Token Taxonomy Frameworks

Blockchain’s full potential lies beyond “security v. utility”

1. Introduction

The security v. utility token framework remains the dominant classification paradigm for blockchain instruments. But it has many limitations. Security v. utility standards do not capture the full range of blockchain relational and transactional networks and possibilities.

To understand how crypto will and should be regulated, we must begin with rigorous analysis of competing blockchain law and policy frameworks. Exercises like this bear immediate fruit. We see, for instance, that, just as there is not one uniform blockchain movement or “agenda,” there should not be a one-size-fits-all regulatory or classification approach.

Consequently, this analysis outlines a dynamic new taxonomy, classification, and analytical framework for blockchain tokens that builds on the security v. utility binary, thereby extending its usefulness.

Modeled on current Securities & Exchange Commission (SEC) blockchain classification standards, including the Howey test, this model seeks to reconcile the needs of blockchain developers with the legitimate needs of regulators to protect the public.

The proposed framework splits tokens into five general categories, with anticipated further delineation within each category: (1) security; (2) utility; (3) hybrid; (4) hyperutility; (5) research.

2. Proposed Framework

The proposed framework extends along a utility spectrum.

On one end of this spectrum are tokens that embody traditional investment contracts, known as (1) security tokens. The other extreme represents purely experimental and/or (5) research token schemes.

As analyzed below, the space between (1) security tokens and purely experimental (5) research tokens is already bursting with projects that do not fit well within existing boxes. Thus, there is a clear need for a taxonomy that covers a broader range of current and forthcoming blockchain use cases.

As we will see in case studies below, better classification is a prerequisite for better regulation and blockchain governance processes.

Recognizing the existence of (3) hybrid tokens, (4) hyperutility tokens, and (5) research tokens highlights the need for “sandbox” regulatory exemptions in order to optimize underlying market/tech processes, produce new types of social welfare gains, and unleash new modes of economic production.

Beyond the security v. utility binary, the case studies below also show the need for dynamic approaches to token classification, in contrast to the more static formal frameworks in use today.

Dynamic models are more flexible and responsive to shifting stakeholder expectations in the blockchain space. Hence, they promise greater legitimacy and security.

3. Formal Methodologies

As applied to blockchain, the Howey test now extends far beyond case law.

The jurisprudence around Howey now includes a long and rapidly growing line of progeny cases, as well as multiple instances of formal regulatory guidance from the SEC (e.g., first “no-action” letter in re: ICO; SEC 2019 Guidance on ICOs; SEC position on Ethereum; etc.).

There is also a growing body of SEC enforcement precedent in the blockchain space.

3.1 Beyond Howey

Separately from the SEC, other U.S. agencies that claim crypto oversight power include the Consumer Financial Protection Bureau (CFPB), U.S. Department of Treasury, Office of Foreign Assets Control (OFAC), as well as numerous state administrative and enforcement agencies. The proposed federal Token Taxonomy Act also seeks to extend IRS tax jurisdiction to token gains — retrospectively to January 1, 2017.

We also observe concurrent growth in global regulatory efforts (e.g., ECB analysis of crypto assets) at different stages of drafting and implementation.

Full surveys of crypto regulatory schemes must therefore include multiple sub-national and transnational efforts. To limit scope, however, the analysis below focuses on U.S. regulatory postures as representative of current and expected global trends.

3.2 Crypto Law & Policy

The formal sources of authority listed above are highly instructive. They become even more useful when juxtaposed against the aligned and competing policy aims that these laws and regulations actually effectuate.

This is a big reason we should adopt both legal realist as well as policy-oriented jurisprudence approaches to regulatory design. In the blockchain context, policy-oriented jurisprudence offers distinct advantages over more rigid positivistic logics because of its explicit acknowledgement that legal frameworks are often key drivers of social change, and vice versa.

4. Current Frameworks

4.1 Doctrinal Frameworks

Today’s dominant crypto classification framework is embodied in the Howey test.

Applied to crypto/blockchain instruments, Howey asks if a given crypto scheme is a so-called (1) security token versus a (2) utility token based on a list of factors. The basic standard in this binary test is to what extent an ICO or other token scheme holds itself out as an investment contract.

If the buyers of a given token reasonably understand it as a type of investment vehicle or, say, a distributed ownership instrument with the promise of residual returns, then it likely resembles a security, and should be regulated as such.

On the utility side of this binary spectrum are projects like Ethereum. Because the main purpose and function of Ether/ETH is to serve as the native currency and/or “gas” on the decentralized Ethereum network, the token serves a core operational function on the network as opposed to paying out returns like dividends or the like.

In the Ethereum case study, the utility argument usually proceeds as follows: (1) because ETH directly facilitates operation of the network, (2) Ethereum’s core value proposition is not some specified return on an investment, but rather (3) the ongoing secure operation of a large-scale global decentralized computing network. For historical reasons, ETH just happens to be a publicly-traded crypto instrument, but it was not sold under promise of future gain.

4.2 Enforcement Frameworks

The SEC’s Howey test has been applied by SEC officials through direct action and also indirectly.

For instance, in a public speech at the Yahoo Finance All Markets Summit on June 14, 2018, the SEC’s Corporation Finance Director William Hinman outlined a regulatory framework for digital tokens based on the level of decentralization of the token network. Applying this expanded standard, Hinman concluded that, for a network like Ethereum, “current offers and sales of Ether are not securities transactions.”

Though not formally binding, the guidance of a senior SEC official is highly persuasive on U.S. courts pursuant to settled canons of legislative and regulatory construction (see, e.g., Chevron doctrine). Because of its general pro-crypto effect, the Blockchain Association, a U.S. lobbying group, even went so far as to formalize the contours of an emerging “Hinman test” and to lobby for greater adoption.

Yet lest one infer a laissez-faire trajectory to these regulatory currents, the SEC has also assumed a vigorous enforcement posture. For example, the SEC recently announced a settlement that serves as precedent for holding individuals liable for, inter alia, operating unregistered decentralized crypto exchanges.

4.3 Legislative Frameworks

Crypto regulation is not just a matter of applying existing laws and regulations to specific blockchain instruments and/or broader crypto economic contexts (regulation of exchanges, potential regulation of wallet providers, taxation, capital control regimes, etc.).

In the U.S., both federal and state legislators are also asserting jurisdictional reach over the growing blockchain sector.

Prominent examples in the U.S. include Wyoming’s pro-crypto law, and related state-by-state efforts. At the federal level, Congress is currently considering the Token Taxonomy Act, and there are even calls by some legislators to ban cryptocurrencies altogether (e.g., Rep. Brad Sherman). Many related legislative efforts are currently undergoing reconciliation and harmonization.

Substantively, the key point of every intervention like this is to define the subject of the intended legislative reach. After defining and classifying a given crypto instrument, legislators can then charge enforcement authorities to carry out a given legislative scheme. This is a main reason why blockchain classification/taxonomies are now central battlefields in age-old global regulatory contests.

4.4 Theoretical Frameworks

There are several competing theoretical frameworks for token classification, which can be called: (1) propertarian; (2) contractarian; (2) institutional; (3) functional.

Four examples from policymaking, academic, and industry sources show how these divergent theoretical approaches translate into classification postures.

4.4.1 Propertarian Approaches

Wyoming represents what can be styled as a propertarian approach to crypto regulation.

The Wyoming taxonomy breaks with Howey and advances a three-way breakdown based on property law principles: (1) digital securities (e.g., investment contracts); (2) digital consumer assets (e.g., utility tokens); (3) virtual currencies (e.g., Bitcoin and other alt coins).

The key characteristic of this regulatory posture is the use of strong private law principles (property, contract, etc.) and public law doctrines (Due Process, federalism, criminal prohibition of rehypothetication, etc.) to affirmatively defend and promote blockchain operators. A key tactic in this strategy is the creation of formal sandbox protections, including potential limitations on liability for blockchain developers and other blockchain industry actors (custodians, exchanges, etc).

Wyoming’s approach is especially notable because that state’s regulatory posture has emerged as a model for other states.

4.4.2. Contractarian Approaches

Like propertarian approaches, contractarian approaches to crypto regulation are premised on strong conceptions of private law regimes, particularly well-established freedom-of-contract rights. A defining characteristic of the contractarian approach is to foreground strong contract rights, including schemes for sweeping global “contractization” of existing property rights regimes.

By classifying specific blockchain forms as bundles of contract rights, proponents of this view tap into increasingly harmonized global contract law regimes (e.g., lex cryptographica, lex mercatoria). By alienating and encumbering greater bundles of property rights and rebundling these rights as “smart contract” instruments, blockchain actors can achieve purported efficiency gains over property law regimes, which are usually local, and hence, deeply fragmented.

A strong contractarian (see also, Willistonian) approach to blockchain instruments can also potentially disclaim and limit various other types of quasi-contractual and non-contractual liability, including equitable, tort-based, and statutory theories of obligation.

The dominance of the contractarian approach is especially evident in the growing segment of blockchain dispute resolution and crypto arbitration. In this sphere, many actors benefit from foregrounding blockchain disputes as strict contract disputes. Hence, for instance, these disputes would/should be prima facie arbitrable, allowing prevailing parties to tap into well-established contract-based remedial mechanisms (e.g., enforcement rights under the New York Convention).

4.4.3. Institutional Approaches

The institutional approach to crypto regulation focuses on the extent of blockchain institutional centralization and coordination/control. This approach is reflected in the Hinman test and in the scholarship of crypto theorists like Angela Walch.

Howey itself is a type of centralization standard, offering courts and regulators various factors for determining the level of financial and operational control that issuers have over their putative security/non-security instrument. In many ways, whether a scheme is part of a “common enterprise” within the meaning of Howey is an inquiry into the degree of centralization and “effective control” that issuers have over their issue.

Importantly, the institutional approach looks to the formal and informal institutional connections between crypto operators (including lines of direct command and control between developers vis-a-vis code repositories, blockchain crisis governance, coordination between miners, exchanges, and developers, and the like).

As SEC crypto enforcement actions become more routine, it is reasonable to infer a parallel rise in IRS/Treasury crypto enforcement actions, with increasing refinement of different “effective control” standards and factors. Thus, many new institutional approaches are likely to proliferate in the coming years.

4.4.4 Functional Approach

The fourth general theoretical approach to token classification can be called a functional approach. Building on the institutional approach, the functionalist view tackles classification from a far more rigorous empirical standpoint.

Functionalism is exemplified by Parallel Industries’ TokenSpace project, IOTA’s regulatory posture, and projects like Bitcoin SV. Importantly, functionalism is also the de facto posture of global law enforcement bodies.

The main feature of the functional approach is a rigorous forensic examination of actual patterns of blockchain behavior, including various “hard,” “soft,” and “friendly” forking behaviors and market trends.

The functional approach posits that regulatory efforts should track actual blockchain operations (and functional lines of liability), even if it means lifting the “veil of decentralization” and imposing lines of liability despite formal/institutional liability limitations.

4.5 Need for Dynamic Taxonomy Frameworks

The four approaches highlighted above are not mutually exclusive. There are many overlaps between them, such as between institutionalism and, say, functionalism. A survey of these approaches also reveals the need for a broader and more dynamic classification framework in both substantive and procedural terms.

Substantively, a dynamic classification/taxonomic framework is one that allows stakeholders, including developers, to define their technology by measure of overall utility that is produced by a given product, service, algorithm or system — over time. Procedurally, a dynamic classification framework is one that gives meaningful opportunities for stakeholders to make classification and reclassification demands.

For instance, a dynamic classification framework should permit developers to launch products as, say, tokenomic (5) research projects, and upon reaching scale, obtain reclassification as, say, a (2) security token.

Conversely, developers may be interested in launching a version of a platform token as a (1) security token, followed by, say, a process of gradual decentralization, where the token matures to serve (4) hyperutility functions.

By way of example, existing large platform tokens like ETH seem especially well-suited to eventual reclassification as hyperutility tokens.

Moreover, as blockchains continue to undergo radical transformation (e.g., Ethereum 1.0 transition to Ethereum 2.0), the need for dynamic classification models will only continue to increase.

5. Illustrations

The following case studies illustrate the importance of dynamic taxonomic modeling beyond the security v. utility binary.

One must begin by noting that, while it is common to analogize crypto-economic processes (e.g., Initial Coin Offerings/ICOs) to existing legal forms, processes, and institutions (e.g., Initial Public Offerings/IPOs), legacy comparisons have limitations.

Are “smart contracts” legally enforceable? Are Bitcoin/Ethereum money and/or “currency” — ? Are crypto instruments “property” — ? These foundational questions underscore that blockchain’s most interesting and transformative possibilities lie in the proverbial gray areas.

To illustrate some of the gaps and blind-spots in existing schemes, we can turn to blockchain examples like human tissue/organ markets and novel approaches to blockchain insurance and systemic risk.

5.1 Kidney Today For Kidney Tomorrow

In 2012, Alvin Roth and Lloyd Shapley won the Nobel prize for economics. Their breakthrough was a novel approach to markets that incentivizes market participation (such as commitment to donate human organs) by creating market assurances of in-kind later-in-time exchange.

The logic is simple: if you donate one of your kidneys today, you should have a higher likelihood of receiving a kidney transplant if you need it tomorrow. In real material terms, everyone is better off in a large organ transfer system.

Roth and Shapley showed how and why these markets would flourish. In his Nobel Prize lecture, Roth explained the urgent need for new market models of this type.

The reason [that today we] do the surgeries simultaneously is that you cannot contract on a kidney in the United States. It is illegal to give valuable consideration for an organ for transplantation. That mostly means you can’t buy and sell organs, but it also means it is hard to enforce any kind of agreement such as ‘today we give you a kidney and tomorrow you give us a kidney.’

The solution is to rethink so-called “matching markets” with insights from game theory and to remove as many barriers to market-network participation as possible. This allows us to re-examine the very nature and function of legal agreements.

In the space of ten years (from 2003 to 2013), Roth and Shapley’s work led to a ten-fold increase in the number of successful kidney matches in the U.S. This approach continues to scale exponentially, with no sign of slowing.

5.2 To OrganChain & Beyond

Irrespective of one’s views on, say, the ethics of “marketizing” human tissue, network-based approaches to market scaling often give better outcomes than pre-existing models of economic exchange.

Blockchains are proving themselves to be powerful tools for value capture from network effects, at global scales. Per Moore’s Law, is is reasonable to expect that tomorrow’s BlockTech will greatly exceed today’s capabilities. In the healthcare context, this potentially means better diagnostics, optimized health record management, and far smarter billing technologies.

Just as Roth and Shapley unlocked massive utility and welfare gains from uniting different national kidney pair donor systems into one unified system, the massive welfare gains from an eventual global OrganChain, KidneyChain, TissueChain, and so on, are self-evident. From this perspective, life-saving blockchain technologies become questions of when, not if.

Our taxonomies should facilitate these types of innovations, rather than stifle them.

Today, developers working on real-world “kidney token” schemes should feel comfortable thinking of their token scheme as a (4) hyperutility and/or (5) research token. University researchers and organizations like the Red Cross should not have to retain securities lawyers in order to launch life-saving technologies and humanitarian assistance schemes on the blockchain.

Dynamic and permissive classification schemes serve to reduce developer anxiety towards regulation. Less regulatory anxiety means more development. Everyone benefits from sandbox environments that promote use cases like these, including regulators who may need a kidney or other organ transplant in the years to come.

5.3 Case Study: TabooKey’s CREDO

Roth and Shapley’s approach to so-called “matching markets” applies far beyond organ transplantation. Matching markets include job markets, online ad markets, school choice, online dating “markets,” and many other types of socio-economic participation and exchange.

New types of global blockchain insurance markets also demonstrate the value of a more flexible sandbox approach to crypto classification and regulation. Viewing token classification through the prism of global risk markets is useful because it orients us to new types of transactional alignments, improved modes of production, and greater value capture in far more granular ways.

TabooKey, for instance, is a startup that leverages blockchain advances to institute robust global risk mitigation strategies — beyond just financial instruments.

One way of thinking about TabooKey’s CREDO project, for example, is as a sandbox-within-sandbox economic development engine. The mechanism by which CREDO stimulates economic development is by “wrapping” liquid cryptocurrencies into credit reserves for re-apportionment and incubation of governance-approved subsidiary development projects (e.g., dApps, process-improvement research, ongoing security audits, etc.).

Leveraging lessons from public-sector and also private-sector lending models, CREDO seeks to create a dynamic, scalable, and robust expansionary credit envelope for carefully-curated blockchain ventures.

Are CREDOs (1) securities or (2) utility tokens under the Howey test? Are CREDOs a (3) hybrid token scheme?

It depends.

5.4 Classifying CREDOs

While it may be tempting to immediately liken CREDO to various established “reserve banking” models, and to borrow regulatory toolkits from those domains, classification of CREDO as a financial instrument (and/or, worse, as a banking enterprise) would undermine vital corollary processes that extend CREDO/TabooKey’s utility far beyond that of a traditional security or basket of analogous existing financial instruments (e.g., derivatives; credit swaps; etc.).

In short, defining CREDO as a (1) security token would fail to capture the actual value created by CREDO “wrapping” mechanisms, especially as they pertain to CREDO network risk mitigation processes.

It is better to think of wrapped tokens like CREDOs as sui generis legal forms, pending maturation of the processes they are designed to unlock. It is even better to think of tokens in an ecosystem like TabooKey as fluid instruments that can evolve from one classification to another over a span of years.

There is no policy or formal reason why tokens cannot launch as securities but then transform over time into non-security instruments (e.g., analogous to a listed company’s transformation into a private firm).

5.5 More Risk Today For Less Risk Tomorrow

Just as Roth and Shapley’s used game theory to unleash new genres of efficient organ matching “markets” or “games,” TabooKey’s projects can also be viewed as new paradigms for managing global financial and economic risk.

For instance, in one of the most innovative applications of existing legal forms to tokenomics, TabooKey-incubated projects can serve as new forms of micro-sureties, permitting an infinite range of guarantor relationships with underlying “smart contract” parties. In other words, TabooKey’s approach to wrapping and scaling opens the door to different types of bond-type configurations, with staked third-parties automating their various performance, payment, and subrogation rights and obligations.

Thus, just like Roth and Shapley revealed the wisdom of potentially planning for future risk of kidney loss by joining a donor pool when one’s kidneys are still working well, TabooKey allows present value capture through far more efficient allocation of future risk of loss.

Crucially, the proposed surety/guaranty postures are not limited to crypto financial instruments. One can imagine a long list of examples where on-chain payment and performance bonds will significantly minimize contractual counterparty risk, especially when tied in to real-world off-chain remedial mechanisms.

The underlying economic mechanisms are based on the same principles as contract, insurance, surety, letters of credit, and various other types of financial derivatives. But functionally and institutionally, TabooKey programs operate along new lines of economic exchange in far more nuanced ways than any preexisting functional equivalent.

5.6 Crypto Utilitarianism

The technological means by which blockchains will allow on-chain and off-chain risk shifting are still largely underdeveloped.

Yet because we all benefit from technologies that allocate material risk of loss in more efficient ways, we should all encourage and facilitate the development and deployment of technologies like this. The same holds true for underlying legal frameworks.

Through the prism of global risk mitigation markets, one can see that the economic potential of optimized insurance and surety markets exceeds trillion dollar scales. At full potential, TabooKey has the potential to constructively disrupt global insurance and re-insurance services, producing net positive economic effects for everyone in the form of greater global competition for lucrative premiums, and greater coverage opportunities.

Great reward, of course, implies great initial risk.

The comparison to Roth and Shapley deserves to be made again. The commonality between new organ transfer schemes and TabooKey is a radically expanded operational window for risk allocation, risk shifting, and smarter overall resource allocation. Once integrated into other base-layer and Level 2 blockchain processes, systems like TabooKey have the potential to mature into fully dynamic market analysis and correction tools.

These are paradigm shifting technologies, and they need to be analyzed from the perspectives of multiple stakeholder groups — from global networks of end-users, to enterprise actors, and beyond.

Once we appreciate this broader systemic view, we can conclude that general-purpose blockchain toolkits like, Ethereum, TabooKey, Polkadot, and so forth, are clear examples of blockchain (4) hyperutility applications, and should be classified as such (until new circumstances require re-classification).

6. Policy Recommendations

The key takeaway thus far is that the best way to capture new value is to permit innovators like Roth, Shapley, and their blockchain kin, to improve underlying technologies so that global stakeholders and market participants can decide winners and losers, instead of well-intentioned regulators.

6.1 Reciprocal Sandboxing

The best way to achieve the aims of innovators (sandbox protections to permit products and services to reach global market participants) and the aims of regulators (protection of the public) is for both sides to acknowledge the other’s legitimate scope of activity. From there, working together to develop new frameworks and methodologies is much easier.

6.2 Dynamic Modeling

Legal framework that are responsive to dynamic market conditions are far more legitimate and durable than those that seek to squeeze a round peg into narrow preexisting square holes.

As technologies evolve, so must our legal frameworks.

Because they anticipate rapid evolution from the outset, dynamic frameworks raise the likelihood of better market/regulatory outcomes than more static classification models like state-by-state “smart contract” legislation and/or the proposed Token Taxonomy Act.

6.3 Open Engagement

Token classification schemes grow more sophisticated each day.

The best way to stay abreast of best practices across policymaking, academic, and industry spheres is to increase opportunities for institutional engagement and cross-pollination.

As a nonprofit research body, CleanApp Foundation welcomes the opportunity to provide additional analysis and expertise on these issues.

[Thank you to Anuj Das Gupta for providing excellent peer-review and constructive critiques. Thank you to Liraz Siri for providing insight into TabooKey projects and highlighting the need for dynamic approaches to classification. We respectfully ask that you CleanApp all real and perceived errors.]