In 2016, the US Securities and Exchange Commission (SEC) found vital flaws in the DAO smart contract, which ultimately led to investors losing $150 million worth of Ether. To protect consumer interests, the regulatory body investigated the project and found the DAO offering to be “securities in disguise.” The project met all the criteria of the Howey Test meaning that DAO tokens were then deemed as securities by the US SEC.
Although the incident created intense debate in the crypto community, it helped bring an important aspect to the forefront – tokens that are “securities” and those that are not. This was important for investor protection as well as for the growth of the blockchain space. The US SEC and FINMA came up with two broad categories – utility tokens and security tokens.
Before we move on to understanding each type of token, it is important to know why this distinction is needed.
With the US SEC’s toughening stance on blockchain products and Initial Coin Offerings (ICO), companies have to understand the thin line that stops a utility token from becoming a security token. In case tokens pass the parameters of the Howey Test, they will be deemed as securities by the US SEC and, therefore, subject to federal laws and regulations. Companies that fail to register themselves with the US SEC before their ICO in such instances will suffer penal actions later on.
For companies with tokens that qualify as securities, additional requirements in the form of KYC (Know-Your-Customer) and AML (Anti-Money Laundering) guidelines exist.
Apart from escaping the wrath of the regulatory bodies, businesses need to know the difference, in order to offer structured blockchain products. For companies that pay employees in the form of tokens, security tokens representing equity will be more appealing than utility tokens. Utility tokens can also be useful, since they are readily traded on various exchanges and an employee can ideally cash them out at any time.
Another aspect to consider is the perspective of external stake holders. Institutional investors are fond of security tokens, since it gives them a clear idea of their interests in a company. This is why the tokenomics of a project hugely influences investor decisions.
These are app tokens or app coins, which provide investors future access to products and services on the company’s platform. Most ICOs are centered on utility tokens, in exchange for capital. A famous example is the Filecoin ICO in 2017, the highest grossing ICO of the year that raised $257 million through the sale of its tokens, which provided decentralized cloud storage solutions to its token holders.
The investor here is basically taking a risk that sometime in the future, the company will have developed a sound platform and usable token on the proposed network. That is why investment decisions concerning ICOs are taken after careful consideration of multiple factors.
A majority of utility tokens came into existence after the launch of the Ethereum blockchain. The platform enabled blockchain companies to tokenise solutions to real world problems. Decentralised applications, or Dapps as they are called, could be created by developers with their own tokens, within minutes.
These are tokens that derive their value from external tradable assets. On the premise that a startup abides by all the regulatory guidelines, security tokens can offer a wide range of features. Perhaps the most appealing feature is the ability of a company to create digital representation of its stock.
In technical terms, a token has to pass the Howey Test, stipulated by the US SEC, in order to qualify as a security token. It has to fulfill clauses such as whether it is a money investment with an expectation of profits. If it is a common enterprise where profits come from a third-party source.
An example of an SEC-regulated token would be Polymath. Regulating security tokens is a complex procedure at present. Even with the presence of the Howey Test, it isn’t possible to classify them, since cryptocurrencies, at their basic level, are meant to be global currencies.
So, in case these tokens are launched outside US borders, the securities laws of the country where it is based come into play.
Choosing between the two types of token is subjective; as they fulfill different objectives. But it is important to be aware of the complexities that come with each type of token.
They are easily created, not subject to regulations, and very often have turned out to be scams. Companies can go insolvent or simply negate the validity of these tokens, which can lead to investors losing a lot of money. We saw examples of this fairly regularly through 2018, which has made investors cautious now. Blockchain companies now have to show a Minimum Viable Product (MVP), with testing reports, to gain credible investors.
These are legitimate tokens, but the process of approval is rigorous and exhaustive. The US SEC is not only interested in the Howey Test, but also in the credibility of the team behind a token. Firms have to disclose their financial records for the US SEC. In USA, there is a limit to investments for such projects and also a clause for who can invest and who can’t.
Only established companies have the resources to tokenise real-world monetary assets, in terms of manpower and technology. Also, the aspect of taxation, which differs from one jurisdiction to another, comes into play here. Unless countries establish a structured tax regime for tokens, Security Token Offerings (STOs) will suffer.
Both utility tokens and security tokens are expected to increase in value over time, with appreciation of market prices. Therefore, it can be difficult at times to distinguish between the two. A recent example is the Binance token (BNB), which can now be used as a medium of exchange, even when this was not the intended use for the token at the time of creation.