It’s still fairly common to see disputes between project operators and regulators regarding whether or not a particular asset qualifies as security or a utility token. And, in some circumstances, a token might be both.
Here, we’ll disambiguate these terms and pinpoint the main criteria needed for a token to qualify as a utility token.
As a first step, it makes sense to differentiate coins from tokens. The general differentiation is that a coin is the base currency of a network, whereas a token is issued on top of a network. Using this definition, assets such as BTC, ETH, Cardano’s ADA, or Polkadot’s DOT could be classed as coins. By contrast, Uniswap’s UNI or Chainlink’s LINK are both tokens, as they exist as smart contracts on Ethereum.
Coins are generally limited in their functionality and behave similarly to fiat money. For example, ETH is used to pay for transactions on the Ethereum network and store value for those who hold it. However, ETH doesn’t carry out any additional functions within applications running on the Ethereum blockchain, aside from transaction payments.
A utility token offers a specific utility within a decentralized application. For example, the token may grant token holders the right to use the network, as is the case for Filecoin, which allows users to access decentralized file storage, or Axie Infinity, where the AXS token permits players to join the game.
Utility tokens may also be used to confer loyalty benefits and rewards, as with EQONEX’s EQO token. EQONEX users can accrue EQO by performing taker trades on the exchange and earning further EQO through staking and lending.
Another type of utility token is the governance token, which has become popular in decentralized finance. Governance tokens convey voting rights to token holders. For example, holders of Compound’s COMP token can vote on which new lending pools and assets the protocol will support.
Security tokens are another category of tokens created as an investment vehicle. A project set up from scratch as a security token will need to undergo all the necessary regulatory activities to ensure that it is legally permitted to be sold and traded in a given jurisdiction.
However, the differentiation of security tokens and utility tokens has become a hotly debated topic in the cryptocurrency sector over the years. Within two years of Ethereum’s launch in 2015, the platform became overrun with new tokens. Many were created by legitimate entrepreneurs and innovators who envisaged using blockchain and cryptocurrencies to solve legacy problems across various industries.
However, Ethereum’s easy tokenization also apparently overcame a problem as old as innovation—finding the funding necessary to bring an idea to reality. In 2017, the initial coin offering (ICO) became the go-to method of funding a new crypto project.
While project owners were happy to tout their newly-minted digital assets as utility tokens, the fact is that the waters quickly became muddy. Even if a token issuer insists that its token is for pure utility, many people in 2017 bought tokens with the clear expectation that they would go up in value. Around the same time, it became evident that many projects were simple pump-and-dump scams with no utility or purpose.
Inevitably, the regulators stepped in, and several projects purporting to sell utility tokens ended up settling with agencies such as the U.S. Securities and Exchange Commission (SEC) for the unregulated sale of securities.
As such, token offerings are now more tightly regulated, so it’s easier to differentiate between a security and utility token. Although regulations can vary between jurisdictions, in general, it comes down to whether or not the token is intended as an investment with the expectation of returns. In the U.S., this test is called the Howey Test; however, many other financial regulators across Europe and Asia use comparative tests.
Now, when conducting token sales, some projects opt to undergo the necessary regulatory filings upfront and sell their tokens in a Security Token Offering (STO). This method can allow more freedom to operate in the long term and reduces the risk that the project will later become subject to legal scrutiny. However, it does incur costs and administration.
That said, many issuers of legitimate utility tokens that don’t have any role to play in fundraising are now simply bypassing the token sale altogether. With no money exchanging hands, it’s evident that the project isn’t selling unregistered securities. As such, tokens that undertake a so-called “fair distribution” model can legitimately claim to be utility tokens.
EQO is one such example, minted and distributed to EQONEX clients according to a fair and transparent set of rules. DeFi has many other examples of equitable distributions not involving a sale. In 2020, Uniswap airdropped its UNI token to all those who had used the exchange since it had been in operation. Many DeFi projects also offer tokens as incentives, for instance, to liquidity providers.
If these differentiations seem somewhat nebulous, you aren’t alone. Due to the developing nature of the digital asset segment, even the terminology takes some time to establish and become embedded. However, blockchain and tokenization continue to offer plenty of exciting opportunities, financial and otherwise.
Ian Fleetham, Head of Trading at EQONEX, shows how to trade Perpetuals on the EQONEX Exchange. Use EQO-D, the first EQO airdrop, and cross-collateral to make the most from your trades.