Britain’s Financial Conducts Authority (FCA) has issued detailed guidance on what it considers an exchange token, a security and a utility token with a consultation period now opening until April 5th prior to the publication of final guidance.
“This is a small but growing market and we want both industry and consumers to be clear what is regulated, and what isn’t. This is vital if consumers are to know what protections they’ll benefit from and in ensuring we have a market functioning as it should,” Christopher Woolard, executive director of Strategy and Competition at the FCA, said.
The 46 pages long consultation document defines a security as “an instrument (i.e. a record, whether written or not) which indicates an ownership position in an entity, a creditor relationship with an entity, or other rights to ownership or profit. Security tokens are securities because they grant certain rights associated with traditional securities.”
An issuer of a security does not need to be authorized, they say, but they have to comply with Prospectus directives and with certain restrictions on promotions. Any other intermediary, like advisors or exchanges, may need authorization.
Considering the complexities of this area, they have opened a a direct support service accessible by completing a request for support form. They say:
“Almost 20 per cent of applications for support during 2018 have been cryptoasset- related propositions. These applications covered a wide variety of cryptoasset business models.”
In addition, firms that are authorized or may require authorization can apply for participation in the sandbox test environment.
“We saw a number of firms that use cryptoassets to facilitate regulated payments activities. In more recent cohorts, we have seen an increasing number of firms using cryptoassets to issue debt or equity instruments. Across our first four cohorts we have had 276 applicants, of which 89 moved forward to testing – a third of which used DLT or cryptoassets in some form,” they say.
Exchange tokens are bitcoin, eth and likewise tokens that aim to primarily act as a currency of sorts. Providers there may need to comply with AML/KYC requirements.
What is a security and what is a utility (not a security) is described in depth through some examples which we will quote extensively.
First, they take a technology neutral approach. Just because a security is issued through the blockchain, for example, doesn’t mean it is not a security.
Second, just because you call something a utility token doesn’t mean it is actually a utility token. And third, decentralization is more an indicator of whether rights are conferred. Some have suggested this contravenes the so called Hinman Test, but we’re not very sure about that interpretation.
The case examples provided are some of the most common scenarios involving ICOs. We won’t list all of them because there are quite a few, but we’ll quote below at length:
“Firm MN issues a token that grants the holder early access to a new line of clothing to be released by the firm, at a discounted rate. This would be similar to rewards-based crowdfunding where consumers have contributed to a project in exchange for early access to items from the new firm’s new clothing line. This token will be considered a utility token, and not considered a Specified investment as set out in the RAO, nor a MiFID Financial Instrument.
Case study 8: Firm OP operates an online casino. It issues tokens through an ICO that allows the token holders to use the casino. Any winnings are paid out in the OP Tokens. OP Token holders are also able to vote on which new betting games to add to the online casino’s products, however the accompanying whitepaper to the ICO expressly states that Firm OP is not obliged to honour the outcome of any such vote.
The tokens grant no additional rights in respect of any payments, ownership or control. The rights these tokens grant token holders are not the rights we associate with Specified Investments. The tokens are not securities. This would not be a Specified Investment as set out in the RAO, nor a MiFID Financial Instrument.
Case Study 9: Firm QR, a well-known luxury car manufacturer, issues a token that allows the token holder the right to test drive a new limited-edition car for an hour. The token will be tradable on secondary markets where the price can increase or decrease depending on the demand for the limited-edition car, but will not confer any additional rights on the token-holder like payments, ownership or control etc. This will be a utility token.
Case study 10: Firm ST is a cryptoasset firm that is raising funds to build a network for data. The firm issues tokens that give the token holder the right to data held within the network, but the tokens do not confer additional rights on the token-holder like profit, ownership or control. The tokens are not tradable on secondary markets. This will be a utility token.
Firm KL issues a token that references a share in firm PB. The token is structured so it can’t be traded in the capital markets or transferred from one person to another. This token is considered a Specified Investment, but not a transferable security. The token is classified as a security token.
Firm IJ invests in fine art using the funds it receives and pools frominvestors and hires it out for use at corporate events for a fee. It issues tokens to investors in proportion to their contributions. These tokens also entitle theinvestors to receive a share of the fees generated by the art rental, and the profitsit makes when it sells the art from time to time. The token holders have no day- to-day control over the art or the rental fees. The token holders’ contributions are pooled, so are the rental fees and profits from art sales, and the art is managed asa whole by IJ. The tokens that represent the participants’ share in the investment are therefore likely to constitute units in a collective investment scheme.
Firm EF issues a token that it describes in its whitepaper document as a ‘pure utility token’. The token allows the holder to access a product the firm is still developing. The token also allows the holder to share in profits in line with their holdings, once the product launches. The developers have been careful to make sure the token will not be able to be traded on the capital markets.
Despite the token being described as a utility token in the whitepaper, its lack of tradability and the fact that it offers access to a future product – this token would likely still be considered a Specified Investment given it confers on the holder rights similar to Specified Investments, i.e. conferring on the holding the right to share in profits in line with their holdings. This token is likely to be a security token.
Firm CD, incorporated in the UK, has created a social trading platform, called the CD Platform, for users to easily exchange fiat currencies for exchange tokens. The firm issues ‘CD Tokens’ which are exchanged for fiat funds and these tokens are used to purchase other exchange tokens.
This alone is not enough to categorise the CD Tokens as security tokens. However, the CD Tokens also confer on the holder a right of ownership of the CD Platform proportionate to the number of CD Tokens held, and a right to participate in the profits of CD Platform (if any), to be paid annually in the form of a dividend.
These tokens are likely to be the same as or similar to shares and the tokens are therefore security tokens.”
In this last example they appear to be saying that if the token is sort of given away for free kind of like reward points, it won’t be a security, but that’s only if the token doesn’t also provide voting rights or dividends.
The approach doesn’t really appear to be much different from the SEC, with the more interesting part here left out. That being, what process do security tokens have to go through.
It is quite unfair that rich billionaires can fund whatever start-up they want without going through any process, while smart kids with reasonable savings are effectively shut out.
Rules are needed, but fair rules. Where investment prohibitions in securities are concerned, the current law is an injustice at the scale of last century’s discrimination against blacks, or on sexuality grounds, or on gender, or indeed at the scale of our grandfathers being denied the right to vote because they were not rich landowners.
The law needs reforms, not clarification on what start-up will be discriminated against. Either remove all exceptions, or remove start-ups below $20 million from needing to comply with anything save for the prospectus whitepaper being signed under oath.