At the end of July, the Token Alliance released its first white paper with the objective to establish appropriate business and legal parameters for digital token issuances. And if you’ve read iComply CEO Matthew Unger’s piece on New Token Standards or Open APIs and SDKs? you’ll sense the skepticism towards the establishment of so-called new standards. But all that aside – tokenization of financial instruments has continued to gain traction, with over $20 billion already raised through tokenized offerings such as initial coin offerings (ICOs), security token offerings (STOs), and initial exchange offerings (IEOs).
The financial sector is one that has been historically slow to evolve, and this is often considered to be because of a large number of regulations in the industry, creating the narrative that regulation is anti-innovation. However, quite the contrary, those that choose to move forward quickly and disregard regulation – will ultimately fall behind as new, compliant innovation reaches the market, opening the doors to institutional capital. Security tokens are one innovation that must be built to the standard of securities instruments in the traditional market.
Utility Tokens and Security Tokens
The two most well-known types of tokens are utility and security. Utility tokens tend to be issued in two scenarios:
Scenario One: They are issued with their value based on the fact that they can be used within a particular ecosystem; they were purchased in exchange for a service and are essentially “digital coupons.” For example, if the issuer of the utility token (Company X) provides cloud storage as a service, you can use your utility tokens to access that storage.
Scenario Two: In the second scenario, utility tokens hold what we would consider perceived value. This is because they are being issued for projects that have not yet been developed and represent future access to a company’s services or products.
The defining feature of utility tokens and which differentiates them from security tokens is that they are not meant to be used as investments. Unfortunately, simply stating that a token is not meant to be used as an investment will not be enough. Most projects that claim to have “utility tokens” still hit the key points of the Howey test, deeming them in fact, securities, and subject to securities laws. Additionally, many projects will simply allude to the fact that you are buying low and things like a restricted token supply will make it go….well…to the moon – a great way to get the conversation started with the SEC.
Security Tokens
Security tokens have real-world assets backing them up. For example, the tokens could represent equity in a company or real-estate which gives them tangible value, with an assignable fiat currency value. They can be liquidized, pay dividends, share profits, pay interest or be invested which makes investing in these tokens attractive. These tokens must adhere to securities laws. Currently, there are major use cases emerging for three different categories of securities: debt, equity, and derivatives.
These subcategories hold different types of value. The securities umbrella also further extends outward to asset classes such as bearer bonds, royalties, convertible notes, options, smart swap contracts and smart futures contracts and so on. Simply put, you can equate the subcategories of assets under securities in the token market to those in the traditional financial market.
Debt tokens are issued out by lenders and represent debt owned by a company. They can be thought of as loans or IOUs often with an interest rate multiplied or compounded against the principal amount loaned (invested) to a company. They are a type of capital raised through debt that enables the buying and selling of loans within a high-liquidity environment. Depending on the wording of the legal agreements, as well as the structure and functions available in the token, debt tokens may incur unique tax and reporting requirements for anyone issuing, or in some jurisdictions even transacting with, the token.
Equity tokens are the most common form of security tokens and in many cases, investors believe that the terms equity and security token are synonymous. On the contrary – they do not mean the same thing and the terms should not be used interchangeably. Part of what makes equity tokens so attractive to investors outside the crypto space is their similarity to equity shares in a company. These tokens earn issuers the capital they need to develop a network, and in exchange, investors purchasing equity tokens could earn returns such as dividends and in some cases, the right to vote on company proposals. Equity tokens have opened up Pandora’s Box and a plethora of questions on governance issues – do equity token holders have voting rights? What are the mechanics for shareholder majorities and board elections? While these questions remain unanswered, many believe that equity tokens will become the predominant ICO token.
Derivatives form the foundation of financial stability in traditional financial markets. They are used to transfer risk from one person to another and can be thought of as insurance contracts on the variation value expressed on an underlying asset. Prediction Markets are in their infancy and have begun placing option bets on the future of specific stock based on derivative products. Financial derivatives are not as common in the crypto space today but many projects are emerging and with security tokens becoming popularized many believe this is set to change sooner than later.
Regulation
Regulation around the issuance of security tokens varies based on a number of dimensions (for example, asset type, jurisdiction, etc.) and each dimension contains various regulatory permutations with a host of regulatory agencies governing them. Despite protest from those who are against any form of regulation, even AML and KYC, it is unlikely that any existing loopholes will be sustainable scapegoats in the long run. While institutional and more traditional investors begin to warm up to the possibilities of security tokens, we are working to develop the critical infrastructure needed to allow such innovation to be used with confidence.
