Blockchain has become the emergent technology of the last few years. Artificial intelligence and CRISPR have high potential, but only blockchain technology has shown the ability to disrupt nearly every industry in existence by making so many new business models possible. Blockchain technology has many useful innovations inherent, such as trust-less networks or decentralization, but one of the most important factors is the use of tokens.
The Power of Tokens
Tokens are useful as an innovation because of how they allow for organizations to run and business models to be reinvented. Tokens are useful methods of changing how organizations run and equity is conceptualized, or they can work in certain use cases to make for fluid online commerce.Generally, tokens are classified as either utility tokens or security tokens. Utility tokens are used to control future access to a product or service. Examples of these are Filecoin or Younow, both of which present the token almost like a gift card.
Security tokens are a bit more complicated, as they are considered to be akin to an investment contract. Motivations for buying these tokens are for future profits or revenue sharing, which comes with a whole host of other considerations. An example of a securities token is Polymath.
Using the Howey Test to Define Tokens
Where things get complicated is on the regulation of these tokens. Appreciating assets are generally regulated by some entity because of the risk and rewards involved, which makes the test of whether a token is a security or not so important. No one would ever say you need to regulate Magic cards just because they have value and are traded for profit by some people, so there needs to be a limit to determine whether a token is a security or not.
The test is referred to as the Howey Test and has been in operation for several decades. There are two conditions the token must fulfill for it to be determined to be a security. The first condition is whether users are buying it with the expectation of future price appreciation, versus a certain use case. It is possible to buy something for a particular use but also generate a profit, but the primary reason for the purchase is what determines this condition.
The second condition is whether there is a single issuer, or if it runs under a network governance. This is basically asking if a certain person or group is in charge, or if it is a more democratic project with many stakeholders.
Comparison of Security Tokens and Utility Tokens
The main reason the distinction between these tokens matter is because of the regulation that is required for security tokens. Many companies have been issuing tokens with tenuous use cases in order for them to be referred to as utility tokens, but are really just security tokens in disguise.
The start-up community has seized the idea of an ICO and started to use it as a shortcut to raising venture capital. One side may argue that this is opening up the massive returns to everyone, but it is also enabling uninformed investors to throw money at risky endeavors.
For this reason, the difference between a utility token and a security token is becoming more and more important. We are even seeing utility tokens refer to their offerings as Token Generation Events (TGE’s) to avoid the worrisome language around ICO’s right now.
One of the main reasons companies would want their tokens branded as utility tokens is the trading restrictions present on securities. Think about the last time you tried to sign up for a stock-trading account and all the paperwork that was involved there. These restrictions slow down the fast-moving startups by hindering them with regulations and due diligence they don’t wish to participate in.
Alternatively, it is actually cheaper to issue security tokens under the current regulatory frameworks. Under Regulation D, Regulation S, Regulation A+, and Regulation Crowdfunding, it becomes cheaper and faster than structuring the offering for utility tokens. This is rather unexpected but can be explained by the lower legal risk that results from this not being as rare a process.
Right now, we are seeing a lot of regulators call out lawyers involved in some of the more suspect ICO’s to say that substance matters over form. Even if a token technically passes the Howey Test, the marketing around some of these projects gives the distinct feeling of a security. In the future we are going to see the need for self-regulation by the crypto community. FINRA is one example of an organization that does this and crypto is an even more complicated industry that is going to have to learn how to self-report and play the game the right way.
The ICO market will likely continue to heat up for a while to come, but when many of these securities in disguise begin to crash, there will need to be much definition between utility tokens and security tokens.
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