FCA Consultation on Cryptoassets — Response to Q7–9 (Other Tokens and Business Models)
I am currently working through the “FCA consultation on Cryptoassets (CP19/3)”. I will submit a written response on behalf of LexByte in due course, but I thought I’d already put drafts out for discussion as I go along, allowing me to improve them on the way. Enjoy, comment, and please do provide feeback if you want (stefan at lexbyte dot io, or message me on LinkedIn)
Q7: Do all the sections above cover the main types of business models and tokens that are being developed in the market?
Q8: Are there other significant tokens or models that we haven’t considered?
Q9: Are there other key market participants that are a part of the cryptoasset market value chain?
The three classes of crypto assets described in the paper are good, but I’d argue they are not quite exhaustive because they are trying to map the tokens to three well-known existing categories — currencies / commodities, (debt/equity) securities, and vouchers — and many tokens have characteristics that make them behave different from classic representatives of this classes in subtle but important ways.
An example used in the paper was that investments in some tokens can be considered a bit like investments in fine wine or in classic cars if those are purchased for investment purposes. First of all, this of course is a big “if” and if people buy a physical asset it is hard to assert whether they buy it as an investment or because they want to enjoy it, so there is a practical legal issue that it might be hard to prove that it is an investment. Moreover, those types of investments require typically significant amounts of money and expertise, therefore there is less of a risk that unsophisticated investors get hurt.
The real comparison in this case would be in my view certificates that represent the (part-) ownership of the economic proceeds of say a cellar of fine wine, or a garage full of vintage cars. Those however are almost certainly collective investment schemes and therefore inside the regulatory perimeter, especially if sold in small ticket sizes to retail investors. The point I am making here is the fact that those tokens can be sold in retail sizes and don’t require any specific expertise makes a difference to whether they should be in the perimeter because it makes it so much more likely that vulnerable retail investors are getting hurt.
The hallmark of many tokens is that they have either a fixed or a deterministic supply. This is a design feature, and the purpose of this feature is to introduce artificial scarcity to allow for investment returns. For utility tokens as defined in the paper for example fixed supply almost never makes sense: a business is designed to grow over time, and growth and eventual market capacity is not predictable in the design phase of the product. So utility tokens should really have two characteristics:
- the company can issue them as they see fit, but they have to keep in mind their capacity to deliver on the product or service promises implied in the token, and
- those tokens get burned when they are used and the product has been shipped or the service has been provided.
Most tokens that have been issued so far do not have those characteristics and therefore should not qualify as utility tokens.
Artificial scarcity is also an issue for exchange tokens because it induces speculative bubbles. Experience has shown that it is hard enough to keep the value of a traditional currency stable where a central bank has sophisticated means of addressing demand and supply. For a token where supply is deterministic there will always be massive swings in value: when the sentiment is bullish people will buy and hold the asset, thereby contributing to the price increase. When the sentiment turns everyone will try to sell, thereby exacerbating the price drop. Without any fundamental value to anchor the prize and without a central-bank-like actor this massive bouts of volatility are unavoidable, so even exchange tokens are a massively speculative investment unless they are only held for a very short period of time.
We should also look at token from a functional view and how they are used in practice within the development cycle of a product or a service. If tokens are pre-sold in significant quantities before the product or service is fully functional and before it can absorb all tokens issued then this is a form of financing the development. If the tokens are bona fide utility tokens, including according to the criteria above, this is de-facto a product-based crowdfunding campaign and should be regulated (or not) just like one.
Most tokens that have been issued in the past however are not utility tokens in that sense. In fact, most of them are designed in a way to appreciate in value with the overall value of the network. Note that this is different from the way utility tokens appreciate in value: the latter might be sold at a discount, but ultimately their price is capped at the value of the product or service provided. The protocol tokens however are designed to increase in value with the overall utility of the network — they are “equity” in the network if you so want, and economically they are very similar to tokens that say give the right to collect transaction fees in the network.
If those tokens that finance the development of a network are not considered security tokens then this gives rise to an important regulatory arbitrage. Let’s consider a company that wants to develop this network and that needs to raise financing. It has inter alia the following options
- raise equity and charge users of the network
- sell a revenue participation token tied to the network volume
- sell an protocol token that is designed so that its value will appreciate in line with network volume
In many cases options 1–3 are economically equivalent, and especially 2 and 3 are often nearly indistinguishable economically. If option 2 is considered a security token and option 3 considered and exchange token then we have a classic regulatory arbitrage situation that is pushing people down one route. In this particular case this has a number of important drawbacks:
Firstly, retail investors are offered investments that are essentially early stage equity investments, but without any of the important protections in place that for example crowdfunding rules would provide. Secondly, because this way of raising funds is so much cheaper and more convenient companies will try to go down that route whenever they can, thereby reducing the volume of investment opportunities with appropriate investor protections. Last but not least, many business models do not work well with a token shoehorned into them, so regulation drives businesses down an inefficient route.
To summarize: there are many tokens that are economically equivalent to product- or equity-based crowdfunding. To avoid regulatory arbitrage and the loss of consumer protection and the market distortions this entails those token offerings should be regulated in a manner equivalent with the corresponding crowdfunding deals.
Stefan Loesch a managing partner at LexByte, an advisory firm specialising on tokenised investments. He has more than 20 years experience in financial markets, and his previous roles include advisory at J.P. Morgan and McKinsey and quant development at Paribas. He is the author of “A Guide to Financial Regulation for Fintech Executives” (Wiley 2018).
