Blockchain Tokens: What Are They & What Do They Do?
Most people today have heard of what Bitcoin is, but are somewhat unfamiliar with the related concepts of financial technology (FinTech),[1] and the concept of tokenization.[2] Blockchain tokens are implemented on the blockchain network [3] Blockchain is a shared immutable ledger that records transactions and tracks assets in a decentralized network.[4] This immutable distributed ledger uses independent systems (nodes) to record, share, and synchronize transactions.[5] All transactions on a blockchain network are cryptographically and chronologically linked making them accessible to anyone and everyone on the network, while still providing anonymity through users with anonymity.[6] While a user can own a Bitcoin, it is the Bitcoin network that is the blockchain that the user’s Bitcoin is traded on.[7] Blockchain tokens and the concept of tokenization refers to something that is traded on a blockchain network and represents a right its owner has.[8]
Tokens are defined by the dictionary as “something serving as indication or proof of something else.”[9] Tokens used on a blockchain network have two general forms — fungible and non-fungible tokens (“NFTs”), [10] – and many uses.
You may have already heard of NFTs in the news.[11] NFTs can represent ownership over real world and digital art, property, etc., with each token giving right to its own independent, unequal value with its own digital signature.[12] In comparison, a fungible token is identical to every other token of the same type and can be traded for a token of the same value.[13] Cryptocurrencies, like Bitcoin, are fungible tokens — each individual Bitcoin is worth exactly the same value as another Bitcoin.[14] One big legal issue today involves NFTs and intellectual property law: an NFTs ‘proof of ownership’ is not a valid copyright, which would need to be bargained for separately.[15]
While the basic difference between fungible tokens and NFTs is somewhat simple, the three general token classifications: security tokens, utility tokens, and currency tokens, can be more complex.[16] There is an additional type of token called a hybrid token, which is a hybrid of some of the above classifications, but it is not always considered its own classification.[17] The aforementioned classifications help quickly explain what a type of token does, and its applicable regulatory body.
While Bitcoin is a fungible currency, it is regulated less like traditional stocks, measured in dollars, and more like commodities like wheat[18] Commodies are regulated like stocks but, under the Commodity Futures Trading Commission (“CTFC”), with less regulation.[19]. There is some distinction between coin currency tokens and utility tokens, which have a wider functionality than coins.[20] Utility tokens provide value to investors in many different ways, but they cannot be considered as straightforward as currency tokens.[21]
Typically during an Initial Coin Offering (“ICO”), a company sells utility tokens which offer a means of payment that can be used on the company’s platform for services rendered.[22] A utility token acts like currency as they can be exchanged for goods and services but can only be done so if exchanged with the issuer, just like how a coupon or voucher from a specific store can be used at that store to pay for goods.[23] This is much like a ride voucher for Uber, the utility token (or the ride voucher in this analogy) is not actually money but can be used to pay for services.
Utility tokens generally are not considered securities, however, as the Securities & Exchange Commission (“SEC”) has stated that ICOs need to be registered as securities – the fact that a token qualifies as a “utility token does not prevent the SEC from treating the token as a security.[24] This came about as a result of SEC’s Decentralized Autonomous Organizations (“DAO”) report, the DAO was an ICO that was plagued with fraud.[25] Tokens which pass the four part test from S.E.C. v. W.J. Howey Co.[26] are subject to regulation. The four factors are whether (i) there is an investment of money, (ii) there is an expectation of profit, (iii) the profit is derived from the efforts of others, and (iv) it is a common enterprise.[27] Currency coin tokens and most utility tokens fail the Howey Test, and are therefore not subject to SEC regulation, which would greatly increase the cost of the company implementing the token, [28] requiring it to pay registration fees to the SEC in addition to its own increased legal fees for the process.[29]
Security tokens are investments and users who hold them can gain ownership interests to a company. If you buy a tokenized version of a stock, you will acquire the same rights that you would get when you buy stock via a traditional stockbroker — profit share and voting rights. The only difference is that a token comes in digital form.[30] Any blockchain token that passes the Howey Test can be considered a security token, as well as a security, and is subject to SEC regulations.[31] Companies issue security tokens through a Security Token Offering (STO).[32] Investors using security tokens can also invest in real world assets, such as real estate, that are represented by the token.[33] This can be done through the use of the blockchain network and currency token that the developer uses. Tokens representing shares of a blockchain developer company are fungible, as one share of common stock is not any different than another share of common stock. Security tokens can also be NFTs, such as FACTOR-805, a company that sells security token NFTs representing real life real estate.[34] Each token in this scenario is unique and has its own independent value, representing ownership interest to a unique piece of real estate. Security tokens are generally more trustworthy for investors compared to other tokens due to the fact they are regulated by the SEC and must register as securities.[35]
Hybrid tokens are token types that have been argued as not being their own classification, they combine elements of utility and security tokens.[36] These tokens are much more likely to satisfy the Howey Test than utility tokens, and as a result are classified as securities to be regulated by the SEC,[37] which as mentioned above increases the cost on the company greatly.[38] These token types can give a holder both economic rights in the company like a security token, and access to a utility on the blockchain network of the company.[39] An interesting example of a hybrid token is the Binance Coin (“BNB”), which can be used to pay transaction fees on the Binance Exchange.[40] When paying these transaction fees using BNB, the token holder gets a discount on the transaction fees on the exchange, and the exchange redistributes 20% of the profits to token holders by ‘burning’ tokens, which reduces the supply of all tokens and adds value to each investor.[41] The BNB token acts like a utility token by allowing users to pay fees on the exchange with an added discount, and like a security token by increasing the value to investors, this dual nature is what makes it a hybrid.[42] Blockchain tokens show us what can be accomplished on blockchain networks today, much like the progression of the internet, as blockchain technology becomes more prevalent users will be able to better understand it and the tokens it uses, much like how internet users went from thinking video streaming was crazy to having it commonplace today [43]
Footnotes
