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What Are Utility Tokens?

Please Pick Your Crypto Level
7 min read

What Are Utility Tokens?

SPLITTING HAIRS: COINS VS. TOKENS

Coins are a term reserved for cryptocurrency assets that are easily exchangeable for goods and services and therefore are equivalent to a more traditional form of “currency”. Similar to fiat currencies like USD or CAD, these coins behave like traditional money since they are fungible, divisible and easily exchangeable. The most common example of this would be Bitcoin.

On the other hand, assets called tokens, often don’t carry much value outside the scope of the blockchain project that issued them. These are still technically “cryptocurrencies” since that term is just a broad way of recognizing digital assets that are exchanged using an encrypted distributed ledger. However, tokens, do not function in the same way as coins since they are not easily exchangeable for goods and services, unlike traditional forms of money. An example of this would be ERC-20 tokens.

Since tokens are tied to a specific blockchain entity, their value is derived from the workings of this project. For example, if the underlying blockchain project that issued the token has not garnered much attention from investors, the value of the token will be lower. Therefore, the value of a token is completely dependent on the blockchain with which it is associated.

Although the inner workings of a blockchain can have an impact on the value of coins as well, the prices of these assets are also dependent on other factors. For example, the fact that a coin can easily be exchanged for other crypto or fiat currencies has a major impact on its price. Ultimately, the price of the coin is then determined not just by its own blockchain network, but also in the context of assets for which it can be exchanged.

IS IT A SECURITY TOKEN OR A UTILITY TOKEN?

The difference between a security token and utility token is rooted in the names. A security token is equivalent to financial security like a stock or bond. These are issued by blockchain companies to generate capital but also act as a representation of equity held by the investor in the company. Therefore, security tokens function as financial assets.

As for utility tokens, the “utility” is a good or service provided by the issuer which can be purchased using these tokens at a later date. Essentially, utility tokens are like a pre-order or a concert ticket since they have a very specific function that can only be redeemed at a certain date in the future. As such, utility tokens are not like traditional financial assets. Granted, utility tokens may still be traded for coins or currency if there is an interested counterparty, similar to how a concert ticket may be sold if there is a willing buyer. However, there may not always be enough of a market presence to execute such trades at a fair price.

Utility tokens can be used for a wide range of functions outside of simple transactions. For example, The Aventus Protocol promises to deliver a “Blockchain for Ticketing”. The Aventus website states that “The protocol permits rights holders to define rules across the ticketing supply-chain including promoters, venues, primary/secondary agents – to which everyone must adhere.” In this instance, the blockchain would deploy a utility token that represents the tickets to a concert or event. These utility tokens would then be distributed based on certain permissions established by the rights holder, like the performing artist.

REGULATING THE WILD WILD WEST

In 2017, as more upcoming blockchain companies issued tokens to generate investment capital for their projects began emerging, there was an opportunity to exploit the lack of regulations. The tokens space quickly gained the reputation of the
‘Wild West’ as many tokens were exposed to be scams.

This has led to efforts by certain token issuers to try to self regulate. In fall 2017, at the peak of the ICO craze, the Token Alliance was formed, which had private sector companies, law firms, exchanges and consultancies amongst its members. This organization was created in an effort to self-regulate the token market.

The other regulatory body that has a large impact on the status of tokens is the Securities Exchange Commission (SEC). The SEC is an independent federal body in the United States responsible for enforcing securities laws, proposing securities rules, and regulating the securities industry. Therefore, many curious investors outside of the U.S. have looked to the SEC for the security classification of tokens.

The SEC uses the “Howey Test” for testing whether an instrument qualifies as an investment contract in terms of the securities act. This four pronged test from the 1940’s is used to determine if an instrument, like tokens, can be classified as a security, and therefore regulated as such by the SEC. This classification is important since it can help stabilize these volatile markets.

However, in the past year, the SEC has charged several token companies with issuing unregistered securities on a case by case basis, which has created even more uncertainty in the market, since no clear-cut rules have been implemented across the board.

CONCLUSION

All in all, it’s important to understand the role that tokens play in the world of blockchain. The fact of the matter is, cryptocurrency cannot be stripped from blockchain technology. Often times, the “blockchain without bitcoin” narrative is sold to curious investors, however, digitized tokens are central to the incentive and security model that makes blockchain technology so promising. Therefore, regulations surrounding tokens will be critical for how these markets develop in the future.

Disclaimer: This post is intended for informational purposes only. The views expressed in this post are not, and should not be construed as investment advice or recommendations. This document is not an offer, nor the solicitation of an offer, to buy or sell any of the assets mentioned herein.

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