Much uncertainty exists throughout the world on the legality and legal classification of crypto tokens. In the United States, Ripple was sued recently for allegedly selling unregistered tokens (XRP) in a violation of U.S. securities laws. The US SEC and CFTC have held hearings and are assessing whether to classify certain tokens as securities and/or commodities. Both agencies have issued guidance on this (see, for example SEC and CFTC), but many issues remain.
Some industry experts have commented on the classification of three of the biggest tokens- bitcoin, ether and ripple. Many believe bitcoin and ether are not a security. However, debates exist as to whether ether or ripple are. Over 1500 crypto tokens exist, each with a different set of characteristics, function and purpose. The SEC has said most tokens are likely securities under the Howey Test.
So what are the differences between crypto tokens and how should this impact their classification? The industry hope for guidance from the SEC and CFTC sometime soon. It is hard to predict exactly where this will come out. However, it is useful to consider what has been done in Switzerland.
Earlier this year, the Swiss Financial Market Supervisory Authority (FINMA) issued guidelines which explained how it intends to address Initial Coin Offerings (ICOs). It distinguished between certain types of tokens and certain types of ICOs, but the core principles focus on the function and transferability of tokens. In the Guidelines, FINMA stated:
In assessing ICOs, FINMA will focus on the economic function and purpose of the tokens (i.e. the blockchain-based units) issued by the ICO organiser. The key factors are the underlying purpose of the tokens and whether they are already tradeable or transferable. At present, there is no generally recognised terminology for the classification of tokens either in Switzerland or internationally. FINMA categorises tokens into three types, but hybrid forms are possible. It identified three types of tokens.
- Payment tokens which are synonymous with cryptocurrencies are tokens which are intended to be used, now or in the future, as a means of payment for acquiring goods or services or as a means of money or value transfer. Cryptocurrencies give rise to no claims on their issuer and have no further functions or links to other development projects. Tokens may in some cases only develop the necessary functionality and become accepted as a means of payment over a period of time.
- Utility tokens are tokens which are intended to provide digital access to an application or service by means of a blockchain-based infrastructure.
- Asset tokens represent assets such as participations in real physical underlying companies, or earnings streams, or an entitlement to dividends or interest payments. In terms of their economic function, the tokens are analogous to equities, bonds or derivatives. Tokens which enable physical assets to be traded on the blockchain also fall into this category.
Based on these criteria, (function and transferability), FINMA indicated that it will handle ICO enquiries as follows (see also the diagram in the Guidelines, page 8):
- Payment ICOs: For ICOs where the token is intended to function as a means of payment and can already be transferred, FINMA will require compliance with anti-money laundering regulations. FINMA will not, however, treat such tokens as securities. Given that payment tokens are designed to act as a means of payment and are not analogous in their function to traditional securities, FINMA will not treat payment tokens as securities. This is consistent with FINMA’s current practice (e.g. in relation to Bitcoin and Ether).
- Utility ICOs: These tokens do not qualify as securities only if their sole purpose is to confer digital access rights to an application or service and if the utility token can already be used in this way at the point of issue. If a utility token functions solely or partially as an investment in economic terms, FINMA will treat such tokens as securities (i.e. in the same way as asset tokens). Utility tokens will not be treated as securities if their sole purpose is to confer digital access rights to an application or service and if the utility token can actually be used in this way at the point of issue. In these cases, the underlying function is to grant the access rights and the connection with capital markets, which is a typical feature of securities, is missing. If a utility token additionally or only has an investment purpose at the point of issue, FINMA will treat such tokens as securities (i.e. in the same way as asset tokens).
- Asset ICOs: FINMA regards asset tokens as securities. Asset tokens constitute securities if they represent an uncertificated security and the tokens are standardised and suitable for mass standardised trading. An asset token also qualifies as a security if it represents a derivative (i.e. the value of the conferred claim depends on an underlying asset) and the token is standardised and suitable for mass standardised trading. In the case of the pre-financing and pre-sale phases of an ICO which confer claims to acquire tokens in the future, these claims will also be treated as securities (i.e. in the same way as asset tokens) if they are standardised and suitable for mass standardised trading.
FINMA stressed that individual token classifications are not mutually exclusive. Asset and utility tokens can also be classified as payment tokens (referred to as hybrid tokens). In these cases, the requirements are cumulative; in other words, the tokens are deemed to be both securities and means of payment.
There is some logic to these classifications, but it remains to be seen whether the US adopts a similar approach.