How a Potential Crypto-asset Security Classification Would Threaten to Unwind The Budding…

In light of recent news that U.S. regulators are reviewing crypto-assets under securities laws, it has become clear that classifying crypto-assets within the framework of traditional financial instruments has proven to be a daunting task for several regulatory bodies as well as Congress, and for good reason. Crypto-assets that function as utility tokens, or tokens representing vouchers to receive products or services employed by specific decentralized platforms, simultaneously represent characteristics of currencies, commodities, and securities alike. Think of utility tokens akin to the Dave & Busters’ Power Card, which is its company-specific voucher to play games at its locations.

The emerging asset class launched from relative obscurity to international stardom in the span of less than a year, and the level of regulatory bodies’ understanding of the technology has not kept pace with its explosive growth. The eye-popping returns earned by early investors in crypto-assets have birthed a new crop of over-exuberant and under-educated retail investors pining to get involved. While many if not most development teams are genuine in their mission to launch novel decentralized platforms, the lack of regulation in the space has predictably incited malicious actors to create fake ones and dupe retail investors into purchasing their associated crypto-assets. In response to this quickly materializing urgency to protect investors, regulators are understandably rushing to enact legislation. However, expediting the implementation of regulation without properly understanding the technology and its vast implications for the future of commerce could have significant consequences. Specifically, unilaterally classifying all utility tokens as securities will limit their mainstream adoption and greatly hinder the technology’s potential to alleviate economic inefficiency across industries.

To illustrate the classification confusion, let us discuss the second most recognized and capitalized crypto-asset network that recently dodged a security classification: Ethereum (Note: it is important to mention that this issue still threatens the decentralized economy despite Ethereum’s commodity status because there are hundreds of utility tokens that may well qualify as securities due to their centralized development and promotion). Ethereum has been described as a decentralized world computer that has enabled virtual money to be programmed into self-executing digital contracts. If, say, the owner of a ski mountain (who profits from greater snowfall) and a nearby municipality (who suffers higher plowing costs with greater snowfall) wanted to hedge risk with a weather derivative contract so that they are financially compensated when the amount of winter snowfall is unfavorable for their business and vice versa, they could do so without banks using Ethereum. For this reason, the platform has been lauded for its ability to enable the trustless peer-to-peer exchange of value over the Internet without needing to pay fees to third parties. Institutions including banks, credit agencies, and lawyers are trusted third parties in the traditional economy whereas Ethereum mediates financial transactions with immutable and publicly visible code.

As Ethereum works today, Ether is charged every time data is written onto the blockchain (launching a digital contract, debiting or crediting a user’s wallet balance) thus making Ether the medium of exchange and effectively a currency on the platform. Dually, because Ethereum is fortified by massive pools of computer processing power, Ether can be thought of as proxy asset to the securing computational power itself, thus earning it the title of a commodity. Lastly, Ether has been said to embody an investment contract between a decentralized network’s development team and those who purchased Ether in its Initial Coin Offering. An ICO marks the launching of a decentralized network and the initial public distribution of these token vouchers guaranteeing the right to receive a product or service from the network in the future, and the SEC has taken a liking to these tokens as securities because their initial sale is an excellent way to raise capital for the network’s past and future development.

As you can imagine, the above illustration is not entirely thorough, but it serves to establish a fundamental understanding of the complexities of the issue. Now, while there are many poignant arguments both for and against classifying utility tokens as securities from regulators and industry participants alike — as well as multiple public announcements from the SEC, CFTC, and members of Congress addressing the issue — I will not attempt to analyze and discern what was meant by existing statements. What is clear, however, and apart from my personal view of the best regulatory framework I personally see best fit for utility tokens, is that a securities classification would disincentivize mass participation and threaten the economically efficient future that blockchain technology promises.

This great threat to utility tokens is rooted in the tax laws surrounding securities. Every transaction involving a security, whether it’s the purchase or sale of a stock or bond, constitutes a taxable event in which capital gains must be reported and partially forfeited to the IRS. While seemingly inconsequential on the surface, the taxation of utility tokens in this way would likely deter the crypto community at large from participating in decentralized networks altogether. Let me reference the recent popularity of a game launched on the Ethereum blockchain called CryptoKitties for context. Don’t let the infantile name distract you from to the overarching importance of the application to the future of decentralized platforms. The game not only demonstrates user demand for decentralized applications, the dire need for scalability solutions, and the power of non-fungible tokens to represent unique digital collectibles, but it also allows us to comprehend the real-world impact of an Ether security classification.

In the game, users purchase unique tokens whose properties produce a CryptoKitty with randomized features, some more rare than others. Users can then buy and adorn their pet with a variety of accessories, breed them, and trade them. While fun and frivolous, the game reveals that every customization of or interaction with the CryptoKitties requires Ether to add the transaction to the blockchain which under current securities laws would initiate a taxable event. Thus, every casual user would need to log the value of Ether and the amount spent at the time of each and every CryptoKitties transaction over the course of a year, calculate their capital gains and losses caused by the fluctuation of the value of Ether, and report them to the IRS. Considering the hundreds of thousands of CryptoKitties in existence aggregating near eight figures in value, the tedium of this process is palpable and certainly enough to intimidate potential new users into avoiding the platform altogether. Additionally, with regard to enterprise applications being built on Ethereum, the savings it could afford participants by more efficiently coordinating economic activity or circumventing third party fees will be significantly reduced by tax liabilities, further diminishing the power of the technology.

In conclusion, the regulatory bodies investigating crypto-assets need to fully educate themselves and consider with care how their classification of the instrument will affect its functionality. Ultimately, their decision will be industry-defining and could limit the effectiveness of the technology if they rush into unfitting regulation. Miscategorizing utility tokens would threaten the maxim on which the crypto community has amassed its following and vigor, an ideology that permissionless economic freedom is a fundamental right of all humans. Classifying utility tokens on active decentralized networks as securities is a rash decision, and a better one might be to consider utility tokens securities only when they are sold preemptively to the platform’s public launch because it is in this instance that they purely act as a vehicle for fundraising.