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Security and Utility Tokens: What Did I Just Buy?

Written by John Butler
Posted March 9, 2018

Let’s be honest, there's a lot going on in the world of digital currency...

With over 1,500 tokens on the market, investors often find themselves in a state of digital token overload — especially new investors with less exposure to the rapidly changing market.

That being said, one of the easiest ways to start weeding through the digital currency market is to learn the difference between a “utility token” and a “security token.”

But why is it so important to know the difference between these two types of tokens?

Well, knowing the difference can help investors to make wise investment decisions, understand what they're buying, and prepare for any tax implications that may come with specific tokens before they take the plunge.

To help you to actually understand the difference between the two token types, our team has reviewed statements from the Securities and Exchange Commission (SEC). These statements were made in July 2017 during the SEC's investigation of the DAO token sale.

We've used these statements to provide definitions of both security tokens and utility tokens. We've also included examples of these types.

So, let's get started...

What Is a Utility Token?

In the world of digital currency, utility tokens can be quite confusing.

The simplest definition of a utility token is this: a digital token that has an active purpose within its blockchain network or an active purpose as a global tool.

The word "active" is critical here.

It's very common for the company that releases a token to say it's a utility token because it has a planned function within the network. But in these cases, unless the token is already being actively used, the SEC won't consider it as a utility token.

Here are a few examples of real utility tokens...

Bitcoin

The most famous utility token is Bitcoin. At its introduction in 2008, Bitcoin was intended to act as a peer-to-peer digital currency. But over the course of its lifetime, Bitcoin’s purpose has changed. The lines have blurred, and it’s become an investment and a store of value.

So now, when investors buy Bitcoin, they're actually buying a digital currency that interacts with its own blockchain network.

It also has a real purpose. You can actually buy things with Bitcoin and there are Bitcoin ATMs...

Ether

Ether might be the world's best example of a utility token.

When investors buy the digital asset Ether, they're actually buying a digital asset that functions as the gas within the Ethereum network. It helps in fueling the decentralized applications (DApps) on the Ethereum network.

Some may argue that ether is a security token because it was used to raise funds for the Ethereum development team. But even though ether has been used to raise funds, it has also been an active part of its own network from the very beginning.

If you'd like to learn more about ether, you can find the full details of it on our Ethereum resource page.

What Is a Security Token?

In the simplest sense, a security token is a contract.

When investors buy these tokens, it's the equivalent of buying stock. Investors buying tokens and anticipating that they will increase in value or pay dividends in the future.

A lot of the world's most famous security tokens have masqueraded as utility tokens for years. Here are a few examples...

EOS

Currently, the EOS token is considered a security, regardless of what the EOS team says.

The EOS token was launched using the Ethereum blockchain. The company has yet to disclose whether or not it will transfer its token onto the EOS network when the network launches in late 2018.

That means the EOS token doesn't provide a critical function to the EOS network. So, investors buying it can only hope that it will increase in value like a security.

So, How Do You Know What a Token Is?

It may seem like there should be a simple answer, but this is digital currency. In an evolving market, it’s easy for companies to manipulate investors through marketing.

What that means is, as we've already noted, companies often market security tokens as utility tokens.

And oftentimes, even though the token doesn’t really perform a function in a blockchain project, a coin is introduced so the company can claim that it performs a function.

A good example of this is Ripple. Ripple Labs has run amok with the SEC in the past, causing the SEC to question whether it should consider XRP to be a security or a utility token.

Ripple tried to rebut by saying XRP can be used within its blockchain tools. But many of the banks that use Ripple’s blockchain banking tools don't use XRP, meaning the token isn’t actually needed to use them.

This is a good example of a gray zone in digital currencies. And initial coin offerings (ICOs) make that zone even grayer.

Luckily for investors, the SEC has a test to determine whether or not something is considered a security by U.S. law.

That test is called the Howey Test...

What Is the Howey Test?

Now, the Howey Test isn't anything new or groundbreaking. And it certainly wasn't intended for just digital currencies. It's actually been around since 1946.

Basically, the test demands that investors ask two questions of digital currencies...

For starters, is the digital token that you purchased being sold as an investment?

An investor basically has to ask whether or not that token is providing another purpose. A good example is to determine whether or not that token is actually providing value in a blockchain network. Is it being used to increase computing power or to facilitate DApps like Ethereum does?

That’s question number one.

Question number two is whether or not that token is dependent on a person.

In this example, an investor has to ask whether a token’s value is created by one entity (like Ford, Tesla, or Microsoft) or a community (like Bitcoin’s busy miners).

If a token is dependent on one entity, it's most likely a security.

Based on these standards, investors should be able to determine whether the token they've purchased — or are considering purchasing — is a utility token or a security token.

Of course, what a token is could depend on at what stage you bought it. For instance, if you bought a token during an early fundraising round, even if that token one day helps to develop a blockchain network, it might still be considered a security token...

Bottom Line: There Are a Lot of Securities

At the end of the day, because of this is a market, the vast majority of digital currencies qualify as securities.

The SEC doesn't evaluate a token on its intended use but instead on what it's primarily used for.

Meaning that, even if it has some abstract intended purpose, if investors are holding it as an investment, it will most likely be considered a security.

For many companies launching an ICO, this ruling is a pain and a setback. And when it comes to proving whether or not a token is a security, the burden of proof falls on the company.

But for investors, it’s actually a positive. It allows the SEC to get involved and protect investors against fraudulent companies...

Tax Differences

One of the key differences between these two types of tokens is something that we've noted many times in this report: The SEC has the power to regulate and prosecute securities. This means that with security tokens, there's a bit more protection for investors. And as regulations evolve alongside the digital currency market, fewer schemesters will be able to venture into the space.

The future of regulation for utility tokens is a bit murkier...

On February 19th, the Wyoming House of Representatives became the world's first elected body to exempt certain blockchain-based tokens from money and transmission securities laws. This action sparked debate about whether or not utility tokens should be treated differently from securities tokens in the tax realm.

If Wyoming's bill becomes law, it will likely influence future utility regulation and provide a model for other states.

Currently, digital tokens are considered "property" by tax law. And because property law is generally a state matter, it leaves states with the freedom to develop their own regulatory and tax measures for Bitcoin, Ether, and other tokens.

For more on current digital currency tax law, you can view the SEC statement here.


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