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Utility Vs. Security Tokens: A False Debate
Jan 10, 2019
We may look back on this moment as a turning point for tokenized ecosystems. In an increasingly hostile regulatory environment, the latest point of contention centers on whether the industry will shift towards security tokens, or if utility tokens are here to stay.
Yet this is largely a false debate. Companies looking to build and launch a blockchain project should not have to choose between security and utility tokens, as doing so could compromise the initial intent or design of the platforms and tokens. To the contrary, dual-token models enable companies to maintain the original functionality of their business models while remaining compliant with securities laws.
How did we arrive at the security vs. utility token debate?
2017 saw the rise of the ICO, while 2018 saw its fall, along with inevitable enforcement by the Securities and Exchange Commission. Some lament the SEC’s involvement as hindering the blockchain industry, but regulation may be essential for the mass adoption the community aspires to achieve.
Institutional investors are unlikely to invest in a token economy like the one that existed in 2017. Hence the importance of ensuring compliance with the regulations that protect people from scams, price manipulation, and other malicious actions.
Though institutional investors could certainly rocket blockchain-based platforms into the mainstream, it’s also important to maintain the spirit of decentralization and individual empowerment. Bitcoin was intended to eliminate the need for financial intermediaries in value transactions. In the financial world, such a notion is incredibly empowering to people at the mercy of giant, centralized institutions that are not incentivized to look out for consumer interests.
Ethereum expanded blockchain’s potential applications from finance to use cases in healthcare, advertising, entertainment, and more. Along with dozens of other blockchain platforms, it also enabled the creation of tokens with specific functions on a given platform or network. These are referred to as “utility tokens.”
The ICOs of 2017 were primarily utility token fundraises, but the majority of these tokens failed to pass the Howey Test. Because people expected utility tokens to gain value from the efforts of the founders and development teams, utility tokens started to look an awful lot like securities; until recently, the SEC’s stance on utility tokens was encapsulated by Chairman Jay Clayton’s statement, “I believe every ICO I’ve seen is a security.”
Since then, enforcement actions have become common and the jury is still out on many other tokens. The ambiguity around enforcement is partly responsible for the plummeting values and negative perception of the token economy.
Why a Dual-Token Model?
Selling tokens to raise capital for a blockchain project that is not yet operational could lead a “utility” token to be perceived as security, bringing many cautious founders to change course and launch “security tokens” instead.
This is an expensive and time-consuming debate, involving specialized legal counsel, with potentially disastrous implications on the future functionality of the tokens. For example, selling a security token to raise capital could restrict the flow of tokens, due to KYC and settlement requirements.
Once a token is sold as a security, it’s unclear if regulators will ever see it otherwise. Security tokens are designed to adhere to regulatory requirements, which could add unforeseen time delays, costs and limitations for some individuals or even entire jurisdictions. They are treated like digitized shares of stock, unlike utility tokens that are intended to be closer to airline miles or rewards points. As a result, the transfer and use of security tokens could severely hinder a platform’s global audience and efficiency.
At Filmio we are adopting is a dual-token model, with (1) security tokens, for fund-raising, because it is important to protect investors; and (2) utility tokens, for operations, because the benefits of decentralized systems can only be realized when there are incentives for maintaining and enhancing them.
Utility tokens are important because in a democratic ecosystem it’s crucial for people who cannot easily buy or trade in securities to be able to access the company’s services and platform. For example, Filmio’s fans can vote on which movies receive funding, with their voting power proportionate to the number of FAN tokens they hold. It wouldn’t be possible to operate a decentralized and democratic ecosystem if large swaths of people were left out.
Another aspect of tokenization lies in its capability to incentivize behaviors. In a digital ecosystem where tokens retain real-world value (but not necessarily monetary value), token rewards encourage community participants to take actions that bolster the overall network. In the Bitcoin ledger, for example, miners are rewarded for uncovering new blocks. If it weren’t for the block rewards in bitcoin, there would be very few miners. The key role of token rewards is what makes the separation of tokens from blockchain untenable.
As William Mougayar pointed out, “It would be disastrous to the blockchain industry if we labeled utility tokens as securities when the primary ownership intent is one of usage, not profits.” He goes on to make a case that utility tokens represent a new form of innovation, and that “Just as the Securities Act adapted to online trading, it must adapt and bend to accept the realities of the blockchain’s new paradigm.”
If we accept the need for regulatory compliance as well as recognize the essential functions of utility tokens in decentralized ecosystems, dual-token models constitute the only viable path forward. Indeed, embracing both types of tokens could propel blockchain into the mainstream and beyond.