People are just becoming acquainted with the idea of digital money in the form of cryptocurrencies like bitcoin, where transactions are recorded on a secure distributed database called a blockchain. And now along comes a new concept: the blockchain-based token, which I’ve been following as a blockchain researcher and teacher of courses about cryptocurrency and blockchain tokens.

In the last 18 months, digital developers have raised more than US$20 billion through a funding process called “initial coin offering” – many of which use tokens. There are two common categories of them: “utility” tokens and “security” tokens.

Utility tokens

Utility tokens are essentially cryptocurrencies that are used for a specific purpose, like buying a particular good or service. For example, if you want to store information online, the most common way today is to become a customer of a hosting service like Google Drive, Dropbox or Amazon Web Services. You reserve a certain amount of storage space on those companies’ servers and pay for it with dollars, euros, yen or other national currencies.

But there is another way. The Filecoin network, for instance, expects to provide similar cloud storage services without itself operating buildings full of massive servers. Instead, its users will store their data, in encrypted form, on the spare hard drive space of other regular people. This needs a different form of tracking of how much space a person uses, and a new way to pay all the people whose hard drives host the data. Enter the utility token, in this case called Filecoin.

As a customer stores more data, the network will deduct from their balance of Filecoin tokens and will send those tokens to each storage provider based on how much data they’re hosting. Customers can buy more tokens with whatever currency they wish, and hosts can exchange them for any currency they choose – or keep them to spend on storage of their own data.

In addition to automating the data use and payments, Filecoin tokens offer another advantage over regular currencies: They can be used in much smaller increments than pennies, so prices can be very accurate.

Filecoin’s goal is a cloud storage system that is as trustworthy and secure as commercial operations, but decentralized. The utility token is simply a tool that makes this approach possible.

Security tokens

A security token, sometimes called a “tokenized security” or a “crypto-security,” is more than a currency – it often represents ownership in an underlying real-world asset. Like traditional stocks or bonds, they’re regulated by the U.S. Securities and Exchange Commission. Regular securities are tracked either on paper or – more likely these days – in a centralized database. Security tokens use a blockchain system – a decentralized database – to do the tracking of who owns which assets.

Using blockchain-based security tokens expands trading beyond regular bankers’ and stock-market hours, and may enable faster finalization of transactions. In addition, a marketplace based in software that allows smart contracts can automate various aspects of regulations and reporting.

Security tokens make it easy for customers to access multiple investments: Just as a single E-Trade investment account can keep records for a variety of different stocks and bonds, a blockchain-based digital wallet can do the same for a range of different security tokens, representing equity, debt and even real estate.

Connection to cryptocurrencies

Neither kind of token requires its own blockchain, the way the bitcoin and Ethereum cryptocurrencies do. Instead, tokens can outsource their ownership accounting systems, attaching them to preexisting blockchain ledgers. This in effect creates a new subledger, say of the Ethereum network’s ledger, just for that particular token. Every user who sends a token that is tracked and recorded on Ethereum pays a small transaction fee to the Ethereum network to validate the transaction.

Tokens are still at an early stage of development. I expect to see lots of innovation around how to use them for years to come.

Stephen McKeon is an Assistant Professor of Finance at the University of Oregon. This article was originally published on The Conversation. Read the original article.

A Hong Kong venture capital firm has reportedly agreed to invest $160 million in Chinese security token exchange tZero. As reported by China Money Network, Hong Kong-based GSR Capital has entered into a $160 million purchasing agreement with the security token exchange tO.com Inc (tZERO) for its security tokens at US$10 per token.

GSR Invests $160 Million in Security Tokens

GSR, founded in 2004 by Sonny Wu and Richard Lim, manages three separate but complementary teams working towards sector leadership with an aim to bringing their investment strategies to global projects.

tZero exchange is a majority-owned subsidiary of online retail giant Overstock.com that was created with the goal of focusing on the development and commercialization of blockchain technology as it is implemented into the financial sector (fintech).

The tZero exchange security token runs on Ethereum network as ERC-20 coins. The purchase does not constitute company equity nor offers any voting rights. The agreement does, however, entitle GSR to dividends. All investors receive 10% of the adjusted gross revenue on a quarterly basis according to the China Money Network. In order to accommodate the investment from GSR, tZero has extended its security token offering (STO) until August, 6 2018.

STO not ICO

Security token offerings, unlike the more recognizable initial coin offerings (ICO), issue a security coin which is defined by being backed by external, tradable assets. One of the main applications of security tokens is that they grant companies with the ability to issue tokens that represent shares of company stock. Security tokens come under federal securities regulations in the US and any other country which has existing security trading laws.

Many existing cryptocurrencies are fighting the security classification as it would make them subject to restrictions regarding who can invest in and exchange the tokens.

Some new offerings though are embracing the title of security token, created to abide by regulatory frameworks. This way an offering is both cheaper and more efficient than conducting an ICO using utility tokens. More significantly, it also reduces legal risk and provides protection for both the company and its investors.

tZero CEO Saum Noursalehi said that;

“We are overwhelmed by the support we have received from all of our investors, and thrilled to have GSR on our team as we seek to launch the world’s first security token exchange. This investment from GSR further validates tZERO’s strategy to introduce blockchain to capital markets, and this partnership will accelerate our global expansion efforts.”

tZero previously announced a joint venture with BOX Digital Markets in order to launch the first regulated security token exchange. The exchange is planned to be funded by the current STO.

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The SEC just brought a very firm dose of clarification to the cryptocurrency markets.

US Securities and Exchange Commission (SEC) director of corporate finance William Hinman has just clarifiedthat the SEC will not be categorising Ethereum or bitcoin as a security, and that tokens can change function and category over time.

This outcome was widely expected, but still proved enough to give Ethereum prices and trading volume a clear jolt.



Further developments

Hinman also further clarified the SEC’s line of thinking, saying the organisation was more interested in enforcing the spirit of the law, in line with the letter of the law.

“We should frame the question differently and focus not on the digital asset itself, but on the circumstances surrounding the digital asset and the manner in which it is sold,” he said.

This basically suggests that all ICOs will continue to be classified as securities, as he previously indicated, while new tokens can still be freely distributed through faucets or airdrops without necessarily falling afoul of securities laws.

He also outlined the circumstances where a token can and cannot change its stripes, and morph from a security to a utility token over time.

“Can a digital asset that was originally offered in a securities offering ever be later sold in a manner that does not constitute an offering of a security? In cases where the digital asset represents a set of rights that gives the holder a financial interest in an enterprise, the answer is likely ‘no’.”

Hinman also clarified that the tokens of a genuinely decentralised network, and those which are genuinely useful and serve an actual network function, might escape being automatically classified as a security.

“What about cases where there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created? I believe in these cases the answer is a qualified ‘yes’,” he said.

Ethereum qualifies on both counts because there’s no actual central enterprise being invested in and because the token serves a network function as gas. It probably qualified as a security during its initial sale, but what’s done is done and now it’s home free.

Meanwhile, bitcoin qualifies because there’s no central enterprise being invested in and because it was first distributed through mining rather than a sale. And because it’s reasonable to assume that back in 2009 no one expected actual profits from that gimmicky bitcoin thing.

Elsewhere it might put coins like NEO and its paired GAS token in an interesting position, where one (NEO, or the coin formerly known as Antshares) might qualify as a security but the GAS utility token might not.

EOS might fall on the wrong side of the line, with an exorbitant token sale carried out by a single central and identifiable company, a network that depends on a centralised and identifiable centrefold of block producersand no functional application for the token yet. EOS parent company Block.one was well aware of this during the token sale and explicitly warned buyers that the token did not necessarily serve a purpose or have any value, but that might not satisfy the SEC.

The hard line

The coins that explicitly give holders a financial interest in the enterprise are a minority, but there might still be some grey areas around a user’s expectation of profits from buying or holding a coin. The value of most tokens is dependent on the functionality and value of the network they serve, so there might still be an argument that almost all tokens can represent a kind of financial interest in the network as a whole.

According to Hinman, this might come down to a buyer’s expectations when purchasing a token, and most new token sales would probably fall on the wrong side of securities laws even if the coin does serve a genuine network function.

“Central to determining whether a security is being sold is how it is being sold and the reasonable expectations of purchasers,” he said.

“Just as in the Howey case, tokens and coins are often touted as assets that have a use in their own right, coupled with a promise that the assets will be cultivated in a way that will cause them to grow in value, to be sold later at a profit. And, as in Howey – where interests in the groves were sold to hotel guests, not farmers – tokens and coins typically are sold to a wide audience rather than to persons who are likely to use them on the network… Marketing efforts are rarely narrowly targeted to token users. And typically at the outset, the business model and very viability of the application is still uncertain. The purchaser usually has no choice but to rely on the efforts of the promoter to build the network and make the enterprise a success. At that stage, the purchase of a token looks a lot like a bet on the success of the enterprise and not the purchase of something used to exchange for goods or services on the network.”

Simply slapping a “this is not an investment” sticker on an ICO does not exempt a token from securities laws, Hinman noted.

“For a while, some believed such labeling might, by itself, remove the transaction from the securities laws. I think people now realize labeling an investment opportunity as a coin or token does not achieve that result… simply labeling a digital asset a ‘utility token’ does not turn the asset into something that is not a security.”

The takeaway

Whether a coin is a security depends on the buyers’ expectations, which could naturally go either way, and the resale of securities tokens on a secondary market (the exchanges) can complicate things. Broadly, Hinman suggests that token creators can clear themselves by not just going for a cash grab, not being scammers and genuinely trying to create and distribute an actual functioning and useful product.

That probably rules out most coins.

Ethereum and bitcoin are in the clear, but many others should probably start getting very nervous right about now. According to Hinman’s broad strokes, and definitely not to be used for real legal analysis speech, a coin might be in the SEC’s crosshairs if:

  • It was initially distributed and sold in an ICO, or otherwise in a way that qualifies it as a security.
  • It does not yet have any genuine utility.
  • It has not achieved sufficient decentralisation, and it’s possible to identify a single entity behind the token.