We’ll tell you what security and utility tokens are – how they differ and what they are for. This is important, since many tokens, by decision of the American regulator, may be “outlawed”, which promises many problems of blockchain startups and, possibly, their investors.
Why is it important
Case decision DAO
In the summer of 2017, SEC published a report on the case of the hacking of the blockchain-startup The DAO, according to which the tokens of this project were recognized as “digital” analogues of securities. SEC called such assets “security tokens” and decided that their issue and sale should be in accordance with The Securities Exchange Act of 1934 and other legislative acts that regulate theUS securities market.
The SEC Regulation applies to all tokens, the issue and sale of which took place in the framework of US jurisdiction. This means that the activities of some blockchain startups can be suspended, even if they were created before June 2017. There are precedents: SEC closed Munchee startup, which collected $ 15 million for developing a mobile application.
According to The Wall Street Journal, the SEC was not limited to statements, but began a large-scale investigation into the activities of all companies that raised money with the help of ISO. And quite successfully, since several dozen startups, after talking with the SEC, decided to return the money to investors and pay a fine, without giving these actions wide publicity.
This is a minority. Most claim that they have released utility tokens, and therefore their actions do not fall under the regulation, therefore the company may not return the money and continue its activities. To protect their positions, both sides use the Howey test.
This test is a questionnaire formulated by the US Supreme Court during the SEC v. W. J. Howey Co, which was held in 1946 in Florida. With this test, the court determined whether the purchase of an asset was an investment contract, which became the general rule for all subsequent proceedings due to case law.
Howey test includes four questions:
1.Do you invest money?
2.Do you expect to get the benefit of the investment?
3.Do you invested money in a common enterprise?
4.Will the Profit be received from the actions of third parties?
According to the SEC, in the case of tokens and cryptocurrencies, 4 questions can be reduced to two and they will be formulated as follows:
1. Does the token provide its holders with the opportunity to finance a blockchain start-up and provide the right to a share in profits, ownership of a part of assets and / or the right to manage a startup?
2. Do Investors invest in a project whose profit is generated from the activities of third parties (not investors)?
If the answer to one of these questions is yes, the SEC is likely to recognize the digital asset as a security and will require its issuance and sale to be in accordance with federal rules applicable to classic securities: bills of exchange, bonds, stocks, and so on.
Howey test is not the only one. There are other laws in the United States that assist the courts in understanding whether to consider an asset as a security or not. These include:
● Reves’s Family Resemblance Test, accepted by the Supreme Court in 1990. This test assesses the investment expectations of investors: if during an issue, negotiation, advertising, or servicing an asset, the issuer or its representatives manipulate investment income expectations, promising significant profits, this is a security token. The nature of “manipulation” can be anything.
● Risk Capital Test, accepted by the California Supreme Court in 1961. This is a test that shows whether an asset is risk capital. According to him, even club membership — a membership card — is a security because “investors risk their capital in anticipation of gaining the benefits of membership in a club that is under the control of member issuers”.
● Blue Sky Law. Some states have their own laws that regulate the securities market. Lawyers and industry professionals call them laws. «Blue Sky Law». The first such law was passed in 1911 in Kansas. He served as a model for similar laws passed in the other 47 states from 1911 to 1933. Now most of these laws are summarized in the Uniform Securities Act of 1956.
These are tokens with the help of which users get access to the software utility (or service) of the blockchain platform. They do not promise any benefits, do not give ownership rights to the land, property or other assets of the company, and are not analogs or substitutes for loan agreements. Currently, utility tokens are the most common type of coin.
The price of utility tokens during ICO is determined by the issuer – arbitrarily or by the results of economic analysis. After the coins enter the stock exchange, the price changes under the influence of the supply and demand ratio: if a project is demanded by users, the demand for its functionality grows, therefore the demand for tokens also increases, which increases their value in the market.
Coins such as Stellar Lumens, NEM, NEO Gas and Ethereum are excellent examples of utility tokens. Ethereum does not promise benefits from resale or dividends, but it can be used to create and initiate smart contracts on the ethereum blockchain. NEO Gas and NEM work on the same principle, Stellar Lumens are used to pay for transactions within its own system.
Utilities, sales and resale of utility tokens do not fall under the jurisdiction of the SEC, so most blockchain startups use this type of virtual coin to finance their projects during the ICO. However, at the same time, developers often hint to investors about the opportunity to get not only access to the blockchain, but also “very likely” profits from the growth rate of the token after its release on the stock exchange – most of the white paper have calculations of the growth of capitalization and the cost of tokens.
This is a financial instrument, the main function of which is to make a profit by increasing the price of an asset and / or activities of third parties. Security tokens give holders the right to: share in profits, dividend payments, company capital, assets or their shares, debt payments, etc.
An example of security tokens are tZERO, Pinkdate, Bibox, Polymath and ICONOMI coins. tZERO — This is a platform that runs blockchain startups with security tokens in accordance with the rules of CES and FINRA. To finance its project, tZERO issued coins whose holders are entitled to quarterly dividend payments.
The Polymath, Bibox and Pinkdate teams went the same way, directly stating in white paper that their tokens would not be needed anywhere, their only value is dividends. The startup team ICONOMI first positioned its coins as utility, but after tightening control decided to “restart”, releasing security tokens in full compliance with CES and FINRA regulations.
5 key differences between Security and Utility tokens
1: The main purpose of the issue
The main difference between security and utility tokens is the purpose of their emissions. If the coins were issued mainly for the sake of raising funds for something – this is security tokens. And here it does not matter whether it is possible to use tokens as tokens to pay for goods and services on the platform. The main thing – what goal does the issuer pursue in the initial issue of coins?
For example, Munchee startup tokens had practical application within their own platform, but the project team wrote in white paper and repeatedly stated that it would be possible to resell their coins later and earn a lot of money in this way. That was the reason for closing the project.
Utility tokens, on the other hand, are issued mainly to be used to access the blockchain functionality. For example, the most famous cryptocurrency in the world – Bitcoin – was created to become an alternative to Fiat and remove the monopoly of states to issue money. There are no promises or even hints about possible profit in white paper of Bitcoin, only the principles and technical nuances of the payment system functioning.
2: Property rights
Utility tokens do not give ownership of something – it’s just a digital “key” with which you can start the blockchain mechanism or its individual element: an application, a smart contract or a payment gateway. Security tokens are always entitled to:
● commitment to dividends;
● physical or digital asset: oil, dollars, patent, real estate;
● Issuer’s credit obligations to the holder of tokens;
● participation in the management of the company;
The right to pay dividends is given by the previously mentioned tokens tZERO, Pinkdate and Polymath. Digix coins give the right to real gold bars, a joint project of IBM-Natixis-Trafigura tokenizes transactions with oil, and Steem Dollar gives the right to credit obligations to investors.
In addition to security and utility in crypto-world there are still reward and donation tokens. They do not open access to the blockchain functionality, but they also do not give ownership rights to anything, so their emission and continued existence are not under the jurisdiction of CES and FINRA.
Reward tokens — These are reputation points or loyalty points (bonuses, promotions, discounts) that are accrued to users of the platform in exchange for useful actions: registration, purchase of goods, viewing advertising, completing a task, etc. Donation tokens — it’s just some kind of points without any obligations and functional load. They are charged for donations to the project.
3: Marketing and Target Audience
Projects that produce utility tokens focus marketing efforts on attracting potential users of the blockchain and / or its individual elements. Therefore, they participate in conferences, lecture halls and prefer to place advertisements in the specialized media that their potential users read.
For example, a joint project of IBM and Maersk to create a logistics platform for maritime transport — TradeLens. TradeLens advanced in specialized magazines, at conferences of carriers and logisticians. In addition, well-known experts and industry managers were attracted to participate in the development and promotion of TradeLens.
The marketing promotion of security tokens follows a different scenario: issuers are looking for investors, with an emphasis on potential gain, and not on the blockchain’s opportunities. Their target audience is business angels and accredited investors (whales).
Business angels are very rich people who invest personal funds in startups in exchange for a share in the business. At the same time, quite often they provide not only financial, but also expert support, helping the project team to develop a strategy for attracting investment capital.
Accredited investors, or whales, are people and companies that can operate with large capital without feeling pressured by banks and regulators. In the US, the rules for their activities are spelled out in Rule 501 of Regulation D SEC.
To become a privately accredited investor in the States, you must meet one of the criteria:
● net assets – from 1 million dollars;
● personal income of 200 thousand dollars a year or 300 if it is family income;
● to be the general, executive or simply director of the company issuing the proposed security.
A company can become an accredited investor if all of its shareholders meet the requirements of an accredited investor or the value of its assets is equal to or greater than $ 5 million.
4: “Burning” coins
Startups such as Binance, Tron, Ripple, DigiPulse, SCRIV and many others regularly or in some cases destroy (“burn”) their coins in order to reduce their money supply in the market. This, according to the Law of supply and demand, contributes to the value of the remaining coins.
Such a policy indicates the basic value of the coins and the function they perform – bringing money to the issuer and investors. Thanks to this, the SEC can indicate that tokens of such projects meet the criteria of the Howey and Reves’s Family Resemblance Test.
Consequently, their emission and distribution must take place within the framework of the legislation on securities.
Startups with utility tokens will not burn their coins, because their value lies in accessing the blockchain, not investment returns. It’s like burning a concert or plane ticket.
5: The desire to get to the exchange
In one of his speeches, SEC Chairman Jay Clayton stated that the appearance of coins on the stock exchanges immediately after the completion of the ICO and their active sale are a strong reason to assume such tokens as securities. The desire of startups as soon as possible to place their coins in the crypto exchange listings also indicates this.
Such aspirations can be seen by:
● aggressive marketing strategy;
● early agreements with the exchanges on the placement of coins;
● short terms for placing coins on stock exchanges in a roadmap;
● predominance of investors and business angels in the composition of advisors.
If a company launches utility tokens, it primarily focuses on attracting potential users, since without them the cost of tokens after placement on the exchange will drop dramatically. If there are a lot of users, this will create a demand for tokens, which will contribute to the growth of quotes.
Regulators may intervene at any time. Closing the Munchee project after the end of the crowdsale shows that the SEC can initiate an investigation and close the project at a later stage. Since, from the point of view of the law, if a “digital” or classic security was not issued according to the rules, then it should be removed from the market and the money returned to investors.
Information disclosure.The presence of the Anti-Money laundering (AML) and Know Your Customer (KYC) procedures indirectly indicates the legality of the project and gives a greater chance of a refund if it is closed, especially if this procedure is passed at an early stage of the crowdsale indicating the amount of investment.
Tokens evolve. During a speech at Princeton University, SEC chairman Jay Clayton said that tokens could evolve from the category of securities to utilities.
For example, the broadcast, according to the head of CES, initially belonged to the category of “digital” securities, but as the architecture and capabilities of the platform developed, it became utility.