In 2017, the traditional method of startup fundraising (using VC methodology) was completely revolutionized. A boom in the launching of ICOs saw literally hundreds of companies turning their attention to the blockchain and creating a digital currency born in the form of an invest-able token. This manner of crowdfunding which has seen unprecedented levels of increased popularity has found its wings clipped by regulators and authorities who have picked up on a few worrying issues. Authorities such as the SEC have taken an in-depth look at the tokens being produced by ICOs and have decided that the majority of them could be classified as a security.
This classification does not, however, apply to all tokens and some that are being developed off the blockchain can be considered as utility tokens.
There are, of course, more than two types of token such as equity, work, share-like, and asset-backed but it is important to focus on the two types – the utility and the security. By understanding the difference between these two types of token each ICO can choose a more suitable regulatory pathway.
By the end of July 2017, the SEC dealt a big blow to the ICO world by declaring that DAO (Decentralized Autonomous Organization) tokens were securities and were therefore subject to federal securities laws. It was never the intention of token creators for them to be considered as securities but as the companies that issue these tokens, often increase in value over time, the token begins to perform as a security.
The Chairman of SEC, Jay Clayton added that “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.”
But to decide whether a token should be classed as a security, one can put it through the Howey Test. The test seeks to find if a token has the following attributes; does it offer the chance to invest money and then to share in the profits of an enterprise managed and partly owned by respondents, and does the scheme involve investing money in a common enterprise with profits that come only from the efforts of others. As most ICO tokens fall into these categories, as such they fall under the jurisdiction of the US federal law.
The other popular type of token is a utility token and it serves a role where security tokens are resulting from the company receiving unwanted attention from securities regulators. In short, a utility token can be defined as representing future access to a company’s product or service. The defining feature of a utility token is that it is not designed as an investment, but rather as an IOU (I owe you) of sorts for future use. If utility tokens are structured properly, this means that they cannot be considered as a security token and therefore cannot be governed by federal laws.
There are already some very successful utility tokens on the market such as the ones issued through Civic. Civic has created 1 billion utility tokens that offer access to identity verification services in a decentralized and token-based system. These tokens each represent a unit of account for the Civic network and the more the network grows, the more utility the token is worth.
Out of 226 ICOs, only 20 of the tokens issued are actually used for the running of the applicable networks and are therefore utility tokens. Another example of a company that uses utility tokens is Storj. These tokens allow the holder to use space on their network and the token crowd-sale raised over half a million dollars in 2015.
Shawn Wilkinson explains:
“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.”
Another way of explaining how a utility token works is by describing it as a coupon for the company and the services that it provides. For example, a retailer accepting pre-orders of a video game that has not yet been released. This kind of token differs from the usual ICO token that most people are used to and whilst it cannot be applied to every company, it is perfect for some. There have already been instances where utility tokens have replaced the role of a security token and have therefore allowed the blockchain solution to fulfill its primary goal – an example being Filecoin which raised an impressive $52 million.
Utility over Security
Whilst on paper, choosing a utility token over a security token might seem easy enough, there is more to it than that. If a company is unable to find a place in any categorization for their token, then it will become a securities token but if the token can be placed in them, it makes sense no avoid it being a security and having to negate a regulatory minefield. The first step is to decide whether it is fungible or non-fungible.
Utility fungible and non-fungible tokens
These are tokens that can be interchanged for another token. The fact that it is fungible means that the goods, service, token, or asset is interchanged with another that has an equal value. Gold is often considered as an example of a fungible asset as one ounce of gold, whether in coin, ingots, or dust form is still worth the same amount of money.
A voter token is another example of a situation where both blockchain and tokens can be utilized without the need for a native security-style token. These governance tokens allow those that are using the network to vote and a utility token is sufficient for this purpose. Similarly, membership tokens are also considered to be fungible utility tokens due to the fact that the token is only being used to access the platform and utilize the services.
A non-fungible token is one that is used to determine the ownership of a token or digital asset, such as CryptoKitties. A number of ICOs clearly fit into the above categories rather than that of a non-fungible securities token, so why have many decided on a native securities-style token which leads to regulatory pressure?
The definition and beyond
The very definition of security token and utility token were created before the advance of the blockchain era. Founder of Fusion and creator of QTUM Dejun Qian states that tokens are still a really new idea and they are something that should be defined on a case by case basis.
“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 of different opportunities for the Blockchain.”
According to Qian, we should move past the security vs utility point of view: “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.”