Security Tokens

The SEC states that the ‘Howey Test’ can be used to determine whether a transaction is a security or not. Two conditions of the HT are:

1. If the primary objective of a commodity is to make a future profit, it qualifies as a security.

2. If there is a single entity issuing a financial instrument, rather than a democratic network governance-based organization, then it’s a security.

A token derives its value from external, tradable assets or it can increase in value based on the efforts of others, it may be classified as a security token and become subject to securities regulations. Failure to abide by these regulations may result in penalties and derail a project, thus it is critical for businesses to meet all their regulatory obligations. Once classified as a security token, a wide array of applications are permitted, the most promising being—the ability to issue tokens that represent shares of company stock. An example is the online retailer Overstock.com. tZero is one of Overstock’s portfolio companies. tZero held an ICO to fund the development of a licensed security token trading platform. tZero tokens are issued in accordance with SEC regulations, and token holders are entitled to quarterly dividends derived from profits of the tZero platform.

Coin vs Token

All cryptocurrencies are a form of money, but not all of them can be referred to as coins. Bitcoin is a coin because its purpose is to facilitate payments across a decentralized network. Ethereum and Ripple facilitate payment transactions across a decentralized network, but unlike bitcoin Ethereum also enables smart contract use, still these are classified as coins. Another test to judge if a cryptocurrency is a coin is if the cryptocurrency has its own underlying blockchain. Bitcoin, Ethereum, and Ripple have a prominent payment use case and they also have their own blockchain network, and this is why they are classified as coins.

Others like “Golem Project” for example do not classify as coins, the GP has a cryptocurrency called GNT which facilitates the use of the Golem DApp, but this project is built on top of the Ethereum blockchain and use the platform’s native cryptocurrency (Ether).

Thus, if a token has a payment use case as its primary function and has its own blockchain, then it’s a coin, but if the token has secondary assets and is not supported by their own blockchain they are tokens.

Businesses use ICOs to raise capital. Through ICO trading platforms investors, receive unique cryptocurrency “tokens” in exchange for their monetary investment in the business. It can be understood as a form of crowdfunding through the creation and sale of a digital token to fund project development. The token functions like a unit of currency that gives investors access to certain features of a project run by the issuing company. These tokens are unique because they are used to fund open-source software projects that would otherwise be tough to finance with traditional structures.

According to US statutory requirements, ICOs must adhere to regulatory requirements only if they are issued as security tokens as opposed to utility tokens. The ICO fundraising model functions as follows. Startups raise capital by issuing tokens on a blockchain and then distributing tokens in exchange for a financial contribution. These tokens, which can be transferred across the network and traded on cryptocurrency exchanges can serve several functions—granting access to a particular service or entitling the holder to receive company dividends.