Cryptocurrency tokens exploded in 2017. According to a recent report from Fabric Ventures and TokenData, token sales — which are often referred to as initial coin offerings, or ICOs — raised over $5.6 billion in 2017. There were 435 ICOs which raised an average of $12.7 million.
The large majority of tokens to date are utility tokens. However, 2018 is primed to be the year when utility tokens lose traction to a new type of token called a security token.
What's the difference between the two? Polymath Network CEO Trevor Koverko explains it this way:
Almost every token that exists today is a utility coin. Bitcoin, Ethereum, Ripple are all utility coins. A utility coin is simply just access to a protocol. They’re not technically considered a security by regulators because they’re products. You don’t actually invest in them. You buy them and you use them to access the protocol. That’s why they’re called utility coins. Security coins are financial products. These are tokenized funds, tokenized real estate, tokenized commodities. These are tokens that literally represent ownership in a real asset.
Security tokens represent a much smaller share of the market than utility tokens. But many leading experts believe that the paradigm is going to change as 2018 progresses. A ton of capital is expected to flow into the cryptoassets ecosystem from Wall Street, not to utility coins but to security coins.
Why is this shift expected to occur, and why has the cryptoassets landscape been dominated by utility tokens thus far? The main reasons center around regulations and compliance.
In July 2017, the U.S. Securities and Exchange Commission (SEC) issued formal guidance stating that the offering and sale of digital tokens “are subject to the requirements of the federal securities law.” Since that time, and even before then, most blockchain startups seeking to raise money through an ICO have been very careful to design their tokens as utility tokens, largely to avoid the cumbersome and costly process of adhering to SEC rules and regulations.
However, many of these companies have launched tokens that plainly have not made any sense. Their tokens have not fit their respective business models. The token utility they describe is weak at best and fraudulent at worst.
These companies launched tokens as utility tokens because it has been way easier to do so. Utility tokens are easier to launch than security tokens because they are not regulated. This means that the ICO company can do marketing online and they can pursue non-accredited investors and retail investors. And they do not have to bear the heavy costs typically involved with regulatory compliance.
Additionally, once the SEC released their guidance in July 2017, every major cryptocurrency exchange made it clear that they would not list any token deemed to be a security token. By listing a security token, an exchange could find itself in violation of SEC regulations, and no exchange has been willing to explore these murky waters. As a result, from an investor’s perspective, the biggest current problem with security tokens is they have nowhere to go to get liquidity.
But this is rapidly changing. Several platforms are launching during the first half of this year that provide end-to-end solutions for security tokens to launch with full regulatory compliance, including KYC (Know Your Customer) and AML (Anti-Money Laundering) compliance.
SPiCE Venture Capital founder Carlos Domingo shared his thoughts about the potential size of the security token market:
It’s inevitable that security tokens will transform equity just as bitcoin has transformed currency, because they afford the owner a direct, liquid economic interest and the expedited delivery of proceeds. Every type of ownership can be tokenized, which is a massive multi-trillion dollar addressable market.
In order for the security token boom to become reality, holders of security tokens must be confident about their ability to gain liquidity. There are also several security token exchange platforms launching within the next six months.
The conversation around cryptoassets and the regulatory environment is heating up. On Feb. 6, the United States’ two major financial regulatory authorities — the SEC and the Commodity Futures Trading Commission (CFTC) — held a dedicated hearing on virtual currencies. Overall, the outcome of this hearing was neutral to positive for the growth of cryptoassets. As CFTC Chairman J. Christopher Giancarlo said in testimony prepared for the hearing:
We are entering a new digital era in world financial markets. As we saw with the development of the Internet, we cannot put the technology genie back in the bottle. Virtual currencies mark a paradigm shift in how we think about payments, traditional financial processes, and engaging in economic activity. Ignoring these developments will not make them go away, nor is it a responsible regulatory response.
I personally agree that 2018 will be the year when security tokens gain the proper infrastructure and ecosystem that enables them to surpass utility tokens in terms of volume in 2019. The combination of platforms that enable regulation-compliant security token launches mixed with exchanges that provide liquidity for security tokens, as well as an open-minded regulatory approach that has indicated a desire to not stifle innovation, all bodes well for the future of securitized cryptoassets.
Ben Arnon is a former vice president of Global Brand & Agency Partnerships at the Facebook-incubated company Wildfire and served as Head of Industry at Google, where he led a sales team focused on bringing innovative media and technology solutions to leading Fortune 500 brands.