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Author: @El Crypto Chapo

US congress is painfully struggling through an attempt to determine how existing legislature applies to tokens. Should cryptocurrency tokens be considered a security and be subject to all existing SEC regulation as common stock is today?

In case you’ve been living under a rock, there is a great deal of disagreement with respect to how this new asset class should be regulated, and for good reason. One of the fundamental challenges with structuring pragmatic regulation for digital assets is the fact that these tokens can serve widely varying purposes.

Tokens are difficult to define as some can be redeemed for services, others represent ownership of physical assets, and still others may be used as company stock or strictly as a payment method/currency.

Regulation that may make sense for one type of digital asset may be highly impractical and unnecessary for another. If the primary goal is to have practical legislature that protects investors and does not stunt innovation growth, the first step must be defining what type of token is being regulated.

SECURITY TOKENS

A security can be defined as any tradeable asset. Traditional securities include stocks, bonds & options. Securities are currently defined by performing the Howey Test, which was created in 1946, allowing regulators to determine what will be subject to regulation by the SEC (Securities and Exchange Commission). According to the Howey Test, a transaction is defined as a security if:

  1. There is money (or other asset) invested
  2. There is an expectation of profit from the investment
  3. Money is invested in a common enterprise
  4. The efforts of a promoter or third party is the source of profit (investment is passive)

A crypto token that derives its value from an external source that can be defined as a security under the Howey Test is considered a security token. In summary, if the token is being sold as an investment (expectation to profit) and it relies on the project team (third party) to recognize profit, it could be argued that it meets the definition of a security. Boiled down, if the primary use case for a digital asset is a share in future profits from revenue, dividends or simple price appreciation — it is a security token.

Examples: Polymath, Ravencoin, tZERO, etc

UTILITY TOKENS

Utility tokens are akin to digital coupons that can be exchanged for goods or services. They are not designed as investments and there is (theoretically) no owner expectation of profit or increase in value.

For this reason, they are exempt from the federal laws which govern securities. An example of a functional token is Siacoin ($SC), a project which aims to decentralize cloud storage by taking advantage of all the world’s unused hard drive space. An owner of Siacoin tokens can redeem these for future cloud storage space once the network is live & the service is fully operable.

This type of digital asset does not represent a company’s share or equity ownership. With that said, utility tokens can see sizable appreciation in value based on the demand for the underlying product or service. With fixed or limited supply, the simple supply/demand curve will result in increased token value if usage matures and network traffic accelerates.

Given that these tokens are traded in an open market, there is also a substantial amount of speculative investment money wrapped up in “utility” tokens which currently are not redeemable for any tangible product or working service.

Examples: Bitcoin, Ethereum, VeChain, etc

WHY IT MATTERS

Security tokens are subject to regulation by the SEC, are limited to accredited investors and can only be found on certain exchanges.

Utility tokens, also known as app coins or user tokens, are exempt from the federal laws which govern securities.

If a digital asset is defined as a security token, it will need to be registered with the SEC and will be subject to the paperwork, due diligence and increased scrutiny that comes with all registered investment products. For this reason, startups typically make a strong attempt to represent their tokens as having a well-defined use case & avoid any appearance of engaging in any type of activity which looks or smells like a security offering.

In fact, many are referring to their ICO (Initial Coin Offering) instead as a TGE (Token Generation Event) solely due to the fact that the term “ICO” was derived from IPO (Initial Public Offering).

The bulk of ICO’s (TGE’s) exclude investors from the USA as they have not yet defined if their platform will be defined as a security or utility token. The risk of issuing an unregistered security is too great to take as the repercussions could completely derail a project. Ironically, today’s lack of regulatory clarity in America may be limiting innovation investment more than the ultimate legislature will.

The challenge of creating effective legislation in this new space could be dramatically simplified if it was easy to differentiate between these two types of tokens. Unfortunately, there is no objective means of making this determination today.

The Howie Test is the most applicable, widely accepted, objective set of rules which can help to determine what is and what is not a security. However, it was written in a way that was intentionally vague and broad.

In order for US Congress to make meaningful progress in defining rational laws for this new asset class, we first need a better way to differentiate between the types of tokens that exist. There needs to be a framework that clearly and objectively outlines what characteristics will classify a token as a security and what will fall into the scope of the respective laws in place.

The US needs a new Howey Test, one that is written specifically for this new class of digital assets. Creating structure and clarity in an arena that is chaotic and unique will be a tall task, but if congress wants to get it right, this is where it must start.

References:

1.http://consumer.findlaw.com/securities-law/what-is-the-howey-test.html


Also published on Medium.