Utility tokens are a distinct category of cryptocurrencies. Unlike coins and security tokens, utility tokens provide users with dozens of features on blockchains and dApps (decentralized applications). As smart contract blockchains like Ethereum continue to scale, more blockchain developers are issuing unique utility tokens for their Web3 projects.
Now that more cryptocurrencies are available on exchanges, many investors are asking themselves, “What is a utility token?” Why is it so significant to distinguish utility tokens from other types of tokens? Are there legal implications to separating utility tokens from other crypto projects?
What is a utility token?
A utility token is a cryptocurrency on a smart contract blockchain that serves a specific function in a crypto project's ecosystem. Unlike cryptos like Bitcoin (BTC), utility tokens aren't designed to be a real-world medium of exchange. Instead, a utility token only has a use case within its respective smart contract protocol.
Most often, utility tokens aren't mined into existence like Bitcoin or Litecoin. Instead, Web3 project leaders "pre-mine" their utility tokens and send them to team members, early investors, and the general public.
Any crypto project can release utility tokens on a smart contract blockchain to grant users access to special features. For instance, utility tokens can be used to purchase in-game items in metaverse titles like The Sandbox. Some utility tokens like Uniswap's UNI may grant holders voting privileges on a dApp.
The point is that utility tokens only serve a function within their respective ecosystems. While utility tokens have monetary value in the open crypto market, they aren't trying to be a medium of exchange, inflation hedge, or a long-term store of value. Instead, developers create utility tokens to drive growth and engagement or raise funding for their dApps.
What are the primary uses of utility tokens?
There are dozens of possible use cases of utility tokens. A few common ways people use utility tokens include:
- Voting: Utility tokens give people the right to vote on upcoming improvement proposals on a dApp. Technically, if a utility token gives people this privilege, it's known as a "governance token." While every dApp has different rules for blockchain governance, one of these tokens typically represents one vote.
- Gaming: Many blockchain-based games have utility tokens that can be used to buy in-game items like NFTs (non-fungible tokens). Also, these utility tokens often serve as a rewards mechanism in play-to-earn games like "Axie Infinity."
- Crypto exchange perks: Some centralized crypto exchanges (CEXs) like Binance, KuCoin, and Crypto.com offer utility tokens to reward holders with perks like discounted trading rates.
- Tipping: Utility tokens may serve as a dApp's built-in tipping mechanism. In addition to rewarding content creators, this function may influence the ranking of comments or videos on a social media dApp's main page.
- Paying network fees: People have to pay transaction fees using a smart contract blockchain's native utility token. For instance, people who want to use a dApp on Polygon have to use the MATIC token to confirm transactions.
What do ICOs have to do with utility tokens?
Utility tokens weren't possible before the Ethereum (ETH) blockchain began operations in 2015. Ethereum was the first project to introduce smart contract functionality, which refers to coded commands that use "if/then" statements to perform automatic tasks on a blockchain. All utility tokens live on smart contract blockchains, and many of these cryptocurrencies use Ethereum token standards like ERC-20.
While utility tokens were around before the 2017 bull run, they gained mainstream prominence during the "ICO craze" of 2017-2018. During this time, hundreds of new Web3 projects began offering initial coin offerings (ICOs) to investors as a way to raise funds.
Many of these ICO companies claimed they were selling their "utility tokens" to early investors. However, in reality, most of these tech start-ups had no intention of providing token holders with utility. Indeed, developers typically used the "utility token" label to evade sanctions from the U.S. Securities and Exchange Commission (SEC).
As authorities caught wind of the many scams in the ICO space, they began drawing more precise distinctions between a utility token versus security token. A cryptocurrency must provide a viable use case beyond mere speculation to qualify as a utility token. Valid utility tokens also can't be connected with partial ownership in a company or third-party endeavor.
In contrast, a security token represents partial ownership in a third-party enterprise. For instance, a token that tracks the price of Amazon's stock would be a security token. There are also innovative trading platforms offering security tokens representing partial real estate ownership.
Since security tokens are defined as "securities," they must register with the SEC. Utility tokens, however, don't need SEC approval to list on crypto exchanges.
Governance token vs. utility token
A governance token is a utility token that allows investors to vote on proposed changes to a dApp. Developers usually publish improvement proposals in a smart contract and let the community vote by staking their governance tokens. Once the voting period ends, the smart contract automatically tallies the vote and records the results on the blockchain.
Other than voting rights, governance tokens share all the traits of other utility tokens. Indeed, most governance tokens have many non-governance-related uses in DeFi. For example, people who hold Uniswap's UNI tokens can lock them into a liquidity pool and earn a percentage of transaction fees.
All governance tokens are utility tokens, but not all utility tokens are governance tokens. If a utility token doesn't give holders a say in blockchain governance, it's not a governance token.
Is Bitcoin a utility token?
Bitcoin isn’t a utility token. In fact, Bitcoin isn't a "token" at all.
The term "token" only refers to a digital asset created for a Web3 project on a pre-existing blockchain. In contrast, "coins" are cryptocurrencies that are native to their blockchain and function as a medium of exchange. Other prominent "coins" in cryptocurrency include Litecoin, Dogecoin, and Bitcoin Cash.
Both the SEC and the U.S. Commodity Futures Trading Commission (CFTC) have repeatedly said Bitcoin is a commodity. Therefore, Bitcoin falls under the CFTC's jurisdiction.
Are NFTs utility tokens?
Although many NFTs are no more than digital collectibles, more creators are adding use cases to their NFT collections. Yuga Labs' Bored Ape Yacht Club (BAYC) NFTs granted holders access to VIP events like "Ape Fest" and members-only websites like "The Bathroom." As the BAYC grew larger, Yuga Labs offered valuable crypto airdrops like Mutant Serum NFTs and APE tokens to people who held their BAYC NFTs.
There are also many companies and celebrities experimenting with high-utility NFTs. For example, the Kings of Leon was the first band to release a new album as an NFT. This band also released special "ticket" NFTs that grant holders access to VIP concerts.
Although NFTs aren't inherently utility tokens, developers can find applications.
Utility token examples
To better understand what sets utility tokens apart from other cryptocurrencies, it can be helpful to run through a few examples:
- Smooth Love Potion (SLP): SLP is a central utility token in Axie Infinity. Players can earn SLP tokens for winning battles and completing quests with their animated "Axie" monsters. Gamers can also use their SLP tokens for breeding or leveling up their Axie NFTs.
- LINK: Built on Ethereum, Chainlink is the largest decentralized blockchain oracle. Anyone who wants to use Chainlink's oracle services needs to pay transaction fees with its ERC-20 LINK token. These LINK tokens also serve as a rewards mechanism for Chainlink's node operators.
- BNB Coin: Released by the CEX Binance, the BNB Coin initially gave Binance customers discounts on trading fees. However, now that Binance created its BNB Smart Chain, people can also use the BNB Coin to pay for gas fees on dApps like PancakeSwap.
- Basic Attention Token (BAT): BAT is an ERC-20 cryptocurrency on the dApp-friendly Brave Browser. The Brave team wants to use BAT to revolutionize online ad incentives. Brave users can sign up for BAT rewards and receive monthly payouts depending on how many ads they view. People can also use their BAT to tip advertisers they like.
While investors can buy utility tokens for price speculation, it’s not the purpose of these cryptocurrencies. Utility tokens are designed to be used on their respective protocols. From gaming and voting to tipping and transaction fees, utility tokens should always serve a function in their expanding Web3 ecosystem.
Speaking of use cases, Worldcoin wants more people to see the real-world applications of cryptocurrencies. We also aim to put a share of our crypto in the hands of every individual on the planet for free. We’re also airdropping free DAI currency tokens. Subscribe to our blog to know more.