Security, Currency or Utility, How Do You Classify Your Cryptocurrency?

Security, Currency or Utility, How Do You Classify Your Cryptocurrency?

Security, Currency or Utility, How Do You Classify Your Cryptocurrency?

The Blockchain Boom saw a tremendous rise in Initial Coin Offerings (ICO’s) from hundreds of start up businesses in 2017. With a total crypto market cap reaching an all-time high of over $700B in January this year, it’s no wonder that tokens are coming under the spotlight to determine their functionality and legal responsibility.

ICO’s are now raising more than any other crowdfunding method in history, but what exactly is it that you’re buying? We hear the words like cryptocurrencies, utility tokens, app tokens, or user tokens being thrown around, but what do they all mean? Are they the same?

With the hype surrounding ICO’s and the ever-increasing number of people buying into them, it’s important to know what it is the investor is buying and what exactly the company is selling.

These terms are often spoken about interchangeably, but in order for companies and investors to protect themselves, the classification and understanding of the token being sold and bought is important.

Despite the many terms going around, the majority of tokens in the market can be grouped into 3 main classifications. We will discuss these below.

Currencies

Cryptocurrencies put simply are “digital cash”. Designed to be used in the same way as traditional fiat, they are a store of value and a medium of exchange.

Bitcoin was the first cryptocurrency and application of blockchain technology. Bitcoin became the “hot word” in 2017 due to the unprecedented growth in which its value grew 1300% from the beginning to the end of the year. It was created to be used in the same way as any traditional fiat, with the added benefit of running entirely off a peer-to-peer network requiring no centralised authority to control it.

Since Bitcoin, many other digital currencies have entered the market including Litecoin, Dash, and Monero, which all serve to be used as a store of value and method of payment.

While decentralised and no longer controlled by a single central point, currencies are still in the early stages and the practicality of them being used to pay for your morning cup of coffee requires further development of the technology, and a wider acceptance across more retailers.

Utility Tokens

Utility tokens are by general consensus defined as a token that has a functional use in a network beyond a monetary value. These are the most common type of tokens being issued on the blockchain and if created well are exempt from having to abide by securities regulations.

Utility tokens can cover a wide range of uses and can be broken down into different types depending on their purpose. Some utility tokens provide a user with the ability to access or purchase a company’s product or service. Think of purchasing a voucher to spend at a local retailer, and trading that voucher in, in exchange for their goods or services. Other utility tokens are used to provide governance within a network, or to stake the token to contribute work to a network.

Utility tokens typically should not be considered an investment, as they should serve a purpose within the network to fulfil their functional component. However, if there is a finite supply of them and demand goes up then the value of the token may go up.

Security tokens

A security token comprises an investment contract, where there is an expectation of future profit to be made. Profit would most commonly be made through price appreciation, shares in the company, or dividends. If a company can adhere to all the regulations that fall under securities, often this can be easier and cheaper than issuing utility tokens under an ICO. What’s more, because there is regulation and a legal framework surrounding securities, there is more transparency around a security issuer’s obligations and responsibilities, while the holder of the security has clearer understanding of what it is they are investing in.

tZERO is one of the first blockchain companies to be issuing a fully compliant equity security token, and holders of the token will receive a dividend on the gross revenue of tZERO.

The Howey Test

Being able to show a use for your token within the network is not enough to discount it from being considered a security. To help with this clarification the Howey test is implemented. The Howey test was created by the Supreme Court to aid in establishing whether or not a transaction qualified as an investment contract. In order to pass the Howey test and not fall under the laws of a security, the following 4 criteria must be considered:

  1. There is an investment of money
    2. There is an expectation of profits
    3. The investment of money is in a common enterprise
    4. Any profit comes from the efforts of a promoter or third party

The more a token satisfies these 4 questions, the greater chance it has to come under scrutiny from a body such as the Security and Exchange Commission. Put simply, if there is any expectation of a profit from the purchase of a token, it’s more likely to be considered a security.

While there are some key criteria to determining if a particular token is considered a currency, utility token, or security, it is important to note that there is no concrete definition of each, and some tokens continue to have components of multiple “types”. It is likely the terms will still be used interchangeably while this technology evolves or until further clarification is given. Despite guidelines such the Howey test to help with classifying tokens, there are still no certainties that tokens deemed utility tokens or otherwise not a security token are 100% free from regulation or security consideration, as many of these regulations are still are still being formed.