic securities registers and clearing houses to a blockchain infrastructure.

Payment token

Payment tokens are classic cryptocurrencies such as Bitcoin, Monero and Litecoin. You are not bound to a project; their purpose is correspondingly versatile. Payment tokens usually have their own blockchain on which the "account balances", i.e. the transaction history, are recorded.

The purpose of payment tokens is payment. Accordingly, they have properties similar to money.

What is the Howey test?

Do investors invest money with the understandable expectation of a return? Is the issuer a company with the usual hierarchical structures? Is the return of investment (ROI) under the control of the issuer?

If all of these questions can be answered with yes, the Howey test is considered positive. Ergo: According to the definition of the SEC, the instrument is a security. The Howey test is also used for crypto tokens. Because although utility tokens often want to evade their label as a security, judging by their structure, in most cases they can only be classified as such. So the Howey test looks at the underlying substance of assets, not how it is labeled.

At this point it should be noted that the US is the largest financial market in the world, but not the only one. As is known, regulations can differ depending on the jurisdiction; accordingly, the Howey test is not used everywhere. However, it has been shown in the past that many states follow the fundamental thrust of the US authorities. The regulatory treatment of tokens in the USA should therefore have a great signaling effect.

What can security tokens do?

One often speaks of the institutionalization of the crypto market. Because until then, major financial institutions such as asset managers and banks have largely stayed away from the young market for digital assets. Security tokens could play an important role in the imminent building of bridges.

1. Investor protection

Security tokens are tokenized investments and therefore generally regulated financial products. Issuers must be listed with the responsible securities regulator with their real names and company address; Exit scams, as they were on the agenda during the ICO hype 2017, are difficult to impossible.

2. Tradability

Due to their structure as blockchain assets, investors can trade security tokens peer-to-peer. Exchanges, whether state or private, have to comply with certain regulations, but the advantage is that security tokens can be traded around the clock. Because blockchains don't close - unlike traditional stock exchanges.

This also implies a faster trading speed than in the traditional financial market. After all, with blockchain assets, investors do not have to wait for the assets traded to be booked for several days. The booking of token trades based on blockchain is almost instantaneous.

3. Fractional ownership

Asset classes such as real estate, works of art or stocks sometimes have high unit costs. They are often so high that private small investors have little access to these markets.

It is completely different with STOs. Security tokens allow high-priced investments to be scaled down into individual tokens. In this way, even investors with less deep pockets can assert fractional ownership claims to shares, bonds or valuables and thus gain access to markets that were previously closed to them.

4. Range

Security tokens are becoming an asset class for everyone. While investors can only purchase conventional securities on exchanges, buying security tokens is quite simple. With so-called STOs (Security Token Offerings), i.e. the process of issuing tokenized securities, security tokens can be purchased directly. The peer-to-peer structure thus reduces friction losses that can lead to a reduction in trading volume in the complexity of the traditional financial sector.

Conversely, this means that security tokens are a potentially attractive participation vehicle for small investors. After all, the token form makes assets accessible that, due to their complexity, were previously reserved for professional investors such as banks or family offices.

Where can I buy security tokens?

How can you buy and sell security tokens? Where can I buy and sell security tokens? In principle, investors have two options for investing in security tokens: on the primary market on the one hand and on the secondary market on the other.

1. Primary market

Newly issued securities are traded on primary markets. The first acquisition of a new financial product always takes place on the primary market. This applies equally to the traditional financial sector and the crypto market.

While stock corporations bring company shares to the market via IPO (Initial Public Offering) via stock exchanges, security tokens can be sold via STOs. The advantage: The companies can also issue regulated securities as a GmbH.

(BTC-ECHO has dedicated its own tutorial to the STOs. You can find it here.)

2. Secondary market

If investors want to sell securities to third parties, they do so on the secondary market. There are several options for trading security tokens: Investors can sell the security over-the-counter (OTC); the token changes hands with the private key.

Or they resort to trading venues. Due to the regulated environment in which security tokens operate, the secondary trading venues must also have received regulatory approval.

However, it should be difficult to prevent conventional Bitcoin exchanges from making their platform available to customers from other jurisdictions. Then the regulations of the domestic authorities no longer apply, but those from abroad. Investors could avoid the strict European standards in this way. If the Malta-based Bitcoin exchange Binance decides to set up a trading environment for security tokens, BaFin will find it difficult to prevent German citizens from participating.

Conclusion

Security tokens are securities. Although they are issued and traded on a blockchain, unlike utility tokens, they do not have to have a blockchain use case. STOs can best be compared with the classic IPOs, the IPOs. Compared to the latter, however, STOs offer some advantages: Companies do not have to first set up a stock corporation and can thus save costs. On the investor side, security tokens offer the first fully regulated investment case with blockchain application. The token structure allows investors to trade security tokens on the primary and secondary market peer-to-peer. This saves you intermediation costs. Companies issue security tokens on the primary market in what is known as a security token offering.