3 Ways to Safely Design Utility Tokens

3 Ways Token Creators Approach Legal Frameworks for Tokens

When designing a utility token, token creators must carefully consider their legal approach within the regulatory framework. There are three mainstream perspectives in the web3 community regarding how to handle legal compliance when launching tokens.

The first approach, though popular, is considered reckless. Proponents of this view argue that regulatory authorities will not succeed in regulating cryptocurrency, and that blockchain technology and decentralized systems will evolve faster than regulators can establish rules. However, this perspective ignores the substantial body of legal precedent. Dozens of court cases demonstrate that regulatory bodies have successfully identified legal violations in digital assets distributed through token sales and Initial Coin Offerings (ICOs), treating these assets as investments under securities legislation. Companies taking this approach have faced severe penalties. Regulatory compliance is not optional but a legal requirement that all token creators must respect.

The second approach involves attempting to sell digital securities while avoiding regulatory oversight by exploiting ambiguities in securities law. This strategy fails approximately 99% of the time. While token creators might hire attorneys for a $5,000 to $10,000 legal opinion, regulatory investigations examine each case individually and thoroughly. Courts evaluate the actual underlying economic relationships rather than relying solely on formal paperwork, meaning that poorly structured tokens will be reclassified as securities regardless of documentation.

The third and most rigorous approach involves conducting comprehensive legal research to determine whether a token should be structured as a security token (investment contract) or a utility token. Although this method is rarely followed in the crypto industry due to its high cost and slower time-to-market, it represents the best practice for building a sustainable foundation. Companies that invest in proper legal research during tokenomics design establish stronger long-term stability for their communities and projects.

Why are Utility Tokens Better than Security Tokens while Working within Federal Securities Laws?

Under federal securities law, a token is classified as a security if it creates expectations for token holders to receive profits derived from the efforts of others. Conversely, any token falling outside this legal definition is considered a utility token. This distinction is significant because utility tokens offer substantial advantages over security tokens:

Utility tokens require substantially lower legal expenses compared to security tokens, which demand extensive compliance documentation and regulatory filings. Unlike security tokens, utility tokens do not require additional government reporting or ongoing compliance monitoring. Because utility tokens are not classified as securities, they typically receive minimal regulatory attention from authorities. These tokens trade on vastly more venues—approximately 100 times more trading pairs and decentralized finance opportunities are available for utility tokens compared to security tokens. Additionally, utility token holders are not subject to Know Your Customer (KYC) and Anti-Money Laundering (AML) requirements that restrict security token trading.

3 Ways to Design and Market Utility Tokens to Reduce Securities Risk

Method 1: Distribute Tokens Through Earning Mechanisms Rather Than Sales

Token sales represent a significant red flag for regulatory enforcement, as they resemble traditional securities offerings. However, numerous successful tokens have avoided this scrutiny by distributing tokens through alternative mechanisms rather than direct sales. Examples include Bitcoin, Axie Infinity, and airline frequent flyer programs.

When tokens are minted and distributed rather than sold through a centralized offering, it becomes difficult to apply traditional securities regulations. This approach works because there is no single issuer conducting a securities sale, and token recipients must perform work to earn their rewards.

Creative distribution mechanisms include earning tokens through physical activity, as demonstrated by StepN, which allows users to mint tokens by walking or running. Gaming platforms like Axie Infinity enable players to mint tokens by participating in blockchain-based gameplay. Hardware providers such as Chia Network compensate participants who loan excess hard drive processing capacity. Bitcoin represents the most prominent example, rewarding miners with BTC for providing computational resources. Traditional loyalty programs follow this model as well—airlines distribute frequent flyer miles to credit card holders and passengers who fly with their carriers, creating valuable rewards with redeemable cash value.

Method 2: Structure Payouts as Bonus Points Rather Than Dividends

When distributing value to token holders, structuring payments as bonus points or rewards is legally safer than paying dividends. These bonus points can provide holders with tangible benefits such as service discounts or exclusive feature access.

Lofty.ai demonstrates this approach through a tokenized real estate investment platform where users stake tokens to earn rewards including VIP deal access and exclusive NFTs. This structure maintains 100% utility token characteristics and avoids securities classification. In contrast, if Lofty distributed staking rewards in fiat currency or cryptocurrency, regulators would classify the token as a security token.

Braintrust, a decentralized freelancing platform, illustrates another successful model. Participants can mint BTRST tokens by inviting users to the network and completing peer-to-peer vetting processes. Token holders redeem BTRST for utility benefits including discounted software, specialized career resources, and exclusive perks. This reward structure clearly demonstrates utility token value without creating investment expectations.

Method 3: Avoid Creating Profit Expectations

A critical mistake most web3 token projects make involves public communications that create expectations of financial profit. This practice, often called "moon talk," significantly increases regulatory enforcement risk. Problematic statements include claims such as "Invest in our coin," "Our coin will experience significant appreciation," "Stake our coin for unrealistic returns," or predictions about future exchange listing prices.

These statements are particularly problematic because many retail investors lack substantial financial and legal education, making them susceptible to exaggerated profit claims. When project leaders or team members publicly make such assertions, they create documented evidence that the token functions as an investment contract expecting profits from the enterprise's efforts—precisely the definition used to classify tokens as securities.

Conclusion: Creating Utility Tokens are Safer than Security Tokens

Issuing and managing security tokens requires substantially greater legal investment and carries significantly higher regulatory risk compared to creating utility tokens with genuine holder benefits. While multiple legal frameworks exist for designing utility tokens, they all fundamentally follow one principle: token holders must perform meaningful work to earn tokens and receive real benefits from their participation.

Web3 projects should prioritize legal compliance throughout their token design process, ensuring that their tokenomics structure and marketing communications maintain clear utility token characteristics. By following these three design approaches—distributing tokens through earning mechanisms, structuring payouts as bonus points, and avoiding profit expectations—token creators can build sustainable projects that operate safely within existing federal securities regulations.

FAQ

What is a utility token?

A utility token is a digital asset that grants access to services within a blockchain ecosystem. Unlike security tokens, it represents no ownership or voting rights, but enables specific platform functions. Its value fluctuates based on service demand and usage.

What is a security token?

A security token is a cryptographic asset representing ownership of underlying assets, backed by real-world value like equity, real estate, or commodities. It combines blockchain transparency with regulatory compliance for institutional-grade investments.

Is ETH a utility token?

Yes, ETH is primarily a utility token for the Ethereum network. It powers transactions, smart contracts, and pays gas fees. ETH also functions as a store of value and has evolved beyond pure utility purposes.

What are the risks of utility tokens?

Utility tokens face regulatory uncertainty, market volatility, liquidity risks, and adoption challenges. Value depends on network usage and adoption rates, which can fluctuate significantly.

What is the key difference between utility tokens and security tokens?

Utility tokens provide access to services within blockchain ecosystems, while security tokens represent ownership in real-world assets and require securities regulation compliance.

How do regulations differ for utility tokens versus security tokens?

Utility tokens access blockchain services with lighter regulation, while security tokens represent asset ownership facing strict compliance requirements including registration, disclosure, and investor protection standards.