Back in 2017, “ICO” was the buzzword in the blockchain community. The ICO boom that began in Spring 2017 helped raise US$6.2 billion for a total of 875 projects. However, going into 2018, the bubble had popped and the market for ICOs dried up by the third quarter of 2018.
Investors and the industry itself has matured since then and buzzwords such as “tokenization” and “security tokens” have taken over. In other words, the blockchain industry keeps getting more and more interesting, and we all must keep up.
As it turns out, there are various types of tokens that everyone should be aware of. Some of these tokens overlap with the traditional securities industry, while some are completely new innovations. So let’s dive into the different types of tokens and their functionalities. However, make sure you first understand the difference between a token and coin.
There are 3 main types of tokens: payment tokens, utility tokens and security tokens.
Payment tokens have their own blockchain and are considered as a medium of payment. They are simply “cryptocurrencies” and they function as digital cash. These tokens have inherent value and can be used in financial transactions.
Any cryptocurrency that is built on its own blockchain and serves as a medium of payment falls under the category of payment tokens. Some of the most popular payment tokens are Bitcoin and Ethereum.
Can payment tokens replace fiat currency?
Although payment tokens serve as a medium of payment, they are an unpopular choice for making payments compared to traditional fiat currencies such as the US dollar. This is because they are unstable, and their price value changes on a daily basis.
To combat volatility, new payment tokens known as “stablecoins” are designed, which are pegged to a stable currency. The most popular stablecoins are Tether and TrueUSD. As of now, the circulating supply of US dollars is US$14.6 trillion, compared to the US$3.6 billion market cap of Tether.
A utility token refers to a cryptocurrency that is issued in order to fund the development of the project behind it. It can be later used to purchase a good or service related to that project. Hence, utility tokens contain within themselves the spirit of crowdfunding and they represent a particular function or service that they offer to the owner. The price of value of a utility token comes supply and demand principles. The token is worth a certain price if buyers and sellers agree to that price.
E.g. Basic Attention Token (BAT) can be used to obtain a variety of advertising space on the BAT platform. Other utility tokens include Siacoin and Filecoin.
A token that passes the Howey Test is known as a security token. Basically, a security token is any cryptocurrency that pays dividends, profit shares or invests in a profit potential project. Security tokens derive their value from an underlying, tradable asset. Since they are classified as investment contracts, they are subject to federal securities and regulations.
What type of regulations are there?
In Hong Kong, security tokens are likely to be classified as “securities” under the Securities and Futures Ordinance (SFO). If so, they will be subject to the securities laws in Hong Kong. According to the SFC, “any person who markets or distributes Security Tokens (whether in Hong Kong or targeting Hong Kong investors) is required to be licensed or registered for Type 1 regulated activity (dealing in securities) under the SFO.” Additionally, security tokens would be regarded as “complex products” and hence additional investor protection is required.
The regulations for the distribution of virtual funds are likely to encompass intermediaries of security tokens. The regulations are highlighted as follows:
- Selling restrictions: The intermediary that markets or sells the security tokens must be registered under a Type 1 license and is only permitted to sell to professional investors.
- Due Diligence: Proper due diligence must be conducted to develop an in-depth understanding of the STOs. This includes assessing the background and financial soundness of the entire team, scrutinizing all material related to the STO such as the whitepaper and other marketing materials, and verifying that all information provided to clients is valid and accurate.
- Information for Clients: Intermediaries should provide information to potential clients in relation to the STOs in a clear and comprehensive manner. Prominent warning statements that highlight the risk associated with virtual assets should be provided.
In the United States, security tokens must fulfill the following requirements:
- Regulation D: The creator of the security token should solicit offerings from investors in compliance with Section 506C. Furthermore, if the creators do not fill in “Form D” upon sale of the security tokens, they must register the security token with the SEC.
- Regulation A+: The compliance with this regulation allows creators to attract non-accredited investors for a total of up to US$50 million. This regulation tends to be more time and money consuming.
- Regulation S: If the security token is being traded in foreign countries, then Regulation S and the regulations of the foreign country apply.
What are Security Token Offerings (STO) and why are they important?
A STO is essentially a middle-ground between an Initial Public Offering (IPO) and Initial Coin Offering (ICO). It is a way to raise money through a regulated token, where the details of ownership are recorded on a blockchain.
STOs represent the best of both worlds: the traditional ecosystem and the disruptive cryptocurrency market. There are 5 benefits of STOs:
- Regulatory Compliance: Since companies list their tokens as securities in the first place, they are not classified as ‘unregulated security’ like most ICOs. Startups and traditional firms benefit from complying with national and international regulations in the early stages of the project. Furthermore, through encoded compliance laws, AML and KYC regulations can be automated.
- Immutable Record of Ownership: There is a record in the ledger supporting every fact, and it is statistically difficult to change that. All the procedures are transparent and the database can be monitored by everyone, promoting security in the entire ecosystem.
- Liquidity: Since security tokens enable fractional ownership, illiquid and exotic asset-classes such as real-estate, artwork and eSports will benefit from an influx of investors.
- Reduction in Cost: Presently, transferring ownership involves lawyers and company secretaries to handle the paperwork of that transaction. Tokenization would automate part of the process, saving both money and time.
- 24/7 market: The market can function 24/7, which is an advantage over the traditional securities market.
The Bottom Line
From the invention of the first blockchain in 2008 to the age of tokenization we are experiencing today, the blockchain technology is evolving into a paradigm-shifting invention with revolutionary use-cases. While it is too early to conclude that blockchain is as important an innovation as the internet itself, it is surely the biggest opportunity set for our society over the next decade.