In 2017, Initial Coin Offerings (ICOs) brought in $6.2 billion across 875 ICOs, a number that was already surpassed in the first quarter of 2018. As we go into the new year, the ICO party seems to be over but tokens will continue to evolve with a better understanding of the varying token types and new distribution methods such as Airdrops gaining traction.
To understand the current path of tokens evolving, we need to look at the ICO boom and bust of the previous years.
The ICO Boom: raising millions in seconds
The Ethereum coin and eponymous blockchain platform sparked a development boom in 2016 as it became easier to create decentralised applications (dApps) and native tokens. Ethereum democratised the market for blockchain projects and laid the foundation for a promising new component of the crypto ecosystem: the Initial Coin Offering, a fund-raising mechanism where tokens are sold to the public in a bid to improve a project’s liquidity.
ICOs really took off in 2017 when it seemed every new blockchain project was launching its own token and raising funds armed with little more than a whitepaper. The projects covered a wide range of categories with Infrastructure, Finance and Communications in the top 3.
As the value of Bitcoin kept growing exponentially, mainstream interest in crypto surged and new money came pouring in. The ICO machine was going full steam ahead. New ICOs headlined crypto media every week, praised for securing millions of dollars in mere seconds – open-source web browser Brave raised $35 million in 30 seconds.
The biggest ICOs to date include EOS ($4.1 billion), Telegram ($1.7 billion), Dragon Coin ($320 million), Huobi ($300 million), Hdac ($258 million) and Filecoin ($257 million).
Regulators raise concerns over investor protection
But just as there seemed no end to the ICO delirium, increased regulatory scrutiny began to slow down the machine. Cracks in the foundation began to appear when the SEC published The DAO Investigation Report in July 2017. It concluded that the company behind the DAO tokens should have been registered as a securities issuer.
The regulator dealt another blow in December 2017 with a cease-and-desist order issued to Munchee, a project that was planning to raise $15 million with its ICO. In the order, the SEC said it had conducted an analysis of the Munchee tokens and concluded that the token offering was in fact a securities offering unregistered with the SEC and therefore in violation of US securities laws. The agency placed emphasis on the fact that Munchee's marketing materials created the expectation of profit among investors, derived from the managerial and entrepreneurial efforts of others.
The primary focus for financial regulators is investor protection and making sure that companies are not offering investment opportunities while circumventing existing financial market regulations. While regulatory approaches vary per jurisdiction, they are all relevant for an ICO: the project must meet the regulatory requirements of every participant’s jurisdiction, in addition to the jurisdiction of the company.
Regulatory guidelines on ICOs
The SEC has provided their views on regulating ICOs stating: “If the ICO involves an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others, it constitutes an investment contract and thus a security.”
William Hinman, SEC Director of the Division of Corporation Finance, further clarified that when the token’s network becomes sufficiently decentralised, to the point where the efforts of the third party are no longer a key factor for determining token value, the SEC would cease to regulate the token as a security. Bitcoin and Ethereum have reached that tipping point, whereas other tokens – particularly those associated with unreleased platforms – have not.
Other countries such as China have taken a blanket ban approach to all ICO related activities while other regulators have merely offered vague guidelines such as Hong Kong’s SFC saying: “Some tokens may be considered securities and will be regulated as such.”
This is not sufficient guidance for a well-informed business decision. Perhaps the ambiguous language is more telling in terms of it being an indication of the need for a regulatory framework that is able to accommodate crypto tokens and ICOs.
The 3 types of tokens
The increasing regulatory scrutiny did not suddenly end the ICO frenzy, but the uncertainties did severely hamper the industry with alternatives to token distribution methods such as Airdrops becoming preferred. In response to tokens being considered securities when they were not intended as such, the crypto community identified three different token types based on varying functionalities:
While these should be considered as business distinctions rather than universally accepted legal distinctions, they are in line with the recent guidelines published by Switzerland’s FINMA. The Swiss regulator has agreed to classify tokens along the same lines, where payment tokens are not securities but fall under the Anti-Money Laundering Act, utility tokens are not securities as long as the platform is functional at the time of offering, and asset tokens are considered securities.
Defining the 3 token types
Includes: Bitcoin, BitUSD, Monero, Cardano, Litecoin
This token type is the classic cryptocurrency, sometimes referred to as digital coins or payment tokens. Speaking broadly, the main purpose for cryptocurrencies is to facilitate easy and fast peer-to-peer transactions and to function as items of inherent value – similar to cash.
The largest and most valuable cryptocurrency is still Bitcoin which has hovered around $5,500 in the second half of 2018. While Bitcoin still dominates the crypto industry with more than 51% market share and a market cap of around $110 billion, a large number of other currency tokens have also performed well.
Known as altcoins, these tokens have changed certain aspects of their blockchain protocol in order to introduce features that the Bitcoin blockchain did not have. Examples include Litecoin (LTC) which was designed to process transactions quicker at a lower cost, and Monero (XMR) which is purpose-built for preserving the privacy around transaction amounts and wallet addresses.
Stable coins are another type of currency token which have recently gained market share. A stable coin is a type of cryptocurrency that is pegged to another asset like the US Dollar, Euro or Japanese Yen. They are designed to provide the same reliability and functions as established fiat currencies but with the added benefits of digital currencies. The peg between the stable coin and the asset is maintained either by fiat collateral (Tether USD), crypto collateral (BitUSD), or non-collaterised smart contracts (NuBits).
Includes: Ethereum, Filecoin, BAT, Augur, VeChain
What distinguishes utility tokens from security tokens, is that they provide users with access to a platform and its products or services. As opposed to currency tokens which seek widespread adoption to gain retail acceptance, utility tokens are only good for spending at the issuer’s “shop”.
For example, Filecoin plans to provide a decentralised cloud storage service, taking advantage of unused computer hard drive space. Available storage space is purchased using the native Filecoin utility token. Another example is the Basic Attention token (BAT), designed to be used as a payment medium within the Brave browser for users, publishers and advertisers to interact: offering and accessing content.
While it’s a fine line, businesses argue that as long as utility tokens can actually be used to gain access to an application, and their ability to do so is not affected by price fluctuations in the market, they are indeed utility tokens. Buying tokens with the expectation to make a profit in the future, primarily from the efforts of others, is reserved for security tokens.
Includes: tZero, Kairos, Vaultbank
Security tokens, or asset tokens, are backed by tangible assets like a company’s profits or shares. They provide buyers with part ownership of a project in proportion to how many tokens are acquired and are created with the primary purpose of attracting investors. Besides acting as digital shares, security tokens can also be used to tokenise physical assets such as gold or plots of land.
As such, companies offering security tokens through a Security Token Offering (STO) require licensing from regulators and would have to clarify their goals in their whitepaper and outline milestones, explaining how they intend to drive token value.
STOs are considered to be the ticket for crypto businesses to reach a new level of legitimacy and acceptance in the financial community as it combines the features and protections of traditional assets together with the benefits of digital assets.
It’s still early days for security tokens with only a few notable names including SPiCE VC for the venture capital market, tZero offering a securities trading platform, Kairos specialising in AI-enabled face recognition, and Vaultbank offering asset-backed security tokens linked to its business lines.
Tokens will continue to evolve
Although somewhat useful, as in any field where innovation moves faster than the language to contain it, simple categories often fail to capture actual complexity. When it comes to token types, these categories are not mutually exclusive.
There could be hybrid tokens that both function as an asset and utility token. In fact, as the Munchee case showed, even if a business states its token to be a utility token it doesn’t mean regulators will see it the same way. Even FINMA states that a utility token is considered a security token, if it is offered at a time when the platform on which it is supposed to operate is not functional yet.
As crypto continues to ascend and diversify in 2019, the questions facing both businesses and regulators are manifold. Does a platform need to have paying customers or simply have a Beta version to be considered functional? Are reward tokens gained from platform activities, redeemable for services at a later stage, still utility tokens? Does it matter if utility tokens increase in value simply because the associated platform is growing its user base with a finite amount of available utility tokens?
The uncertainties will remain for the time being as regulators update their views in response to tokens and crypto-economics. But token innovation will not wait. Businesses will continue to set the pace and evolve tokenisation and distribution methods with the aim to drive user adoption of their products and services.