It has now been 10 years since the Bitcoin whitepaper has been released.
A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution — Satoshi Nakamoto, Bitcoin Whitepaper.
While Initial Coin Offerings may have tarnished the “utility” label to many as a means to skirt regulation, utility tokens do truly exist. The original utility token, Bitcoin, was created with the purpose of incentivizing security and providing access to the Bitcoin Network. The network itself could not function without the role that the token plays in the system’s architecture. Its value is determined by an open market demand of the token.
Without ownership rights issued to holders of these tokens, projects saw it as an opportunity for a capital raise with little to no responsibility once the offering was complete. The general idea is that these tokens are bought purely for utility speculation on the respective platforms and as the demand grows for the platform’s services, the results are a price appreciation of the token. This last year we saw a boom in these offerings attempting to copy this model. Yet, due to being issued by a central party unlike Bitcoin, the regulatory status of these tokens and platforms themselves have worried many involved in the marketplace.
Security Tokens Versus Utility Tokens.
Written by Fornaro Law - Website
This seems to be the subject of every conversation in the Crypto Space this year. The reason that it has become relevant lately is that representatives from the Security Exchange Commission (“SEC”) have declared that most every token that they have analyzed is a Security Token. These statements come after two years of crypto based companies all claiming that their tokens are Utility Tokens.
So, who is right? As nothing is absolute, we believe that the discussion should be based around the actual use case and the how the token is used.
That being said, what is now getting an even greater buzz is how to define the various terms that are being discussed. The confusion as to token classification and definitions is what is causing people to debate. The terminology is misleading and has caused many a user to invest in a token which is subject to SEC regulation.
So, what is an ICO? STO? Utility Token? Security Token? The terminology in the space has failed us. It may be that the terms have been tainted as a result of the bad actors and improper definitions. This is especially true when many of the users out there are trying to craft definitions which would allow their tokens to avoid SEC regulation. Just do a simple search for the definition of a Utility Token and you will find wildly inaccurate definitions.
Bad terminology is causing tokens to be mislabeled and improperly classified. Improper classification of a token leads to problems with the SEC. Especially since the SEC thinks most tokens are in fact Security Tokens. Further, bad terminology leads to distrust. For example, ICO’s, or Initial Coin Offerings, have garnered a poor reputation because most, if not all, of the tokens offered via ICO are in fact Security Tokens and are subject to SEC regulation. This has led to investigations by the SEC and loss of capital for users and a negative effect on consumers.
As a space, we must come to a common agreement regarding terms and definitions. If we are to build a solid and untarnished reputation, the Crypto Space must settle on accurate definitions which are both informative and in accord with the SEC. We must cut loose terms which have been tarnished, such as ICO. We must replace these terms with accurate terms that build confidence. For example, ICO should be replaced with Security Token Offering (“STO”). STO more accurately reflects the true nature of what is being offered (a Security Token) and helps to better inform the average user. It is almost like a do over as it relates to naming.
So, how do you get past the bad terminology and the self-serving definitions? How do you know if your token is a Utility Token or Security Token? You must know how the SEC views tokens and how they have defined Utility and Security Tokens. You must get past the inaccurate definitions and look to the tests established by the Courts and the SEC to determine the true nature of your token.
Fornaro Law and the Crypto Space
Before I get into the topic at hand and explain the difference between Utility and Security Tokens, I find the need to share the profound effect that the Crypto Space has had on Fornaro Law and myself.
From a legal perspective, the world of cryptocurrency is an unbelievable opportunity to work on something that is cutting edge. This is clearly the first time in my career where I was able to get into an area of the law and a world of which very few are aware. As an attorney, I am always looking to provide proper guidance and to protect my client. The world of Crypto has presented new and novel challenges and exciting opportunities. I have been inspired by Crypto since I first was introduced to it in June 2016, by a friend and client. Since then, I have thought of little else. However, I digress.
The concept of an Initial Coin Offering (“ICO”) and the tokens that were being sold was one of the first challenges that faced our clients. During 2016 and 2017, the ICO and tokens became popular topics and novel opportunities. Companies that wanted to raise money, simply sold tokens to individuals in exchange for fiat money, Bitcoin and altcoins.
The goal of an ICO is to raise money to advance a project or use case using an underlying DLT (i.e. Blockchain). A token offering through an ICO is simply a fundraising effort. This is no different than any other start-up company wanting to raise capital. The difference being a crypto start-up and a start-up company that is not connected to cryptocurrency, is that the non-crypto company has to follow the SEC regulation process. These securities must be properly registered or they must seek an exception to the regulation before raising funds. Current exceptions to the Regulation are Reg D, Reg CF and Reg A.
Because the SEC and other governmental entities had never been exposed to tokens, blockchain and fund raising in this fashion, they did not necessarily know how to respond. As such, the market developed without regulation.
As the ICO market exploded and large amounts of money was raised, the government and the lawyers realized that what these new start-up companies were trading and selling, were securities. After all, people are buying these tokens with the hopes of a rise in price of the token and the chance at future profits. It is pure speculation.
The SEC sat on the sidelines watching in 2016 and 2017. Unfortunately, because some of the ICOs were fraudulent, the SEC stepped into the game in 2018, when it issued approximately 80 cease and desist letters against ICOs in February 2018. This also had the unintended effect of causing distrust of ICOs.
There was a period in 2017 and 2018 when our clients were ignoring our legal advice, because we were advising them that the token that they were developing, and selling, were securities and that they should consider treating them as such. The client’s marketing teams would not have it. We were consistently told that our advice would stifle sales and would destroy the project. We were also told that the token that was being sold was a utility. We were informed that there was no regulation yet, so none had to be followed.
Those discussions came to a head and companies that were raising money began struggling because of the cease and desist letters from the SEC and general uncertainty as it related to regulation.
That being said, it is time to describe the very important distinctions between Security Token and a Utility Tokens.
What is a Token?
A token is a unit of value. It is a right to an asset or a commodity, on a blockchain network. One should not underestimate the profound effect that Tokens have on the blockchain space and the world in general. Tokens provide a bridge between the world of finance and the blockchain. Further, some tokens speed up traditional finance. With tokens, a transaction which would traditionally take days can now be accomplished in mere hours. Tokens also expose their users to expanded markets and a bigger pool of investors than would be available in traditional finance. Another benefit is that tokens prevent institutional manipulation and corruption by middlemen by eliminating these elements from the transaction. Finally, as licensed trading platforms are developed, tokens will have an ease of liquidation not currently present in traditional financial transactions.
Utility vs. Security?
There is a lot of confusion as to the definition of a Utility Token. One need only do a quick google search to get a variety of wildly different definitions. Many of these definitions are merely wishful thinking. Fortunately, the SEC has provided some guidance. The SEC has said that at its most basic, a Utility Token is simply a token which grants a right to participation. It has no inherent value, no promise of investment potential or future profitability. It is simply a permit to utilize a certain platform. Utility Tokens do not have a central “enterprise.” There is no promise of future goods or services. SEC Chairman Jay Clayton has stated that “Tokens and offerings that incorporate features and marketing efforts that emphasize the potential for profits based on the entrepreneurial or managerial efforts of others continue to contain the hallmarks of a security under U.S. law.” This starkly contrasts with the attempts by promoters to classify their tokens as Utility Tokens. These attempts have proven to be futile. The SEC has said that simply calling a token a “utility” token or structuring it to provide some utility does not prevent the token from being a security.
The SEC has observed “in order to raise money to develop networks on which digital assets will operate, [promoters] often sell the tokens or coins rather than sell shares, issue notes or obtain bank financing. But, in many cases, the economic substance is the same as a conventional securities offering. Funds are raised with the expectation that the promoters will build their system and investors can earn a return on the instrument – usually by selling their tokens in the secondary market once the promoters create something of value with the proceeds and the value of the digital enterprise increases.” Accordingly, the SEC has found that most tokens which are labeled “Utility Tokens” are, Security Tokens.
A Security Token derives its value from an existing, outside and tradeable asset. This is in stark contrast to a Utility Token which is really a coupon for future use with no existing and tradeable asset. To really understand what a Security Token is, one should understand securities. Securities are basically tradable financial assets. These can be stocks, bonds, notes, shares, etc. A security is a way to own something without taking possession of the item. Securities are a way for companies to raise money from a pool of investors in the capital markets. These investors then are promised a return on their investment. When these things are accomplished through a token, the token is a Security Token.
The Howey Test.
When securities are involved, the SEC regulates them. How does a token become subject to SEC regulation? By meeting the criteria of the Howey Test. The Howey test was established by the Supreme Court of the United States to determine when a certain arrangement between parties involves an investment contract (security) which would be subject to SEC regulation. What is the Howey Test?
The Howey Test examines three criteria to determine if a token is a security for purposes of the SEC; (i.) there is an investment of money, (ii.) money is invested in a common enterprise and (iii.) the buyer expects to profit from the efforts of others. Depending on the facts and circumstances of each individual ICO, tokens offered or sold may be securities, and, in fact, most have been determined to be securities by the SEC. "I believe every ICO I've seen is a security," SEC chairman Jay Clayton declared during his testimony before Congress. As always in life, there are of course exemptions.
If a token is deemed a Security Token, this is not necessarily a death knell for the token. The SEC provides specific exemptions for certain Security Tokens which allow these tokens to avoid registration with the SEC. The SEC allows exemptions under Regulation D, Regulation S, Regulation Crowdfunding, and Regulation A for issuing securities without the need to register the same. While an explanation of these exemptions is beyond the scope of this article, know that there are options to avoid registration with the SEC for a business whose token would qualify as a Security Token.
In addition to the Howey Test, the SEC has issued a list of questions that it considers in determining if a token is subject to SEC regulation:
Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?
Are independent actors setting the price of is the promoter supporting the secondary market for the asset or otherwise influencing trading?
Is it clear that the primary motivation for purchasing the digital asset is for persona, use or consumption, as compared to investment? Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Are the tokens available in increments that correlate with a consumptive versus investment intent?
Are the tokens distributed in ways to meet users’ needs? For example, can the tokens be held or transferred only in amounts that correspond to a purchaser’s expected use? Are there built-in incentives that compel using the tokens promptly on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment?
Is the asset marketed and distributed to potential users of the general public?
Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application?
Is the application fully functioning or in early stages of development?
A token that passes these tests is deemed a security token for purposes of SEC regulation.
The Push for Regulation!
It is imperative that you know that the SEC is classifying the vast majority of tokens as “Security Tokens.” How does this affect your token? Your investment? The simple answer is greatly. However, there are benefits inherent in SEC regulation which will benefit the Crypto Space in the long-run.
Over the past year we have seen a great push, in the U.S. and overseas, for increased regulation of tokens. This is largely due to the nature of the token in relation to the financial industry. Truly, not since the invention of services such as mobile banking has there been such a revolution in the finance industry.
With great change, regulation is inevitable. Understanding new and disruptive technologies has never been a strong suit of government. However, regulation is inevitable given the effect on consumers in this space. One need only look at the wild swings, and fraud, associated with ICOs for an example of the growing pains associated with tokens. Governments are now attempting to address the rampant fraud and scams which are prevalent in the ICO markets. While there is great concern as to whether governments will be able to correctly regulate the space, there are some advantages to regulation.
Why is this important if you are a casual investor in tokens? If a token is classified as a Security Token there are heightened legal risks, duties and obligations that the issuer must consider. Compliance with these processes is a costly proposition. Accordingly, if you have invested in an ICO, and the issuer has not classified the token as a “Security Token,” then your investment is in trouble because your ICO token is most likely a Security Token. SEC Chairman Jay Clayton appears to believe that every ICO he has seen is a security, remarking that he wants “to go back to separating ICOs and cryptocurrencies. ICOs that are securities offerings, we should regulate them like we regulate securities offerings. End of story.”
This is exactly why a switch from the term ICO to STO is vital. If a user is informed in advance that the token they are investing in is a Security Token and subject to SEC regulation, they will be more informed and aware of the risks associated with investing in securities. After all, the average user is more aware of how securities are traded than cryptocurrency. Further, once classified as an STO, the user will know that the Security Token is properly classified and registered with the SEC.
How Much Regulation?
There is a lot of confusion as how aggressive the SEC will be in regulating Security Tokens. Preliminarily, we must remember that the SEC is not looking to stifle innovation. They are looking to protect the public. Therefore, it is important to the SEC to monitor and control the explosive growth of the Crypto Space.
The SEC and the Congress have taken a proactive and pragmatic approach to regulation of Security Tokens and a commitment to the growth of the Blockchain and other distributed ledger technologies. During my recent visit to meet with the SEC, the CFTC and 12 different Congressional aides, I am happy to report that I saw nothing to indicate that these entities would work to stifle the growth of the technology. To the contrary, they were very open to doing what they could to advance the Crypto Space.
Regulation of Security Tokens is not all bad. A review of the history of traditional securities indicates that regulation takes a big bit out of corrupt practices by issuers. Regulation will help to protect the consumer from scams, fraud and other corruption which are prevalent in the current ICO markets. This legitimizes the space while protecting consumers. Security Tokens will provide credibility to a space that has been suspect in the past. This is a net positive for regulation.
Whether you are contemplating a blockchain business or are an investor in tokens, it behooves you to understand the difference between Utility and Security Tokens, their regulation and the effect on the Crypto Space. Security Tokens are the next profound step in the development of the space. They are subject to regulation, but that regulation serves to legitimize the space and fight against fraud. Whether you are a casual observer, or a dedicated blockchain business, you must know and understand Utility Tokens and Security Tokens.
Security tokens will create a larger market than US public equities within the decade.
Written by Rhythm Technologies - Website
While the debate of the regulatory future of utility token offerings are still ongoing, some have embraced existing regulation with open arms. With blockchain-based tokens, we now have the ability to send value anywhere in the world with the simplest smartphone and an internet connection, all done without the legacy financial system acting as a middleman facilitating transactions. This is value in the form of bits of code being transferred. What these bits of code represent are up to the users. What we will begin to see are traditional securities removing middleman exchanges by entering the blockchain ecosystem. The ownership to an underlying asset is linked, by law, to a digital token on a network. Stocks, bonds, and investment contracts are being legally tethered to lines of code and provide financial rights to the owner, e.g. voting rights, profit share rights, redemption rights, equity, and dividends.
Think of traditional assets similar to that of mailed physical letters and tokenized assets to that of emails. Bitcoin first brought us programmable money and with that we are now discovering the power of programmable securities.
Anyone who is not sold on crypto-assets just needs to look at how quickly newer generations adopt technological changes and trends. We are seeing a new market emerge, one where younger generations can relate to and participate in. As of last year, more millennials viewed Bitcoin a greater store of value than gold and it’s no surprise. Their first investment experience with traditional finance was in 2008 with the “Great Recession”, pair that with growing up in a virtual, border-less world, I’d have expected even more to own some already. – Brennan Nacol – COO of Rhythm
Tokens Will Consume Finance
The global financial system has improved immensely because of the digital age. Relative to pre-internet days, there is no reliance on anything physical in the process but they still can only streamline the process to a certain degree. At the end of it all, they still need to be involved to facilitate the exchange, which creates a level of friction that will never disappear. By tokenizing private securities, assets can be traded on secondary markets without the burden of traditional private securities. The benefits of a purely digital financial system can allow for a future in which the security token market can exceed the US public equities space within the next decade. There are over $544 Trillion worth of assets worldwide that inevitably will become tokenized on blockchains because of 4 main reasons.
Fractional Ownership. A Bitcoin can be broken down into one millionth of a coin. The same can be done with a security token. Almost all traditional assets have a minimum investment requirement which creates a level of friction for the investor. Optimal allocation of assets have historically been out of reach.
There will come a day where individuals may be able to pay for a coffee with an incredibly small percentage of an Amazon stock as seamless as using their debit card. Maybe even receive a discount on the coffee as well because their portfolio holds a small fractional percentage of Starbucks stock.
A 36.5 million dollar condominium in New York City has just been sliced into digital shares, and thanks to blockchain technology, you could own a piece of it.
Exposure. Wall Street struggles to scale to meet the new global economy created by the internet in an ever growing connected world. Complex ledgers between the worlds different financial centers create a barrier. Before Bitcoin, only increased centralization of powers could break them. A new ledger system secured by open and public blockchains have paved a new way forward for the trading of securities.
Regulation, restrictions and compliance can be coded into each token. When imagining global securities, an investor could have a portfolio made up of publicly traded companies from all over the world. Hundreds of thousands of companies all in a single investors portfolio are now possible with the efficiency of tokenization. Each one of these global companies could account for only pennies of your total investment portfolio.
In the United States alone there are over 20 million small business. If we consider the future in which the majority of these securities are tokenized, it could mean trillions of dollars being secured upon blockchains and in the portfolio of individuals across the world.
Removing Middlemen. Smart contracts or code that executes a specific command on the blockchain allows for completely programmable securities. This benefit ties in to our first two points, making fractional ownership financially viable as an investor. Even a small reduction of fees and execution time can create new dynamics in the marketplace for portfolio allocation and trading. While trades may execute quickly on traditional exchanges today, the settlement of assets can take much longer. The documentation required to verify the transfer of ownership at the correct price and time can stretch this process into days. Why can Bitcoin settle in minutes, if not milliseconds with the Lightning Network? It is a peer-to-peer solution.
With a security tethered digitally in a smart contract, the means of exchanging that security between buyers and sellers has the ability to transfer peer-to-peer. Banks and brokerage firms can be removed from the process with regulatory compliance baked directly in the code. Decentralized exchanges (DEXs) are becoming increasingly scalable and efficient, lowering the barrier to entry and allowing for more participants in the financial system.
Liquidity. Liquidity simply is the ability to turn an asset into cash. Take a common investing vehicle in real estate such as a REIT as an example. They are deemed relatively illiquid. There is typically a mismatch of buyers and sellers in the marketplace. Real estate is capital intensive and also very sensitive to it’s cost. Private REITS, like private securities today, offer little or no liquidity. The reason for a lack of liquidity is that the buyer and seller can’t find each other easily. Each transaction has fundamental transfer restrictions on shares or interests. You can’t just go sell easily, even if you do find a buyer. There are very complex requirements, both regulatory and contractual that the issuer has to manage.
Along the same lines, take a piece of artwork. It could be worth ten million dollars but the seller needs to offload it immediately. In reality, the artwork marketplace has only a handful of buyers at that value. There is a good chance that the seller will also have to take a reduced valuation due to this lack of liquidity. This is known as an illiquidity discount. On average it is 20-30% across the security marketplace.
This can be taken the other way as well in the form of a liquidity premium. The more liquid an asset is, the bigger increase of value to investors. Just because you tokenize an asset doesn’t automatically make it more liquid. Liquidity will only increase if market depth does also. When a security is tokenized, it becomes easier to trade on a secondary market due to the lack of middlemen. It does not lose cost-effectiveness while gaining market depth. Using a trust-minimized exchange paired with fractional ownership allows for the reduction of friction between buyers and sellers. That benefit will force institutions and companies to consider tokenization as a means to stay competitive in an ever growing global marketplace.
Securing Security Tokens
Created value in theory should naturally flow down through the stack to the foundation. A protocol using Proof of Work (PoW) or Proof of Stake (PoW) is only as secure as the chain is valuable. The means of security in these systems uses value based game theories. Financial incentives to stake either energy or tokens provides a balance that fuels the consensus mechanisms. Relationships between assets and the base layer are yet to be played out at scale to determine the ratio of value of the chain itself and the assets secured upon it. Long-term, only the most secure,decentralized and censorship resistant blockchains will acquire the value of the world’s financial system on their backs. While many investors may be chasing the latest tokenized offering, the protocol layer is the the sector to watch.
We are seeing Ethereum lead the public blockchains in an attempt to gain their market share of tokenized securities. If this trend were to continue, the demand for Ether (ETH) would grow as it is the fuel to help power the exchange of these assets on the chain. The value proposition of Ethereum can then be equated to that of the infrastructure facilitating the new global financial system. There is also a slightly more indirect investment view that a world of tokenized securities, no matter the specific blockchain, all need a single settlement currency. Fiat in its current form is incompatible with this new financial system. Bitcoin, however, fits the criteria of such a currency. As an example, dividends will need a digitally native currency to paid out to holders in. These concepts deserve their own post and will be built upon in a follow up.
Why is standing in the way?
A lack of infrastructure. We are seeing the security token stack develop in the form of compliance and exchange layers needed to bring liquidity to the market.
As liquid as the future of security tokens are, there is a massive amount of infrastructure components that still need to be built to realize it. As the market currently sits, they remain severely illiquid. Fully regulated layers of the system are still being formed. We are seeing the security token stack develop in the form of compliance and exchange layers needed to upgrade the current system.
The stack is further along than it may seem. Cryptocurrency exchanges are transitioning as fast as they can to offer security tokens. Earlier this year we saw the largest exchange, Coinbase, gaining approval for listing security tokens. Even more exciting are the statements from Nasdaq on their openness to incorporate blockchain assets. They have already partnered with some of the larger cryptocurrency focused exchanges and may themselves transition into one.
The issues persisting have already started to smooth themselves out. While the process may seem slow, for an upgrade of the financial system this is moving at a breakneck speed. Different from the upgrade to the digital age, value is being created in new places. Looking at this simply as a performance increase, the largest opportunities as an investor will be missed.
Fornaro Law is very proud to have clients and entrepreneurs involved in the cryptocurrency industry. As we follow the trends of Bitcoin, Ethereum, Ripple and other cybercurrencies and see the power of the underlying technology of the blockchain, we understand that compliance, structure and legal advice is needed to support these pioneers in this blossoming industry.
The founders of Rhythm Technologies have continually helped innovators take advantage of new opportunities that weather the changing economic landscape. The group seeks significant opportunities that, through innovation, have the potential to dislocate markets. We believe success is built by a combination of innovation, capital and strong working relationships. Technical development, marketing, and business consulting for blockchain related projects.
Not intended as financial, legal advice.