What Are Crypto Tokens?
Are they Securities? That is yet to be seen.
However, the Securities and Exchange Commission (SEC), which is the government agency tasked with regulating U.S. securities markets and enforcing the rules of the Securities Exchange Act of 1934, is taking action on it.
In a recent development, two major players in the cryptocurrency sector, Binance and Coinbase, have been sued by the U.S. Securities and Exchange Commission (SEC). The SEC has accused both exchanges of violating securities laws by operating as unregistered exchanges and selling digital assets that should have been registered. The agency has argued that most crypto tokens are no different from stocks, bonds and other securities, and that companies offering them must register with the agency and make accompanying disclosures, like any traditional exchange or brokerage.
What is a Crypto Token?
Crypto tokens are digital assets that are built on existing blockchain platforms, such as Ethereum, Binance Smart Chain, or Solana. They represent various assets or utilities and can serve different purposes within decentralized applications (dApps) and blockchain ecosystems.
Tokens are distinct from cryptocurrencies in that they are not standalone currencies or mediums of exchange like Bitcoin or Ethereum. Instead, they are typically created and issued on a blockchain platform that supports smart contracts. Tokens can have different functions, including but not limited to:
Utility Tokens: These tokens provide access to a particular product or service within a blockchain-based platform. For example, utility tokens can be used to pay for transaction fees, access certain features, or receive discounts.
Security Tokens: These tokens represent ownership of an underlying asset, similar to traditional securities. Security tokens may offer holders rights to dividends, profit sharing, or voting power within a project.
Asset-backed Tokens: These tokens are backed by physical or digital assets. For instance, gold-backed tokens represent ownership of a certain amount of gold stored in a vault.
Governance Tokens: These tokens enable holders to participate in the decision-making process within a decentralized autonomous organization (DAO) or blockchain project. Governance tokens allow holders to vote on proposals, changes to protocols, or allocation of resources.
The history of crypto tokens is closely intertwined with the development of blockchain technology. Around 2012, Mastercoin (now known as Omni) became one of the earliest projects to launch a token on top of the Bitcoin blockchain. It aimed to provide additional functionality and features beyond Bitcoin's native capabilities.
The emergence of the Ethereum blockchain in 2015 revolutionized the token landscape. Ethereum introduced a Turing-complete programming language, enabling developers to create and deploy smart contracts. This led to the proliferation of Initial Coin Offerings (ICOs) in 2017, where numerous projects raised funds by issuing their own tokens.
However, the ICO boom also raised concerns about regulatory compliance, investor protection, and the prevalence of scams. In response, regulatory bodies started taking a closer look at the token ecosystem, leading to the distinction between utility tokens (used for accessing services) and security tokens (representing ownership in an underlying asset).
Since then, various blockchain platforms have emerged, each with its own token standards and capabilities. For instance, the Binance Smart Chain introduced the BEP-20 token standard, and Solana has SPL tokens. These platforms expanded the possibilities for tokenization and facilitated the growth of decentralized finance (DeFi), non-fungible tokens (NFTs), and other token-based applications.
Cryptocurrencies and Musical Chairs
It’s a bit ironic that the subject of my first investments-related article for Deeper Roots is about crypto. To provide some context for readers unfamiliar with my background and views on crypto. I have over 20 years of experience as an institutional investor and consultant, with deep expertise in capital markets and interest rates.
When I first encountered cryptocurrency in 2009 or 2010, I thought that it would be a passing fad. I believed that it was too inefficient and energy intensive to be adopted broadly. I was wrong. At least about the passing fad part.
Shortly thereafter, Bitcoin became widely hyped among internet savvy Millennials who didn’t have first hand investment experience during the tech-wreck of the early 2000’s. In early 2011 it broke the $1/BTC barrier, soaring in price all the way to $32/BTC within a few months. Then it crashed all the way down to $0.01/BTC. A phenomenon that has seemingly become quite regular for the “digital asset class”. It is truly reminiscent of musical chairs, you don’t want to be left standing all alone when the music stops.
As I mentioned, I have always been skeptical about the utility of blockchain technology. Here are some of the reasons why:
Scalability: One of the primary challenges is scalability. Traditional blockchain networks, such as Bitcoin and Ethereum, often face limitations in terms of transaction throughput and speed. As the number of participants and transactions on the network increases, the scalability issue becomes more pronounced, resulting in network congestion and slower transaction processing times.
Energy Consumption: Many blockchain networks, especially proof-of-work (PoW) consensus mechanisms like Bitcoin, require substantial computational power and energy consumption. The energy-intensive mining process can have negative environmental implications, contributing to carbon footprints and raising concerns about sustainability.
Governance and Regulatory Challenges: The decentralized nature of blockchain presents challenges in terms of governance and regulation. The absence of a central authority or governing body makes decision-making and establishing standards more complex. Regulatory frameworks are still evolving, and there is a need to strike a balance between innovation and protecting consumers and investors.
Privacy and Security: While blockchain is often touted for its security features, it is not entirely immune to vulnerabilities. Private information, if not properly handled or encrypted, can be exposed on the blockchain. Moreover, the decentralized nature of blockchain can make it challenging to rectify errors or fraudulent activities once data is recorded on the ledger.
User Experience: The user experience of interacting with blockchain applications can be less intuitive compared to traditional systems. The complexity of managing private keys, understanding wallet addresses, and dealing with transaction fees can be barriers to adoption for mainstream users.
Interoperability: Blockchain networks typically operate independently, which can create challenges for interoperability and data sharing between different platforms. Achieving seamless communication and compatibility across multiple blockchains is still a technological hurdle that needs to be addressed.
Upgrade and Consensus Issues: Implementing upgrades or changes to a blockchain network can be challenging due to the need for consensus among network participants. Achieving consensus can be time-consuming and may lead to contentious hard forks or disagreements within the community.
Fortune Favors the Brave
I certainly won’t pretend to be an expert on cryptocurrencies or similar technologies. The SEC’s case is not related to the technology or use cases for crypto. It is related to the process used by Coinbase and other exchanges to sell or “IPO” tokens to public investors.
According to the suit, the listing and selling process is remarkably similar to the well known practice known as “pump and dump”. That’s where the security is hyped up on-line, with dedicated marketing campagnes and even in commercials.
It remains to be seen how the landscape for crypto assets will evolve and what it will mean for investors. There is a chance for the development of decent regulation, which could allow advisors to provide better analysis and recommendations to their clients regarding the appropriateness and veracity of crypto investment.
Don’t get Forked
Presently, most financial advisors have no idea how to evaluate cryptocurrencies and other digital assets. Much of this is through no fault of their own. It is very difficult to tell what is real and what is fabrication in the digital world.
Fewer advisors still are aware of the tax implications and legacy concerns of owning or transacting in crypto. Sadly, many have become aware by learning the hard way.
I began my investment career as an analyst working on a very large pension fund. I had the responsibility to put a valuation to illiquid, non-traded assets. This included venture capital assets and investments. At the end of the day, I was able to do this by having the appropriate resources and deep access to reliable information about the assets to develop pricing models.
The value of Bitcoin and other cryptocurrencies is based on supply and demand of emotion and sentiment. Unlike standard fiat currencies, It is founded upon the belief that you (the owner) will find someone else (a buyer) who will pay more than you did for the crypto.
There is nothing else to back it up - there is no taxing authority, no reserves, no economic value. Only the belief that there is someone else out there who will buy it from you for more than you paid for it.
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