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CRYPTOMARKET

The Rise of the Security Token

As many believe, security tokens are the next big thing in the cryptocurrency and blockchain spheres. The reasons for investment in an ICO may be that the ICO’s token or coin has an innate advantage – it gives the owner of this asset access to a service, a say in how the ICO develops or even a share of the project’s earnings; if the project is a viable one, its innate benefits will increase over time, which in turn will push the price of the token up, which means the buyer will make a profit.

The first ICO debuted in 2014 seven projects were able to raise a total of $30 million for their individual projects. 2015 saw another seven projects using token sales to raise money – garnering a total of $9 million in the process. It was in 2016 that ICOs started proliferating, with 43 new projects raising funds through digital crowdfunding. The total amount raised was $256 million. It was also during this year that the infamous DAO hack attack took place, which caused the project to fail and even led to a hard fork in the Ethereum blockchain. Then, in 2017, ICO activity exploded: 342 new tokens were issued through ICOs, raising more than $5.4 billion worth of funds. ICO sales were frenzied affairs. The fear of missing out kicked in and fundamentals were thrown out the window. By that time, ICOs had overtaken the more traditional venture capital as the number one method of raising funds for blockchain and cryptocurrency related projects.

2017 has also introduced the turning point for ICOs as securities, when the US Securities and Exchange Commission (SEC) announced that if any token sold to US investors had the attributes of a security, then the US Securities Laws would be imposed on that token sale. However, the challenge that ICOs are facing is whether their token offerings are classified as utility tokens or security tokens. The difference is that security tokens are backed by external assets that are tradeable. They give companies the ability to issue tokens that can represent shares of its stock. Such tokens fall under the purview federal securities laws. Utility tokens can be used to access a project’s services or products. They are not meant to be investments and they do not give the token holders any ownership of the company (the way security tokens do). Such tokens can be compared to gift cards that can be exchanged for services or products.

To figure out whether a token is a utility or a security, the Howey Test is applied. This helps clarify whether a sale can be qualified as an investment contract. If it is, then the token sale is a security and therefore must follow securities regulations. The four premises in the Howey Test are: the buyer is investing money or assets; the buyer expects to make a profit by investing in this project; the investment or project is in a common enterprise, and the profits depend only on the efforts of a third party. However, there are a few grey areas which is the reason for the lack of clarity on whether tokens would qualify as utilities or securities. The definition of ‘common enterprise’ is not clear. This term has not been properly defined, which has led to several litigations with regards to investments. Also, there is no clarity on how the SEC plans to use the Howey Test on cryptocurrencies.

At the end of the day, the Chairman of the SEC, Jay Clayton, seems quite clear in his mind that all tokens are securities. While ICOs may have designed their tokens to be used as utility tokens, the SEC looks at how they are being used: the “substance over form” rule. This means that if you bought tokens issued during an ICO in the anticipation that they would increase in value (and so generate a profit), then that asset would qualify as a security token – even if the ICO wants it to be a utility token.

Hence, the security token is indeed the future. The cryptocurrency world suffers from lack of regulation leading to a certain amount of lawlessness. Governments across the world will not allow this sort of a free for all to continue. The SEC has already begun its crackdown on ICOs and their related coin offerings in the US. And other countries’ regulators are also taking steps to regulate this nascent industry. With lawmakers looking at regulating the industry, it is becoming more and more likely that security tokens will be the next big thing in the cryptocurrency world.

Since the regulator crackdowns on token offerings, many ICOs have been desperately trying to avoid having their tokens classified as securities. This is because of the belief that once a token has been deemed a security, regulations and, restrictions are imposed which can severely limit a project’s ability to create a widely adopted platform that is necessary for its success.

However, there are many advantages to an ICO being a security, and no longer should a token be structured to avoid regulation (or avoiding the US altogether in many cases). These advantages will help overcome the issue of scalability in the long run. Issuing security tokens that are compliant with Federal laws is cheaper and more efficient than issuing utility tokens in an ICO. There are multiple ways in which security tokens can be issued while being compliant with regulatory frameworks – under Regulation A+, Regulation D, Regulation S, and Regulation Crowdfunding. Legal risk is reduced, and both the issuer and the investor are protected under securities laws. This means that more institutional investors rather than get-rich-quick speculators would be interested in investing in an ICO. It is very positive for the project as it would have solid backing to succeed. Also, security tokens carry some enhancement to conventional financial products by getting rid of the middleman from the investment transactions (normally some banker). The elimination of intermediaries’ results to free market exposure, faster deal execution, lower fees, lack of financial institution manipulation, automated service functions and bigger potential investor base.

Furthermore, projects that have already registered their tokens as securities will not be troubled by the crackdown on entities that do not comply with the securities regulations. This means that their business will not suffer major interruptions because of SEC enforcement actions on unregistered securities offerings. If an ICO issues tokens as utilities but they are later deemed as securities, then that project could end up in trouble – even to the extent of being shut down. The issuance of unregistered securities is in violation of the Securities Act 1933. And over and above financial penalties, the issuer could even face up to five years of prison. The secondary trading market could also face criminal charges.

Even if the SEC does not have the bandwidth to deal with violators of the law, the people who invested in the ICO can initiate private litigation against the issuer and even against the secondary trading market that facilitated these unregulated transactions. It is not only the Federal Securities laws utility token issuers need to worry about. There are also the Blue Sky laws, which are the state-specific securities laws. And this plays a critical role in ICO transactions as issuers also need to be compliant with the laws of the states in which their buyers reside – if they are not registered as securities. However, ICOs that are issuing security tokens can seek SEC exemptions such as Rule 506(c), Rule 506(b) as well as Regulation Crowdfunding. Federal laws trump Blue Sky laws. Most buyers do not use their tokens as the utilities they were meant to be. The larger percentage holds their tokens waiting for their “investment” to grow. If an ICO registers its token as a security, then it can offer even greater benefits to its investors such as profit shares, dividends as well as voting rights. The beauty of security tokens is that the same asset can also double up as a utility and still do what it was designed for – to be used in native transactions within the entity’s services or products. Utility tokens do not have that versatility of being a “dual-token”.

The objective of regulators like the SEC is not to strangle nascent markets such as the ICO and cryptocurrency market. It is, however, the regulator’s duty to protect ordinary investors from being taken advantage of by scammers. The more legitimate ICOs are also struggling with the bad press the industry is getting because of a few rotten apples. Most of the pioneers in this ecosystem have welcomed regulations and structure in these new markets. The bottom line is that where there are rules and laws in place with regards to a code of conduct, not just for the issuers but also for the buyer, it leads to a more stable and fair platform on which people can trade, which in turn leads to growth and evolution. And while these are early days, security tokens proponents believe that they will have the advantage over utility tokens in the long run.

Currently, more and more projects are looking to release their tokens in compliance with the SEC guidelines and this trend is only going to grow. Emerging projects such as Polymath and Tokenise.io, and platforms such as Poloniex, Equibit, and tZERO plan to boost the importance of the security token industry. Many advocates think that the prospect of tokenized asset ownership can soon entice retail investors and businesses. Whereas traditional stock markets bear by opening hours, proponents think that there is a chance for financial markets to work with the same globally, around-the-clock reach, which makes the digital currency market appealing to the public. Additionally, security tokens allow every member in a big group of investors who may lack the resources and connections to invest in venture capital to take on a small portion of the pie with real, reasonable assets (fractionalizing, sensible investment opportunities). Then it is possible to trade those assets along with other investors, establishing liquidity. Meanwhile, entrepreneurs can access bigger pools of capital and maintain greater control of their corporations than they would along with traditional investment schemes. On top of that, the cryptocurrency could build unparalleled opportunity in industries like real estate development wherein 3000 investors may acquire a project, instead of having three private equity companies. In this way, security tokens offer democratized access to investment for investors and entrepreneurs alike.

In 2017 the major trend was ICOs raising funds for utility tokens to make speculative gains. But this defeated the entire purpose of the ICO – to foster innovation by offering entrepreneurs funds, scale, anonymity, and fungibility. Therefore, there is a high-likelihood that security tokens will take center-stage in 2018 and 2019. The coming years are about to introduce a massive rise in the figure of prominent security tokens. It is now time for the entire crypto industry to re-evaluate its stance on security tokens and look at it as the path forward in the evolution of crypto and blockchain ecosystems.

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ICO Crowd is the world’s first and foremost publication on Initial Coin Offerings (ICO).