Tokenization: The Revolution Is Now – Technology


    I. OVERVIEW

    The future is here. The ideas of tomorrow are happening today.
    Practical applications for Digital Ledger Technology
    (“DLT” or blockchain) are not merely notional exercises
    by anti-establishment, disenfranchised free thinkers. No, the
    revolution is now. The movement is happening, and investors,
    corporations large and small, and industry are jumping on board
    every day. Whether a mom-and-pop dry cleaner or a professional
    sports league, all are looking for their place in this new
    decentralized financial (“DeFi”) world. However, with any
    movement, with any unconventionality, comes questions. The two most
    common perhaps-How can I use this to make money; and, What are
    my risks?

    The law is not yet mature in this area. However, we know
    regulatory agencies are paying attention to this space and, based
    on their actions thus far, we know how to mitigate risk so
    individuals and businesses can operate within defined parameters
    and with less fear of the unknown. To that end, this alert seeks to
    provide an overview of the different types of cryptocurrency tokens
    (security token, utility token, and non-fungible token), common
    regulatory considerations associated therewith, and implementation
    strategies to maximize transactional security without triggering
    unnecessary regulatory scrutiny.

    II. CRYPTOCURRENCY TOKENS

    A cryptocurrency “token” is a custom, digital asset-a
    string of characters that may provide the holder the rights to an
    underlying asset issued on top of a blockchain. A blockchain is a
    decentralized, distributed ledger consisting of blocks (records)
    used to track transactions. Tokenization, simply, is the process of
    converting the rights (ownership, leasehold, license, etc.) to an
    asset (anything of value) into digital form on a blockchain.1 On
    blockchain (“on-chain”) transactions rely on “smart
    contracts” which are a series of conditional (if-then)
    statements written in code to form the basis of a self-executing
    contract.2

    Broadly, tokens fall into two categories: fungible and
    non-fungible. While fungible tokens can be used like currency to
    facilitate exchanges of value on a particular blockchain,
    non-fungible tokens represent an emerging class of unique, digital
    assets that are also tracked and traded on-chain.

    A. Fungible Tokens

    A fungible token-for example, Bitcoin-relates to a unit of value
    that can be traded or freely exchanged, and is effectively
    indistinguishable from other tokens in the same ecosystem. A
    Bitcoin is a Bitcoin, and one Bitcoin is not more valuable or rare
    than any other Bitcoin. Fungible tokens often work similarly to
    fiat currency-for example U.S. Dollars. Like one $20 bill has the
    same value as any other $20 bill, a fungible token, regardless of
    when it was mined (minted), who previously owned it, or for what
    value the token was previously exchanged, has the same value as its
    fungible counterparts. Just as a shopkeeper does not distinguish
    one $20 bill from another before accepting it in exchange for
    goods, a fungible token provides the same value to transacting
    parties as any other like fungible token. Accordingly, fungible
    tokens provide the basis of all on-chain payment systems. Fungible
    tokens likewise are divided into two primary forms: (1) security
    tokens, similar to money-classified by regulators as a security,
    and (2) utility tokens, similar to a gaming arcade token-issued for
    functionality with a specific purpose.

    1. Security Tokens

    Security tokens represent tradeable financial assets that are
    deemed to be “securities” under applicable law and are
    therefore regulated. Just as a share of stock in a public company
    comes with the expectation of profit, so too does a security token.
    As discussed in greater detail below, it is not uncommon in this
    space for tokens distributed through Initial Coin Offerings
    (“ICO”), originally purposed as utility tokens, to become
    security tokens depending on the issuance’s underlying facts.
    While there is certainly value to security tokens, securities come
    with a host of regulations. In lieu of facing such regulations,
    issuers often opt to avoid introducing security tokens onto an
    ecosystem.

    2. Utility Tokens

    Utility tokens are the other type of fungible tokens. A utility
    token is a blockchain-based asset that a holder can exchange for
    something else of value, typically a good or service offered by the
    token issuer. Borrowing from the example above, utility tokens work
    similarly to game tokens at an arcade. A player exchanges currency
    (either fiat or digital) for tokens to play games or ride rides
    within the arcade. Even though the game tokens may only have value
    within a particular arcade, the tokens themselves are fungible-in
    that one is the same as another-and the player uses the tokens for
    a specific purpose, limited to the ecosystem of the arcade.

    The uses for utility tokens are limited only by the issuer’s
    imagination. Most frequently, however, utility tokens are used on
    particular platforms-such as on a website or in a mobile game-to
    purchase or obtain something of value on those platforms. For
    instance, a videogame developer may issue utility tokens to raise
    money to fund the creation of a game, and then allow the token
    holders to redeem the tokens for in-game purchases upon its launch.
    Outside of the game, however, the tokens have no value.
    Importantly, utility tokens are not offered as
    “investment opportunities.” Rather, utility tokens offer
    current or future access to a company’s products or services,
    not an expectation of future profit.

    B. Non-fungible Tokens

    Non-fungible tokens (“NFTs”), on the other hand,
    relate to unique digital assets rather than a standard measure of
    value. Therefore, the holder of one NFT cannot necessarily obtain
    equal value by exchanging a token for another NFT within the same
    ecosystem. If something can be digitized, perhaps even if not, it
    can operate as an NFT. Indeed, NFTs have been used to transform
    collectibles-for example, a digital work of art-into one-of-a-kind,
    verifiable assets that can be traced, authenticated, and
    sold/traded on-chain. NFTs are particularly well-suited to prove
    ownership, identify the uniqueness of assets, and identify
    counterfeits from originals. This is because each asset’s
    identifiable information is immutable on-chain. NFTs not only
    differ in functionality from fungible tokens, but also fall under
    an entirely different coding protocol and structure compared to
    those of fungible tokens.3

    Recently, NFTs garnered the art world’s attention when an
    NFT created by the digital artist Beeple sold for $69 million. With
    the creation of the NBA’s Top Shots (which allows users to
    purchase a token of a particular NBA highlight clip), the sports
    world demonstrated its desire to get in on the NFT action. Although
    the digital asset that an NFT relates to may be infinitely
    replicable-anyone can run a Google image search for Beeple’s
    artwork or watch NBA highlights on YouTube-the token itself is
    limited by a predetermined quantity and quality the issuer assigns,
    which, as with any other asset, creates scarcity and drives demand.
    Indeed, an NFT’s value stems from collector culture, the desire
    for patronage (i.e., supporting a particular artist, player, or
    team), and proof of ownership. Think owning a signed 1986 Fleer
    Michael Jordan rookie card, versus having a picture of the
    same.

    Where NFTs and other on-chain assets differ from other assets is
    in their immutability, and therefore their transparency. Anyone can
    view a painting in a museum, but who’s to say that painting is
    an original? What if the curator was wrong? What if the provenance
    is forged? With DLT and NFTs, the expectation is that those worries
    disappear. With NFTs, authenticity is built into the code. The code
    is transparent, verifiable, and immutable. The blockchain creates a
    certificate of authenticity for each token so the originating
    source is identifiable.

    III. REGULATORY CONSIDERATIONS4

    A. Utility Tokens

    Tokens are issued through various forms of token offerings, most
    commonly through ICOs, where purchasers acquire tokens in exchange
    for payment. If an ICO offers a security token-distinct from a
    utility token-the offering is subject to regulation by the U.S.
    Securities and Exchange Commission (“SEC”) under federal
    securities laws.5 According to the SEC’s 2019
    guidance framework, the Howey test governs whether a token
    is a security (or “investment contract”) thereby
    triggering registration and subsequent reporting requirements.6 It is
    worth noting that a token may be characterized as a security even
    if the issuer intended otherwise.

    In SEC v. W.J. Howey Co., 328 U.S. 293 (1946)
    (“Howey“), the Supreme Court determined that
    “an ‘investment contract’ exists when there is [1] the
    investment of money [2] in a common enterprise [3] with a
    reasonable expectation of profits [4] to be derived from the
    efforts of others.”7 The test is conjunctive. An item
    must satisfy each of the Howey test’s four elements to
    qualify as an “investment contract” and therefore invite
    SEC scrutiny.8 The materials used to promote the
    sale of the digital assets, and the manner in which they are
    offered, sold, or resold are particularly relevant to whether the
    token is a security.9 To be sure, the Howey
    test applies to any contract, scheme, or transaction, regardless of
    whether it has the characteristics of typical securities.10

    SEC leadership remarked in 2018 that “where the digital
    asset is sold only to be used to purchase a good or service
    available through the network on which it was created,” it is
    unlikely to qualify as a security.11 So by structuring an ICO and its
    tokens not as an investment designed to generate profit for the
    investor, but rather as a new method of payment accepted on the
    issuer’s platform-like arcade tokens-an issuer may be able to
    avoid regulatory requirements applicable to securities.12
    While the SEC lists a litany of considerations in its 2019
    guidance, issuers hoping to avoid security classification should
    ensure that tokens do not give “the holder rights to share in
    the enterprise’s income or profits, or to realize gain from
    capital appreciation of the digital asset.”13 Additionally,
    issuers should maintain “apparent correlation between the
    purchase/offering price of the digital asset and the market price
    of the particular goods or services that can be acquired in
    exchange for the digital asset.”14

    Importantly, the SEC recognized that price appreciation of a
    token “resulting solely from external market forces (such as
    general inflationary trends or the economy) that impact the supply
    and demand for an underlying asset generally is not considered
    ‘profit’ under the Howey test[.]”15 As
    such, issuers offering utility tokens used for goods and services,
    rather than as a speculative investment designed to increase in
    value over time, mitigate the risk of security classification.16

    B. Non-fungible Tokens

    Although the SEC has not yet commented specifically on NFTs, it
    is reasonable to assume the Howey test and related
    considerations likewise govern NFTs. Under the framework discussed
    above, an NFT connected to a collectible or an item intended for
    use-for example, tickets to an event or other experience-is
    unlikely to fall under the definition of a security.17
    The blockchain serves more as a means of authenticating the
    underlying asset than creating a market for investors reasonably to
    expect to profit from its appreciation. However, if issuers offer
    NFTs to the public with the promise of liquidity and/or increasing
    the NFT’s value through the daily continued services of the
    issuer, such a token will likely trigger SEC scrutiny. Marketing,
    while not dispositive, is also critical to the analysis. Deliberate
    packaging of NFTs is essential. Issuers not intending to create
    securities must ensure they do not create an expectation of a
    return on a passive investment, and instead need to focus on the
    qualities particular to that token.

    C. Additional Risk Mitigation

    Issuers should also devote the time and resources necessary to
    develop and implement comprehensive know-your-customer
    (“KYC”) and anti-money laundering (“AML”)
    policies that govern both the initial sale of tokens and any
    subsequent financial transactions. As with any monetary
    transaction, an issuer must be careful not to conduct business with
    individuals or entities subject to legal restrictions such as those
    imposed by U.S. Department of Treasury, Office of Foreign Assets
    Control. Requiring customers to create an account, identify their
    location, provide contact information, and agree to terms and
    conditions clarifying their rights and responsibilities are an
    excellent way to alleviate risk. Likewise, clear disclosures should
    describe exactly what a purchaser will receive to ensure compliance
    with consumer protection laws. For instance, an NFT may include
    ownership rights over a purchased image, but not the copyright to
    the original image. Transparency is key. It reduces the risk of
    misunderstanding between issuer and customer, and is a fundamental
    pillar on which blockchain was built.

    IV. MAKING TOKENS WORK

    A. Utility Tokens

    Again, utility token applications are limited only by the
    imagination of the issuer. Indeed, the benefits include the ability
    to access a new demographic and expand to an ever-increasing
    customer base who prefer cryptocurrency to fiat currency. Utility
    tokens, similar to gift cards, provide instant liquidity through
    their sale regardless of whether the token is redeemed immediately
    or on a future date. Purchasers of utility tokens benefit by
    locking in prices and eliminating the risks associated with
    volatile cryptocurrency fluctuation, and the uncertainties
    associated with inflation-the value of utility tokens are generally
    fixed at sale.

    The first step in the offering process is selecting (or
    creating) a reliable blockchain platform on which to launch the
    utility token. Overwhelmingly, issuers tend to prefer the Ethereum
    platform for ICOs-over 80% of ICO projects use the Ethereum
    platform, while only 8% choose to build a custom platform, with the
    remainder launching on an Ethereum competitor’s platform.
    Ethereum is extremely popular as a platform because it is so
    accessible, easy to code on, and very large, thus adding an
    additional layer of security while staying true to its foundation
    of decentralization and cryptographic application.

    Preparing for a launch should involve drafting a
    “whitepaper” and developing a marketing campaign to
    capture the details of the ICO, describe the terms of sale, provide
    legal disclosures, and properly market the token as a utility token
    exchangeable for defined goods and/or services. Issuers are
    increasingly using dedicated ICO websites, or carveouts on existing
    websites, to post whitepapers and to conduct conventional
    advertising to generate awareness of ICOs in advance of
    launching.

    At least at the outset, developing and launching on the Ethereum
    platform allows the issuer to create tokens using the code provided
    by Ethereum. The industry-standard ERC-20 token outlines smart
    contract parameters, which provide the protocol to automatically
    execute and document events related to the tokens with the terms of
    the agreement between buyer and seller directly written into lines
    of code. Prior to launch, issuers should audit smart contracts and
    conduct test transactions to ensure transactions will appear on the
    Ethereum blockchain as designed. Finally, launch the ICO and
    standby as the information necessary for accounting and
    recordkeeping appears on-chain.

    B. Non-fungible Tokens

    Individuals and companies are just beginning to explore the
    possibilities of tokenizing assets. Thus far, we have seen art,
    videos, and the first Tweet tokenized and sold (to name a few).
    However, as NFTs expand in popularity, so too will the product
    base. And why not? NFTs and DLT reduce the risk of counterfeit and
    fraud. Using an event ticket as an example, tokenization allows,
    and ensures, the ability to track each individual ticket sold in
    case an issue arises with a particular ticket-for instance,
    policing an anti-scalping policy, the need to ascertain who holds
    the valid ticket when two fans show up with identical printouts, or
    if a security concern arises and there is a need to quickly
    determine the identity and location of ticket holders.

    Establishing an NFT is relatively easy. First, decide which
    blockchain to use. Ethereum again dominates the market. Minting an
    NFT on the Ethereum blockchain requires only an Ethereum wallet
    that supports ERC-721-the Ethereum-based NFT token standard. Next,
    build a marketplace or use an existing NFT marketplace. Tokenize
    the assets and upload them to the marketplace. Finally, start
    selling NFTs on the marketplace by setting conditions of
    sale-including the date and time a token becomes available, whether
    it is available for a fixed price or in an auction format, and any
    other information necessary to compose a smart contract. Again, the
    blockchain records all transaction information thereby making
    accounting and recordkeeping information instantly retrievable.

    V. CONCLUSION

    The economy of tomorrow has arrived. Enterprise built on
    blockchain. While we have only just begun to scratch the surface on
    new applications for blockchain and tokenization, the possibilities
    are endless. Tokenization is the way of the future. Now is the time
    to enter this growing space and capture the benefits of
    innovation.

    Whether launching utility tokens that holders redeem for
    products and/or services, or transforming unique items into NFTs,
    tokenization provides access to a growing market of cryptocurrency
    users and creates new and unique revenue streams. Innovation
    beckons opportunities that will shape businesses for years to come.
    Welcome to the new era.

    Footnotes

    1. A
    token itself is merely a cryptographic string of numbers and
    letters that contains no independently meaningful data. It relates
    back to potentially valuable data or another digital asset (the
    cryptographic code is a “stand-in” for real
    data).

    2. On the
    Ethereum blockchain, for instance, smart contracts are written in
    an Ethereum-based contract code called Solidity. By relying on DLT,
    smart contracts are both immutable and distributed, which
    eliminates the need for an intermediary to verify or facilitate
    transactions that automatically execute upon the satisfaction of
    objective criteria.

    3. On the
    Ethereum blockchain, for instance, NFTs use a different source code
    than fungible tokens and follow the protocols in ERC-721, rather
    than ERC-20 for fungible tokens.

    4. This
    section is meant to provide an overview of the regulatory
    considerations when classifying tokens. It by no means is a
    complete discussion of potentially applicable securities laws and
    regulations. As “security tokens” are, by default,
    securities and therefore subject to securities laws, this section
    and the sections that follow focus on the regulatory considerations
    of the remaining categories of tokens.

    5. SEC,
    Framework for “Investment Contract” Analysis of
    Digital Assets
    (Apr. 3, 2019) [hereinafter SEC Guidance],
    available at
    https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets.

    6.
    Id.

    7.
    Id.

    8.
    SEC v. W.J. Howey Co., 328 U.S. 293, 300
    (1946).

    9. SEC
    Guidance.

    10.
    Id. at 298.

    11.
    William Hinman, Digital Asset Transactions: When Howey Met Gary
    (Plastic) (June 14, 2018), available at
    https://www.sec.gov/news/speech/speech-hinman-061418.

    12.
    Id.

    13.
    SEC Guidance.

    14.
    Id.

    15.
    Id.

    16.
    Id.

    17.
    Id. The facts and circumstances regarding any particular
    NFT would, of course, need to be examined against the SEC’s
    guidance to ensure the token does not qualify as a
    security.

    The content of this article is intended to provide a general
    guide to the subject matter. Specialist advice should be sought
    about your specific circumstances.



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