What are the similarities between a one dollar bill, a share of a company, and a prepaid gift card? The answer is … not so much! The same is true of the similarities between virtual currencies, security tokens, and utility tokens; in truth, not so much. Yet, if you follow the world of digital tokens in the media and popular press, you would think that virtual currencies, security tokens, and utility tokens are all very similar because they are often concurrently and interchangeably discussed under the topic of “cryptocurrency.” On the news, in numerous blog articles, and even in investment prospectuses, “cryptocurrency” is used to describe virtual currencies, security tokens, and utility tokens even though they are very different concepts, each of which is subject to different legal frameworks and regulations. While each of these items is created on distributed ledgers using blockchain software, from both a legal and a functional perspective, the similarity ends there. We should rethink the use of the word “cryptocurrency,” and instead use the terms that are specific to the categories that have developed: virtual currencies, security tokens, and utility tokens. In our descriptions below we provide further information on the meanings of each of these categories.
A Cryptocurrency is a math-based, decentralized virtual currency that is protected by cryptography — i.e., it incorporates principles of cryptography to implement a distributed, decentralized, secure information economy. Cryptocurrency is a shorthand term for “cryptographic” currency. Cryptocurrency is a type of “virtual currency” as compared to the fiat currency that is used more commonly, such as the dollar or the euro. Virtual currencies are intended to be used as currency; and, similar to all currencies, they are primarily intended to be used as a medium of exchange. While some persons speculate on the value of one currency versus another currency, the intent of currency is for use as a medium of exchange and not as an investment.
In the United States, the Commodity Futures Trading Commission (CFTC) regulates commodities, including currencies. In its 2015 decision regarding Derivabit (an online facility that connected buyers and sellers of Bitcoin), the CFTC determined that “Bitcoin and other virtual currencies are encompassed in the definition and properly defined as commodities.” The CFTC confirmed this position in the Primer on Virtual Currencies, published on October 17, 2017. However, as virtual currencies are not securities, they are not regulated by the Securities and Exchange Commission (SEC).
A Security Token is a digital token that represents equity, debt, an investment contract, or other security in an enterprise. It is not a coin nor is it intended to be a currency. SEC v. Howey is the seminal Supreme Court case for determining whether an instrument meets the definition of security. The four conditions that must be satisfied in order for the instrument to be considered a security are:
- It is an investment of money;
- There is an expectation of profits from the investment;
- The investment of money is in a common enterprise; and
- Any profit comes from the efforts of a promoter or third party.
In a report published in July 2017 entitled Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934, the SEC pronounced that the Howey test should be applied to determine whether a digital token is a security token. If a digital token meets the four prongs of the Howey test — like all others securities — it will be regulated by the SEC. Security tokens are securities, not currencies or commodities, and therefore they are not regulated by the CFTC.
A Utility Token is a digital token created for consumption only, not for investment. It is also not a coin. If one is purchasing a utility token for investment purposes, it is likely to be considered a security token, and the SEC adheres to this view. A utility token is a token that can only be used on the one platform or network from which it is issued and cannot be converted to fiat or digital currency. The logic is similar to that of gift cards or loyalty points. Gift cards or loyalty points can only be used on one platform or network and are often representative of a prepayment for future services.
In discussing the difference between utility tokens and security tokens, SEC chairman Jay Clayton stated that “A token that represents a participation interest in a book-of-the-month club” should not be a security token. On the other hand, tokens in “a yet-to-be-built publishing house with the authors, books and distribution networks all to come” would likely be a security token because “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.” Mr. Clayton has repeated this view in written testimony before the Senate Banking Committee.
While we are on the topic of nomenclature, can we all refrain from using the term “ICO”? ICO stands for Initial Coin Offering. The typical ICO refers to the offering of digital tokens which are generally either security tokens or utility tokens. It has nothing to do with “coins” whatsoever. Additionally, an ICO is usually not the initial offering of the issuer. While ICO rhymes with IPO and is a catchy term, it should not be confused with an initial public offering of securities.
As the market for digital tokens continues to accelerate, we hope that the terms for the various types of digital tokens are no longer conflated under the simple but misleading label of “cryptocurrency.” The differences among the types of digital tokens are significant and meaningful and affect the way the law is applied to their sale, issuance, and use. We urge the press, the popular media, and investment professionals to use language describing digital tokens that reflects their intended purpose.