The War on Utility: A Crypto Call to Arms
As in all markets, wars rage in the cryptoassets market. There is the war between insiders and outsiders, between short-term speculators and long-term hodlers, and between purchasers using crypto-style fundamental analysis and those using algo-driven strategies.
However, there is at least one war unique to crypto, and let’s consider it now. This is the war on utility.
The utility token is besieged, and lawyers may be the least of its problems. Utility crypto’s shining city on a hill promises 1) to users, wide token sale distribution and a “better-than-free” model, 2) to project builders, cheaper and faster fund raising, and 3) to buyers, the premium of liquidity, boosting token prices and permitting faster recycling of resources into new crypto projects. Alas, an array of forces could consign utility crypto to the lost era of Camelot. Among them are certainly some U.S. securities lawyers, but a perhaps unaware axis is aligning elsewhere as well: multiple-token projects, security token aficionados, medium-of-exchange token critics, bitcoin chauvinists, minds closed to utility token valuation methods, and those riveted on the value of incentivizing computing resources and building infrastructure rather than on the “mere utility” of user-facing crypto. Ours is a call to arms.
The SEC has ramped up pressure — too much — on gatekeepers to funnel more sales of utility tokens into either securities registration or exemptions therefrom. The key argument for applying federal securities laws is that token buyers look for a profit based on the efforts of others. However, this proves too much, considering:
(1) Utility tokens are not equity, and are more similar to paid API keys. It is hard to imagine requiring securities law registration/exemption for sales of API keys. Although there may be paths such as Reg A+ to allow for more timely transferability of registered tokens, so as not to hinder operations, for many projects the legal logic for doing so is hazy.
(2) Despite suggestions otherwise from the SEC, the functionality of a token at the time of sale is not a particularly useful distinction under the securities laws. In December, the SEC’s Chairman said that “a token that represents a participation interest in a book-of-the-month club may not implicate our securities laws” but that tokens “more analogous to interests in a yet-to-be-built publishing house with the authors, books and distribution networks all to come” could be a different story. However, in crowd funding, the status of a product at the time of pre-order is not particularly helpful in determining whether such an order should be exempted from securities registration/exemption. Consider, as another analogy, tokenized tickets to the last World Cup — would anyone really have argued that whether their sale was a securities offering depended on whether the venues were built yet (many weren’t)?
(3) The open source nature of most utility token projects further supports treating their token sales as revenue, not capital formation, under Howey’s “efforts of others” prong. Open source inherently invites the efforts of third parties, either on the source code or through distributed apps running on the platform. Token sales can provide funding for open source projects that would often, as shared infrastructure, be un-fundable by sales of securities.
(4) The CFTC has classified bitcoin as a commodity, a better default classification for utility tokens than as a security. As an exec from a Fortune 50 corporate VC shop recently noted, institutional investors doing due diligence on bitcoin in 2009 would have never bought any — there was no network and the team was anonymous. At its core, the appeal of utility tokens is to users.
Let’s return to first principles: commodifying utility is central, not tangential, to crypto. In the halcyon days last spring, ICOs of utility tokens offered a full bloom of promises: wider distribution of tokens in a sale, not just to accredited investors; the lure of a new better-than-free model, where early adopters could benefit financially; the lower-cost fund raising of revenue as opposed to the issuance of securities; the incentive to transact on the platform with a native currency, without having to integrate into third-party payments providers, reducing costs and enhancing privacy; and much sooner liquidity for token purchasers than could be achieved by private equity investors, and token price premiums reflecting this liquidity.
Jousting with the SEC should not distract us from the risks to this promise of utility crypto from other revanchist attacks. These attacks come from many quarters.
There is an attack on the “brittle” value of many “medium-of-exchange” (MoE) utility tokens. One impressive foray is by Vitalik Buterin himself (see here), distinguishing between MoE tokens sold in the first instance by the actual providers of the service and those sold by the exchange itself, through which providers are to transact using the tokens. Although the value of the former is “backed” by the service to be provided, the value of the latter lacks a firm equilibrium, resting on market assumptions of the day.
Alas, bitcoin and altcoin hodlers, don’t ask for whom the bell tolls, it tolls for thee. Bitcoin itself is a network providing for peer-to-peer transfer of un-censorable store of value by means of a native MoE token. The value of the computer power of Bitcoin’s nodes and miners does not “back” bitcoin, in that this power is not presold to those who buy bitcoin. Bitcoin’s equilibrium value is thus no more stable than that of many MoE tokens. Rather, Bitcoin’s value depends on assumptions about what use cases will shift to its network, and the fiat value of those use cases, just as do the values of many MoE utility tokens.
Multiple-token economies have sprouted on premises that undermine the value of crypto in commodifying utility. Some projects use multiple tokens to facilitate legally compliant sales of security tokens for project fundraising. The utility tokens may provide access to the service, often for fees related to transaction volumes. These fees go in turn to the holders of the security tokens. The lower-value utility tokens swirl ineffectually among the actual users of the service, with little more impact on user behavior than unmarked raffle tickets. The only way the security tokens can give users a stake in the growth of the service is if the users buy them, because the security tokens are not mined, earned, or otherwise used in the service. Alas, under U.S. securities laws at least, private sales of the security tokens go only to accredited investors. Thus, paraphrasing a broader crypto critique in Forbes (here), the value of some of these security tokens comes less from enabling a new utility as from siphoning cash from operations.
Utility also suffers from defections by those who throw up their hands at valuing utility tokens as a “currency” supporting a project’s “GDP,” and who then flee to the seemingly more friendly confines of valuing security tokens. The valuation of security tokens that entitle the holders to a share of fees, profits or assets is certainly a more familiar task. Like any schism, this one in valuation undermines efforts to reach consensus on how to value utility tokens, and thus their long-term viability.
Another danger to utility tokens is asphyxiation from misguided chauvinism. Some crypto investors enthralled by tokens as incentives for open source contributors to support a project show little interest in tokens as incentives for users to support a project. Plying token economics to incentivize provisioning of computing resources (nodes, miners, what have you) for a network is seen as high art (hard science), while wielding it to lure users to join and evangelize a service is seen as an attempt to graft a token into a legacy business model, resulting in tragic Frankencoins wandering the landscape shunned by crypto society (for an interesting list, see Deadcoins’ here).
Finally, although crypto cognoscenti naturally look for opportunities in building crypto’s infrastructure, given the early stage of development and integration of a number of crypto’s constituent technologies, history suggests sleuths of opportunity turn a blind eye to consumer-facing utility token projects at their peril. Consider a minority view of the merits of consumer-facing as compared to infrastructure crypto projects, based on how the commercial Internet has created value. It turns out that a number of key consumer-facing successes built much of their own infrastructure, and the most market cap in the process. FANG, GAFA, FAMGA — however you would slice and dice the reigning tech giants — are not infrastructure companies. Google has invested billions into capex like datacenters, but funded first and foremost by advertising revenue, primarily from its consumer-facing search engine. At this point, the results of debates about where crypto value will accrete, at the application or protocol layer or at different layers depending on the use case, do not seem sufficiently decisive to ignore the potentially large value that utility tokens could create.
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