A guide to preventing irresponsible token sales for DApps that don’t need a token.
2017 saw an explosion of token sales around the world, where “ICOs” fundraised over $1.7 billion from January to September alone. The crypto-crowdfunding model, in many ways, forced the hand of regulators like the SEC and even U.S. Congress to quickly formulate authoritative perspectives on the legality of utility token sales versus security token sales.
“Prospective purchasers are being sold on the potential for tokens to increase in value — with the ability to lock in those increases by reselling the tokens on a secondary market — or to otherwise profit from the tokens based on the efforts of others. These are key hallmarks of a security and a securities offering.” — SEC Chairman Jay Clayton
A still polarizing and ongoing conversation about taxing cryptocurrencies, either when trading or when they increase in price, led to the current position, in the United States, that capital gains must be paid on what is legally considered “property.” Of course, many of these conversations happen within the context of bitcoin (BTC), and are sometimes not inclusive of the other 1k+ alt-coins currently in existence. The legal ambiguity and current understanding that cryptocurrencies do not have the status of ‘legal tender’ creates a whole host of regulatory questions for entrepreneurs and investors alike hoping to responsibly proceed into the space.
Of course, such responsibility is understood, or, rather demonstrated, by a select few in the space.
The question for blockchain entrepreneurs, enthusiasts, and technologists alike, “How do token sales change the culture of fundraising for ‘blockchain’ companies?”
The sane answer is, THEY DON’T, or at least they shouldn’t. Many decentralized applications (DApps) do not remotely need their own token and there’s a growing issue of fraudulent token sales like that of AriseBank or Bitconnect that are scamming people for millions (if not billions) of dollars worldwide. In addition, grey areas that have created a flow of lawsuits like that of Tezos, further stressing the need to escape legal ambiguity around cryptocurrencies. Venture capitalists should know that you invest in a ‘blockchain’ company the same way you’d invest in a ‘normal’ company. When it comes to the topic of token sales, a regulatory focus on hosting utility token sales and policing security token sales should be considered.
But what is the difference between a utility token and a security token? How do I know if I need a new token at all for my application? Let’s get into it.
Utility vs. Security
The best way to invalidate a token’s potential utility, is to see if any of its attributes (or the attributes of how it’s being marketed) fit the definition of a security. The best assessment method to use to see if your token is a security is to utilize the Howey Test, which outlines the following security attributes:
- Offering an opportunity to contribute money and to share in the profits of an enterprise managed and partly owned by respondents
- The scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others
A security has been sold, in other words, when the value of one’s transaction hinges on another’s work (BitTrust). It is, therefore, relevant to the future of blockchain tokens (BitTrust). Referencing the “Security Law Framework for Blockchain Tokens,” we can abstract the following definitions for what a utility token and security token is:
- Security Tokens: Security tokens are representing shares of a business. Any token that can’t pass the Howey test should be considered as a security and fall under the 1934 Security Exchange Act.
- Utility Tokens: Utility tokens are services or units of services that can be purchased. They don’t represent a share of the business. They can be compared to API keys, used to access a service
Fungible vs. Non-Fungible Assets
One important aside is the differentiation of fungible and non-fungible assets, as there are fungible tokens and non-fungible tokens. Fungibility is a good or asset’s interchangeability with other individual goods or assets of the same type. For example, since one kilogram of pure gold is equivalent to any other kilogram of pure gold, whether in the form of coins, ingots, or in other states, gold is fungible. Non-fungible goods/assets, by contrast, cannot be interchanged. Persons, for instance, are not fungible. Non-fungible goods are often unique (persons, artwork, land, events,) limited in time or location or source or accessibility, and generally, but not always, are not essential to life.
The latter differentiation, paired with understanding the difference between a utility token and a security token, is extremely helpful when developing the token economics of your proposed system. These definitions put you in the mind frame of ensuring (1) that you need a token in the first place and (2) whether or not your token is interchangeable with others.
Undoubtedly Proving Utility
So, what are some example of utility tokens? Are they all the same or are there varying categories of different ways utility tokens might be used?
Here we’ll take a look of the different ‘types’ of utility token. If your token doesn’t fit one of these categories (without the need to force it to), then your team is on your way to proving your token’s utility.
Utility Fungible Tokens
Utility tokens that are interchangeable for one another are fungible utility tokens. On Ethereum, a fungible token follows the ERC20 standard, or “”Ethereum Request for Comments”. This is an official protocol for proposing improvements to the Ethereum network. ‘20’ is the unique proposal ID number.” In addition, there is a backwards-compatible additional improvement to ERC20 that new token developers should take into account, called ERC827 that usurps the capabilities and elegance proposed by ERC223, another attempted standard to build on ERC20.
Within this grouping of fungible ERC20 and ERC827 tokens, there are a few categories of utility that a token may fit into:
- System Incentive Token: A system incentive token is a token that is required to incentivize actors within that particular network to demonstrate a desired behavior. Normally, a DApp does not need a native token to provide its users an incentive to demonstrate a specific behavior, but, occasionally, it is necessary to utilize a native token as this incentive due to the need to directly correlate the value of that token and the work being done (separate from secondary market speculation of a utility token for a parent system — like ETH on Ethereum). **TCR Token and or Blockchain Token
- Voter Token: A token needed for governance rights within the given platform’s network. Governance tokens enable the token holder to vote on important parameters that make the network operate. Perfect examples of networks that utilize voter tokens are MakerDao and adChain.
- Membership and/or Stake Token: Membership tokens are tokens required to access the services of the concerned platform. Normally, these platforms utilize a staking mechanism that keep transacting parties accountable. Usually, a stake token is also a membership token, meaning that it both gives you access to the platform and zed platform requires the token holder to stake their transactions with the same token. An example of a platform that utilizes a membership stake token is Dether and SpankChain. An example of a platform that uses a membership (not stake) token is Gnosis.
Utility Non-Fungible Tokens
Utility tokens that are not interchangeable for one another are non-fungible utility tokens. On Ethereum, a non-fungible token follows the ERC721 standard, emphasizing the asset’s uniqueness. ERC721 is a proposed* standard that would allow smart contracts to operate as tradeable tokens similar to ERC20 (Nash).
Within this grouping of non-fungible ERC721 tokens, there are a few categories of utility that a token may fit into:
- Ownership: Digital assets — anything from artwork and music to a cool looking crypto-kitty, are considered non-fungible. They can be exchanged to new owners, but each transaction has a unique set of considerations that determine the sell price.
What a (new) Token is NOT Needed For
A new token isn’t needed if there’s no natural utility for it —don’t try to force yourself into an “ICO” for the potential of fundraising, because it may put you in a damning legal position (reference Tezos). The following are features that a native token are NOT needed for:
- Normal payment disbursement: A native token is not needed for payments that do not serve as a reward for network participation, but, rather, act as an automated and immutable record of how much is being paid between agents. If the use of the token within the proposed system is easily interchangeable with existing tokens, then it is not needed.
- Membership without stake: A native token is not needed for a system that simply wants to leverage it as a method of membership to the platform (essentially creating their own micro-economy common services easily payable via another cryptocurrency). The use of the token must have direct utility to the platform’s ability to function — and not simply interchangeable with any other token.
Define Utility before Using a Token
In conclusion, it’s important to carefully define the needs of your system, and where a utility token might be useful, before diving into the legal abyss of a token sale. Don’t full yourself into false need — be honest just as you would when validating the need for your idea. Only then, will your team gain credibility in the broader cryptocurrency and blockchain space. As an easter egg, there’s an excellent token classification framework here that takes an even more systematic approach to how to categorize a tokens.