Utility tokens: definition, difference from security tokens, and why this matters to regulators like the SEC

Utility tokens provide value to the users of a specific dApp or blockchain ecosystems and are different from security tokens, which constitute pure investment contracts. However, regulators – especially the SEC – sometimes view utility tokens as securities. Why is that – and should you as a buyer  get concerned?

Token or coin: learn the difference

Before we turn to the differences between utility and security tokens, we should go over the token vs. coin debate. Very often these terms are used interchangeably, but is it correct? 

You’ll read a lot of different opinions online (‘they are the same’), but perhaps the clearest distinction is this: a coin runs on its own blockchain, while a token operates on an existing chain created by someone else. Under this classification, BTC, ETH, LTC and DOGE are coins, but UNI, USDT, DAI, USDC, etc. are all tokens. The following chart shows the largest tokens by market cap:

Interestingly, all popular stablecoins (USDT, USDC, BUSD, DAI etc.) are tokens. So far there is no major stablecoin that runs on its own chain – but this may change soon. Facebook-backed Diem  blockchain will have a stablecoin as its main asset. 

In terms of purpose, you could say that a coin is designed as a medium of exchange for its blockchain, as well as to store value – in short, as the chain’s native currency. First-generation coins in particular, such as BTC, LTC, BCH, and DOGE, were designed primarily as currencies. By contrast, a token is a unit of value issued by a specific dApp or platform, and it can have very different roles – from giving access to services to entitling the holder to a share in the profits. Which brings us to our main  topic: utility tokens and how they differ from security tokens. 

Utility token vs. security token

What is a utility token?

There is no single accepted definition of a utility token. We can describe it as a digital asset that has value within its own ecosystem and provides its holder with certain privileges and rights (i.e. utility), for example:

• access to the platform and its services; 
• the right to vote on technical improvements and upgrades;
• access to member-only features;
• possibility to pay for items and services on the platform;
• loyalty rewards, etc.
  

What is a security token?

 A security token is a type of an investment contract that meets the definition of a security in the jurisdiction where it’s registered. Usually security tokens entitle the holder to one or more of the following:

• a right to a share in the project’s profits;
• an ownership stake in the project or an asset;
• a right to receive dividends or fixed income.
  

While there are occasional security token offerings (STOs), the vast majority of projects holding IDOs (initial DEX offerings) and IEOs (initial exchange offerings) list their tokens as utility. This is because a security token should (in theory) be registered and regulated as a security - a tedious and sometimes expensive process. And indeed, holding DOT, LINK, or MATIC doesn’t mean you’ll receive a percentage of the profits earned by Polkadot or Polygon, so they seem to satisfy the definition of a utility token. Or do they?

The SEC (U.S. Securities and Exchange Commission) has a view on what constitutes a security – and it all comes down to the so-called Howey Test. 

The Howey Test

The name ‘Howey test’ comes from the landmark 1946 Supreme Court case: SEC vs. W. J. Howey Co. To make a long story short, the company (founded by a certain William John Howey) owned vast orange groves in Florida. It offered investors an interesting deal: buy a tract of land with orange trees and then immediately lease it back to W. J. Howey Co, which would take care of them and harvest the oranges. The buyer wouldn’t have to do anything but collect the profits from the sale of the produce. 

The SEC concluded that the leaseback contracts were an unregistered security and sued Howey. The district court in Florida initially decided against the SEC, but the Supreme Court eventually confirmed that Howey had been selling investment contracts – that is, securities. In the process, Justice Frank Murphy formulated what we now know as the Howey Test.  It defines an investment contract as:

1. an investment of money (can also mean ‘assets’, such as cryptocurrency)
2. in a common enterprise
3. with an expectation of earning a profit
4. the profit being a result of the efforts of a third party.
   

Based on these criteria, the SEC has repeatedly attacked ICOs and IDOs (e.g. Telegram’s TON) as unregistered security offerings – but why?

Applying the Howey Test to blockchain tokens

Bona fide blockchain projects sell tokens with the goal of building something useful, so they view their own tokens as utilities. However, many speculative ICO, IEO, and IDO investors buy tokens not because they plan to use them on their respective platforms in the future, but rather because they hope to sell them at a profit once the price goes up. 

So, following the Howey Test scheme, 

• an IDO participant invests digital currency (USDT, ETH, etc.)
• in a common enterprise – a blockchain platform that hasn’t been built yet;
• expecting that the price of the token will go up in the future, so that they can sell higher than the IDO price;
• and that price increase will result from the project team’s hard work (development, marketing, partnerships etc.).
  

Importantly, the SEC admits that a token itself isn’t a security but just a piece of code. The Commission is interested in how the asset is sold and what the buyers expect. If the sale’s objective is to develop the enterprise and the buyers are non-users, then the asset is a security in the SEC’s eyes. 

On the other hand, the SEC won’t view a token as a security if a network is decentralized enough that the founders’ efforts don’t determine its success - or if token purchasers can’t reasonably expect any specific group of people to run the project in such a way as to make the token more valuable. This, by the way, is the reason why ETH isn’t a security as per the Commission.

Of course, a project that sells tokens to fund the development can later evolve into a proper decentralized network, and the need to register a token as a security can hamper this process. Understanding this, one of the members of the Commission, Hester M. Pierce, recently submitted a so-called safe harbor proposal that would give developers a 3-year grace period before they have to determine if their token sale needs to be registered. It remains to be seen if this proposal is eventually implemented.

Possible courses of action for projects

1) Exclude US investors from the token sale

Will it work?

Probably, if there is a proper KYC projects can exclude US investors if token is not registered as a security 

The SEC’s primary concern is that unregistered securities (=tokens) could end up in the hands of US investors. For this reason, many projects expressly ban USA residents from participating in their token sales in the Terms & Conditions, but it’s not enough. Filtering users by IP address doesn’t do the job, either: someone using a VPN can easily circumvent the restrictions. A better solution is a KYC, or identity verification. 

Case in point: Polkastarter

Even though IDOs seem like a more decentralized way to raise funds than IEOs, you normally have to pass a KYC to take part in a token sale on an IDO platform like Polkastarter, DAO Pad, or BSCPad.

Every project decides on its own whitelisting and KYC rules, as well as a list of excluded countries. Normally users are asked to submit an ID and a selfie with that ID, so if US residents are excluded (as they usually are), someone with a US driver’s license or passport won’t pass the check. 

This method isn’t perfect, however. Even if a project manages to filter out US users at the token sale stage, it’s difficult to prevent them from buying the tokens later in the secondary market (we’ll encounter this issue again with Telegram’s TON – read on). 

Still, most IDO projects being small (around $500k per sale), it’s unlikely that the SEC will go after them in full force. The Commission has bigger fish to fry, after all - such as Ripple. There is an ongoing lawsuit, wherein the SEC claims that the original XRP sale in 2013 was an unregistered security offering. Ripple Labs, Inc. In response, Ripple has demanded that the Commission disclose the internal documents that explain why transactions with XRP should be considered securities while those with ETH or BTC shouldn’t. The outcome of this case could clarify the utility vs. security definition for projects going forward. 

2) Build a platform first, distribute tokens later

Will it work? 

Not for large and prominent projects, though it might work for a small cap token

One of the Howie Test’s criteria is investing in a common enterprise – that is, building a blockchain platform. If a company completes the development using its own funds and then conducts a sale, it can theoretically claim that the token doesn’t fit the Howie Test. 

Case in Point: TON

Telegram Open Network’s ICO became one the largest in history, raising $1.7 billion for 2.9 billion GRAM tokens. Only accredited investors could participate, and they would only receive the tokens once the blockchain was launched. Moreover, the contract included an explicit ban on re-selling, offering, or pledging GRAM to a third party before the launch. This way, once GRAM tokens were delivered to the buyers, they would already have practical utility within the TON ecosystem and so wouldn’t constitute a security. 

This strategy didn’t work, however. The SEC obtained a restraining order and blocked the distribution in October 2019, just three weeks before the planned launch. The Commission’s grounds were simple: once the initial buyers received their GRAM, they were free to re-sell them in the secondary markets (presumably for a profit). TON founders had no way of preventing US residents from buying those tokens. 

Eventually Telegram quit work on the project, paid a $18.5M fine, and repaid the ICO investors. The company also raised $1 billion by selling bonds  and is reportedly considering an IPO, while the TON project lives on as Free TON.

3) Design a real utility token

Will it work?

Should work, though it can make it more difficult to attract buyers. 

Case in point: Turnkey Jet 

In 2019, the SEC issued its first No-Action Letter concerning a token – basically saying that it won’t try to block an unregistered token sale, since the token doesn’t have the characteristics of a security. 

The Commission wrote the following about  Turnkey Jet’s blockchain platform: 

"The platform used to sell the tokens will be fully developed and operational at the time of the sale. The funds from sales will not be used to develop the platform.

The tokens will be immediately usable for their intended functionality (purchasing air charter services).

The tokens will be transferable on the internal platform only.

The tokens will be sold at the same price throughout the existence of the company.

The company will offer to repurchase tokens only at a discount of the face value.

The tokens are marketed in a manner that emphasizes the functionality of the token and not the potential for the increase in market value.

Thus, to be considered a utility token and not a security, a token must be for consumption only. Utility tokens appear to be very similar to gift cards: a prepaid store-valued token to be used as an alternative to cash for purchases within a particular company."

In short, there was no way to make money with the token, so there was no reason to view it as an investment. However, two years later, Turnkey Jet’s site doesn’t mention the token, indicating that the blockchain solution didn’t catch on. Perhaps users weren’t that interested in booking charter jet flights with tokens, after all. 

4) Issue a stablecoin instead of a regular token

Will it work?
It should: a stablecoin’s price doesn’t increase, so buyers won’t be able to make a profit.

Case in point: Diem

We can’t know for sure if the utility vs. security debate caused the Diem Association to opt for a stablecoin rather than a regular token, but it might be one of the reasons. The Facebook-backed project faced a lot of regulatory scrutiny  when it first announced a stablecoin called Libra, pegged to a basket of currencies. The new Diem stablecoin will be pegged to the US dollar and issued by Silvergate Bank, which will also manage the stablecoin’s USD collateral. A pilot could be launched in late 2021, and the specially created Novi wallet has already been approved in most US states. 

As Pontem is building an experimental network for Diem to let developers test out Diem-compatible dApps and gain early traction, we are closely following everything that happens around Diem, including potential regulatory issues. Even if the launch of Diem is delayed for any reason, developers will still be able to test out their Diem-compatible apps on Pontem Network, tap into the liquidity of the Polkadot ecosystem, and gain traction. 

5) Register the token with the SEC

Will it work?

It might, with the help of good lawyers – but it may take so much time and money as to make the whole project useless.

In the past, quite a few token sales were registered under the so-called Regulation D (Reg D), but recently a new procedure has emerged, called Reg A+. The main technical differences between them are these:

• Reg D only allows projects to raise funds from accredited US investors, and it’s the issuer’s job to verify that each investor is accredited; by contrast, Reg A+ gives the right to attract money from both qualified and unqualified investors;
• A Reg D offering is not capped, while Reg A+ allows one to raise up to $50M;
• With Reg A+,the tokens can be immediately resold in the secondary market; Reg D has a lock-up period of one year;
• Reg A+ security can be listed on NASDAQ or NYSE, while those registered under Reg D are considered private securities.
  

The downside of Reg A+ is that the approval process can take many months, and the legal costs can be too high for a blockchain startup. Reg A+ offerings are more of an option for larger projects with a working product and good initial traction. 

Case in point: YouNow

Streaming platform YouNow built a blockchain, called Props, to reward content creators and viewers with tokens. In July 2019, it became one of the first projects to get SEC approval for a Reg A+ token offering. According to the team, the whole process took two years. 

Unfortunately, the Props reward program was shut down a few months after launch. Since the token was registered as a security, any update required an additional approval, which made the whole program difficult to develop. This doesn’t invalidate the concept of Reg A+, but perhaps it isn’t the best fundraising format for early-stage startups.  

Summary

• A coin runs on its own blockchain, while a token is launched on an existing chain; some coins and tokens are designed primarily to act as currencies, while others offer utility of other types;
• Utility tokens provide value within their specific ecosystem: access to services, voting, loyalty rewards, etc.
• Security tokens are investment contracts that entitle holders to a stake in the project, a share in the profits, dividend income, etc.
• Most popular tokens (DOT, MATIC, UNI, LINK etc.) can be considered utility tokens under this classification
• The Howie Test defines a security contract as investment of money into a common enterprise with the goal of extracting profit, and that profit should result from the efforts of others;
• Under the criteria of the Howie Test, most tokens sold at IEOs and IDOs can be seen as securities, since many people buy them in order to re-sell later for a profit;
• The SEC (Securities and Exchange Commission) often attacks initial token offerings on these grounds and even managed to block some major ones, including Telegram’s TON;
• There is no bulletproof way to avoid issues with the SEC, apart from registering a token as a security. 
  

If you buy tokens at IDOs or IEOs and you are not from the US, you probably shouldn’t be too concerned. Most of the sales are too small to attract the attention of the SEC, and now that a KYC is in place on most platforms, the procedure has become much more civilized. In any case, it’s worth knowing the difference between utility and security tokens, since this regulatory debate will continue to affect the development of the blockchain industry in the future.

If you’d like to learn more about DeFi and Pontem Network, join our official Telegram channel. And stay tuned to learn about our upcoming updates!