By Avtar Sehra
Cryptocurrencies and Native Digital Tokens
The introduction of Bitcoin  in 2009 provided the tools and infrastructure to transact primitive native digital assets (bitcoin in the case of the Bitcoin blockchain) over the open public Internet without trusted intermediaries. However, in order to create new tokens one either needed to deploy and scale a new blockchain network (likely forked from Bitcoin), or issue tokens on top of an existing blockchain network such as Bitcoin (through metadata encoded into raw transactions). The former was an uphill struggle due to challenges of scaling and achieving network effects for a new blockchain, and the latter was challenging due to the complexities of trying to encode sufficient information related to new tokens into raw Bitcoin transactions. Neither model was ideal.
However, with the introduction of Ethereum  in 2015 came the concept of decentralized smart contracts. The Ethereum blockchain not only provided the infrastructure for transacting primitive digital assets (ether in this case) but also provided the capability for easily creating and autonomously managing other secondary digital tokens of value over the open public Internet without trusted intermediaries.
Using this concept of smart contracts, which are effectively applications running atop a decentralised network, tokens can be created and allocated to users, and made to be easily tradable. This process of creating tokens and distributing them to users in return for a network’s primitive digital assets (cryptocurrency) is called an Initial Coin Offering (ICO), and can be seen as a novel distribution channel for new digital assets.
This is not meant to be an introduction to the technically rich world of cryptography, blockchains and consensus mechanisms, for which there are numerous excellent entry level resources (e.g. The highly detailed and yet accessible introduction by F. Ametrano ). However, the key point to keep in mind is that secondary tokens are not like primitive assets (cryptocurrencies such as bitcoin and ether) that are intrinsic to the “structural integrity” of a blockchain network.
Open public peer-to-peer value transfer networks, such as Bitcoin or Ethereum, need to survive complex attack vectors in an open hostile environment — where all parties (hosting or accessing the network) are assumed to be self interested and focused on maximising their own value. In this scenario the key question is how can all parties be incentivised to work for the greater good of securing the network while fulfilling their self-interest.
This leads us to a key innovation of the blockchain network, the native digital token or cryptocurrency. As well as being the subject of transactions between parties on the network (the users), the cryptocurrency also provides incentive for key parties (e.g. miners) to compete and reach consensus as quickly and securely as possible on the state of the blockchain ledger. The state of the ledger can simply be who owns what token or from a smart contract perspective the output state of an executable code that most likely moves tokens based on some form of payoff logic. The reward for securing the network and reaching consensus on the final state is either a new supply or transaction fees paid in the native cryptocurrency of the network.
In this model, trust is created from mistrust through a consensus mechanism, such as expending energy in the proof of work (PoW) mining process, which makes the violation of the “sanctity of the blockchain ledger” expensive and economically unfavourable to the alternative of securing the network and being rewarded in the native store of value for the effort of doing so.
While PoW is deemed to be wasteful in terms of energy expenditure it is currently the only viable consensus mechanism that is shown to be effective at scale. A number of research efforts are underway that involve other more novel means of achieving consensus, such as proof of stake (PoS), where users stake their native digital assets in order to participate in the consensus processes, or more sophisticated hybrid models that combine PoW and PoS.
From this perspective, an open public blockchain is a self-contained system that is simple and beautiful in its implementation, and requires no more rules and controls than are necessary. Here you can see the core purpose and the unique nature of a cryptocurrency, and why it is fundamental to a blockchain network:
Cryptocurrency is the atomic element from which the open public blockchain network is forged.
On the other hand a secondary token, that is created on top of a blockchain network, is merely a representation of some “property rights” i.e. the blockchain acts as an independent “custody or notarisation” layer to securely record one’s ownership/access rights to some product or service that may be intrinsic to or extrinsic to the network itself.
Essentially, one can leverage the network effects of the underlying open public blockchain and its cryptocurrency to securely and transparently create and issue secondary tokens through an ICO process. However, the value of the secondary tokens will need to be judged on the rights they offer, and the enforceability of such rights.
A deeper discussion on the quality of ICOs is provided in the write up on ICOs and Economics of Lemon Markets (here).
One of the most obvious and natural use cases for ICO based secondary token issuances is to represent some form of traditional security e.g. equity, debt, participation in profit sharing, etc. As well as issuance, allocation and transferability being programmed into an immutable smart contract, one can also predefine a set of events such as cash flow rules that can be triggered either at set times or by specific external events. There are a number of reasons why a public blockchain infrastructure makes sense for the issuance and administration of financial securities, which are mostly related to custody regulations around how client money and asset are managed through their life cycle.
In addition, structuring of more complex tokens that represent property rights in other real world assets are also often discussed e.g. issuing fungible units of ownership in a physical asset or a number of assets. When secondary tokens refer to off-chain ownership/access rights there is added complexity related to asset servicing (managing ongoing performance of assets on behalf of investors) and trustee service (acting on behalf of investors to enforce their rights if things go wrong).
However, since the “offer and sale” of securities is in and of itself highly regulated, several models have been devised by startups to enable the issuance of tokens through an ICO distribution model whilst not falling afoul of securities regulations. As well as the question around whether a token is a security or not there are also a number of other unanswered questions related to tax of capital gains and KYC/AML rules. These are some of the regulatory and statutory financial considerations that are currently an ongoing area of scrutiny and development  .
The SEC investigative report  highlighted that classifications of digital tokens as a security will depend on a case by case basis and will relate to the facts and circumstances, including the economic realities of the transaction. In addition, while the SEC has highlighted that ICOs similar to the The DAO (i.e. decentralised investment funds) are securities, it is still not entirely clear what the boundaries are for token issuances in general. To add to the complexity it is also unclear how regulators around the world uniformly view tokens issued through an ICO process, and what factors would trigger their oversight, to say nothing of how tax authorities approach the category.
Even with the SEC’s report this is the wild west of financial services, where value is blindly being created through regulatory arbitrage, and where there is probably more at stake than there ever was was with the emergence and commercialization of the Internet.
In the case of financial instruments there is a whole complex legal framework in place to manage structures of contractual agreements referring to “extrinsic assets”. These can start from simple secured contracts, where assets remain on an issuers balance sheet but investors may have recourse against an issuer to the value of the assets if something goes wrong with the performance of the contractual agreement.
A little more complex than secured contracts are covered pool contracts where investors rights to the underlying secured assets are protected by legislation i.e. if an issuing company fails the secured assets such as mortgages are ring-fenced to meet investor’s contractual performance expectations, where these rights can be protected by statutory laws in Europe.
A much more complex and legally stringent model is that of securitisation, where there is a “true sale” of underlying assets to a special purpose vehicle in which the investors may have rights based on a contractual agreement. Securitisation is the most versatile, however it can be the most complex to structure and execute in a safe and legally enforceable manner.
More details on different modes of issuing secured financial instruments and blockchain coming very soon.