If you’re a tech-savvy investor, you’re likely already acquainted with the benefits of blockchain technology and digital assets. Maybe you’ve already participated in some initial coin offerings (ICOs) — and if you have, you must have noticed that ICO projects tend to stress that their tokens are “utility” and not “security.” Sometimes they even have a whole section in their white paper explaining why this is so. Does this mean it’s bad for a token to be a security — or is it a viable alternative to utilities? Is it wiser to invest in startups that openly claim that their tokens are a security? And what is the difference, anyway? Read on to find out.

The ICO dilemma

Imagine you’re a blockchain startup intent on revolutionizing some market — money transfers, energy production, travel, insurance, gaming — what have you. You’re convinced that blockchain is essential for the task, since it will bring added security and transparency, remove intermediaries, and decrease costs. However, launching a startup — blockchain or otherwise — is also expensive, so before beginning your revolution, you’ll need to raise funds somehow. So, you create your own token and sell it during an ICO event, receiving “hard” cryptocurrency, like Bitcoin or Ethereum, in return.

Your new token is supposed to be the underpinning of your blockchain network or platform. It’s designed to provide holders with access to company services. Holders of utility tokens can use the assets to purchase or sell goods or services on the associated site. So, for instance, Golem allows users to rent their unused processing power to companies making 3D imagery — and receive Golem tokens in return; WePower tokens represent units of green renewable energy that can be traded; and the Binance coin can be used to pay trading and exchange fees. In other words, a utility token is purchased to be used — and in theory, every ICO contributor is a potential future user of the proposed service. Utility tokens are not meant as an investment — that is, one does not purchase them in order to receive profits in the future. Here is where the trouble and confusion begin, however.

Why does the SEC have a problem with ICOs?

The U.S. Securities and Exchange Commission, or SEC, is probably the world’s most potent financial regulator. Its stated mission is “to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation.” The SEC was created in 1934, and most of its activity revolves around preventing securities fraud and making sure that companies that sell securities are honest about what they’re doing and conform to all the regulations.

The SEC might be a friend for investors, but it’s no friend of ICOs. According to the regulator, many of the “utility” tokens offered by ICOs represent investment contracts rather than true utilities — in other words, they are securities and should be properly registered as such. Last February, SEC chairman Jay Clayton famously stated, “I believe every ICO I’ve seen is a security.”

To understand how the SEC determines what counts as a security it’s useful to take a look at the Howey test. It was developed in 1946 as a result of a famous court case (SEC vs. W. J. Howey Co.) and provides four signs of a security:

1. People invest money…

2. with an expectation of a profit…

3. into a common enterprise…

4. where any profit is a result of a third party’s actions.

Now let’s return to our blockchain startup. Are all those backers really purchasing tokens to use the proposed insurance or travel platform in the future? Perhaps some of them are, but most expect to sell their tokens once they’re listed on a digital exchange and their price rises (if the project is successful, that is). In other words, token buyers expect to receive a profit from a common enterprise (the startup), and that eventual profit depends on the efforts of the project team. What do we have here? A security! And if you’re a startup selling securities but presenting them as “utility” tokens instead of registering them with the SEC, you are committing securities fraud.

Curiously, blockchain startups don’t often make much effort to mask the fact that their tokens are an investment. In many white papers and on ICO websites, you can find mentions of token price growth, listings on crypto exchanges, and so on. ICOs basically tell you, “Yes, you will be able to sell our tokens later at a profit!”

You shall not pass!

Matters of securities registration aside, perhaps the SEC wouldn’t be so interested in ICOs if there wasn’t so much fraud on the market. A good recent example is Centra, which raised $32 million. It was a scam: The project lied about having partnerships with credit card brands as well as about holding state licenses, it falsely guaranteed investors dividends, and it created fake social media profiles for its fictional team members, using private individuals’ photos without permission. Centra’s three founders were arrested by the FBI at the instigation of the SEC in April 2018 and were forced to return all illegitimately obtained gains (plus interest and additional penalty fees). They also received a permanent ban from taking the role of an officer or director of a public company and a lifelong restriction from participating in offering securities, digital or otherwise. (As an aside, let’s note that the SEC doesn’t possess criminal authority, but it does have the right to launch thorough investigations to find those responsible for committing securities fraud and bring them to justice.)

In another well-known case, the SEC moved to block the operations of Titanium Blockchain, which had raised $21 million. The startup had lied about having partnerships with companies such as Boeing and Walt Disney and claimed that investing in Titanium was like investing in Google. All assets of the company are now frozen.

Finally, let’s mention a statement made by the SEC on November 2, 2018 that it is currently investigating “dozens” of ICOs, some of which are still ongoing. We probably haven’t seen the last of the arrests yet.

The rise of true security tokens

A way out of this conundrum may lie in real security tokens — designed, marketed, and registered as securities. A security token can give its holders the right to participate in the distribution of dividends, receive interest, share in the profits, and invest in tokenized assets to generate income. Sometimes holders of security tokens may even get a say on decisions made by the organization.

Security tokens are offered not through ICOs but STOs (security token offerings), are subject to the rules imposed by the SEC and other regulators, and are traded at specially licensed exchanges. Such exchanges are still few, but we can expect to see more of them emerge as security tokens attract a mass following. Major market players are already moving in this direction. For instance, Coinbase has obtained a license to trade security tokens, while Binance has struck a partnership with the Maltese stock exchange for the same purpose.

Sure, running an STO requires additional effort on behalf of a startup, but at the same time it significantly reduces investor risk and can create a positive image around a project, distinguishing it from the now-tainted ICOs.

A few prominent security token offerings have already taken place. Among them are Blockchain Capital, a venture capital firm that ran the first-ever STO; Science Blockchain, an investment fund and incubator, and Lottery.com, whose security token holders receive yields based on the company’s gross raffle sales. Finally, the widely publicized project Polymath is working on a platform for developing and launching STOs that (so it promises) will become the Ethereum of STOs.

Thaler.One’s real-estate-backed digital security

Thaler.One, a company dealing with real estate investments in digital assets, is one of the players on the emerging security token scene, offering a real-estate-backed digital security. Up to 85% of the proceeds from the first round of the token sale (and up to 95% in subsequent rounds) will be used to acquire properties in the EU and UK, which will then be developed and sold or rented at a profit. A portion of this income will be paid out to token holders as dividend, with a forecasted dividend income rate of around 15–20%.

Next, Thaler.One will issue special digital shares, called Thaler.Block, representing ownership rights for specific properties, essentially tokenizing them. A special marketplace will be created for real estate agents and sellers, on which each property will be converted into a digital asset (tokenized). The company will charge real estate sellers a fee for tokenizing their assets, as well as a commission on successful sales. Part of this revenue will also go to the holders of Thaler.One tokens, with the projected income rate from one property at circa 5%.

The company offers its digital security for US$1, with a presale soft cap of US$30 mln and a hard cap of US$50 mln, followed by a crowdsale soft cap of US$50 mln and a hard cap of US$100 mln.

Thaler.One CEO Will Andrich says the team chose to create a digital security to better comply with regulations. “We’re an honest investment company, and we want to do things right. So, even though applying for certification and licenses is complicated and time-consuming, it shows our investors we’re a serious, trustworthy company.” He adds that the process of becoming SEC-compliant is complex and expensive. “Nonetheless, though, the team is dedicated to the mission and willing to work hard to create a company that can improve both the real estate investing and crypto worlds.”

STOs are coming

2019 may prove to be the decisive year for security tokens. Soon we will see if they can indeed usher the power of blockchain into the traditional investment world through regulation and backing by real-world assets, revitalizing digital investments and resolving the conflict between crypto startups and state regulators. Are security tokens set to rule the blockchain landscape? The emergence and rapid growth of such large projects as Blockchain Capital, Polymath, and Thaler seems to be a good indication that they are.

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