Schrödinger’s Token: Securitility and the Need for a New ICO Securities Framework

Is the ICO token a security or a utility? Here is a thought experiment …

An entrepreneur working on her ICO is penned up inside a steel chamber writing her whitepaper to raise $100 million to tokenize the cat-food economy. There are two tokens inside the chamber with her: a security token and a utility token. Also inside the chamber is a Geiger counter that will emit over the course of the next hour with equal probability either a tiny bit of radiation or nothing. If radiation is emitted, a relay will open and trigger a tiny explosion that will destroy the security token. If nothing is emitted, the contraption will instead destroy the utility token.

So, after an hour, what’s inside the chamber? What is the nature of the token at the heart of our fearless entrepreneur’s whitepaper? Is it a security or a utility?

Of course, quantum mechanics tells us the answer. It is a securitility — both security and utility. But, note, as soon as an outside observer peeks inside the system, the wave function collapses and instantly the token must choose: security or utility.

To some observers, perhaps to those who intend to use the token to purchase catfood, the token is a utility. To others, who may instead seek to re-trade the token in the future at a profit based on the hard work of our entrepreneur, the token is a security.

But these observers do not matter, for in our system (and here we depart from physics), we have an Observer of observers: the Securities and Exchange Commission (SEC).

To the SEC investigator, there is no ambiguity. When he opens the chamber, the wave function collapses in the same way each time. The SEC observes a security token. The investigator closes the chamber, bars the door, and jails the entrepreneur inside her steel chamber for a Section 5 Violation of the Securities Act — unregistered sales of securities.

And that is the state of our system today, but it cannot be this way tomorrow.

This week’s editorial in the WSJ will chill the ICO market in the United States, and it will spook anyone who completed one, or who is about to complete one. If you can read that editorial and still raise millions from US investors for your token, you are more risk-loving than me, possessing some combination of faith in your litigators, endless buckets of money, and a willingness to go to prison. Of course, it is also possible, that ICOs simply move outside the US to venues that innovate legal frameworks for achieving ICO, and that the US will be shut out of a critical market.

Looked at one way, chilling a speculative market fueled by bitcoin billions and irrational bets on vaporware whitepapers may well be in society’s interest. But looked at another way, all the money sloshing around has attracted the smartest people to the most exciting greenfield technology of our times, the blockchain, and if it is not choked off, generational companies will be created. Just like in the Ninteties, there will be a thousand Pets.com for every Ebay and tens of thousands of Geocities for every Amazon.

Currently, most, and maybe all, ICOs are selling tokens to investors who hope the token will appreciate in value as the ecosystem for the token is created and then expands as a result of the hard work of the people associated with the project. Even if there are eventual utility attributes to the token, the fact remains essentially every ICO is selling tokens to investors who will never use the token for its utility. Our entrepreneur can yell and scream that her cat-food token has utility, but then why is she selling it only to wealthy people who are certain to resell it, and why is she selling it before it can even be used?

If it is a security, then it is subject to the regulatory framework governing securities, including the Securities Act of 1933 and the Exchange Act of 1934. Some believe the current crop of ICO tokens are self-evidently securities under the Howey Test, a Supreme Court framework for deciding if a given instrument is a security. What’s more, if it is a security, than most crypto exchanges (coinbase, gdax, binance, bittrex, etc.) would not want to touch it, as there is no crypto exchange currently set up (as far as I know) that will trade a security token, whether it be registered or unregistered.

That of course is the essence of the token as security argument. However, the token as utility argument is compelling too. Imagine our fearless entrepreneur creates the cat-food token, and uses it to trade for cat food. The token here is not a security. It is a method of exchange. You can imagine other non-security tokens as well. For example, any token that acts like a pre-sale or early-access token. If the token entitles you to 1 bag of cat food, then if you buy 5 of these tokens intending to get cat food, you do not own a security. Similarly, if the token primarily gives you access to a particular server or venue, then in what sense could it be considered a security?

The securities framework existing today is ill-equipped for security tokens. For one thing, imagine filling out the paperwork. Who is the company behind the decentralized token, a non-profit foundation? the company who created the token? What’s more, today, companies register certain shares and can unregister them, but the system doesn’t contemplate securities such that the entire class of securities cease to be securities. But that’s not an insurmountable problem. That’s the innovation to the securities framework that is needed.

The securitility would solve many of our problems. There would be safeguards and disclosure consistent with a securities sale. But, on a certain day and by meeting certain standards, the security nature of the token will cease and at that point, the token will be a pure utility token, and can be traded on crypto exchanges alongside other coins. Critically, any solution must work for BOTH private and public companies and ideally require no more than half the legal fees of a traditional S-1.

Long live the securitility!