The dot-com bubble burst only recently in the first few years of this century. Nearly 16 years after, we are in the midst of another spectacular crash — the crypto crash of 2018. More than 80% of the value of cryptocurrencies have been wiped out within less than a year — if we are keeping scores, this is worse than the 78% loss in value during the dot-com crash.
Nonetheless, many are predicting that things should improve from here, and the crash paves the way for recalibration in the ecosystem for the benefits of crypto tokens in general. Crypto resources and platforms may make a move away from focussing solely on currency and crowdfunding applications to spreading their portfolio into more utility-driven projects and gain further legitimacy in other traditional industries.
Does the crypto crash strengthen the token economy?
Before we attempt to answer, let’s review components of the token economy — starting with the idea of a token, then the various crypto tokens including cryptocurrencies, ICOs, other security tokens, to their applications, the legal environment, recent events and the crypto crash of 2018. Finally, let’s explore whether crypto tokens and blockchain technology, in general, are poised to benefit from the crash and become the next generation standard in many industries. Sections covered below are —
- Tokens — Are Commonplace
- Tokens Can Be Digital — Crypto Tokens
- Crypto Tokens — Utilities
- Applications of Crypto Tokens
- Crypto Tokens — The Pros, Cons, and Risks
- Crypto Tokens and Regulations
- Initial Coin Offerings (ICOs)
- ERC Standards
- 2018 Market Events & Regulatory Trends
- What’s Next?
1. Tokens — Are Commonplace
The transit system in Toronto (we call TTC), like many other cities, uses tokens. The token carries with it the promise of service — a one-way trip or a value — a one-way fare. Similarly, in casinos, we get tokens that represent money. The stocks and bonds are tokens too since they represent certain value and voting right or right to an amount or an asset. Similarly, it can be argued that the banknotes are also tokens. Even the movie ticket is a token.
A token is a representation of an asset — could be a product, service, a right or money. Simple enough.
The word ‘representation’ is key since no tokens have any intrinsic value. However, it gets its value from representing some asset — a product, a service, a right, an investment so on so forth. Therefore, the value of the token exists because of the issuer’s promise to deliver the asset it represents. In most cases, its also backed by law. For example, nothing in my subway token ensures that it covers me for $3 or a single fare — but only the promise TTC makes to honor the tokens, and my faith in TTC to keep its promise is what makes the token valuable and useful to me. If TTC does not honor tokens in large numbers, legal actions could also be taken.
Are currency notes tokens? yes, they are.
Similarly, there is no intrinsic value of any currency note anywhere — its a piece of printed paper backed by nothing — well, except the law of the land which carries promise from the issuing banks and government, and the many users having faith in those entities. Shares or bonds are similar — the value is derived due to speculation and demand-supply economics arising from the reputation of the issuer and the expectation of them honoring the amount, which is bound by law in many countries.
To sum up, there is no intrinsic value carried within any currency notes or any tokens — the bonds, equities, subway tokens, etc., the value is derived from several factors —
- The expectation that the issuing entity would honor the promised value — out of benevolence or avoiding loss in reputation or legal actions
- The government, the laws, and regulations protect these in most cases and ensure remediation in case of dispute
- Speculations and demand-supply economics due to their utility
2. Tokens Can Be Digital — Crypto Tokens
Now, in a digital age, when every data is being stored digitally, what if we converted the physical tokens — let’s say my TTC token — into a digital one. If this was done merely by taking a picture of the physical token and storing digitally on the phone — would TTC agree to honor the value?
No, of course not. The reason is a well-known issue called ‘double spend problem’ — since it is a digital picture, I can copy and create as many duplicates as I want, such that I and everyone else I know and don’t know can then ride the Toronto subway for free forever.
To create online digital currency, privacy activists and mathematicians aimed to solve this ‘double spend problem’ starting from the ’80s — using cryptography such as hashing and chaining of data. Many of their ideas advanced cryptography however failed to catch on as usable products — they were either flawed in some way or ahead of their time. My other article covers this journey in further detail.
The first successful product for digital online currency happens to be Bitcoin, launched in January 2009. The underlying technology of bitcoin is called blockchain.
If you want to read on blockchain technology in further detail, please check my other article, its a quick 30 minute read.
The digital tokens are built with the cryptographic locking mechanism that solves the ‘double spend problem’.
However, let’s still remember, that precisely similar to a physical token, honoring the value remains with the issuer and the ecosystem, and generally, no intrinsic value is included within the bitcoin or cryptocurrencies or ICOs or any other tokens issued using blockchain or cryptographic platforms. Therefore, in addition to ensuring the right technology, one must follow the correct use of legal processes and backing when releasing these.
While we discussed them in the same light and argued that they are very similar fundamentally, one critical difference between tokens and currencies are that currency retains value outside of a specific platform or ecosystem while tokens don’t. For example, my TTC token would not be accepted outside of TTC lets say in a coffee shop or another city, whereas, the currency notes can be exchanged for another currency in a different country — therefore, still usable and carries its value.
Similarly, for the cryptocurrencies Bitcoin and Ethereum, they are traded outside of their platforms and carries value, while, many other digital tokens such as utility tokens that are developed using the same technology do not.
3. Crypto Tokens — Utilities
The versatility of the crypto tokens allows them to be used in diverse roles and purposes to generate various features.
- Tokens allowing a right in a platform — this can be of access, governance, voting — for example, Numerai, Tezos
- Exchange of value within a network, resulting in maintaining economy within a platform — for instance Steemit, Kik
- Pay a toll for getting certain access to operate smart contracts or pay a security deposit or usage fees — such as in Gnosis or Augur
- Functions can include onboarding or networking within a platform where the token provides incentives for usage of the platforms — for example, Dfinity, Brave
- Currency or Cryptocurrency is the most popularly known application of digital tokens. Prime examples are Bitcoin, Ethereum
- Finally, the tokens can be structured to receive earnings or profit or benefit sharing, all possible due to smart contracts running on the blockchains.
4. Applications of Crypto Tokens
Following on the utilities discussed, it can be seen how applications of these tokens can take various forms.
In many cases, the process remains the same. However, the underlying assets and therefore, aspects of the contracts change. Some of the more common applications are —
- Asset Tokens — represent natural assets including oil and precious metals such as gold
- Cryptocurrencies — represent digital currencies — bitcoin, ethereum
- Crypto-Fiat Currency — represent national fiat currency, recent example of Petro in Venezuela
- ICOs or Initial Coin Offering — represent an initial offering of digital shares or coins newly created, aimed at raising funds like IPOs
- STOs or Security Tokens — represent an underlying investment (or security) asset
- Utility Tokens — represent an underlying non-investment asset
5. Crypto Tokens — The Pros, Cons, and Risks
Crypto tokens have several advantages over its traditional counterparts. Since the entire execution process is digital — e.g., less paperwork, along with the use of blockchain technology to achieve disintermediation — e.g., fewer intermediaries, and use of smart contracts for business logic — e.g., higher automation.
- Automation — use of blockchain and smart contracts to implement business logic, ensures automation in the process-flow, thus simplifying and reducing the execution burden
- Cost — blockchain provides disintermediation, thus fewer middlemen and fewer fees; digital process along with the use of smart contracts ensure less complexity, less paperwork, again simplifying process reducing cost
- Scale — digital and can be easily integrated with the internet and marketed to a global audience
- Speed — blockchain achieves disintermediation, removing many middlemen thus a faster process of the initial offering and subsequent trading
Some of the disadvantages and risks are —
- Small ecosystem — as cryptos are still a relatively new technology, used by only a fraction of developers, institutional and retail investors
- Privacy risk — Like any crowdfunding, it is a very public and transparent way of raising funds which may be challenging in protecting privacy including IP addresses and other proprietary details. hiring a lawyer helps
- Fulfillment — Majority of token sales and ICOs fail in reaching their goals — can affect brand and reputation
6. Crypto Tokens and Regulations
Disintermediation should not be about skirting the law.
We saw digital tokens represent assets in non-duplicable digital format. Therefore, these are assets and should fall within the scope of all legal guidelines governing assets. Furthermore, several use cases of tokens mirror traditional securities and therefore, those should follow all securities regulations/guideline.
The Howey Test — to determine if an asset is a security
This test originated from a 1946 Supreme Court case to ascertain whether a transaction is a security investment or not — if it is, then it is required to be registered to the US Securities and Exchange Commission or SEC to be as such. Per the Howey Test, the transaction becomes an investment if —
- It is an investment of money
- There is an expectation of profits from the investment
- The investment of money is in a common enterprise
- Any profit comes from the efforts of a promoter or third party
The term Money has later been expanded to include assets other than money. As well, depending on the specific situation, different terminology such as common enterprise can be interpreted differently. Most importantly, if profit is not coming from the investor, but the promoter or a third party, then most likely the transaction is categorized as an investment, and thus deemed to be a security. Therefore, should follow all securities regulations including SEC filing.
There are other alternative tests that came in some instances in the ’90s to ascertain this. In recent times, especially after the DAO hack in 2016, David Siegel’s article is a great read. After a few other thefts and wild price fluctuations in cryptocurrencies, the SEC has become more vigilant starting late 2017.
Security Tokens Vs. Utility Tokens
A digital token, if deemed to represent an investment or a security asset — through Howey and other tests, should follow securities regulations and procedures to remain compliant and avoid penalties. Generally, these are traded as investments.
Utility tokens work within an ecosystem — think TTC tokens — and allow rights or service, etc. only within that specific network. These are not security instruments, therefore, need not be filed with SEC.
Regulations — For Security Tokens
Regulation D — allowing to avoid being registered with the SEC, requires an electronic filing of “Form D” after the offering
Regulation A+ — requires to register with SEC, takes longer compared to other options
Regulation S — no need to file with SEC if the offering is outside of the US, however, still requires to abide by regulations in each country where offered
Without a doubt, security tokens represent securities, therefore, should follow any and all legal and regulatory requirements in countries it is offered
Disclaimer — these summaries of US securities law, including Regulations D, A+, S are my personal opinion. They should not be used as legal or investment advice. One should consult a lawyer for legal and regulatory considerations.
In a nutshell, except few utility applications, almost all crypto tokens can be argued to represent security, and therefore, subject to security regulations in every jurisdiction. The rules applied are nearly 70 to 80 years old and the precedences cited are from disputes from the 1940s about citrus groves, when nothing remotely close to digital, leave alone cryptographic, was in public use. These are outdated policies, precedences, and regulations that desperately needs new efforts and language to define and regulate this 21st-century industry — to help it flourish and reach its potential and transform almost every other sectors.
7. Initial Coin Offerings (ICOs)
Bitcoin, the first public blockchain platform was developed with a specific set of functionality in mind — a currency and peer to peer digital cash applications, and therefore it allowed very minimal customization or programming capability to developers.
Vitalik Buterin, the inventor if Ethereum, saw this gap and developed the Ethereum platform with programmability in mind. Ethereum Virtual Machine, a self-contained software that runs on Ethereum network, is Turing complete — which means it can be used to run any software program — allowing the process of creating diverse blockchain applications, beyond currency and peer-to-peer payment, more accessible than before.
In 2013, Ripple Labs created and sold 100 billion XRP tokens to fund the development of Ripple Platform.
Later in 2013, Mastercoin built tokens on top of bitcoin transactions and sold nearly 1 million Mastercoin tokens.
By the middle of 2014, Ethereum was launched, and the foundation sold nearly 60 million tokens raising $18.4M at the time — making it one of the most successful crowdfunded projects of all time.
Ethereum enabled smart contracts to be run on its platform, and this was one of the critical reasons why Ethereum became so successful — developers could create a variety of applications and features allowing rules and logic to be purpose-built for transactions to take place. Unlike standard contracts and enforcement mechanisms, these smart contracts once built and deployed, acted like automatic enforcement of business logic without any exception. Ethereum attracted substantial developer attention and action by allowing developers to create whatever they wanted with minimal restrictions. Developers were restricted only by their imaginations and developed numerous applications, exponentially more than previously seen on any blockchain platforms.
The Ethereum platform unleashed the power of decentralized systems allowing smart contracts to structure crypto tokens as initial coin offerings. ERC-20 on Ethereum platform became the defacto standard of crowdfunding using crypto tokens — initial coin offerings or ICOs became mainstream.
In 2016, a startup working to build a Decentralized Autonomous Organization, aptly named “The DAO.” The goal was to create an autonomous venture capital firm without any person managing the investments — rather smart codes would provide logic and automation for those actions.
Launched on the Ethereum network, the startup went through a massively successful token sale and raised around $150 million.
Shortly after the launch, exploiting shortcomings in the smart codes, around $50 million was siphoned off by an unknown attacker. The Ethereum platform was sound, and the failure was within the DAO developers’ code that left it vulnerable to for hacking. However, given the amount of the stolen funds and magnitude of the situation — the Ethereum community voted to retrieve the stolen funds through changing codes in already launched software, creating a hard fork, and moving the stolen ethers to the rightful owners.
While the hard fork solution retrieved the stolen money, therefore, restored confidence in the platform to some extent, the precedence of tampering already written code and reversing transactions went against the very fabric and value proposition of any blockchain solutions — of security, immutability, tamperproof architecture, and anonymity.
The DAO failed after it was hacked.
The Token Sale Rush started in 2016
The DAO hack made news and arguably, contributed to spreading the word about ICOs that attracted many more developers.
The ease of structuring a token on the Ethereum platform using ERC-20 and the flexibility of leveraging smart contracts to add more innovative features were absolutely killer in attracting many developers and ICOs.
Isn’t it amazing that all of this started in the past couple years and Etherscan.io showing more than 158,000 token contracts that are now live on the Ethereum platform? Even if more than 90% of them are single timers and trials, but the amount of interest and activity is astounding.
Per Max Galka’s article, of Elementus.io, around $28 Billion have been raised in token sales, with barely anything in 2014 or 2015, then starting with Ethereum and then DAO in 2016, and then exploding in numbers and amount starting around mid of 2017 until August 2018. You should also check out the excellent animation.
Deploy ICOs in 6 easy steps
The Ethereum platform makes it very easy to develop and deploy ICOs.
Following blockchain developer Stephen Hall’s methodology, as shown in this article, a functioning ICO can be launched from nothing by anyone who can follow simple instructions. And maybe in merely a few hours, you can deploy and verify your brand new ICO.
An IPO takes months and months of work from several teams. An ICO is the crypto parallel of an IPO. We saw that in just a few hours, sitting on a laptop, with a phone and a credit card, one can define the rough structures of a functional offering. This clearly demonstrates how revolutionary the technology is.
However, note that these steps covered here are more like building a basic structure of an ICO — for comparison, let’s say, a ‘Hello World’ page using HTML — and not tied to any real asset or value. The point here is not to advocate the building of ICOs in few hours or without any developer, but the fact that the Ethereum platform makes the process much simpler.
8. ERC Standards
ERC 20 tokens have now been made possible on Hyperledger; however, for this section, we will primarily focus on the Ethereum platform to discuss structuring and deployment of digital tokens.
The first and most widely used standard ERC-20 still reigns supreme with more than 90% of all projects using this standard. Second generation standards fix some of its flaws and add functionality for regulatory compliance.
What is ERC
ERC stands for Ethereum Request for Comment — these are standards on the ethereum platform for creating digital tokens. Can be understood merely to be a prebuilt container or structure, where, one can fill in certain details to then quickly compile and launch the token.
The most used standard for digital tokens on Ethereum platform with more than 90% digital tokens using this standard thus far with literally hundreds of thousands of tokens built with this standard.
The key to its success lies in its simplicity — requiring only 6 essential functions to create the tokens —
- allowance() — ensures transaction validity before adding to the chain
- approve() — is a function to keep total token supply constant
- balanceOf() — keeps track of the token balance in each user wallet
- totalSupply() — determines the total amount of tokens to be created
- transfer() — used for initial transfer of tokens to participant’s address
- transferFrom() — token holders to send tokens after the initial transfer
However, there are some design flaws including a serious one that has caused loss of around $3 million tokens thus far. The defect arises from a difference in the process for sending tokens to a smart contract as opposed to an ordinary wallet, and in case someone mistakenly uses the other, wrong, method for transmitting tokens to a smart contract, the tokens are permanently lost.
This standard fixes on the design flaw of ERC-20, and is backward compatible with ERC-20. As well, uses only half the ‘gas,’ which is the transaction fee within the ethereum network.
However, have not been very popular thus far with developers.
Allows creation of non-fungible tokens (called NFTs)- which essentially means not all tokens are the same, and therefore, can be used to tokenize assets or different value in the same network.
This is supported by many projects including 0x protocol, Toshi, OpenSea.
In addition to fixing the critical design flaw in ERC-20 and being backward compatible with ERC-20, this standard improves upon how tokens are sent — using the same function to send ETH, thus less friction with ethereum users.
Developed with regulatory compliance and interoperability amongst exchanges — this standard allows for easier integration with traditional banking and regulatory filing processes.
“ERC-1404 is a token standard developed with corporate governance, banking, and securities laws in mind.”
Erc1404.org lists several of its benefits including —
- setting investor limits
- enforcing investor whitelisting thus restricting sanctioned entities
- implementing a single regulatory standard that is compliant globally
- tooling to follow legal counsels advice
- interoperability across exchanges
- achieving compliance with domestic/international regulations
9. 2018 Market Events & Regulatory Trends
Following never before seen boom of Bitcoin prices in 2017, the sell-off of most cryptocurrencies started from January 2018, and the price of Bitcoin fell by about 65 percent by the first week of February. Subsequently, nearly all other cryptocurrencies crashed.
Close to $342 billion in the market value of the cryptocurrencies were lost in the first quarter of 2018. By September 2018, cryptocurrencies collapsed 80% from their peak in January 2018, making the crash comparable but numerically worse by few percentage points to the collapse of the dot-com bubble, which saw 78% loss in values.
The fantastic global scale and reach of these instruments also lend them to be susceptible to sell-offs at a worldwide level, contributing to their volatility. Price stability is the critical factor now in bringing back confidence in this industry and crypto-blockchain technology in general.
Several reasons are being discussed to have caused the crash —
- Hype in new technology builds bubbles that burst eventually (remember dot-com)
- Negative sentiment from suspected association with dark money (think drug peddlers)
- Negative sentiment arising from anonymity often equated with illegality
- Speculative and manipulative behaviors (pump and dump schemes, Tether)
- Bad press due to multiple crypto exchanges hacked
- Fear of cryptocurrencies not getting accepted by governments
- Lack of regulatory clarity
- Delay in Bitcoin ETF
Association for Digital Assets Market (ADAM) — Nov 2018
Newsbtc reported last month, ten of the leading financial services and technology firms active in cryptocurrency space joined hands in launching ADAM, with the goal of working closely with financial watchdogs in establishing the code of conduct for this emerging asset class, thus earning the trust of the policymakers.
This is a necessary step to sustain the cryptocurrencies by bringing some rules of the game to bring back confidence and a step in the right direction.
“Over 200 years ago, market leaders came together to draft rules that led to the creation of the New York Stock Exchange. The advent of digital assets requires a similar effort; one that will clarify existing rules and give both investors and regulators the confidence necessary to sustain this market.”
— Duncan Niederauer, the former Chief Executive Officer of NYSE and ADAM Advisory Board Member
Favorable Regulatory Development — Dec 2018
As Altcoinbuzz reported earlier this week, Two U.S. Congressmen, Warren Davidson, and Darren Soto are looking to bring regulatory clarity to the markets by introducing a bill called the “Token Taxonomy Act,”
This bill is aimed at clarifying differences between cryptocurrencies like bitcoin and security tokens or ICOs — whereby,
- cryptocurrencies would be deemed exempt from securities law since they are decentralized
- security tokens or ICOs would continue to be regarded as securities as they are generally issued by one or a centralized party.
Therefore, this bill aims to de-list cryptocurrencies from being treated as securities, thus freeing the users to adopt in a day to day usage situation, removing the filing and some taxation requirements.
10. What’s Next?
Similar to the evolution of the modern banking system, or the more recent internet revolution — the crypto space might go through a few more steps and missteps before digital tokens become the standard.
The corrections after the crash should improve the playing field for the right participants to effect change. Despite the crash, use of digital and cryptographic tokens are transforming many industries. The regulatory environment is evolving. The blockchain is one of the most transformative technologies of the century, and one should be hopeful that after these initial jitters, the technology should mature into more value-driven applications rendering it more ubiquitous in our societies and businesses.
For one — the underlying technology, blockchain, is sound and is being adopted increasingly by large global enterprises.
Second, market forces hype up emerging technology and cause bubbles-bust cycles — for example, we did not abandon the internet after the dot-com crash. The crash might remove much of the speculative, manipulative and dark money influences that caused the bubble in the first place — let’s remember, not many were complaining about the spectacular rise in cryptocurrency prices in 2017.
Third, some regulatory clarity in the space, as starting with ADAM and the Taxonomy Bill, should help to establish ground rules, moderating behaviors of the few bad actors and eventually stabilizing the markets.
Finally, it’s all about the developers of these platforms — the best developers usually flock to the most money making projects in any industry. The crash should push developers now to move away from only developing another quick money making currency application to expanding their development portfolio to other legitimate uses of blockchain and transform traditional industries.
For a quick 30-minute overview of Blockchain technology, you can check my other article here.