Tokens: Digital Assets or Securities?

     1. What is Token?

Blockchain technology completely revolutionized traditional ways of raising funds by business, especially by startups through launching Initial Coin Offerings (ICO). A real boom of ICOs has risen last year, attracting more and more companies into blockchain revolution and issuing own tokens as instruments for easy investment. Given to this new twist of technology development companies involved in launching ICOs have raised millions using new crowdfunding method. Due to many scams and lack of regulations investors’ legal interests happened to be uncovered or even worse they lost all the invested money.

Government authorities from many jurisdictions have taken an in-depth look at the ICOs as such and ICOs’ main tool of raising funds – “Tokens” and decided to implement sort of tests for appreciation whether they are simple consumer tokens or financial instruments (which are strictly regulated).

ICO organizer usually sells blockchain-based coins (well known as Tokens) created and stored in a decentralized form either on a blockchain specifically created for the ICO or through a smart contract on a pre-existing blockchain. ICO investors transfer funds when purchasing tokens whether in fiat money or cryptocurrency accepted by the ICO organizer, in return they receive tokens. In computer security and cryptocurrency, the term token is generally referring to a cryptographic string of numbers and letters that contains no real data but relates back to real data. A token might look something like this[1]:

947153d332beaf39dec6ebae8883bfb84eda47abccccbc2d61436d8d1e81584d.

From legal perspective Token is a cryptographic decentralized proof of certain rights over promised assets, values, profit or any other possibilities by using that token.[2]

  1. Types of Tokens

There is no generally recognized classification of Tokens in Europe or internationally. Following a comprehensive analysis of authorities’ positions related to ICOs and tokens there is possible to distinguish that Tokens are a form of digital currency and usually refer to virtual assets offered through an ICO, being divided into two categories: utility tokens and securitized tokens. Security tokens falls under category of financial instruments, on the other hand, Utility tokens are deemed to be treated as such if those tokens provide online platform or application utility rights without any underlying assets.[3] There are several types of smaller categories or hybrid types of tokens but in front of the law they finally are treated whether utility or security.

2.1. Utility tokens: Utility tokens are used for getting access digitally to an application or service offered via online platform based on blockchain infrastructure.[4] A Utility token is basically a token that used to unlock and acquire a service provided online. [5]

2.2. Payment tokens: Payment tokens are used as means of payment for purchasing services or goods expressing a sort of value transfer. Cryptocurrencies are payment tokens per se, and these coins give rise to no claims on their issuer.[6]

2.3. Asset tokens: Asset tokens representing an asset, equity or a stake of value, giving rise of a debt or claim on the issuer. Asset tokens are backed by a promise to get a share in future company earnings or capital. In other cases, this type of tokens is backed by company’s equity or certain material goods. If we take a look from its function perspective asset tokens are similar to bonds or derivatives.[7]

At the same time there are some mixed types of tokens twisting both payment and asset criteria while being known as hybrid tokens. In these cases, the requirements are cumulative, in other words, the tokens are deemed to be both securities and means of payment. [8]

  1. Utility tokens

In very simple words Utility token is a “digital key” to unlock or provide access to online provided services usually offered by the organizer of the ICO. Utility tokens are usually distributed through smart contracts of an ICO when company’s project is launching. ICO project is launched in order to raise funds for development while investor by purchasing tokens would acquire the right to use the product or service developed by the startup. Utility tokens give a user the ability to use a Blockchain-based platform or an app that provides a certain service while tokens are designed to grant access these services.[9]

Summing up opinions of majority of authorities from various jurisdictions regarding types of tokens and ICO legal status Utility tokens carries absolutely no rights with them other than to access to a service. Some would consider this as a pre-payment for services.[10] Also, this type of tokens can be used as a type of discount or premium access to the goods & services of the ICO project.[11]

From legal perspective of regulating authorities by simply naming tokens as utility tokens as such is not enough in order to treat them like “utility”. Some of regulators issue guidance publications in order to set out the rules to distinguish the legal nature of tokens whether utility or security. Other regulators lay down tokens’ classification in law as well as their specific features, this brings a clear vision and understandability of the rules regulating classification of tokens. Utility tokens are a preferred choice by many companies launching ICOs due to its flexibility and lack of necessity to follow complex and rigid securities regulations. 

  1. Payment tokens (Digital Currencies or cryptocurrency)

Cryptocurrency is the most well-known type of digital token. Cryptocurrencies are digital tokens also known as digital coins that run on a Blockchain. Payment tokens have no central issuer and are not regulated by a specific entity and have no further functions or links to other development projects or ICOs. The only function of the payment tokens is to enable purchases, sales, and other financial transactions.[12]

There are various legal opinions as to whether tokens of this kind constitute securities. Given that payment tokens are designed to act as a means of payment and are not analogous in their function to traditional securities, regulating authorities don’t treat payment tokens as securities.[13]

  1. Security tokens

Term of Security tokens is broad classification that refers to any kind of digital tradable asset through Initial Coin Offerings, which are offered to investors having various forms ranging from coins redeemable for precious metals to tokens backed by real estate.[14] A security is a tradable financial asset which commonly refers to any form of financial instrument[15] that holds some type of monetary value, representing an ownership position in a company (stocks), a creditor relationship with a governmental body or a corporation (bonds), or rights to ownership as represented by an option (option).[16] Legal regulations of securities regulation are intended to ensure that market participants can base make their decisions whether to invest or not in stocks of companies, bonds, shares etc. on predictable, reliable and transparent set of information.

5.1. Asset tokens

In very simple words asset-backed token is a digital token that represents a physical asset.[17] The main advantage of this type of tokens is that they allow for the digitizing of traditional assets such as commodities. Another category of Asset-backed tokens is connected to fungible goods. This category has both advantages as well as drawbacks, last one specifically refers to the lack of investment growth due to their value is linked to physical asset’s price. However, these tokens have a high level of flexibility in terms of ease of use when it comes to physical assets that are difficult to purchase or store such as gold, silver and other commodities.[18]

5.2. Equity tokens

Acquiring Equity tokens the buyer is promised to purchase ownership rights over a part of project’s assets or equity of the company. Usually distributed through ICOs, equity tokens are essentially giving the buyer the right to a portion of the project. This is in proportion to how many of the tokens acquired. In other words, equity tokens can be viewed as digital shares in a company.[19]

5.3. Profit backed tokens

By purchasing this type of tokens investor acquires tokens backed by real profit of existing company or start up profit being generated in future. This category of tokens has similarities with equity tokens.

References*:

[1] https://cryptocurrencyfacts.com/what-is-a-cryptocurrency-token/

[2] https://www.cbr.ru/Content/Document/File/47862/SmartKontrakt_18-10.pdf

[3] https://www.gvzh.com.mt/malta-publications/virtual-currencies-icos-malta-state-play/?utm_source=Mondaq&utm_medium=syndication&utm_campaign=View-Original

[4] https://www.finma.ch/en/news/2018/02/20180216-mm-ico-wegleitung/

[5] https://ellulschranz.com/service/tokens-defined-icos/

[6] https://www.finma.ch/en/news/2018/02/20180216-mm-ico-wegleitung/

[7] https://www.finma.ch/en/news/2018/02/20180216-mm-ico-wegleitung/

[8] https://www.finma.ch/en/news/2018/02/20180216-mm-ico-wegleitung/

[9] https://blog.icoalert.com/tokenomics-what-are-the-different-types-of-tokens-you-can-buy-in-icos-d6518d7bebb1

[10] https://ellulschranz.com/service/tokens-defined-icos/

[11] https://medium.com/swlh/types-of-tokens-the-four-mistakes-beginner-crypto-investors-make-a76b53be5406

[12] https://medium.com/swlh/types-of-tokens-the-four-mistakes-beginner-crypto-investors-make-a76b53be5406

[13] https://www.finma.ch/en/news/2018/02/20180216-mm-ico-wegleitung/

[14] https://strategiccoin.com/3-types-ico-tokens/

[15] https://en.wikipedia.org/wiki/Security_(finance)

[16] https://www.investopedia.com/terms/s/security.asp

[17] https://cryptonews.com/exclusives/tokenomics-discover-five-types-of-digital-tokens-1315.htm

[18] https://cryptonews.com/exclusives/tokenomics-discover-five-types-of-digital-tokens-1315.htm

[19] https://blog.icoalert.com/tokenomics-what-are-the-different-types-of-tokens-you-can-buy-in-icos-d6518d7bebb1

 

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