The State of Utility Tokens

The token economy is flourishing. After a breakout year in 2017, the number of tokenized decentralized software applications has grown exponentially, building the foundation for the next generation of the digital economy. Further progress is not guaranteed. In fact, the future of token-based innovation within the United States depends largely upon the upcoming decisions by US regulatory bodies.

Background

Digital tokens are unique, transferable units that can be created as part of a decentralized software protocol. Through the use of blockchain technology, ownership of these units can be tracked, and transactions can be mediated without the need for a trusted third party. This nascent technology allows for revolutionary advancements in digital currencies, software solutions, business models, and fundraising opportunities. The interest in tokenization is reflected in the over $6.5 billion of capital raised across over 525 token sales occurring in 2017.

Regulatory Overview

This level of capital allocation and consumer interest has unsurprisingly caught the attention of both state and federal regulators to varying degrees. The legal standing and regulatory requirements of digital tokens and their sale remain largely unclear, although many regulatory bodies are vying to control the space.

According to the Internal Revenue Service (IRS), virtual currencies are considered property and are taxed accordingly. The Commodity Futures Trading Commission (CFTC) believes virtual currencies to be commodities, and this opinion was recently upheld by a district court in New York. The Financial Crimes Enforcement Network (FinCEN), by contrast, categorizes virtual currencies as money and is therefore leveraging the Bank Secrecy Act to subject exchangers to stringent anti-money laundering rules. The Securities Exchange Commission (SEC), however, remains the regulatory elephant in the room because they have yet to clarify their official position on whether all token sales are subject to securities laws.

Token Models

Not all tokens operate in the same way. In fact, their programmable nature allows for a functionally infinite amount of applications. While there is no taxonomy of token use cases, there are three main categories of token models: stores of value, security tokens, and utility tokens. Each is designed for a different use case and bears its own regulatory concerns.

— Store of value tokens like Bitcoin appear to be beyond the scope of SEC securities laws at the moment. However, SEC commissioner Jay Clayton has claimed “simply calling something a currency or a currency-based product does not mean it is not a security.” It appears likely that these tokens will be regulated as commodities for the time being.

— Security tokens have a massive potential to transform traditional financial asset classes but, because they fall explicitly under security laws, they face much less regulatory uncertainty. These will look like — and be regulated as — securities, but with many of the added benefits that blockchain technology provides.

— Utility tokens, also called app tokens or user tokens, provide or facilitate the provision of a product or service within a decentralized application. Very simply put, the sale of these tokens can function as “digital coupons” for a product or service and can be sold to the public in order to generate capital to build out the application and jumpstart the user-network. The future regulation of utility tokens and their sale remains undetermined.

Why Use Utility Tokens?

A common critique of utility tokens is to propose that distributed applications simply build their software around store of value tokens like Bitcoin or Ether, instead of developing an entirely new token. When a distributed application uses a token like Bitcoin, it does inherit the token’s utility (high security), but it also inherits its constraints (high transaction fees, long block time). This is why it is so important for competitive distributed software applications to build their own native token, so that they may maximize the utility function that their token enables.

Utility tokens should not be evaluated on their own; rather it is important to observe the integral role they play within distributed networks. Though some of these benefits can also be enjoyed by security tokens, the full potential for this technology for user applications can be achieved through Utility Tokens. When a token is built specifically for a distributed application, it can provide value-adding features that are exclusive to utility tokens. A few examples include:

Security — Centralized applications lack security due to their single point of failure in the event of a data breach or hack. Distributed applications leverage blockchain technology to cryptographically secure transactions across a network of computers, preventing any single point of failure and maximizing security.

User Control — Utility tokens allow for valuable personal data to be securely represented in the form of a digital token. Distributed applications allow users to maintain control of their own data, and entitle them to any profit made off the use of that information. This user control is becoming especially important in light of the constant data breaches to which large, centralized tech companies are often subject.

Transparency — Distributed applications are the answer to the black box tech giants. Instead of hoarding data and turning users into the product, decentralized applications leverage utility tokens to create radical transparency. Utility tokens can provide every member of the network the information that they rightfully deserve.

The Case for Utility Tokens

SEC commissioner Jay Clayton recently said, “I believe every ICO [Initial Coin Offering] I’ve seen is a security.” This suggests that every ICO, or token sale, could be subjected to securities laws, ultimately hobbling the token economy within the United States. However It is important to remember that Commissioner Clayton has only “seen” tokens brought to him by the enforcement agency, and was likely not speaking about all of the projects in the space.

Take the Golem Network Token (GNT) as an example of an ingenious utility token that might otherwise not exist if it were treated as a security. Golem is a decentralized peer-to-peer cloud computing network that“enables users and applications [requesters] to rent out cycles of other users’ [providers] machines” using GNT. Requiring users of GNT to be accredited investors, or to exclusively trade their tokens through traditional brokerage firms would impose undue and prohibitive regulation.

It is time for the SEC to recognize utility tokens as a fundamentally new asset class, distinct from traditional securities, and exempt utility tokens from the kinds of regulations that will stifle innovation. Any unreasonable regulation, especially at the national level, will send entrepreneurs and capital overseas. This threat is compounded by the borderless nature of this decentralized technology. The US cannot afford to forfeit its role as a global technological leader, but over regulation may cause just that.

Reasonable Regulation

The free market has created a vibrant and efficient token economy that has remained largely free of regulatory roadblocks until recently. With massive growth comes unavoidable regulatory growing pains, but this does not need to become a battle between the innovators and regulators. Reasonable regulation regarding utility tokens can be achieved in three steps:

1. The regulatory bodies should redouble their efforts to punish bad actors in the space. Swift and efficient action will help to dissuade potential fraudsters and protect consumers and investors.
2. Regulators should work with and empower industry leaders to create a digital currency Self-Regulatory Organization (SRO), similar to the Financial Industry Regulatory Authority (FINRA). This will allow those who know the space the best to develop a set of industry standard best practices.
3. Regulators and government officials should work with the SRO and other industry leaders to craft a policy that is able to foster innovation while simultaneously protecting consumers.