Cryptocurrencies and token classification

Web 3
Written By Ioana Frincu

This article will expand four classification types for tokens emitted on a blockchain using four criteria: Purpose, Utility, Underlying Value, and Protocol layer. The information below should help you understand a new whitepaper you are reading, assess an investment, or even develop your project. Let’s dig in!

By purpose

The following classification is based on the primary purpose of why a token is built and what it is designed to do. This class clearly illustrates three different goals for which a token can be created. The OG of them all here is, of course, Bitcoin. Based on the token’s purpose, tokens can be classified as follows:

  • tokens that are meant to be currencies. These tokens intend to be a ‘pure’ cryptocurrency. They represent a global environment of exchange (like BTC). They act as a store of value.

  • Investment tokens. Such tokens have little functionality and only promise their owners a share of the asset value in exchange for the issuing entity's future success. Such a token is DGX (DigixDAO).

  • Network tokens. These tokens are specially built for a specific network or application. (like GNO — Gnosis). They only have functionality within the issuer’s system, and, unlike cryptocurrencies, they are not intended as a general cryptocurrency.

By utility

What is the utility of a token? Every type of token has its utility, but this particular class reveals the only two ways to provide it on an abstract level.

Utility tokens pay for the goods or services offered by the cryptocurrency issuer. They represent digital tokens intended to fund the development of the cryptocurrency:

  • by allowing holders to access the network that underlines the blockchain. You can also find these tokens under the name of user tokens. They confer to their holder access permission just like an access card does. Examples of this category are BTC (Bitcoin) and STX (Stacks, Blockstacks).

  • By allowing token holders to contribute to the system actively, also called work tokens. Tokens in this subcategory represent a value container to reward specific performances of the users. Here we have MKR (Maker, Maker DAO).

Some tokens do both, like ETH (Ethereum).

By their underlying value

Tokens were created to represent the value of something. Most of them are designed to have a monetary value. But what they mean can differ considerably.

Some work as IOUs (documents that acknowledge a debt owed). So the types of token this class represents are:

  • backed Tokens (like real estate, gold, diamonds, commodities, etc.) represent their value in buying or selling transactions. Asset tokens aim to improve the trading of physical assets on online platforms. In this category, we have USDT (Tether USD) and GOLD (GOLD, GoldMint).

  • Share-like tokens, whose issuer promises to the owner a share (like dividends or profit-shares) in the issuing entity's success. They may or may not have a legal basis. They may or may not come with voting rights. Such a token is DGD (DigixDAO).

  • Those with network value. These tokens are tied to the value generated and exchanged on the network (like ETH). Such tokens are intertwined with critical interactions of the network participants. Currently, most of these tokens have no or weak legal basis.

By the layer of the protocol, they are implemented on

This way of classifying tokens should leave no doubt for the actual context of the blockchain space. In a blockchain application, there are three layers on which we can implement tokens:

  • on the protocol level of the blockchain. These tokens are critical for the blockchain. They have a role in the system’s consensus and incentive mechanisms. These are tokens similar to the blockchain-native (like BTC and ETH).

  • On the crypto-economic level of the blockchain. Such tokens are integral components of the protocol’s mechanisms, but they are not blockchain-native. Tokens on this level are tracked on an underlying blockchain to which they are not integral (like ERC20 on Ethereum).

  • On the application level, on top of a blockchain. These tokens are part of the application’s incentive mechanism for nodes and users. They are tracked on an underlying blockchain, similar to the non-native protocol tokens. These are called (d)Apps Tokens.

Before the final thought, I will mention one more criterion: the legal status of the tokens. This would probably be the most volatile classification of all, and I think that attempting to have a structure of this class is too ambitious. We can expect the legal status to change based on the different jurisdictions and how regulation emerges.

Depending on various factors, such as region, this classification’s concrete cases can be other because current legal frameworks may not be updated for tokens. Some regulators find utility tokens and cryptocurrencies subclasses of the current one.

To make my point clear, I will dive into specific examples of token classifications based on particular countries’ regulations.

Token classification based on specific country regulations

Switzerland

On 16 February 2018, FINMA (Swiss Financial Market Supervisory Authority) published the ICO Guidelines. Based on their function and transferability, we clearly distinguish three types of tokens:

  1. Payment Tokens (or cryptocurrencies), used only as a means of payment. They do not give rise to any claims against the issuer. They have no further functions or links to other development projects. Tokens may only develop the necessary functionality and become accepted as a means of payment over some time. FINMA requires compliance with AML (anti-money laundering) regulations for the payment tokens but will not treat such tokens as securities.

  2. Utility tokens provide rights to access blockchain infrastructures such as a protocol or a decentralized application. Unlike payment tokens, utility tokens qualify as securities if they function solely or partially as an investment in economic terms. FINMA will not treat utility tokens like securities only if their purpose is to confer digital access rights to an application or service.

  3. Asset tokens, which represent assets like the participation in a company, an entitlement to dividends, earnings stream, or interest payments.FINMA treats asset tokens as securities. Therefore there are law requirements for trading in such tokens and civil law requirements under the Swiss Code of Obligations.

FINMA admits that the classification may change over time. Also, Switz regulations acknowledge hybrid forms of tokens. On 11 September 2019, FINMA published a regulatory classification of stable tokens in a supplement to the ICO Guidelines. They consider that stablecoins do not form another category but would classify either as payment tokens, utility tokens, or a hybrid between the two classes, depending on the coin's rights.

Germany

In February 2018, Germany’s Federal Financial Supervisory Authority (“BaFin”) published an advisory letter on the classification of tokens as financial instruments. The classification is based on the tokens’ design and, more specifically, the right and obligations that come with it. According to the BaFin framework for tokens, we have three classes:

  1. Payment Tokens are used as a means of payment or traded and exchanged for traditional and virtual currencies on specialized trading platforms. Here we find Bitcoin, which BaFin has considered to be a “unit of account.” The term is interpreted by the German Banking Act named Kreditwesengesetz (KWG). KWG often references payment tokens as “financial instruments.” According to the document, if you want to render financial services connected with German payment tokens, you might entail a licensing requirement under the KWG.

  2. Equity Tokens issued in the German Securities Trading Act called Wertpapierhandelsgesetz (WpHG) and the MiFID II. Equity Tokens represent possessing rights similar to shares or debt securities. WpHG often references equity tokens as “security” and “financial instruments,” which is the same term that KWG uses for payment tokens and can lead to confusion. Therefore, it is essential to differentiate the two concepts that share the same name. WpHG considers that a token must have four attributes to classify as security: it must: not meet the requirements of a payment token, be transferable, be tradable on a financial or capital market and embody shareholder rights creditor claims or other comparable claims. The last differentiator is the most important when deciding whether an equity token qualifies as a security or a pure utility token.

  3. Utility Tokens. According to the BaFin article, a token must not have a payment token’s attributes, neither of an equity token, to be considered a utility one. Pure utility tokens exclusively represent the acquisition of a real economy service or good and not financial compensation. Such tokens are usually not subject to any regulatory provisions. Utility tokens can show hybrid characteristics, combining elements of the equity and payment tokens. For example, if a utility token also serves as a means of payment, it will likely classify as a “unit of account” and “financial instrument,” according to KWG.

Malta

In the second half of 2017 and throughout 2018, MFSA (Malta Financial Services Authority) started issuing consultation papers regarding virtual currencies. They gathered opinions from the financial services sector and interested stakeholders, which led to the promulgation of three acts: The Innovative Technology Arrangements and Services Act, The Malta Digital Innovation Authority Act, and The Virtual Financial Assets Act (the VFAA). The last one illustrates a framework within which ICOs may be legally issued, and service providers may be set up. The Framework refers to assets that intrinsically depend on or utilize distributed ledger technology (DLT), and it is quite different from the frameworks in the other regions. The DLT assets classify into four categories, as follows:

  1. Virtual tokens, which are a form of digital medium recordation. Their utility is restricted to the acquisition of goods and services. Virtual tokens often include fungible or utility tokens and can not be traded on exchanges. VFAA also provides that if a virtual token that is a DLT asset is converted to another type of DLT asset, it will be treated as the DLT asset type into which it can be converted. Similarly, if a DLT asset is classified as a virtual token, the asset will be treated as a virtual token, with no further regulation needed.

  2. Electronic money, which refers to issues of tokens that electronically store monetary value. Any DLT asset that qualifies as electronic money will be regulated under the Maltese Financial Institutions Act, which transposes the EU Electronic Money Directive.

  3. Financial instruments, which include transferable securities, money market instruments, and units in collective investment schemes. They are regulated under Section C of the MiFID II (Market in Financial Instruments Directive). Depending on the type of financial instrument, specific EU legislation will apply to the issued token.

  4. Virtual financial assets, which are DLT assets that, by definition, are neither virtual tokens, electronic money, nor financial instruments. Bitcoin, Ethereum, and other traditional virtual currencies fit this criterion. Those who want to register their VFAs need to follow a process. First, they have to set up a Malta company and draft a white paper that complies with the requisites set out within the VFAA (Malta Virtual Financial Assets Act). Then, they must register the white paper with the MFSA. If a VFA has been admitted to trading on a VFA or DLT exchange without the issuer’s consent, there is no obligation on the issuer to register the white paper. However, the VFA service providers’ responsibility is to conduct tests that admit a DLT asset to trade on their platforms.

France

On 22 May 2019, French legislation for markets in digital assets (the “PACTE law”) established an innovative regulatory framework for crypto-assets, under the supervision of the Financial Markets Authority (AMF) and Prudential Supervision and Resolution Authority (ACPR). The French digital asset classification reveals two types:

  1. Tokens, defined by the French law, are “intangible asset representing, in digital form, one or more rights that can be issued, registered, stored or transferred through a shared electronic recording device making it possible to identify, directly or indirectly, the owner of said asset.”

  2. Virtual currencies, described in the European regulations on Anti-Money Laundering and Combating the Financing of Terrorism (AMLD5). These tokens represent “value that is not issued or guaranteed by a central bank or a public authority, is not necessarily attached to a legally established currency and does not possess a legal status of currency or money, but is accepted by natural or legal persons as a means of exchange and which can be transferred, stored and traded electronically.” They explicitly exclude security tokens, which are included in the scope of EU financial regulations.

Estonia

Estonia is one of the world’s top jurisdictions for initial coin offerings (ICO), having a well-guided regulation for digital infrastructure applications, including blockchain technologies. If you want to conduct an ICO in Estonia, you must consider several applicable laws for compliance. You must analyze the rights granted by the token and identify whether it classifies as a security or utility token.

  1. Security tokens, also named financial instruments, can be transferred based on an at least unilateral expression of will, or if they provide voting or decision making rights in the issuer, or give the investor a confident cash-flow expectation. If you classify your token as a security one, you must register the ICO project with the Estonian Financial Supervision Authority (EFSA).

  2. Utility tokens do not promise profits or monetary claims and only provide access to platforms or rights to use products or services. In case a token confirms utility tokens characteristics, in most cases, no registration is required. So far, most of the ICOs conducted in Estonia have been classified as utility token offerings.

The United Kingdom

On the 23rd of January 2019, the Financial Conduct Authority (FCA) issued Guidance on Cryptoassets (FCA-GC). The document aims to improve and clarify the regulatory framework of crypto assets in the United Kingdom. The classification reveals three types of tokens, based on the activities and functions each of them has:

  1. Exchange tokens, which are not issued or backed by any central authority. They are designed as a means of exchange and usually represent a decentralized tool for buying and selling goods and services without traditional intermediaries.

  2. Security tokens, which have a specific characteristic that meets a Specified Investment definition, like a share or a debt instrument, as described in The Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (RAO).

  3. Utility tokens that permit holders to access a current or prospective product or service. However, utility tokens do not grant holders rights that are similar to those given by Specified Investments. Utility tokens may resemble Specified Investments only if they meet the definition of e-money.

In November 2019, the UK Jurisdiction Taskforce published a report on English law’s approach to crypto-assets and smart contracts. According to that, crypto assets and smart contracts are property. Therefore they benefit from the security, but not by pledge or lien, as no one can physically possess them. Following the report, the UK High Court claimed that crypto assets are property under the UK common law and may be subject to asset preservation orders to preserve a party’s rights. In the UK, the crypto assets regulator is the Financial Conduct Authority (“FCA”). FCA classifies crypto assets as regulated tokens and unregulated tokens. The regulated tokens are security tokens and e-money tokens. The utility and exchange tokens represent the unregulated type. Both types' regulations are still not 100% clear; therefore, stablecoins and ICOs require a case by case assessment. However, crypto-assets firms will certainly have to comply with the Money Laundering, Terrorist Financing, and Transfer of Funds (Information on the Payer) Regulations 2017, under the supervision of the FCA in this regard.

To sum up, each category has its characteristics and benefits, but having a classification from only one perspective is impossible. To differentiate the types of tokens for a blockchain product, we need to update such categories based on the market’s current state. So if you aim to activate in the crypto space, make sure you define your goals carefully and choose the right token before you start investing or building a blockchain application. Depending on the application’s design and functionality, one must select the type of token that best suits their product. It is essential to differentiate the existing kinds of tokens to use them properly and benefit from their characteristics.

Ioana Frincu
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