May 23, 2024

Token Types (Utility Tokens, Security Tokens, Stablecoins, RWA) and Their Legal Status

TABLE OF CONTENTS

This guide is designed to help founders who want to launch a token and who wish to understand the legal implications of different token types and their issuance

Today, tokens and token distribution methods are the subject of much regulatory confusion. Fortunately, there are two key criteria that can be used to help determine how a token might be classified for regulation, and what legal implications exist for different token issuance routes. 

This guide will focus on the first criteria and explain how different token use cases determine the legal status of the token. We will examine the current criteria used by regulators to help classify different tokens, and look closely at the legal implications of utility tokens, security tokens and real world asset tokens (RWA). We’ll also explore the various legal considerations that apply when issuing each token type.

In a separate guide we have explored the second criteria in more depth to help founders understand how the method of allocation (minting) and distribution of the token determines the legal status of a token. This guide also identifies token-friendly countries for different token types and token distribution methods. Read the guide here.

This guide is brought to you by the team at Legal Nodes, including co-founder Nestor Dubnevych. Legal Nodes is a platform for tech companies operating globally and helps startups establish and maintain legal structures in 20+ countries.

Please note: none of this information should be considered as legal, tax, or investment advice. Whilst we’ve done our best to make sure this information is accurate at the time of publishing, laws and practices may change. For help with the legal structuring of your project, speak to us.

We first published this guide back in 2022, and have since made substantial updates so that it contains the latest developments on:

  • How regulators view tokens in the context of a Web3 project, and how this plays into the tokens’ legal qualification.
  • How token distribution is determined as ‘centralized’ or ‘decentralized’ and what legal implications arise with each distribution type.

This guide is part of a series of new and updated resources that cover the various legal aspects of tokens. If you’re planning a token launch or simply exploring your options, you may find it useful to explore our guide on building your legal strategy first.

The challenges of token legal qualification nowadays

Today, the issue of the legal qualification of tokens remains a controversial topic for regulators worldwide. Unfortunately, there is still no unified approach to the legal qualification of tokens globally. 

Let’s take a brief look at the history of the attempts of regulators to qualify tokens legally and where it leaves the web3 builders right now.

Back in 2017, the US SEC first applied the Howey test to try to determine the legal qualification of a token as a security. After that, similar tests gradually began to appear in other jurisdictions (for example, the Maltese test of financial instruments, and the Lithuanian ICO guidelines test). In addition to regulatory tests, some regulators have gone further and started issuing explanations regarding tokens (Swiss guidance on types of tokens, UK guidance on types of tokens), and some of them even adopted special laws for tokens (Liechtenstein created them for utility tokens, Singapore for payment tokens).

Today, we are observing a new surge of progress by regulators and governments, as they attempt to define the legal status of different tokens. Clear examples of this can be seen with MiCA, the UK regulator’s recent issue of an explanation regarding stablecoins, and, in the UAE, regulatory approvals were given for Ethereum and Ripple tokens.

Additionally, in the last two years, more clarity on regulators’ approach to defining the legal nature of a token has emerged in the US. Unfortunately, however, this is happening through regulation through enforcement (SEC v. Ripple, CFTC v. Ooki DAO, and others)

For many founders, it is these inconsistencies in worldwide regulation that present the biggest challenges, especially when trying to work out how a token or token launch might be viewed by regulators. Let’s now take a look at just how to determine the legal status of a token given all these latest regulatory developments.

What is the criteria for determining the legal status of a token? 

By analyzing case law, regulations, and guidance published by regulators, governments and courts around the world, we can identify two main criteria that regulators consider when analyzing the legal status of a token.

  1. Criterion 1: the use cases of the token that drive the token’ value. By this criterion, tokens are divided into unregulated native tokens of protocols / decentralized networks (utility tokens) and regulated financial instrument tokens or electronic money (security tokens, RWA & stablecoins).
  2. Criterion 2: the method of allocation (minting) and distribution of the token. By this criterion, tokens are divided into those that are issued in a decentralized manner and are out of the scope of VASP / CASP regimes, and those that are issued in a centralized way, and are subject to VASP / CASP regulation.

Both criteria must be analyzed to effectively determine the legal status of a token issuance. This guide focuses on the first criterion: token use cases. To read more about the second criteria, the token allocation & minting process (aka launch strategy), visit this guide.

Identifying token types via their use cases

The technical layers of Web3 projects play an important role in the legal analysis of a token. This is because, within each of the three technical layers, tokens perform different roles and have different use cases. Each token use case can have vastly different legal implications, due to the fact that each technical layer is subject to varying degrees of regulation. We’ve examined the legal implications of each technical layer in our article on DLT, Protocol, and dApp legal structuring. Just like tokens, each layer of a Web3 project has different functionalities and controls things like governance, tokens, and users’ funds using different technical structures. This inevitably generates different risk profiles for each layer, which includes legal, tax and compliance implications that founders should always be aware of.

In this guide, our primary focus is on token use cases on the infrastructure layer (the blockchain network) and the settlement layer (the protocol). Tokens that only have use cases at the dApp level, for example: tokenized in-game items in Web3 games or NFTs, are not included in the scope of this analysis.

Applying the above criterion of identifying tokens by the use case that gives them value, the following token types are identified:

  • Utility tokens
  • Security tokens
  • Real-world assets (RWA) and stablecoins

👉 Launch and issue tokens compliantly

Utility tokens

Utility Tokens are the native tokens of protocols / decentralized networks. The value of this token type is driven by the token’s use within the software infrastructure of the protocol or network. Utility tokens may have the following use cases:

  • Gas fee
  • Access to functionality (on-chain licenses)
  • In-app credits
  • Software fee discounts

This is a non-exhaustive list and there are also additional factors that drive the value of the utility token. These include the ability to use the token to:

  • build a community
  • participate in DAO
  • be involved in the decentralized governance of the DAO (with community / governance tokens)
  • incentivize infrastructure supporters and project contributors (for example, by issuing token grants)

The table below contains a detailed analysis of utility token use cases, with a focus on the four different categories of token holders who are the stakeholders of the ecosystem.

👉 Launch your dApp protocol compliantly

Legal considerations for issuing utility tokens

When planning the release of utility tokens, it is important for Web3 teams to be aware of a number of legal considerations. By taking these into account, builders can put safeguards in place to help ‘defend’ the token’s legal status. In other words, by highlighting these characteristics of their utility token, legal teams can help demonstrate that their utility token should be legally classified as a utility token in the future.

1/ The token value is not dependent on any centralized (off-chain / real world) assets. 

Instead, the token value grows as a result of a combination of factors, and primarily as a direct result of the growth in demand for the underlying protocol or network, in which the token has native utilities. Also, the expansion of infrastructure supporters and the network of developers and contributors who contribute to the open-source ecosystem of the project, play a role in determining the token’s value. Lastly, the growth of the DAO, which manages the decentralized ecosystem can also drive the token’s value.

2/ The token value is not dependent on the managerial efforts of a centralized entity or group of people. 

The main or central driver behind the token value’s growth in the ecosystem is the software infrastructure. There can be several different use cases of the decentralized open-source protocol or network that influence the token’s value. However, there must be no token use cases that create expectations of passive income distribution from the managerial efforts of the centralized entity or group of people. This includes no promises of dividends, interest, or other types of passive income and no promises of a stake in the project.

3/ The token does not have any speculative use case that indicates the token is used as a fundraising or financial investment instrument. 

The token is issued at a time when the main product has already been developed and so the token will instantly have software-infrastructure use cases. These use cases are the main driver of the token value. Additionally, there are no promises in the token description about its listing on exchanges, token pricing, price growth, or market making, etc. Instead, the market independently conducts price discovery of the token at the moment when the product, in which the token has utilities, gains adoption.

Due to the high level of regulatory uncertainty regarding the legal status of tokens, the risks of re-qualifying utility tokens as securities still remain very high. By taking into account the legal considerations outlined above, Web3 teams can take as many steps as possible to try to partially mitigate these risks.

👉 Register a fundraising company for your Web3 project

Security tokens

The value of security tokens is driven by managerial efforts of a centralized entity or group of people. In some cases, the tokens represent tokenized equity of a business project, which is centrally managed by an entity or a group of people. In other cases, the value of the tokens depends on the value of the underlying assets associated with them, or, in other words, the tokenization of assets.

Business projects with tokenized equity usually have dividend tokens, which represent a stake or interest of a token holder in a business project that is managed by third parties. The third party can be both an entity and a group of people. In some case law, groups of people have already been recognized as a general partnership or unincorporated association, which, ultimately, leads to the definition of the group of people as a common enterprise. Therefore, a token in this context is recognized as security, as it falls under the three criteria of the US Howey test: the token is issued by a common enterprise, sold for money, and the token’s value is driven by the managerial efforts of the enterprise.

Ascertaining the value of a token in the context of tokenized assets is a much simpler process. The value of the token is clearly driven by the underlying asset it represents. These assets can include shares of public companies, bonds, precious metals, real estate, land, commodities, and more.

👉 Fundraise for your crypto project

Legal considerations for the issuance of security tokens

The issuance of security tokens falls under the regulation of securities and capital markets in applicable jurisdictions, which include:

  • the country where the company issuing security tokens is registered
  • the countries where there are plans to attract token buyers (some projects wish to engage with global investors)
  • the countries where trading platforms are registered, and where the listing of the security token is planned.

Securities and capital markets legislation differs in each jurisdiction, but there are several general requirements for the issuance of securities that are conceptually similar.

Among them, the following should be highlighted:

  • Preparing a Prospectus / Investment Memorandum disclosing all financial and investment information about such securities
  • Registering investment documents with the regulator (security exchange commissions) and obtaining regulatory approval for the issuance of securities
  • Attracting a licensed custodian for storing issued securities
  • Engaging licensed intermediaries (investment banks / brokers) for the sale of security tokens
  • Listing security tokens on licensed trading platforms (stock exchanges, ATS, etc)
  • Arranging the necessary compliance procedures for onboarding investors (KYC, AML, checking investor accreditation)

For developers of Web3 projects, it is important to remember that the issue of unregistered securities is a violation of the law, which results in heavy fines and even criminal liability, as evidenced by a large number of cases regarding security tokens (particularly in the US).

👉 Get help with all of your crypto business’s legal, tax and contractual matters

Real-world asset tokens (RWA) and the legal considerations for their issuance

In the previous section, we began our legal analysis of tokenization of assets by laying out some important details in the table, under the heading ‘Asset-backed tokens’. The RWA tokenization trend has combined two worlds: the regulated world of financial investment instruments and the unregulated world of decentralized open-source protocols. Let’s take a look at how this symbiosis is structured from a legal point of view.

Based on the table above, for real-world assets (RWA), the protocol ecosystem with its native token serves as a technology provider. Licensed stakeholders use this technology to issue tokenized RWAs.

The role of licensed stakeholders is to ensure:

  • Liquidity is provided to RWA
  • RWA are stored in a licensed custodian
  • A licensed platform is engaged for listing and trading tokenized RWA

In this business model, the protocol and the supporting DAO act as technology providers. Their role is to offer a settlement layer for the tokenization of Real World Assets (RWAs), ensuring these assets are recorded in the decentralized on-chain registry and can be transferred. In addition to providing the technology for settling RWA transactions, oracles play a crucial role in this process. These oracles can be centralized (e.g., licensed oracle companies in Liechtenstein under the Blockchain Act) or decentralized (e.g., Chainlink). Oracles play an important role in this process, as they ensure the accurate display of off-chain RWAs in the on-chain registry.

It is important to note that licensed stakeholders of tokenized RWAs indirectly drive the value of the protocol's native token. They use this token for tokenization and on-chain settlement of RWAs. As more RWA transactions occur within the protocol, the protocol's usage increases, leading to higher demand for the native token necessary for operating the protocol.

Figure out your token’s legal qualification with help from Legal Nodes 

After summarizing the analysis above, it's crucial to reiterate that while the utility criterion of a token, which influences its value, is significant for legal qualification, it's not the sole factor. Another essential criterion is the token's allocation (minting) and distribution, which we have covered in this guide: ‘How Your Token Launch Strategy Impacts Your Token’s Legal Status’.

At Legal Nodes, we regularly support Web3 entrepreneurs and builders seeking to launch new Web3 projects and include tokens for various use cases. We help Web3 founders to:

  • identify their token type, including how it may be legally classified by regulators
  • understand if a proposed token distribution model is ‘centralized’ or ‘decentralized’, and what this means from a legal standpoint
  • set up the legal requirements for token launch, issuance and distribution

For assistance with figuring out the best legal strategy for your token launch and for ongoing support with all your token legal tasks, speak to us today.

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