You Can’t Separate Utility from Security Tokens, Say EU Researchers

European researchers writing for the Oxford University Faculty of Law blog argue that the distinction between utility and security tokens is less important than most assume when it comes to regulation.  

In a Feb. 3 blog post and their paper, “Blockchain Startups and Prospectus Regulation,” Dmitri Boreiko, Paolo Giudici and Guido Ferrarini claim that the conceptual difference between the two types of crypto-assets “should be at least partially abandoned.”

Dmitri Boreiko is an assistant professor of corporate finance and the Free University of Bolzano-Bozen, where Paolo Giudici is a professor of business law. Guido Ferrarini, for his part, is emeritus professor of business law at the University of Genoa, and chair in governance of financial institutions at Radboud University of Nijmegen.

Moving beyond the utility vs. security divide 

The researchers make two key points regarding digital tokens and regulation, which relate both to token taxonomy and to financing models such as initial coin offerings (ICOs) and initial exchange offerings (IEOs).

Token taxonomy — or classification — generally refers to the distinction drawn between utility tokens and security tokens. 

In the United States, for example, a token is considered to have the characteristics of a security — specifically an investment contract — where its purchase is held to be an investment in a common enterprise, in which investors are reasonably led to expect profits that others generate.

A utility token, by contrast, is more limited in that the given digital asset is held to be valid as a means of payment for the services or products that its issuers create. 

In their work, Boreiko, Guidici and Ferrarini argue that the absolute difference between utility and security token is not as clear as some regulators claim. 

For example, where a blockchain ecosystem is large and liquid, a utility token may take on the properties of a currency and can usually be converted to a major cryptocurrency such as Bitcoin (BTC) or Ethereum (ETH) by means of an exchange. It can also directly or indirectly be traded for fiat currency. The researchers write:

“The utility token can be conceptualized both as a mini-currency and as an investment in a platform. That is the reason why all tokens are briefly and broadly dubbed ‘cryptocurrencies’. Indeed, they aim at becoming a general currency or a recognized and easily exchangeable market-specific currency.”

What makes hard and fast boundaries hard to draw, they continue, is that utility tokens combine a customer payment mechanism (similar to currencies), a utility aspect (within an ecosystem or platform) and an investment component (as a tradable asset) — all in one instrument. 

From a regulatory perspective, the line between currencies, financial assets and consumption goods therefore becomes blurred, the researchers say.

Financing models and EU regulation

In the second part of their paper, the researchers look at ICO and IEO crypto financing models. 

Here, they point to the reasonably high trading volume of tokens issued via either route, well after the offering itself. This, they say, indicates that investors see these assets as tradable investments and not merely as utility tokens redeemable for services.

This character as an investment instrument exposes investors to common capital market and financial risks, the researchers note, and regulators should therefore treat these assets as tradable securities in accordance with EU financial markets regulation:

“Have all the characteristics of a capital market instrument. We therefore argue that they are subject to prospectus regulation independently from the utility that they offer to contributors.”

Currently, in a U.S. context, a security token classification can have major consequences for ICO operators and other crypto firms, as securities sales are subject to stringent requirements under federal law. If violated, the penalties can be significant.

In Europe, much attention has recently been focused on anti-money-laundering regulation and cryptocurrencies, while approaches to token taxonomy still remain largely fragmented across different countries.