Blockchain has brought us many useful innovations such as decentralization and trustless networks. One of the key factors for the success of this technology has been the use of tokens. As of today, utility tokens have been a game-changing concept that many startups across the globe are grabbing onto as they crowdfund. Utility tokens are the most popular form of tokens.
In this article, we will dive in and raise your further awareness of these tokens. Enjoy!
What is the difference between Tokens and Coins?
To thoroughly understand a utility token, you must first understand what a token is and its differences with a coin. The rapid emergence of cryptocurrencies led to the misunderstanding and misuse of the terms “token” and “coin,” which are often used as synonyms and considered generally as interchangeable even though they serve two completely different purposes.
Coins – are fundamentally the digital equivalent of money, which is created to store value over time, e.g., Bitcoin. They share the same characteristics as money – they are fungible, divisible, acceptable, portable, durable, and have a limited supply.
Tokens – are digital assets, a representation of something in a particular system. It can be anything from a voting right to a staking option, or unit of value and more. It is able to fulfill many roles in its system and is not limited to a particular role. E.g., tickets to a movie can be considered a real-life token as its usage is limited to specific time and place, and it possesses value only in the movie theater. Digital tokens share the same purpose – they have a particular use case inside a specific project.
In practice, the line between coins and tokens is ambiguous. Both are used to transfer value, as a means of payment, in a similar way that money and shares are used to reward people for work.
What is a Utility Token?
Also known as a user token or app coin, a utility token is a non-physical token that has been created for crowdfunding purposes. This means that when you purchase a utility token, you have paid the issuer money in exchange for tokens so that the company can develop a product, which the token holder can redeem for that good or service.
The main idea of the token is that it should be held and used by its users and developers, as an element of the product; the more people hold the tokens, the more likely the product is to succeed.
Positives and Negatives
Utility tokens bring holders the right to use the network and to obtain the advantage of voting in it. They can also help in the development of an internal economy within the system. Therefore, these tokens are usually built around communities. Often people in these communities have multiple roles apart from just being an investor – early adopters, key users, miners, validators, etc. This is the reason why many successful projects put a lot of effort into their community work.
Hence being a new invention, utility tokens are yet to have established regulations around them since they can’t be categorized as a currency or equity, which has left them open for frauds and scams. In addition, owning these tokens don’t guarantee a stake in a company, which makes them a risky investment.
For the issuer, it is essential to know the differences between the token and the network function, the problem application or protocol it is trying to solve, and the structure of the token sale. The purpose of the token sale focuses on selling a digital asset that has a clear use case in a decentralized application. A well designed token sale doesn’t promise investment returns or profits, but represents a liability to the company and can be considered as a form of pre-payment. It serves a purpose; it’s required to participate in the network, rather than just being a funding mechanism.
The most popular example of a utility token is the ERC20 Ethereum standard. In late 2013, a 19-year-old Vitalik Buterin designed a platform that could hypothetically leverage the blockchain to store and execute computer programs across an international network of distributed nodes. Ever since then, the ERC20 standard has been used by companies to build tokens for their DApps and launch their ICOs, and as of today, Ethereum is the most well-known and established cryptocurrency alongside Bitcoin.
Along with versatile features, the key factor for the success was the simplicity of its deployment – driven by the popularity of Ethereum token standardization, ERC20 token quickly became the industry standard. The ERC20 standard was able to solve a significant problem; blockchain-based marketplaces and crypto-wallets needed a single, standardized set of commands to communicate with their managed tokens, which includes interaction rules between different tokens and token purchase practices.
The death of ICOs
Public ICO sales started to fail significantly around May of 2018 as a consequence of the overall market drop, which resulted in projects running out of resources to keep up with their roadmaps and development while waiting for the market to stabilize before even thinking about exchange listings. This, along with numerous scams, came at the cost of losing the trust of the community and public interest in general.
While ICOs could no longer achieve their public sales targets, investors began to search for alternatives. That’s when the term Security Token Offerings (STO) appeared in the contest. In theory, the idea of an STO sounds very appealing, but in reality, it turned out to be far from creating an efficient market for it. Soon alternative approaches such as Initial Exchange Offerings (IEO) and the DAICO appeared.
A crypto token that passes the Howey Test is deemed a security token. The distinctive feature of security is that once you purchase it you transform money into capital and promise buyer dividends and profits. Securities allow owning an asset without taking possession. However, if the token doesn’t qualify according to the Howey Test, then it classifies as utility tokens which are exempted from regulation and security laws. In general, a token is classified as security when there is an expectation of profit from the effort of others. These tokens derive their value from an external tradable asset, therefore, they must comply with federal securities and regulations. If an ICO fails to comply with these regulations, then it could be subject to severe penalties and potential failure of the development of a project.
The role of the Securities and Exchange Commission (SEC)
The SEC was tasked to prevent companies from sharing misleading or false information with investors, such as counterfeiting reports about their performance or future prospects. The SEC places the same demands on ICOs as it does on stocks and bonds. There are no separate regulations for ICOs that qualify as securities, according to the Howey Test. Additionally, they also apply securities laws to cryptocurrency exchanges, and even digital wallets. The SEC tanked the market by instilling fear into it since compliance can be daunting, and many ICOs fall short – this killed many promising companies and ideas.
The SEC uses the Howey Test which falls under conditions that identify “investment contracts” – to determine whether an ICO is a security token. Here are four conditions you should be aware of:
- Was there an investment of money?
- Was there an expectation of profit?
- Was it invested in a common enterprise?
- Are profits the result of a third-party or promoter’s efforts?
If all of these conditions are fulfilled, the SEC considers the token a security, making it subject to various regulations.
Security Token Essentials: SEC compliance rules
Basic SEC compliance rules and classifications – security tokens can fall under the following regulations:
Regulation D – 504 or 506(C) – allows you to talk to US investors without SEC registration and approval of 504, SEC provided Form D has been filled by the creators after the securities have been sold.
504 – gives you exemption from SEC registration as long as you keep the annual figure raised below $ 5 million. Investors are locked in for a minimum of 1 year.
506(C) – an exemption if you only deal with accredited investors which in simple terms means high value/high earning individuals worth over a million dollars. Again, investors are locked in for a minimum of 1 year.
Regulation A+ – allows the creator to offer SEC-approved security to non-accredited investors through a general solicitation for up to $50 million in investment. This long procedure requires a two-year IPO-level CPA audit, many ICOs have applied for it but only a few have got it. If granted, the tokens are not locked down for a year period.
Prometheum is one of the companies that was granted their approval for a Reg A+ – allowing them to raise $50 million through its ‘Ember’ token. Prometheum is the world’s first blockchain ecosystem for the fully compliant issuance, trading, clearing & settling of tokenized securities.
Regulation S – don’t deal with Americans when a security offering is executed in a country apart from the US and is therefore not subjected to the registration requirement under section 5 of the 1993 Act. The creators are still required to follow the security regulations of the country where they are supposed to be executed.
Regulation Crowd Fund – is capped to $ 1.07 million. Gab has completed running an STO under the framework for a social network offering.
U.S. Securities and Exchange Commission (SEC) vs. ICO
On the 11th of October, the US Securities and Exchange Commission (SEC) filed a lawsuit against the Telegram ICO, which sold $1.7 billion’s worth of tokens. The network was supposed to go live on Oct. 31, but the SEC banned the launch of GRAM tokens and with the approval from Telegram investors it has been postponed until April 31, 2020. The SEC claimed that the sale of GRAM amounted to an unregistered securities offering in violation of federal securities laws.
The SEC used the specifics shared by an investor to subsidize its conclusion that the offering to attract the investor was breaking the law. The SEC cited, “Telegram spoke of its “A+ engineering team” and the “chance for 0x-50x returns on the investments.”
Telegram responded to the offense with a fresh filing on Nov. 12, and lawyers representing Telegram have accused the U.S. Securities and Exchange Commission (SEC) of not observing just practice in criticizing the messaging service company. Read more from here.
The action is just one of several battlefronts for the SEC, which has also engaged in proceedings with Canadian messaging service Kik over its $100 million ICO from 2017.
Initial Exchange Offering (IEO)
In late 2017, the world’s largest exchange, Binance, created the first IEO through Binance Launchpad; a token creation platform that allowed new cryptocurrencies to be sold directly from the exchange. The Launchpad has garnered a lot of attention because of their IEOs have been incredibly successful.
As the name suggests, IEO is managed on a cryptocurrency exchange platform. Unlike ICO, the IEO fundraising process is administered by the crypto exchange on behalf of a startup, which raises the security to an entirely new level. Now the project relies on an exchange or multiple exchanges to carry out crowdfunding, smart contracts, and marketing. Since the cryptocurrency exchange collects a fee from the sales, it is incentivized to help with the marketing and market-making operations.
The token sales are administered through the exchange platform. Token issuers must pay a listing fee and an interest from the number of tokens sold during the IEO. Also, tokens developed by a crypto startup will be traded on numerous exchanges, and their new coins will be listed once the IEO is over.
The IEO Benefits
Exchange listing – listing your project on an exchange is one of the hardest steps towards making a healthy token economy. If an exchange participates in the project’s IEO, then it will naturally help with the listing; the project has already passed the requirements.
Exchange’s user base – the big exchanges user base is far greater than most cryptocurrency marketing campaigns can reach. By choosing an exchange for an IEO means the project will use the exchange’s existing users for their customers.
Credibility – projects that issue an IEO have increased reliability because of the Exchange that has their backs, which in practice means high security, a reliable platform, and active customer service.
Price manipulation – an IEO can prevent, to some extent, price manipulation by demanding a token cap per investor, which inhibits the birth of major shareholders, aka whales. Projects can also require their tokens to be sold at a fixed price throughout the whole IEO process.
What’s in it for the Exchanges?
Marketing – while marketing the project exchanges can use the campaign to market their exchange or their services. It also benefits from increased expertise, experience, and marketing due to the collaboration of joined forces.
Fees – most of the exchanges charges from IEO. It can be in the form of listing fees, expenses, and operations fees, IEO fees, a percentage of profit or a fee in the form of tokens.
New users and trading volume – A newly listed token brings more volume and users to the exchange.
Success through IEO’s
The data shows that Binance has, by far, the highest average USD return on IEOs across the examined exchanges. What is it that makes Binance so successful? Choose a project!
You can find all the listed initial exchange offerings with the top listed exchanges here.
DAICO is an improvement on the ICO fundraising model that contains certain aspects of DAO’s. The idea was brought to daylight by Vitalik Buterin in January 2018 and its goal is to make ICO’s more secure by involving investors in the initial project development process. This enables the token holders to vote for a refund of the contributed funds if they are disappointed with the project’s progress, which completely mitigates the risk of scam.
Funding has been implemented to spread it over time instead of a lump sum, which is assumed to increase and sustain the team’s motivation to deliver the product. Complete trust is never placed on a fully centralized team. Decisions on the start-up fund will be made through a democratic voting system.
How does it work?
The DAICO contract works through a mechanism where contributors can send funds to the project in exchange for network-specific tokens. When the crowd sale period ends, the contract will prohibit anyone from contributing any further, i.e., normal token sales.
Once the contribution period has ended, the tap variable steps in. Tap on the contract can be programmed to predetermine the amount (per second) that developers can withdraw from the token sale funds. Initially, the limit will be set to zero, but contributors can then vote on a resolution to either increase the tap or to return the remaining contributed funds.
If developers hold a large share of the distributed tokens, they only need to influence a small percentage of contributors to vote and gain more funds released for a smart contract.
Contributors’ knowledge is also playing a major role. They need to understand the specific tokens’ price variation and make the right decision when voting to increase the tap or returning the funds. This is why contributors without a comprehensive understanding of the project should not necessarily participate in voting and decision making.
Not many thought about liquidating assets in 2018 since crypto was doing so well. For many, the main issue grew to hold their funds in crypto while paying fiat salaries, and as the market tanked, so did their balance sheets. However, many projects with real use cases survived if they managed their funds responsibly, rather than squandering them on exchange listings, airdrops, and token burns, just to appease investors.
Overall, projects that have had a mechanism for funding continuing development have been successful, while projects relying on donations have been failing. In addition, businesses would be well-advised to consider taking the “no action” letter approach from SEC with any planned token sale, especially during this ongoing period of SEC enforcement uncertainty.