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Tokenization taxonomy. Utility Tokens vs Security Tokens vs NFT

Dive deeper into the difference between 3 main token types: security, utility and NFT.
6 MAY, 2021
Capital Raising
The word "token" was introduced as a result of the development and growth of Ethereum, and it quickly became a catch-all term for all assets built on the Ethereum blockchain. Different tokens were assembled into different groups based on their applications and features, the variety of which sometimes leads to confusion. To make it clear once and forever, let's dive deeper into the difference between 3 main token types: security, utility and NFT.

Utility tokens

Utility tokens are the ones having a specific utility benefit (or a number of such). You can think about a utility token in terms of a casino chip, a token from a table game, or a voucher. They can be earned and used in completely different ways depending on the terms of issuing. A utility token is a type of token that does not reflect a share of a company's stock but rather a necessary tool or mechanism for using the application in question. Just like with a particular service, the price of a utility token is ultimately driven by its supply and demand. Although, this type of token may also function as a bonus or reward mechanism in the decentralized systems: for instance, if you like somebody’s work, just give them an upvote so a certain number of tokens are issued to them. This is a mechanism that enables an indirect earning for the author or creator.
The most common way to use a utility token is to apply them as a payment method instead of fiat currency to purchase goods or services at a discount. Stobox has implemented this way to provide utility to its token STBU as well: you can buy items at a discount if using this payment method instead of USD to purchase the brand new Lucky Ox Merch Collection.

Utility tokens tokens are also the most popular type of tokens among blockchain companies. The vast majority of cryptocurrency exchanges allow users to pay fees in their native utility tokens.

Utility tokens may also serve as a loyalty point. Traditional companies tokenize their loyalty plans so that loyalty points can be purchased and traded on blockchain markets. These tokens are widely used as a compensation and motivation system in decentralized companies. For instance, if you have a social channel where people can post content but you don't want to monetize the network by offering content monetization through advertisements and data collection, you will enable the users to apply utility tokens for rewarding the creators for their contributions to this platform. It will also give the website members a chance to redeem the tokens for specific bonuses and rewards on your site.

The important attribute of utility tokens is that they can be traded freely, unlike security tokens, for the trading of which there are legal restrictions.

Security tokens

Security tokens, aka ownership tokens, are basically conventional securities such as shares, bonds, and investment fund units embodied in a crypto token.

The key distinction is that security tokens are typically issued by private firms (rather than public companies) that are not listed on stock exchanges and in which you can not invest right now. Previously, these businesses could only collect capital from banks or big venture funds. A person could only invest in private firms if they had millions of dollars in their bank account. Security tokens sold by private corporations have the advantage of delivering better yields than traditional public stocks. According to McKinsey Private Equity Research, private markets have grown by 50% more than public markets during the last decade.
An ownership token varies from a utility token in one significant way: if the value of a crypto token is derived from an external asset or company, it is considered a security token and is therefore governed as a security (read about the Howey test further in this article). This means that if you have an ownership token, you have a token that derives its value from the company valuation, assets on its balance sheet, or dividend\interest payments to token holders.

Why are Security Tokens Important?

Cryptocurrency is a highly profitable investment choice. There are thousands of crypto assets to choose from, and knowing which ones are promising will mean the difference between being a millionaire and going broke. Security tokens are an important type of crypto assets necessary to manage risk and build a balanced portfolio, without them crypto investing becomes more risky and getting sustainable long-term profits is harder. Although these tokens often yield lower returns than other types of cryptocurrencies, their advantage is lower risk as they are backed by real assets or business cash flows. Therefore, it is useful to have them as an element of portfolio diversification and as means of preserving the return on investment in more risky assets.

Security tokens give businesses access to new financing opportunities. As a result, investors get the opportunity to invest in high-profit business, which can not be found simply on the stock exchange.

Utility vs security token difference isn’t that distinct as it may seem from the explanation. This creates the additional risk for the issuers of these tokens - especially in the USA. The main-pillar regulating judicial precedent in this area is the Howey test.

What is the Howey Test?

The Howey Test applies to a lawsuit settled by the United States Supreme Court that determines whether a transaction counts as an "investment contract," and thus would be considered a security and subject to disclosure and registration requirements under the Securities Act of 1933 and the Securities Exchange Act of 1934.

If the SEC decides that a cryptocurrency token is a security, a slew of issues arise. In practice, this ensures that the SEC will decide when a token can be offered to US investors and if the project is required to file a registration statement with the SEC.

Due to the extensive wording of the Howey test, most utility tokens will also fall under the definition of securities, even if they were not intended to be so. Because there are many selling and trading securities restrictions, most ICOs are not offered to American investors. Then-SEC Chairman Jay Clayton said in 2018 that any ICO he'd seen could be categorized as a security. There is an additional risk in light of the given statement. If the company issues utility tokens without registering the offering and later the regulator recognizes these tokens as securities, it may result in huge fines or even a criminal charge.

Consulting for Security Token Offerings (STO)
We offer advisory, legal expertise and software solution to help successfully execute a security token offering.

NFT Tokens

Non-fungible tokens, or NFTs, are another name for collectible tokens. Their distinguishing characteristic is that they denote possession of one-of-a-kind products, such as artwork, merch, or ranks. NFTs are about being unique: while utility tokens are fungible, i.e. two of such tokens are the same and indistinguishable from each other, NFT represents a unit of possession strictly one of a kind. In a way, NFTs are similar to baseball cards, all of which are unique and have exceptional value.

As for today, the most recognizable NFT function is to preserve the fact of possession. Using this kind of token allows digital artists to monetize their artworks: owning an NFT with a particular gif, meme, or sketch doesn’t transfer the intellectual right to the possessor, but is an analogue to holding an original painting signed by the author.

Collectible tokens can also be used as digital souvenirs, so to say. By issuing their own branded NFTs, businesses may positively influence the appearance of their brand, as inside the corporate ecosystem, NFTs can represent some ranks or achievements. This would allow people to connect with a brand and experience a sense of belonging to the community. If this case sounds interesting to you, check out our Lucky Ox NFT Merch Collection.

Which type of tokens is right for you as a business to raise capital?

For the majority of businesses, it’s best to raise capital with security tokens, simply by shifting your existing shares to blockchain and selling them to global investors. Utility tokens are not designed to appreciate in value as your business grows, so it’s better to leave them for gamification and community engagement. If you are a blockchain business, however, often a utility token may be a heart of your business ecosystem and it has the appreciation potential directly related to your business growth, so it makes perfect sense to use it as a main driver. Notice that you can actually issue all kinds of tokens simultaneously, not focusing solely on one type. It gives you exposure to different types of investors and maximizes the usage of digital assets.

Which tokens are the best to buy?

There are no tokens that are universally the best. They differ in their volatility, industry, risk-return profile, etc. This means it’s important to always assess tokens as a part of your overall portfolio and your personal preferences: what industries you understand best, what your risk appetite is, what excites you, how you approach taxes, and what your planning horizon is? Based on these factors, you can build a balanced portfolio and understand which tokens fit into it.

Conclusion

Security, utility, and NFT tokens are the three most popular types of tokens one can interact with today. Security tokens represent the shares, investment fund units, and bonds. Utility tokens can be perceived as an inside-product "currency" or "ignition key" that grants you access to goods and services or empowers with other perks. NFTs represent a one-of-a-kind collectible unit, denoting you as a possessor of a certain thing.
6 MAY, 2021
Capital Raising
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