This is a hidden column

getTagNameMorningstarCorporate:InvestingTrends

Types of ICO Tokens and What to Know About Them

3 ways virtual currencies are classified

Lawrence Johnson

 

The amount of money raised through initial coin offerings, or ICOs, has attracted attention from investors, venture capitalists, and government agencies. Understanding the potential, risks, and long-term implications of these tokenized instruments is tricky, given that there are three main types of tokens in play.

3 role types of ICO tokens

Here’s what we know for now when assessing whether virtual currencies—such as blockchain tokens or coins—should be classified as a commodity, a security, or simply as a token.

  1. A security: In July, the U.S. Securities and Exchange Commission indicated that federal securities laws can apply to the activity of virtual organizations that use blockchain technology or distributed ledgers to offer or sell coins to the public to raise capital, depending on the circumstances. If the virtual coins are securities, such organizations must register the offer and sale of tokens unless valid exemptions apply. In addition, platforms that trade the tokens in the secondary market would be considered as “exchanges” under federal law. They must register as national securities exchanges or operate under an exemption. The SEC further underscored in its July report that those operating such exchanges and hold interests in other projects that are securities should consider the requirements of the Investment Company Act. Since then, the SEC established an enforcement division and has charged at least two companies running initial coin offerings with fraud and the selling of unregistered securities.
  2. A commodity:  Like gold or silver, virtual currency can be a commodity that someone trades with the expectation that it will deliver a profit. As early as 2015, the U.S. Commodities Futures Trading Commission determined that virtual currencies, such as bitcoin, can also be deemed commodities in the context of derivative contracts involving  virtual currencies. Moreover, the commission released a primer on virtual currencies. It covers the basics about virtual currencies and the CFTC's role in regulating them.
  3. A token: Some ICO tokens constitute units of service that a decentralized organization or network can render. These tokens can be compared to an application programming interface key, or API key (a software intermediary that allows two applications to talk to each other). And as such, these tokens do not qualify as securities or commodities. These utility tokens can be purchased and traded. But how can you tell if a token is a utility token that’s a unit of service, or a security token that triggers the application of securities laws? This could be especially difficult if the token is sold before the platform is fully operational. To help navigate these perilous pathways, Protocol Labs, Cooley, AngelList, and CoinList collaborated to create a compliant framework for token sales. They propose a so-called “simple agreement for future tokens,” or SAFTs, that allow ICO token sales to comply with U.S. securities laws. SAFTs are essentially investment contracts aimed at projects that want to raise money for non-security tokens. The SAFT framework is designed to ensure that tokens created are less likely to be a security. However, there’s no guarantee that the SEC or the courts would see it that way.

The impact of agency efforts

The cautious pronouncements and actions from government agencies may not eliminate all regulatory uncertainty, but they could help clear out the rabble. Plus, they will foster a healthier and safer marketplace for decentralized networks and organizations.

Hear more fintech insights at the Morningstar Investment Conference.

Register Now

The Advisor Toolkit

Get practical behavioral finance tools to help clients avoid common pitfalls.