crypto

Crypto Quantshots

Be better informed! Get to know the Crypto ecosystem in more detail with reports covering all things Crypto.

Utility Token vs. Security Token: What You Need to Know

Jun 20, 2018

Each week, new developments occur worldwide in the cryptocurrency market regarding various types of blockchain protocols and their distinct tokens. In one of our recent crypto blog posts, we highlight that there are up to 5,500 tradeable cryptocurrency tokens on exchanges worldwide. While this number is lower than the number of publicly traded companies globally, the cryptocurrency space is not even ten years old! Each cryptocurrency protocol seeks to be innovative and transform the status quo. However, it is very important that investors possess sufficient knowledge of the type of token they are purchasing and, for U.S. residents, what the regulatory outlook is in the United States before investing.

So, what exactly is a Utility or Security Token? What are their defining characteristics?

Utility Token

Definition: Utility tokens represent future access to an organization’s products or services. They are not designed as pure investments, which exempts the tokens from Federal securities laws (at the moment). The value of the utilities tokens fluctuates with the value of the respective company’s products/services. Holders may be purchasers of the goods/service, but unlike security token holders, when the utility token is purchased, there cannot be expectations of profits.

Examples: Basic Attention Token (BAT) is a medium of exchange between users, advertisers and publishers who participate in the Brave ecosystem. Holders receive BAT tokens for using the Brave internet browser and for viewing advertisements. Holders can view the token as a reward for using the Brave platform. Other noteworthy examples include Filecoin (FIL) and Golem (GNT).

Security Token

Definition: Security tokens represent an investment vehicle that derives its value from an external asset, which has its own intrinsic value. Security tokens are designed as an investment and are subject to securities regulations. Security Tokens are tradeable tokens that holders own with the intention of making profits on their investment.

Examples: Overstock aims to hold an initial coin offering (ICO) to fund the development of a licensed security token trading platform. The firm aims to issue tZERO tokens in accordance with SEC regulations and token holders will be entitled to quarterly dividends derived from the profits of the tZERO platform. Another example of a security token is the Praetorian Group’s PAX token.

Regulatory Environment

The regulatory environment for Security and Utility Tokens in the United States is still materializing. In December, the SEC stated that initial coin offerings (ICOs) are an effective way to raise funds irrespective of whether they represent securities or not. However, the SEC mentioned that merely calling a cryptocurrency a utility token, “currency”, or a “currency-based product”1 does not mean that the cryptocurrency will not legally be considered a security. As blockchain and cryptocurrency technologies mature and become mainstream, the Securities and Exchange Commission, Commodity Futures Trading Commission, Internal Revenue Service, Department of Justice, and US Congress will develop more specific regulatory guidelines.

The SEC’s mission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.  One way the SEC does this is by focusing on protecting investors from tactics that have been prevalent in the cryptocurrency markets like: scalping, pumping and dumping, insider trading, and more. The SEC has not yet formally opined on every cryptocurrency or token issued. In early March, the first ever ICO was filed with the SEC by Praetorian Group. Up until this point, no ICOs have been formally registered with the SEC. However, SEC Chairman Jay Clayton has indicated that he considers most ICOs, which the SEC has seen, to be security offerings2. The SEC’s Division of Enforcement has brought a number of enforcement actions concerning ICOs for alleged violations of the Federal securities laws3. For example, last July, the SEC reported that the offering and sale of DAO Tokens were subject to the federal securities laws. The SEC stands by the Howey Test4 which was created by the Supreme Court in 1934 to determine whether certain transactions qualify as investment contracts. The Howey Test demonstrates that an ICO represents a security if:

  • It is an investment of money
  • There is an expectation of profits from the investment
  • Investment of money is in a common enterprise
  • Profit is derived from the efforts of a promoter or third party

To summarize, the key hallmarks of a security leave prospective buyers looking to profit from the increase in value of the token – with the ability to lock in those increases by reselling the tokens on a secondary market.  Platforms that trade securities and operate as an “exchange,” are defined by the federal securities laws, and must register as a national securities exchange or operate under an exemption from registration such as that provided for Alternative Trading Systems. Some online trading platforms may not meet the definition of an exchange under Federal securities laws, even if they directly or indirectly offer trading or other services related to digital assets that are securities. Many of the US-based crypto trading platforms have elected to be regulated as money-transmission services. Being predominantly state-regulated, these trading platforms have not been subject to direct oversight by the SEC of CFTC at this time.

 

Recently, SEC chairman Jay Clayton stated that bitcoin (BTC) is a commodity; the SEC does not have direct oversight of transactions in currencies or commodities, including currency trading platforms5. Other experts claim that coins like Bitcoin (BTC), Bitcoin Cash (BCH), and Zcash (ZEC) should be considered stores of value due to their independent monetary bases, and agree that they are neither Security nor Utility Tokens.  There had been speculation that Ethereum (ETH), which was recently offered in a presale, might not be considered a security due to its high level of decentralization and that it essentially is a platform that fuels other protocols. Consistent with this interpretation, the SEC released a report on June 14th that Ethereum failed the Howey Test, and is therefore not considered a security. This would suggest that Ethereum (ETH) may be either considered a commodity like Bitcoin, or a utility token at some point in the future.

It seems that cryptocurrencies can be considered Utility Tokens if they provide holders with use cases. If they can clearly distinguish their platform from those cryptocurrencies that offer holders profit incentives, then they can avoid Federal securities laws. Security tokens seem to be garnering more focus by regulatory bodies. It is likely that clarity will be provided by the SEC, or by an independent regulatory body like some other countries have developed. Brian Quintenz of the Commodity Futures Trading Commission posits the idea that a private cryptocurrency regulatory body may be the best solution6. Stay tuned for the next Crypto QuantShot which discusses how the United States’ current positioning in the cryptocurrency space compares to other major countries in the next Crypto QuantShot.

Sources

  1. https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11
  2. https://medium.com/polyswarm/how-the-sec-is-impacting-crypto-regulation-an-overview-a68962f5c642
  3. https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11
  4. https://consumer.findlaw.com/securities-law/what-is-the-howey-test.html
  5. https://www.sec.gov/news/testimony/testimony-virtual-currencies-oversight-role-us-securities-and-exchange-commission
  6. https://www.cftc.gov/PressRoom/SpeechesTestimony/opaquintenz8
  7. https://www.sec.gov/news/public-statement/enforcement-tm-statement-potentially-unlawful-online-platforms-trading
  8. https://www.sec.gov/news/public-statement/statement-nasaas-announcement-enforcement-sweep-targeting-fraudulent-icos-and