The emerging technology of blockchain is shaking up the industry. Its existence allows major enterprises to form a wide range of new business models that help shape a new breed of investors and consumers. Since its inception, blockchain technology has brought a number of beneficial innovations including the decentralisation and trustless networks. Significantly, this technology has also introduced tokenisation including security tokens and utility tokens.
Currently, tokenised securities and utility tokens have made start-ups to come forth with million-dollar concepts as they move forward to crowdfunding. To further understand blockchain technology, some terminologies must first be defined.
What is a Token?
A token is a form of an asset or a utility for which its value is issued by a company or an entity. It can be a representation of something in an environment. It could give its owner a stake, a voting right, or a valuable asset. Usually, companies issue token when they launch an Initial Coin Offering (ICO), a counterpart of an Initial Public Offering (IPO) in the cryptocurrency market. In ICO, investors would receive a token for their investment.
Tokens must not be confused with a cryptocurrency coin. Crypto coins such as Bitcoin and Ether are independent platforms, which may be used a currency outside from their native environment. Tokens like Golem and OmiseGO are present and used only in an exclusive environment.
When you enter the ICO space, you will most likely encounter the two different types of tokens: Utility Token and Security Token. At first, differentiating the two can be quite confusing but they are fairly easy to understand.
Utility Tokens are user tokens or app coins. These tokens allow its owners to access a variety of products or services offered by an enterprise. In short, utility tokens are not made as a form of investment. For instance, a start-up can make utility tokens and sell digital coupons that users can use when they purchase products and avail of services that they are likely to offer in the future. These tokens can be considered as gateway tokens. Note that since an upper cap on the maximum available token, its value can skyrocket immensely due to supply and demand.
Utility tokens work in two ways. First, it gives token holders the right to use the network. Second, it allows token holders to take advantage of the company’s network by voting. These tokens can be used to generate funding. One concrete example of utility tokens is Filecoin. The company successfully raised $257 million by selling utility tokens. These tokens can be used to access the company’s decentralised cloud storage platform. Another popular utility token is the ERC20 Ethereum Standard. Companies can use this to create tokens for their DApps and eventually launch their Initial Coin Offerings.
Security Tokens, on the other hand, is a digital asset that develops its value from an outside tradeable asset. Since these can be traded, they are under the federal laws that supervise securities. Companies who fail to comply with government regulations often face severe penalties and cessation of project development.
However, companies who successfully comply with government regulations largely benefit as they can offer a wide range of applications. One key feature that security tokens possess is the ability to offer tokens as a digital placeholder for shares of stocks in a company. To put it simply, security tokens serve as a digital investment contract that stipulates legal ownership of the real estate and other investments. Once verified within the blockchain, security token holders can trade tokens for other assets, use the token as a loan collateral, and keep them in wallets.
|Use||Helps startups in funding via ICOs and creates an internal ecosystem within the blockchain. It also gives holders the right to vote.||Serves as an investment contract for digital assets verified within the blockchain.|
|Valuation||Independent from the company’s valuation.||As the company becomes valuable, token value appreciates as well.|
|Potential for Scam||Unregulated and prone to scam.||Heavily regulated and slim chances for a scam.|
|Regulation||Unregulated||Must pass the Howey Test.|
The Howey Test
To help cryptocurrency investors differentiate between utility and security tokens, the SEC formulated the Howey Test.
The Howey Test makes use of two simple questions to help investors differentiate if the token is a security or a utility.
Are the token holders allowed to provide funding for the company’s capital and receive a portion of the profits?
Does the fundraising effort of the ICO entail investment in the project where profits are generated entirely from the effort of individuals other than the creators or founders of the project?
If the answer to any of these questions is a yes, then the token is highly likely to be a security token. Any transaction will be deemed an investment contract if it can fulfill the criteria:
- It involves monetary investment.
- The investment is within a common enterprise.
- Profit comes from the work of promoters or any third party.
Note that a common enterprise can connote different interpretations. However, a number of federal courts have ruled that a common enterprise is a horizontal enterprise where investors pool their assets and money to fund a project.
Another noteworthy information about determining securities is profit. Does the profit come from the investment? Who controls the profit? If investors cannot control the profit, then the asset must be declared a security.
ICOs and Tokens
The US has a Securities Act of 1933, which governs all securities in the state. The primary objective of the act is to prevent fraudulent activities that may result from misrepresentations and deceit. The law also ensures that the issuer of the securities has substantial financial and other relevant investors transparent to its investors.
Any entity that purports to issue securities must submit their investment contracts to the SEC. Failure to comply results in stiff penalties, fines, and lawsuits. The government body also ensures that the market is free from any form of insider trading. Companies must submit necessary know-your-customer (KYC) and anti-money laundering (AML) requirements, which can be burdensome in terms of cost and time.
ICOs is the cryptocurrency counterpart of crowdfunding. Its inception revolutionised the industry by giving start-ups and developers to get more funding for their projects and by allowing anyone to invest in a project of interest by simply purchasing a token.
How Do ICOs work?
First, start-ups and developers will issue tokens in limited accounts to further increase its value. Some companies use marketing strategies to attract investors in the hopes of providing huge profits. Token value can be a pre-determined or it can also depend on how the crowd sale is moving along.
The process is pretty straightforward. When someone wants to buy tokens, they have to send money to a crowd-sale address. When it is acknowledged, investors get their corresponding number of tokens. In Ethereum, proper distribution of ICO among its investors will spell its success.
The success of ICOs helped startups to generate capital without giving up equity and drawing investments from venture capital or any institutional firms. In the report by the Wall Street Journal, as much as $7.15 billion was invested in ICOs in 2018 alone. Most notable is the EOS ICO which has sold more than 900 million ERC20 amounting to as much as $4 billion after only a year of the crowd sale.
One of the most interesting parts of the cryptocurrency market is its fluidity in terms of describing different products. Note that different countries have different terminologies. Some call it digital currency, crypto-token, virtual commodity, payment token, electronic currency, virtual asset, or cyber currency.
Much like how terminologies differ, regulations and jurisdictions differ as well. Countries like Morocco, Nepal, Vietnam, Algeria, Pakistan, and Bolivia restrict any form of cryptocurrency activities. Bahrain and Qatar prohibit local investments in cryptocurrencies but allow their citizens to invest outside their territories. Iran, Bangladesh, Thailand, Lesotho, Lithuania, Colombia, and China do not ban their citizens but have imposed restrictions particularly stopping financial institutions from processing transactions pertaining to cryptocurrencies. To date, a limited number of countries regulate ICOs that use cryptocurrencies as a method to generate funds. Some of these countries include Israel, Switzerland, Argentina, Spain, Denmark, and the UK.