Raising capital with ICOs (Initial Coin Offerings) has become very popular: in 2017 alone, ICOs has raised a combined $3.7 billion. Projects using this model typically raise capital by issuing digital tokens on a blockchain and distributing them to investors for a financial contribution. Such crypto tokens represent a virtual store of value, which can be transferred via peer-to-peer networks and may serve different functions. Depending on their role, crypto tokens may be broadly subdivided into two major types: utility tokens and security tokens.
Utility tokens are used for granting access to a company’s products or services or entitle their holders to be a part of an ecosystem where this token acts as a native currency. Utility tokens are not designed for investments and this leads to a lack of security regulations.
Security tokens derive their value from an external, tradable asset and share specific characteristics with regular financial instruments which are subject to security regulations. The commonly known characteristics are the representation of ownership and entitlement to the residual cash flows generated by the digital enterprise. When the token is classified as a security, it may represent shares of company stock.
A recent study conducted by Satis Group LLC, a premier ICO advisory company, states that over 80 percent of all ICOs are fraudulent. As mentioned, utility tokens are not subject to the same regulatory requirements as security tokens, which opens up a broad field of opportunities for fraudsters of all kinds. The absence of security can be shown as a sort of “freedom” during the ICO’s marketing, but in fact, the token may easily turn out to be a scam. In most cases of fraud, tokens of such projects turn to dust. Investors are not protected from such situations at all. When a token is a utility token: all guarantees and agreements are in words, and if it turns out that a project has no intention of fulfilling development duties with the funds, there’s no law or regulation to help the defrauded investors.
A security token, on the other hand, being subject to security regulations should satisfy legal requirements, thus there’s much less of a chance a project with a token classified as a security would turn out to be a scam. It’s also important to understand that a company cannot easily claim its tokens a security token. Security regulations are firm, and if one fails to abide by regulations, it can result in costly penalties and even threaten to derail the project.
That’s why the emergence of a regulatory framework for the crypto industry is a necessary step. Regulatory interference creates a harmonized legal landscape providing the blockchain community a higher sustainability and reduced entropy in this otherwise highly unstable system. Many opinion leaders in the crypto industry are becoming more inclined in viewing regulations that are essential in the maturation of the crypto market.
“Mature laws and regulatory frameworks will fundamentally change the crypto landscape and will lead to the emergence of regulated and technology driven institutions that will harvest the immense potential of the distributed ledger technologies while adapting to rapidly evolving legal requirements. Control is ultimately exercised by infrastructure through technologies of finance and commerce which is backed by the rule of law. Today architectures of control are managed by private companies as much as by government.” – comments Rayan Goutay, General Counsel at Gatex, an upcoming FINMA-regulated hybrid exchange.
If you’re curious about further of the importance of security tokens, here are two significant advantages when compared to their utility counterparts:
- security tokens are business-model agnostic;
- registering a security token lowers the compliance risk.
Let’s take a closer look
Security tokens fit almost any project specialization. One may need utility tokens only if there’s a legitimate reason justifying the use of the token as a native currency to fuel the project’s ecosystem Registering the token as a security would require a lot of time and effort but in the long run, this will save the business from any anomalies. Failure to understand and to comply with this could result in dire consequence which will paralyze the success of the project.
Compliance risks decrease significantly when the token is registered as a security. Arguments in favor of utility tokens can fail just because laws and regulations are underdeveloped to provide firm unequivocal guidelines. US security laws can have harmful consequences for any project.
You may ask, why not use stocks instead of tokens and stick to the traditional model of private offerings and IPOs?
Firstly, issuing tokens are cheaper. Distributed technologies provide a firm foundation to trust the business models of various financial intermediaries. There are many participants in the common off-chain fundraising mechanisms and they all demand compensation. Lawyers, investment bankers, and other specialists usually cost a lot.
Another advantage of security tokens over their traditional counterparts is the global addressable market: having internet, a verified KYC profile and funds to invest are the only preconditions for being able to invest. This global exposure to public investors changes the way of thinking about valuation and liquidity.
Ideals of freedom and independence have been, and still are, the primary driving force of the crypto community. But the reality has shown that such an approach can also lead to a growth of manipulative trading tactics and requires too much trust. Scam projects and tokens that disappear together with its founders and investors reveal the necessity of regulations in the field.
Registration and licensing under the law are one of the most useful tools for regulators and an absolute must for any business involved in the trading of any type of digital asset. Crypto and blockchain are becoming more and more popular and an inflow of institutional capital is expected, which are intolerant of any monkey business practices. Thus we can say that regulators will be interested in a higher degree of transparency including security tokens.