By now, everyone has heard of ICOs. In 2017, they outperformed venture capital funding and became the number one method of funding blockchain organizations.
But despite their surging popularity, a significant number of people are still scrambling to understand what exactly ICO actually is — and, more importantly, how they can use them to their advantage.
The ICO Boom
An Initial Coin Offering (ICO) is a form of crowdfunding that allows startups to bypass traditional early seed investment. They allow firms to raise capital from multiple sources by selling users digital tokens or “coins,” instead of ownership shares.
Over the past few months, we’ve witnessed a huge boom in the number of ICOs being offered. While many have been genuinely good opportunities, a small number have proved to be extremely problematic.
The problem with ICOs isn’t just that many of them are scams — it’s also that many of the utility tokens offered are actually securities. As a result, they are violating the securities law in the U.S.
In July 2017, the Securities and Exchange Commission (SEC) released a report stating that certain tokens were eligible to be classed as securities, and would, therefore, be subject to regulation.
Following this crackdown, it is becoming increasingly likely that security tokens will soon become the next crypto megatrend.
What is the Difference Between a Securities Token and a Utility Token?
Not all ICOs are the same. There are two major token categories, known as security tokens and utility tokens.
A security token is one that has been backed by external, tradable assets. One of the main applications of security tokens is that they grant companies with the ability to issue tokens that represent shares of company stock.
These tokens are subject to federal securities regulations.
A utility token represents future access to a company’s product or service. It is not designed to be an investment. A utility token might be best compared to a gift card, for example.
The key difference between security and utility tokens is that security token holders are entitled to ownership rights, whereas utility tokens function as coupons and give holders no rights or stake in a company’s platform or assets.
How Do We Actually Distinguish Between Security and Utility Token Sales?
As most participants of ICOs view their participation in ICOs as an investment opportunity, it would make sense to assume that most tokens are securities. However, this is not always the case.
In order to determine whether or not a digital token is a security, we can apply the Howey Test. This is used to confirm whether or not a transaction qualifies as an ‘investment contract’.
If it meets the criteria, then it will be considered as a security and will be subject to additional disclosure and regulation requirements.
In order to be classified as an investment contract under the Howey Test, a token must meet the following requirements:
- The user is investing money (however, later cases have expanded this to include the investment of assets)
- The user expects to profit from the investment
- The investment is in a ‘common enterprise’ (this term has not been precisely defined. Many courts have used different interpretations)
- Any profit comes from the efforts of a third-party or promoter (if an investor’s actions have a large influence on whether or not the investment will be profitable, it is likely that the token will not be classed as a security)
Theoretically, should a token meet these requirements, it will be classed as a security token. Otherwise, it will fall under the definition of a utility token.
However, there is still a substantial amount of ambiguity as to how the SEC will apply this test to cryptocurrencies.
The Current Problem With ICOs
Despite many startups initially setting up their tokens as a utility, the SEC operates using the “substance over form” rule, meaning that they look at tokens according to how they are actually used, as opposed to the way they were intended to be used.
Almost all ICO tokens are expected to increase in value over time as a result of speculation and product development since the supply is fixed.
Therefore, because most people buy tokens with the view of holding them as an investment, many projects are actually viewed as securities.
“I believe every ICO I’ve seen is a security” — Jay Clayton, Securities and Exchange Commission chairman.
As a result, all of these projects violate securities laws. This is frowned upon by regulators.
To bypass this problem for the time being, many projects have simply decided to try and avoid catering to investors based in the U.S.
The Benefits of A Security Token Structure
Issuing security tokens that abide by regulatory frameworks is both cheaper and more efficient than conducting an ICO using utility tokens.
More significantly, it can also reduce legal risk and provide protection for both the company and the contributors — especially since the SEC has increased their enforcement initiatives.
Organizations who fail to comply with these initiatives will risk suffering significant interruptions as a result of unregistered securities offerings.
However, as it stands, many of the organizations holding ICOs have been doing everything they can to avoid having their tokens classed as securities.
This is because once a token has been classed as a security, many regulations and restrictions are introduced regarding who can invest in and exchange the tokens. This can severely limit the organization’s ability to build a widely adopted platform or protocol.
Only Accredited Investors Can Invest in Private Securities Offerings
To fulfill this requirement, investors should meet one of the following requirements:
- An annual income of over $200,000 individually, or $300,000 with a spouse, maintained over the previous two years and with the same expectation for the current year.
- Net assets worth upwards of $1 million, excluding the primary residence (unless more is owed on the mortgage than the residence is worth).
- An institution with over $5 million in assets — e.g. a venture fund or trust.
- An entity made up entirely of accredited investors.
Upcoming Security Token Projects
Overstock’s Security Tokens Exchange
Overstock has recently announced that one of its portfolio companies, tZERO, will be launching an ICO designed to fund the development of a licensed security token trading platform.
The tZERO tokens that are issued from this ICO will be in accordance with SEC regulations.
tZERO token holders will be entitled to quarterly dividends from the profits generated by the tZERO platform.
The launch of licensed security trading platforms like tZERO will drastically increase liquidity for security token investors.
Overstock Links Up With Kodak
KODAKCoin — the cryptocurrency designed to power the recently announced digital imagery platform, KODAKOne — will be the first third-party cryptocurrency to launch on tZERO’s securities token platform.
KODAKOne is a blockchain powered photography platform. The KODAKCoin cryptocurrency enables professional and amateur photographers to receive payment for licensing their work, receive a share of the overall platform revenue, and sell their work through the secure platform.
“The KODAKCoin offering is centered around providing photographers security and peace of mind, and the tZERO platform allows us to provide that same security to our token holders as well.” — Jan Denecke, Co-Founder of the KODAKOne platform and KODAKCoin.
Polymath is the First Ever Security Token Launch Pad
As it stands, there are only a few securities tokens in existence. It is likely that this is largely down to the difficulty of launching one.
Ethereum made it simple for startups to launch their own utility tokens. Now Polymath is aiming to make it simple to create securities tokens.
The platform can be used as a tool to allow financial companies to create and issue their own tokenized securities.
Polymath will be a fully functional marketplace where token issuers and token investors will be able to connect. Their securities token protocol embeds regulatory requirements into the tokens. These tokens will only be available to verified participants.
It will open up the blockchain to legally-compliant securities offerings and provide users with a decentralized protocol to simplify trading of security tokens.
“Currently, there are up to 10 new tokens launching every day and many of them will be deemed securities. The companies launching these tokens need access to investor capital and assistance in navigating the complex legal and technical functions of Initial Coin Offerings (ICOs), and their regulatory requirements. Polymath is guiding traditional financial companies like VC funds, Private Equity firms, and Real Investment Investment Trusts through a securities token generation process by automating key functions for them.” — Trevor Koverko, Polymath CEO
The Polymath ecosystem uses its native token, POLY, to govern its internal transactions.
The Polymath platform went live in the first week of February 2018.
2017 Was the Year of the ICO, 2018 Could Be the Year of Securities…
As we progress into 2018, it is likely that the SEC will continue to ramp up their enforcement and continue their crackdown on non-compliant ICOs.
It is likely that this will be the year that we witness tokenized securities really take off.