ICOs’ move towards security tokens puts them in the regulatory firing line, but it can often be avoided
Startup fundraising, in the traditional VC methodology, was flipped on its head in 2017 when a boom in ICO creation saw hundreds of companies forming on the Blockchain with its attached digital currency being born in the form of an investable token. However, this crowdfunding platform which exploded at a rapid rate has finally been hauled in by regulators and authorities who have noticed a few worrying trends. Bodies like the SEC have had a closer look at the tokens coming out of ICOs and in most cases declared them securities.
Suddenly, what is essentially an attempt to fundraise is subject to federal laws and the company, which is supposedly trying to create something innovative with the help of Blockchain technology, is expanding vast amounts of energy just trying to be by the books. But, there is a way around this. Not all tokens being developed off the Blockchain need to be of a nature that leads them to being classed as securities. There are a few other types of tokens that can be built off the Blockchain, including utility tokens.
While there are more than just two types of tokens, including equity, work, share-like and asset-backed, it is important to hone in on two types that can be used to define a new token coming through an ICO- the utility and the security token. In understanding the difference between the two, ICOs can choose a direction that can work better for them on a path of least regulation.
Towards the end of July last year, the SEC, on catching up to the ICO craze, dealt a telling blow to ICO regulation going forward. Looking back at the DAO tokens from 2016, the SEC declared that ICO tokens may be securities and subject to federal securities laws.
It was never intended for ICO tokens to be securities, but SEC chairman Jay Clayton noted that every ICO token the SEC has seen so far is considered a security and explained that if a crypto-asset issued by a company increases in value over time depending on the performance of the company, it is considered a security. "You can call it a coin, but if it functions like a security, it’s a security.” He added:
“Prospective purchasers are being sold on the potential for tokens to increase in value, with the ability to lock in those increases by reselling the tokens on a secondary market or to otherwise profit from the tokens based on the efforts of others. These are key hallmarks of a security and a securities offering.”
So, by definition, a security token can be found by employing the Howey Test. This test seeks to find if a token has the following attributes- does it offer an opportunity to contribute money and to share in the profits of an enterprise managed and partly owned by respondents? And, secondly, does the scheme involve an investment of money in a common enterprise with profits to come solely from the efforts of others?
Clearly, the most common tokens seen coming out of the majority of ICOs fall into this categorization and thus come under federal law.
On the flip side, there is another style of token that can serve a role in many cases where security tokens are being sought at the peril of the company insighting the ire of securities regulators. A utility token can be defined “to represent future access to a company’s product or service. The defining characteristic of utility tokens is that they are not designed as investments; if properly structured, this feature exempts utility tokens them from federal laws governing securities.”
There are already some highly successful utility tokens, as Vinny Lingham explains the use of utility tokens for Civic, his identity verification coin. “Civic has created one bln utility tokens that provide access to identity verification-related services in a decentralized, token-based ecosystem,” Ligham wrote on his blog. These tokens represent a unit of account for the network. The bigger the network grows, the more utility in the token, and because the number of tokens is fixed. As the size of the network and transaction volumes within it grows, this will create demand for the tokens.”
As if to highlight the underutilization of utility tokens, it was reported that of 226 ICOs, only 20 are used in the running of their networks, that is to say, they are utility tokens, according to Token Report. Storj is another example of a company that utilizes utility tokens, as their co-founder and chief strategy officer Shawn Wilkinson explains: “The Storj tokens we released allow people to use space on the network. We raised half a million dollars through the token crowdsale, and in 2015.” He adds:
“For many companies, utility appears to be an afterthought, but for a token to be successfully adopted into the community, it is the most critical component. With the amount of tokens on the market today, and new ones being launched every day, it's clear there is a bubble, though the size of it might be debatable. When the market slows, the tokens that have no utility will ultimately not have any value at all.”
Utility tokens can be further explained as coupons for the company and the service it is developing. A real-world example is something like retailers accepting pre-orders of video games that have not been released. It is a token that differs from the usual ICO token that many are used to, and while it is not a perfect fit for every company, there already have been instances where utility tokens have filled a role in place of security tokens letting the Blockchain solution focus on its primary goal. This was seen with Filecoin which raised $52 mln.
Choosing utility over security
Of course, as easy as it sounds, choosing a utility token over a ‘normal’ security token to avoid the SEC, there is more to it than that. Some companies will rely on the securities nature of their token, but the standing on it is, there are a lot of companies that won’t.
There are an array of different types of utility tokens, each with different characteristics that could encompass an ICOs’ needs. If the company cannot find a place in any of the below categorizations, then they have a case for building a securities token. However, if the token can fall into them, then really, there is no need to create a new native token which could lead them through a regulatory minefield. It is first important to divide tokens into fungible or non-fungible.
Utility fungible and non-fungible tokens
These types of tokens are ones which are simply interchangeable for one another. The fungible nature of it means that the asset, good or token is interchangeable with one of equal value, and it does not matter about its individuality. Gold is often cited as a fungible asset as an ounce of gold, regardless if it is in coins, ingots or dust, is still worth the same thing.
Thus, in terms of a fungible utility token, where they are interchanged for one another, we can see more categorization. For instance, on the Blockchain, there is the possibility for the System Incentive Token, which essentially are used to get people on the network to perform a desired behavior. A company that bases its ICO around this operation does not need a native app and can operate with a host of other tokens.
The same goes for a voter token which is another situation where Blockchain and tokens come into play, but again, there is no need for a native securities style token for this. These governance tokens enable those on the network to vote, and clearly, a utility token is sufficient for this. In a similar vein, membership tokens are also classic examples of utility fungible tokens as again, the token is just being used to access the platform, and utilize the services.
On the other side of assets, a non-fungible item is one that is unique, such as land, or in the Blockchain space- CryptoKitties.Utility Non-Fungible Tokens are thus mostly used to determine ownership of a specific token or digital asset. So, with a number of ICOs, on face value, clearly fitting into the above-mentioned categories, one has to ask why they decided on a native securities-style token which will lead to regulatory pressures?
Beyond the definition
The definitions of security token and utility token, and even the other ones which are a little more niche are still definitions from a pre-Blockchain era.
Dejun Qian, founder of Fusion and the creator of QTUM, which currently sits in the top 20 on Coinmarketcap, explains that tokens are still a very new and unique Idea, and while people try and pigeonhole them, they should really be defined individually.
“The reason people try to figure out if token is a security or a utility is because people are thinking which laws the token needs to be compliant with. When people say that the token is a utility, it means that the token is designed and embedded in the Blockchain infrastructure. Naturally, it can then serve as a very important part in the Blockchain. It is very creative and can then also provide a lot if different opportunities for the Blockchain.”
But in Qian opinion, we should transcend the bold security vs. utility perspective: “On the other side, there is the token which is regarded as a security. We have current laws covering the securities industry, and there are a lot of things we need to comply with, so people think about it in a similar way. I think we need to put more effort on the utility side, and even something else far beyond only security vs. utility. Because from my perspective, tokens are neither security or utility, it is a new thing and we cannot put a new thing in an existing framework, to determine what it is."