The Case for Utility Tokens
Blog Article Series
Security Tokens may be the Future, but not all of It

There is no doubt that security tokens have taken the stage recently, especially in the US where the SEC has indirectly forced anyone with ICO plans to consider an STO (security token offering) instead. By informally stating that "it hasn't seen a utility token that wasn't a security" the SEC has effectively forced any US-based blockchain company to consider a more expensive but also potentially more compliant and future-proof design of its token as a security.

This is a pity for two reasons. One, an STO is significantly more expensive than an ICO and the only major beneficiaries are the legal advisors. Two, all the innovation that has been created around utility tokens will potentially be overlooked (at least to some degree) by US-based blockchain companies, since they will consider security elements in their token design rather than utility elements.

Due to this, the US stands to lose out in the global blockchain revolution since US-based companies will be hindered in their approach compared to European and Asian companies.

To compare: in the US, the SEC has taken a strict approach indicating that most utility tokens will be classified as securities, although no precise regulation has yet been introduced nor suggested. In Europe and Asia, the picture is much more fragmented. A few countries have proposed or introduced regulation with a much more flexible view towards utility tokens, indicating that tokens with no security properties will normally not fall under securities regulation. So, if you design a token to have only utility within the platform and leave out any dividend mechanisms, revenue-sharing, profit-sharing, and voting rights then in many European and Asian countries, you can relatively easily get an indication from the local FCA that the token does not fall under securities regulations.

An EU directive will be introduced in the beginning of 2019 that may change this picture but most industry insiders expect that this directive will not restrict the design of utility tokens but rather clarify various related points. Many also expect that the US will eventually introduce less restrictive legislation to enable "pure" utility tokens to be designed and issued under less restrictive regulation than securities.

There are essentially three ways forward for a company considering a token issuance to US investors and the optimal approach very much depends on the business model:

(1) A company that has designed a utility token model with a token network effect should stick to their utility token design – but issue it as a security under reg D, S or A. There is no reason for this company to add any security properties to the token such as revenue- or profit-sharing.

(2) A company that wants to tokenize their equity in order to raise funding or wants to raise funding in order to acquire and manage a portfolio of securities or assets should design a token with security properties: revenue-sharing, voting rights, etc. The token can be share-like, bond-like or a hybrid. The recommendation is to design the token such that it falls into one of the traditional categories in order to avoid confusing investors but there is a lot of design space to create innovative new types of securities to minimize investor risk and maximize investor interest. A second recommendation would be to give investors reasonable rights (for voting, liquidation, etc.) as opposed to many STOs we have seen so far.

(3) A hybrid approach. A hybrid token is not recommended as it would target both investors and platform users and hence be confusing. But a dual token structure may in many cases be relevant for business cases where a token network effect is desired and it makes sense to involve traditional investors of some kind. A security token can be designed to attract investors and a utility token can be designed for the users of the platform. The utility token can be given to the investors if it makes sense. It can also be issued on the platform to reward initial users (outside the STO/ICO).

There is a great deal of creative innovation currently happening in the utility token space. More and more ICOs are coming out with well-designed tokenomics models where innovative elements are used, such as token velocity, staking of tokens to encourage trust, token rewards to encourage initial users, token buy-backs based on profits to maintain sufficient future tokens for rewards, discounted services when paid with token rather than other currencies, etc., etc.

We have seen interesting blockchain applications where an innovative utility token model would make perfect sense and could in fact be a crucial element in making the business realistic and scalable. But in some of these cases, due to the pressure from SEC, the team has made a switch to a security token model and abandoned their utility token design. Rather, they should have retained their utility token design and just issued the utility token as a security under reg D, etc.

Written by Claus Skaaning
Published 24.08.2018
View the article on Medium here.