What Is a Token, Anyway?

At the height of the ICO boom in 2017 and early 2018, blockchain startups were awash with funding. VC firms and individual investors poured in their cash, in the hope of making big returns. However, during the second half of 2018, ICO funding had plummeted 90% from its previous highs. The crypto winter took hold. Many projects were ultimately unmasked as scams, and even many legitimate companies went under, once they blasted through the funds they had raised at ICO.

The regulators have now started to intervene. However, the landscape looks very different depending on the jurisdiction and crucially, the type of token on offer.

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US SEC — Your Token Is a Security

Over in the US, the Securities and Exchange Commission (SEC) has made it clear that all token sales are likely to be treated as an offering of securities. This position means that token sales must comply with regulations for securities offerings, or risk falling foul of the SEC, which can result in hefty fines and jail time. Investing in a blockchain startup which is compliant with US securities laws provides token holders with additional security compared to the wild west of the ICO boom.

Otherwise, there has been little progress in US legislation of digital tokens despite attempts by some of Congress to do so. Republican Ohio Representative Warren Davidson previously co-tabled a bill to update the SEC regulations to exclude digital tokens as an asset class. He spoke of the importance of ensuring the US can “compete with Singapore, Switzerland, and others who are aggressively growing their blockchain economies.” However, the bill was unsuccessful.

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Swiss FINMA — We’ll Decide If Your Token is a Security (But It Probably Is)

Switzerland has been more proactive, although it hasn’t gone as far as regulating the issuance of tokens per se. In February 2018, FINMA issued ICO guidelines which lay down the principles for categorizing tokens. The guidelines focus on the function and transferability of the token, to determine whether or not it falls under existing Swiss regulations for anti-money laundering or securities.

There are three categories. The first is payment tokens, which covers cryptocurrencies. Bitcoin, Litecoin, and Ether would all fall under this category. They aren’t treated as securities.

The second is utility tokens, which can avoid being treated as securities if their only purpose is to confer access to an application or service. Crucially, the token must fulfill this criterion at the point of issue. Therefore, many of the ICO’s which took place during the ICO boom fail to meet this requirement, because founders were seeking investment for their projects before any product or service existed.

The third category is asset tokens, which are treated as securities by FINMA. The guidance is explicit that an offer to acquire tokens in the future will be treated as securities, even pure utility is the ultimate intended purpose.

The FINMA guidelines recognize the need to assess each project on a case-by-case basis. However, the strict classification of utility tokens means that many companies are now looking to the security token offering (STO) as a means of remaining compliant with FINMA.

Interestingly though, in the case of insolvency, Swiss federal law only covers monetary debts owed in Swiss francs. It’s not really clear what claim token holders would have if they had made their initial investment in, e.g. Ether.

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EU — We Haven’t Yet Decided What Your Token Is

The EU has yet to formalize any token legislation. However, the Securities and Markets Stakeholder Group (SMSG) has issued a report to the EU securities authority which is similar to the Swiss FINMA guidelines. It recognizes the same token classifications and advises that tokens should be assessed case-by-case against existing EU securities laws to see if they qualify as securities. In the meantime, if a blockchain startup falls flat, token holders have little recourse.

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The STO — A Means of Ensuring Compliance

In light of the move towards treating tokens as securities, many blockchain startups are now looking to the STO to ensure they don’t fall foul of regulators. In performing an STO, founders need to ensure that they perform the necessary know-your-customer (KYC) and anti-money laundering (AML) checks. Depending on the jurisdiction, the company may also need to ensure that their investors meet regulatory requirements, and/or that they’ve filed the relevant prospectuses with the authorities.

Ultimately, the move to a more regulated token landscape is positive. It gives blockchain startups the opportunity to demonstrate credibility and assure token investors of a long-term, sustainable approach to doing business. It may also help to pave the way for future developments such as an insurance scheme for token offerings. If this happens, it will give token holders confidence that their funds are safe regardless of what happens to the company.

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Photo credits:

Photo 1 by master1305 on Freepik
Photo 2 by Nadine Marfurt on Unsplash
‍Photo 3 by Racool_studio on Freepik