A classification structure for all things crypto and a tool to help you ask questions like a regulator
There is a cryptocurrency token for almost every niche market imaginable. Coinmarketcap has listings for 1226 different ones. Presumably, all 1226 of these tokens answer a different business need, have different features, and confer different rights to the holder. It is difficult to make sense of this much variety and to determine what factors a regulator might look to when examining one token or another. Fortunately, there are tools to help with this. Two of these tools are discussed in this article.
First, MME Legal in Switzerland has developed a classification structure for tokens. MME is the firm the founders of Ethereum sought out when they were launching what was the original Initial Coin Offering (“ICO”). They use the term Blockchain Property (BCP) to cover all of the different types of token and coins. I have included their chart summarizing the classification system below.
Adapted from “Conceptual Framework for Legal & Risk Assessment of Blockchain Crypto Property (BCP)”, by Dr. Luka Müller, Stephan D. Meyer, Christine Gschwend, Peter Henschel, MME Publication, 26 September 2017.
In their classification, they divide all coins and tokens into three classes. The division is based on the rights a token holder has and upon which party those rights can be exercised. For example, the tokens in BCP Class One can be traded by the holder for services on a specific platform. They do not convey a right against the generator of the token or a third party, and they do not represent an underlying asset.
The vast majority of tokens being offered in ICOs or Token Generating Events (“TGEs”) fall into a single category in this classification structure: Class one, Application tokens. These are most commonly referred to as utility tokens. The distinguishing feature of this type of token is that it can be used as payment for a specific application. For example, the Golem Network Token (“GNT”) can be used to purchase computing power on the golem ecosystem.
The second tool used to distinguish between a security token and a utility token is called the Securities Law Framework for Blockchain Tokens. It is produced by Coin Center, Union Square Ventures, and Consensys. It is a Google Spreadsheet where you answer questions about a token. Each question has a corresponding score. You rack up a score of over a hundred, and it is likely that the token will be considered a security.
So what are some of the important questions asked in the Securities Law Framework tool. The timing of the sale is a big one. The tool asks if there is a functioning application that accepts only these tokens as payment or if it is still in development. The tool also asks if the token holders have any rights akin to security holders or if they participate in value generation work associated with the token. The tool is directed at the US market, so it is tailored to the Howey test, but the questions it asks and the results it produces have relevance in other jurisdictions, especially Canada, where the dominant legal test for a security, Pacific Coin, is largely derived from the Howey test..
There are a few timing strategies for token sales and platform deployments which are aimed at keeping tokens from running afoul of securities regulations. One is to release a platform with at least minimal functionality at the time of the token sale. The argument here is that the tokens would be exchangeable for services on the platform instead of simply being something that is held with the expectation of profit from the work of others. Without a fully functional platform, it is doubtful that such a strategy will satisfy a regulator. Another approach along similar lines was developed by Protocol Labs, Cooley, AngelList, and CoinList. It is called the Simple Agreement for Future Tokens (SAFT) project. The recommendation from the SAFT project is that you can have a sale before a platform has been developed but instead of selling tokens like you would for an ICO you sell investment contracts. These contracts will be converted into tokens once the platform is completed. The investment contracts would certainly be considered securities and must comply with regulations, but the argument is that the tokens that these SAFTs eventually convert into should not be considered securities. The rationale is that the presence of the functional platform where the tokens can be used should be enough to avoid the security classification.
Neither of these strategies has received the blessing of any securities regulator anywhere. The SAFT project is an interesting solution, but it may have limited investor appeal since if you are not granted a token in the pre-sale, it will not be possible to trade in the secondary market during the time between the pre-sale and the platform launch. This will eliminate most of the opportunity for speculation.
The question of whether or not a token is a security and the strategies employed to try and slide a token into the non-security camp are interesting but ultimately short-sighted. Securities regulators are designed to regulate, and in their realm, they have the rule making power to do so with near impunity. Any new product that captures a significant portion of the capital market and poses significant risks to that market will be regulated. A better long-term strategy is to determine a way to make a token offering compliant with securities laws in a way that is not cost prohibitive. Fortunately, there are some options available. Look for a discussion of them in a subsequent post.
Stephen Pederson is a student legal researcher at Parr Business Law .
So: Originally posted at https://www.parrbusinesslaw.com/think-like-a-regulator/ and reproduced here with permission. Stephen Pederson is a member of the Blockchain@UBC network and president of the UBC Smart Contractors.