Tokens and their meaning

Token – what is that? The topic of cryptocurrency has been omnipresent for years. If you deal with blockchain, smart contracts or virtual money systems, you will certainly also come across the term token.

But what exactly is the meaning and definition of tokens? What role do they play in the context of crypto transactions and assets? What tokens are there and what are they used for?

Topics in our legal advice

Herfurtner Rechtsanwaltsgesellschaft mbH has summarised all important information on the subject in the following text.

Table of contents

1. Token – meaning and definition explained simply
2. Cryptocurrency and tokens
3. Security tokens
4. Tokens: What types are there?
5. Security tokens: 4 functions
6. Howey test
7. Cryptocurrency and tokens: Risks

Token – simply explained

Meaning and definition: Tokens are the basic units for cryptographic operations.

In crypto assets, tokens are special units.  They grant their owner the right to carry out a certain activity on a decentralised resource. A transaction on a particular blockchain can only be carried out by those in possession of a legitimate token.

Tokens are unique units that grant their owner access to a shared, decentralised resource. A blockchain is often used as this resource.

Tokens are only useful within the environment in which they were created and cannot be used outside.

For example, a digital payment with a cryptocurrency can be authorised with this token. However, smart contracts and decentralised applications require both tokens. A transaction on a blockchain can only be carried out by the owner of a token.

This can prevent chain collisions from occurring or unauthorised people from making changes to the blockchain.

Cryptocurrencies, assets and tokens

Tokens, which act as a means of payment or cash, are by their definition a special kind. Whereas those such as Bitcoin, ADA (Cardano) and Ether are used exclusively for financial transactions. In this context, each token represents a specific amount of money.

They have a special significance here. They can reflect a participant’s account balance, e.g. how much BTC or ETH they currently own. They are used to simplify Bitcoin transactions, e.g. payments.

The term “token” often comes up when talking about cryptocurrencies.

Token and cryptocurrency – not synonyms

Tokens are important in the cryptocurrency world because of their many functions. There are a variety of alternative cryptocurrencies to Bitcoin. Together, these form the virtual currency universe. Each of these digital currencies has its own ledger. Cryptocurrencies are built on the blockchain.

Although they are part of the crypto community, tokens do not have their own private ledgers. Tokens, of which there are already many, instead run on the existing blockchains of other cryptocurrencies. Now that we know more about the meaning and definition of tokens in cryptocurrencies, let’s take a closer look.

Importance of tokens in the field of cryptocurrencies

Tokens do not have their own blockchain, but run on other people’s blockchain. For example, in the Ethereum network – which is very popular. After Bitcoin, Ethereum is the second most popular virtual money.

As a rule, tokens are not used as a global payment method like the more popular cryptocurrencies. Instead, they are used as a kind of internal currency on platforms, in companies and organisations. FC Barcelona, for example, uses fan tokens.

With them, the football club lets its fans vote on team matters or buy branded goods. Due to their internal use, the tokens are usually offered for purchase via airdrops or ICOs (Initial Coin Offering).

Increasingly, they are being used to tokenise priceless assets such as works of art, vintage cars and historic buildings. So you can buy a piece of a luxury item or a piece of a property with a token.

EOS is an example of an ICO token that has made it into the altcoin space. For a long time, EOS was a virtual token on the Ethereum network.

Tokens as securities

Tokenised securities are intended to be compliant with securities regulations, which is what security tokens are intended to do.

Security tokens are therefore formally authorised securities.

It is important to recognise the differences between tokens and coins. Unlike coins, which are used outside an ecosystem – for example as a means of payment – and are the original product of their platform, tokens are only used within an ecosystem.

Tokens are created on an existing blockchain and represent a form of utility that can only be used within the blockchain. Security tokens and utility tokens are not very useful outside their token ecosystems.

Token variations and their definition

There are different types of crypto tokens, each with a specific use case and benefit.

Meaning and definition:

Security tokens (Security Token) offer their holders benefits similar to those of securities or capital: For example, those who buy equity tokens invest in company shares and thus perhaps also in voting rights. Start-ups mostly use this option as an alternative to going public to raise capital.

Utility tokens, on the other hand, give their holders access to certain services or a platform.

With these tokens, only one specific benefit is granted at a time. Siacoin, for example, offers decentralised cloud storage.

Asset tokens (backed tokens) are tokens whose value is closely linked to tangible items. These include gold, silver and other precious metals, but also real estate and other forms of capital. Therefore, these tokens act as collateral for actual assets. Tether, for example, is tied to the value of the US dollar, while GoldMint is tied to the price of gold.

They, on the other hand, are mainly used in 3 areas:

1. Security
2. Utility
3. Payment

Are there any major differences between the 3 different types of cryptocurrency tokens?

Service: Utility Token

Tokens that grant their holders access to a platform are called utility tokens.

In most cases, companies use utility tokens to offer purpose-built services. This includes unlocking app features. According to the Securities and Exchange Commission, utility tokens cannot have a financial motivation. In other words, the issuer must not offer a return on investment.

However, there is still disagreement in the United States about the proper classification of utility tokens. According to Jay Clayton, Chairman of the Securities and Exchange Commission, all tokens generated via ICOs are securities.

Identification: Security Token

Tokens used for security purposes are a completely different scenario.

Token-based assets, such as security tokens, are openly advertised as such. As a result, they are treated by regulators as regular securities. For example, companies are required to produce a document commonly referred to as a securities prospectus.

Regulators must first approve the issuance of security tokens. Security token offerings, often referred to as STOs, are the issuance of security tokens.

Meaning and definition – Security tokens and utility tokens have the following important differences:

• Security tokens are regulated capital assets such as company shares
• while utility tokens are mostly used for blockchain applications.

Their structure distinguishes them from more traditional forms of investment.

This results in significant advantages: Issuers do not have to verify the tokens, which makes them independent of settlement agents like Clearstream and Co. A security token can be produced for any common security, whether it is a share, a bond or a certificate.

The most important difference between a regular share and a token is the change from certificates to tokens and the change from electronic securities registers and clearing houses to a blockchain infrastructure for settlement.

Payment: Payment Token

Classic cryptocurrencies such as Bitcoin, Monero and Litecoin are used as payment tokens. This means they have no project obligations and can be used for a variety of other purposes. The “account balances”, i.e. the transaction history, are usually stored on the payment token’s own blockchain.

Payment tokens are used to carry out transactions. Therefore, they are similar to money in their meaning.

4 Functions of Security Tokens

We have summarised 4 possible uses of security tokens for you. We address the risks of tokens in use with cryptocurrencies in the last section.

Function No. 1 – Protection for investors

Tokenised assets, such as security tokens, are regulated financial instruments. Exit scams, as were widespread during the 2017 ICO boom, will be much harder to execute if issuers are listed with their clear name and registered office with the relevant securities regulator.

The institutionalisation of the crypto market is a popular topic of conversation. This is because large financial institutions such as asset managers and banks have largely shunned the emerging market for digital assets. Security tokens could be crucial in building bridges in the future.

Function No. 2 – Ability to trade shares

Because of the way security tokens are structured as blockchain assets, investors can trade them with each other. While all exchanges, whether public or private, must abide by certain rules, security tokens have the advantage of being able to be exchanged at any time of the day or night.

This is due to the fact that blockchains, unlike traditional stock markets, are not closed. Consequently, trading is faster than on the regular financial market.

With blockchain assets, there is no time lag between the trade and the posting of the traded assets, saving investors time. Token trades are immediately posted to the blockchain.

Function No. 3 – Claim to ownership

Real estate, art and stocks, to name a few, can have incredibly high unit costs. It is not uncommon for them to be prohibitively expensive, which discourages retail private investors from participating in these marketplaces.

Security token offerings (STOs), on the other hand, could look attractive to retail investors. With security tokens, high-value assets can be divided into smaller units of value. This opens up previously restricted markets to investors, as they can purchase a fraction of the shares in stocks, bonds or other securities

Function No. 4 – Accessibility & Reachability

Tokenised securities are becoming an asset class more accessible to the general public. While traditional securities can only be acquired by investors on exchanges, the acquisition of security tokens is relatively easy.

Security tokens can be acquired directly in so-called STOs (Security Token Offerings), i.e. the process of creating tokenised securities. The peer-to-peer structure thus lowers the frictions that could lead to lower trading volumes in the more complicated traditional financial industry.

In other words, securities tokens offer ordinary investors a way to participate in the market. Finally, tokenisation makes assets that were previously only available to large institutional investors such as banks and family offices accessible to a wider audience.

Howey test: What is its significance?

The Howey test is a kind of diagnostic assessment.

• Do people put money into investments because they hope to make a profit?
• Is the issuer a traditional hierarchical company?
• Is the issuer responsible for the ROI?

The test is considered positive if all questions can be answered positively. As a result, the instrument is a security as defined by the SEC. Crypto tokens are also subject to the Howey test. This is because while utility tokens try to distance themselves from being classified as a security, their structure almost always forces them to be considered one.

As a result, the Howey test focuses on the fundamental substance of assets rather than how they are categorised.

This should be made clear: The United States is not the only major financial market in the world. Regulations, as we know, can differ from country to country. That is why the Howey test is not always applicable.

However, the past has shown that many states adhere to the basic guidelines of the US government. Token regulation in the United States could therefore probably have a major signalling effect.

Tokens and their risks in the field of cryptocurrencies

It is only through their application in the field of transactions and trading with cryptocurrencies that risks arise for investors and investors. These risks are real and clearly definable:

• Virtual currencies are fundamentally characterised by the fact that they are not subject to any state regulation, control or supervision
• There is therefore no guarantee of value
• This means that there is always the possibility that a cryptocurrency will lose its value.
• Since cryptocurrencies use blockchain technology, every user risks hacker attacks, programming and software errors, manipulation, data theft, etc.
• In addition, there is the risk of falling for fake online trading platforms and thus becoming a victim of fraud.

The devastating results range from the loss of personal data to the entire fortune.

Herfurtner Law Firm always advises caution when it comes to cryptocurrencies – they are an unsafe investment. We advise you nationwide on all legal topics relating to the definition, meaning and function of tokens, digital currencies, investment fraud, cybercrime and fraud (internet fraud and Bitcoin fraud).

If you have invested in or made payments to one of the companies on this list, our lawyers will be at your disposal at short notice.