Why should you choose security tokens for your ICO?
A global trend is clear: more and more new ICOs are choosing security tokens.
Yes, they are harder to spend, but looking to the future they are more promising and are fairer with regards to investors. There are some foreign experts who believe that property rights to many classes of assets will be secured by means of blockchain technology.
Upon arrival to my office for advice, a new client usually inquires on how to issue tokens and what function to give to them to turn them to utility tokens, but I suggest that you first started thinking about security tokens. Why so?
Token types
Global classification distinguishes three types of tokens.
Security tokens are essentially securities, such as stocks, bonds, and so on. Their issuance and management is regulated by the Central Banks (for example, in Lithuania) or special commissions (for example, in the United States).
Utility tokens are certain tokens intended for purchase of a specific service on a particular platform. One of the most obvious examples is a casino token used to play various gambling games in casinos or some kind of points video games or loyalty programs which are used to get discounts or some premium features and services. Such tokens are used as utility tool which makes product better and are hard to eliminate. (can you imagine casino without tokens?)
Services utilities are used much less commonly and apply for services — generally speaking, “I bought some services to use in the future.” One of the most obvious examples is a metro token used for a metro ride of a certain distance. I can use my own tokens — JaroCoin — as an example too: having purchased them you would be able to get my service (advice on IT or blockchain matters from me at any time in the future or attend a private training of South Korean martial art Won Hwa Do).
However, the services utilities are less developed and are often attributed to utility tokens.
At the moment however utility tokens are the most commonly used ones.
Where did the tokens come from?
One of the first and a very successful ICOs was the creation of the Ethereum platform. Its creators wanted to create a “better” bitcoin with the ability to create smart contracts, but they needed some money for that. Then they offered 2000 ethers — a virtual currency which could be used after a year or a few — for a single bitcoin. Today, only 12 ethers can be acquired for a one bitcoin. So, the ones having invested in Ethereum ICO have made a nice profit.
After the first successful ICOs, many other people realised that ICO is a very attractive way to raise money bypassing any legal regulation. What is more, you do not need to give away shares, give up management rights — only to issue tokens that have a certain value on a particular platform.
Securities vs Utilities
The problem is that there are very few businesses that actually need utilities.
The market has been distorted. ICOs have become merely the most easy way to raise money. Businesses are willing to issue utility tokens simply to avoid strict legal regulation.
This is a way for a business to make its life complicated — it has to come up with a specific function of a utility token, even though it would easily be able to charge euros, dollars or simply a cryptocurrency (for example, bitcoin or ether) for their services, should it need programmable money.
Utility tokens greatly complicate the payment process: we need to have an integrated exchange where we exchange tokens, a wallet, where one can see how many tokens have been attributed to any particular address. Basically, we have to exchange them only to able to pay.
Startups vs Investors
Utility tokens have an inherent problem — how to stabilize a price of a utility token?
This question is asked increasingly often by my clients. In fact, it is very hard to do.
Good utility is when its price is more or less stable (for example, one euro). After having bought a certain amount of fuel, you are hoping to go, for example, ten kilometres, with it. Ten kilometres today, ten kilometres tomorrow and so on A utility token can take you ten kilometres today, fifteen — tomorrow, and on the day after tomorrow — only five.
Here we have an inherent dilemma: startups want their services to be used, and investors seek for anything but a stable token. Long-term investors expect a steady appreciation, while others want the value of the tokens to fluctuate to be able to make money from speculation.
Thus, a stable price is one of the problematic aspects faced by the issuers of utility tokens.
Another thing is attracting extra investment — after an ICO, no more tokens can be issued. They are invested in because of their limited quantity and the guarantee that the founders will not “print” three times more tokens in the future, resulting in a significant drop of their value. The standard smart contracts, usually programmed by us, simply do not allow to do that.
In the case of the traditional investment, there are several stages of it and it is possible to issue new shares with the permission of existing shareholders. It also creates a phenomenon that an ICO is meant to attract as much money as possible (with a “reserve” for the future), since there may be no more investment under the current system.
Nevertheless, this problem will have to be addressed in the future.
In my opinion, many utility tokens are, in their essence, security tokens that use utility cover solely to avoid regulation.
How to identify securities?
Elena Vieglelytė, senior associate at law firm COBALT, gives advice to investors:
Make and assessment of what is being acquired — whether a security or a service — the right of the investor and the protection offered by it could come into play in both cases. If a token guarantees passive return, which is paid out without a token holder having to take any actions, the token is a security token in such case. According to the latest decisions of the US supervisory authority, a token that is not a security in its essence but is advertised as an “investment” by the token’s distributor or the token’s distributor provides other information “why the token is going to appreciate”. So if it is worth buying token for making profit from its resale, such token may also be recognised as a security.
If the token you hold has features of securities, you can apply to the Bank of Lithuania for violation of your rights as an investor.
How to register securities in Europe?
The official explanation of the Bank of Lithuania (01/06/2018), provided to the author of this blog, states:
“Security tokens are subject to the requirements applicable to the issuance of securities. This means that before commencing distribution of tokens in European Union, the company should prepare and publish a prospectus approved by Central bank, e.g. the Bank of Lithuania (except for the exceptions provided by the law, for example, if the total sales of the securities offered by the company in the Member States is less than EUR 5 million per year, if the securities are offered to professional investors only, etc.).
In the event that the secondary turnover of tokens is planned, it should be executed in accordance with the procedure established by the Law on Markets in Financial Instruments.
If a company is a financial market participant providing financial services (such as an insurance company, a bank, an electronic money institution, etc.) supervised by the Bank of Lithuania, it could be allowed to distribute these tokens only after having separated its financial services from activities related to virtual currencies.” (Inga Pache)
In my opinion, the state has to mitigate the requirements applicable to security tokens, otherwise this viable market may collapse or go offshore.
For sure, I support the need to protect inexperienced investors, and therefore certain restrictions and safeguards could apply.
According to different sources, Switzerland currently has the best regulation of cryptocurrencies in Europe. But is it ideal?…
Security tokens may give their owners the right to dividends, share of profits, and in some cases certain management rights as well. In most of cases this is exactly what startup companies needs from their tokens.
What do you need to know about new ICOs?
From the point of view of the state, one of the biggest threats to the ICO market is the risks of terrorist financing and money laundering. On the other hand, the greatest risk to the issuers of new ICOs would be an overly rigorous and meticulous state regulation. Therefore, in my opinion, the new ICO projects have to take responsibility and self-regulation themselves to prevent investment of “dirty” money in them. A number of projects have already implemented KYC (for Know Your Customer) and took into account the requirements of the 5th Anti-Money Laundering Directive — AML5. Everyone should be doing that in the future.
With regard to the KYC procedure, with my partners at Blockvis we’re currently working on platform for providing assistance to ICO companies in proper technical preparation for an ICO, which will have integration with the Civic identity platform used to address KYC issues as well as other issues needed to solve during initial coin offerings.
The said tightening also implies that collecting funds through ICOs will no longer be so straightforward and anonymous and, in my opinion, this is a welcome development as it offers more protection to investors.
CONCLUSIONS
1. Choose security tokens for your new ICO. Only use utility tokens if you cannot do without them.
2. Responsible state authorities must mitigate the requirements applicable to the security token ICOs, otherwise they will ruin this viable market or force its participants to move offshore.
3. Such values as dividends, profit shares, certain management rights can be attached to security tokens.
4. New ICOs should pay attention to the requirements of KYC and AML5.
