FAQs for Those Who Are Looking Into Tokens

The blockchain is one of the most exciting innovations leaping ahead of the world today at a tremendous speed. Its decentralized nature is appropriated by industries worldwide.

After Bitcoin became old news with almost a decade, many other tokens started paving their way into the blockchain arena. Over the past year, we have experienced a shining example of the ICO boom, with more than 800 ICOs held and more than $6 billion raised. With the rise of the blockchain, companies opt for a fast, less expensive, and an easier fundraising method through ICOs, leaving IPOs behind. Therefore, drawing attention to a new breed of digital coins referred to as “tokens.”

“Tokens represent a particular fungible and tradable asset or a utility that is often found on a blockchain.”

– Investopedia

Tokens come in digital form and may perform various roles, making them difficult to define. Tokens can act as an internal currency, a right to receive goods/services, a right to vote, a security, a bonus/discount, an asset, etc. These functions are determined by whatever roles the tokens perform in the project.

By nature, tokens commonly fall into one of two categories: utility and security.  Utility tokens represent the right to receive goods/services in the future venture. They may perform like loyalty cards or bonuses. By purchasing a utility token during an ICO,  users can avail the products and services a company aims to provide. Utility tokens aren’t designed as an investment.

Security tokens, on the contrary, perform as “digital shares,” they entitle their holders with ownership rights, just as securities do in the non-blockchain world. The value of a security token is derived from the tradable asset, while the value of a utility token is derived from the consumptive use.

Hicham Errafass, the founder of MeriTT Protocol states, that “This well-discussed distinction between utilities and securities tokens, however, masks the much bigger differences that exist in the token universe: whether or not they are an investment is just one aspect, but there are many others. We believe that in the future a lot of the world’s interactions will be intermediated by tokens.”

Being classified as a utility or security token implies different regulations, resulting in regulatory debates over an ICO legality. While ICOs insist on differences between the two types of tokens, regulators are paying more attention to the reason they’re purchased in the first place. As the majority of buyers are purchasing tokens for further trading and/or holding, governmental institutions are concerned whether their nature will be tangled. Rayan Goutay, a General Counsel at Gatex – the upcoming hybrid FINMA-regulated crypto exchange based in Switzerland, comments: “There is an overlap between the two types of tokens: just like fiat currencies can be bought for the purpose of speculation and investment, people can buy utility tokens for the purpose of investment rather than for participating in the network. Whether or not a utility token is also a security token is ultimately a question that will be decided by the governments, courts, and regulators of the jurisdiction where the token has been issued and/or where the investor holding the token resides. It is an important question as there are many implications that follow from this classification, for example, how and to whom that token can be sold, and what are the tax implications of buying, selling, and holding the token”

“Security is a fungible, negotiable financial instrument that holds some type of monetary value. It represents an ownership position in a publicly-traded corporation (via stock), a creditor relationship with a governmental body or a corporation (represented by owning that entity’s bond), or rights to ownership as represented by an option.”

-Investopedia

Capital markets, the power of modern economics, forms a huge industry which becomes the target of fraud, and this demands a strict legislation in the sector. Security tokenization will revolutionize the traditional IPO sector by introducing a manner in which issuing shares, transferring voting rights and receiving dividends is decentralized . Decentralized, and semi-decentralized exchanges are being created, forming a legislation gap. Security tokenization or issuing security tokens will bring stock exchanges to the blockchain with an open and transparent ledger for all transactions. For instance, this year at WBF in New York, Bruce Fenton, one of the keynote speakers, admitted that today’s stock market is a mess, as it’s managed by hundreds of third parties who don’t trust each other.

“Try moving 100 trillion dollars in volume with 350 brokerage managing security ledgers who don’t even trust each other — and they don’t even trust the issuer!”

-Bruce Fenton, Founder, and CEO at Chainstone Labs

The current system can be changed by bringing securities to the blockchain, offering the same rights with lower costs and leveling the playing field for all participants. The government understands the global trends and is trying to keep up with the pace.

Governed by the principle “substance over form”,  The US Security and Exchange Commission (SEC) has stated that both traditional securities and security tokens are subject to the same federal legislation. The SEC relies on the result of the so-called Howey test to determine whether a token performs as a utility or a security.

The Howey Test was created by the Supreme court in 1946 to determine whether certain transactions can qualify as “investment contracts.” This test is a result of the case, where Howey Co. was selling citrus grove plots to investors. They also offered the buyers the opportunity to lease those plots back to Howey to harvest and sell their products. The SEC insisted leaseback agreements were securities which ought to be registered. This case resulted in the emergence of the Howey Test.

Since then, all traditional securities are determined using the Howey Test, and recently blockchain tokens have been subjected to it.

According to the test, an agreement qualifies as an investment if:

Security laws are protecting investors from scams and fraudulent activities, making a willing company to register a security/security token in accordance with strict rules and regulations, and in case of violations, beyond money penalties, may lead to imprisonment (Section 5 of the Securities Act of 1933).

“Government’s view of the economy could be summed up in a few short phrases: If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it.”

– President Ronald Reagan, 1986

Blockchain regulation hasn’t yet matured and is still in its early development stages. Thus, not everything is regulated yet, leaving “loopholes” for ICOs to be maneuvered. In the situation with tokens, only security tokens fall under security regulations; still, there are debates whether all tokens are securities. Regulators haven’t come to a definite answer, but it should happen at some point in the near future.  

Concerning tokens, the majority of laws are under development; still, some countries have already announced their overall position concerning ICOs, e.g., China banned them while Singapore promotes them. All significant regulators such as SEC, MAS, FINMA, FSA, FSRA, etc. are assessing security tokens and regulating them as a top priority, as they can be subject to fraud, causing substantial financial losses and a significant impact on the global financial system. Utility tokens aren’t regulated much for now, and it’s difficult to anticipate whether or how long this situation is going to last.

Regulator’s actions are aimed to protect token buyers, placing constraints on them along the way. Hopefully, this won’t prevent capital markets from the benefits the blockchain can bring to our future.