Types of tokens, differences

Introduction

The crypto world developed in its early years in a tumultuous and chaotic way and confronted the players in the financial world, including regulators and clients, with a new context in which concepts and terms were unfamiliar and carried with them ambiguities and even dangers. The use of the cryptocurrency terms and the types of tokens were sometimes confusing and based on a poor understanding of their intrinsic characteristics and the differences between the various types. The regulatory bodies that have put their hands on the matter have therefore had to deal with the detailed analysis of the situation, which is in continuous evolution with the birth of new products, services and applications in the DeFi field.

From a regulatory point of view, there are 3 main types of tokens: utility, security and payment tokens.

Payment tokens

Payment tokens, better known as cryptocurrencies, are used as an alternative means of payment and exchange. Unlike fiat currencies such as the US dollar, euro or Japanese yen, payment tokens like Bitcoin are not legal tender and are not backed by a government (except for the recently news of El Salvador). Instead, their main goal is to be a decentralized tool for buying and selling goods and services without traditional intermediaries.

Cryptocurrencies have many more similarities to commodities, such as gold, than traditional currencies. In fact:

– Cryptocurrency performance is not tied to the performance of a particular country’s economy

– Interest rates and monetary policies do not impact the value of cryptocurrencies

– Investors often prefer to own cryptocurrencies while waiting for them to increase in value, and then convert them into traditional currencies.

The authorities of Europe and other countries have clarified that the purchase and use of virtual currencies is considered a lawful activity, as the parties are free to obligate themselves and pay sums that are not legal tender.

A ruling of the European Court about the obligation to pay VAT in case of provision of services of bitcoin/traditional currency exchange has also clarified that virtual currency is not comparable to legal tender, although it has the same purpose of means of payment.

Utility tokens

Unlike cryptocurrencies, tokens are not currency intended as a means of payment, but a kind of coupon that can be converted into products or services of the company that issues them. They became popular as part of Initial Coin Offerings (ICOs) when they were widely used to raise funding due to the fact that this choice, from a regulatory standpoint, was easier than other forms of funding. However, time showed that the regulatory simplicity left room for fraud and scams that mostly resulted in the rapid demise of many startups that left the holders of their tokens empty-handed.

Utility tokens thus grant holders access to a current or future product or service, but they do not grant holders the rights granted by investments in the company’s capital and thus should not be regulated. However, even among regulators there are sometimes partially different interpretations: 

  • The German BaFin states that utility tokens are not electronic money due to the fact that they are not accepted by third parties and therefore clarifies that “any trade-based services performed exclusively with these tokens on the secondary market do not require authorisation”. 
  • The UK authority (FCA), on the other hand, believes that utility tokens in some cases should be treated as electronic money and in these cases activities involving them should be subject to different regulations.
  • As for EU, the European Banking Authority’s report with advice for the European Commission on crypto-assets states that the usage examples of utility tokens may differ significantly and consequently the regulatory treatment may not be the same either.

Security tokens

Security Tokens, also referred to as Asset Tokens, Equity Tokens or Investment Tokens, provide rights and obligations similar to securities or investments such as stocks or debt instruments.

The European Securities and Markets Authority (ESMA) has undertaken a survey among the national competent authorities of EU member states to determine the legal status of crypto-assets and to determine the possible applicability of the EU Financial Regulation ESMA.

The result of the survey showed a convergence towards the common view that cryptoassets that meet the necessary conditions to qualify as financial instruments should be regulated as such, however, the report also highlighted the difficulties in classifying some tokens under the existing rules.

Therefore, BaFin suggests that the general rule for classifying a financial instrument is that it is transferable, tradable in the financial market and includes rights comparable to securities. 

In practice, the line taken at European level is to privilege substance over form, that is, to analyze the characteristics of the tokens and make them fall into the traditional financial categories and then apply the rules of the category.

If rights comparable to those associated with securities are attached to a token, then the token facilitates greater tradability through simplified transferability and greater marketability and is therefore quite similar to a traditional security.

A dynamic world: hybrid models

Of course, token models do not end there. Attempts have also been made at the academic level to produce a comprehensive taxonomy of tokens  and this has resulted in complex classifications built on a large number of characteristics.  

On the other hand, the industry is very dynamic and innovators will continue to strive to come up with different models and already a number of existing tokens combine the different categories. 

To confirm this, FINMA points out that security tokens and utility tokens can also be classified as payment tokens, in which case the requirements are cumulative or, in other words, the tokens are considered both securities and means of payment. Indeed, there are already now many providers who intend to use their utility tokens in the future as means of payment and thus virtual currency. Here the regulators agree again how the general approach in these cases is to define the function of the token and analyze the specific use cases.


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