As continued guidance comes from the SEC, we are facing the realization that most utility tokens could be categorized as securities in the U.S. With the formation of an official cryptocurrency task force and eighty subpoenas sent out to funds and issuers, the crypto community is now on full notice.
So what does this mean for future issuances? How do we approach this new and tokenized world in light of the regulatory headwind?
Traditionally, we have sorted tokens into two main categories: 1) A utility token, such as an ERC-20 token, provides a user with access to a network, similar to airmiles or tokens at an arcade.
2) A security token refers to tokenized securities, which are issued and traded on the blockchain.
The latter may no longer be the appropriate term to use, as security tokens may become the blanket term for both utility and security tokens.
To make the distinction between a security in the legal sense and a security token, let’s use the term investment token.
What is an Investment Token?
An Investment Token is one that behaves like a security and is backed by something tangible, such as an asset, equity, or revenue of a company.
A security is a financial asset or instrument that holds some type of monetary value. Examples include stocks, bonds, options, derivatives.
Investment tokens are meant to serve as an improvement on traditional financial products, removing middle men from transactions. This, according to Anthony Pompliano, Managing Partner at Full Tilt Capital, leads to “lower fees, faster deal execution, free market market exposure, larger potential investor base, automated service functions, and lack of financial institution manipulation.” (For a more in depth discussion of these benefits, please refer to Pompliano’s article here.)
These tokens can be further categorized:
- Share-like tokens have features such as ownership in an entity, LP shares, voting rights, dividends, profit shares, or some interest in the success of a future entity.
- Asset-backed tokens constitute an economic right to a real-world asset, such as art, real estate, power plants, etc.
Some experts predict that investment tokens will become so prevalent, that they will take over all traditional securities currently being issued and traded.
What will happen to utility tokens?
In a world where all tokens may become security tokens, how do we re-categorize the utility tokens with which we are familiar?
Utility tokens may become intertwined with security tokens, or become ‘sequility tokens.’
In the case where a company wants to issue a utility token to give access to a network, it may be able to do so in the following two ways:
#1 — The Two-Tier Model
In this model, the issuer can first issue an investment token that gives the holder a financial right to the company and a proportional airdrop of an additional utility token to use on the platform.
#2 — The Pure Utility Model
Alternatively, the issuer can issue a utility token which has the intended functionality, and register the token as a security or issue under any of the Reg A+, Reg D, and Reg S exemptions.
As we continue to build a new and tokenized world, we expect additional guidance from the SEC in 2018. Until then, we urge all issuers of both utility and security tokens to take your time with the process and obtain proper legal counsel on all related matters.
This is Part 1 of a Security Token Primer series.
Disclaimer: This article does not constitute legal guidance or legal opinion of the author or any entity associated with the author. This article is published to serve as a summary guide of the information currently available to the public. Anyone seeking to issue a token should retain legal advice for the most up to date legal developments.