When a new project development team issues what it deems to be a ‘utility’ or ‘non-security’ token, it means that that token is intended to have a use-case on the future platform to be developed and set into mostly autonomous operation by the developers. The ‘utility’ aspect is intended to mean that the new token will be used to ‘fuel’ the platform and therefore be consumed in the process. For example, a given token may be used to access the blockchain that contains automated tracking for goods, services, lists, preferences, records, shipments, etc., and the new tokens would be necessary for users of the platform to obtain the benefits of the platform.
The problem, rarely discussed, is that most projects proceed with exchange listing their tokens as soon as it’s available, on as many exchanges as possible, before even a viable business plan is drafted, in many cases. There is a major flaw in this strategy. In spite of liquidity being created for the supposed utility token early in the process, the appearance exists that the developers are ready to dump the token once the platform is operational and demand for-or hype around-the token presumably goes up, raising its price, as with any other security. For this reason, as an aside, all project developers and team members should voluntarily implement a mandatory “lock-up” period of their own privately held tokens for a period of one to two years. This will definitely provide additional credibility and potentially additional capital inflow to the project team. The longer the lock-up period the better.
The major flaw mentioned above, after my extensive experience reviewing tokens and the projects they are attached to, is that to purchase a token a user of a platform must buy the token either OTC or through an exchange. This in and of itself presents a conflict of interest. On the one hand the developers what their token to be in high demand and the price to increase as much as possible to increase the platform’s, the developers’, and the investors’ profits; however, they also wish to increase the user base as much as possible, which will eventually hit a maximum growth point once the price of the token continues to increase beyond what a given user is willing to pay for it. The obvious problem in the present business strategy is that once the price of a token gets to a certain point, the users will no longer want to pay for it and/or not be able to pay for it as their company revenues will not permit such expenditures lest their companies go broke.
It is self-evident that the price of a utility token, if there is such a thing, needs to remain stable and predictable so that the user base can calculate the entire cost of the usage of the new platform as far into the future as possible in order to create their capital budgets. If the token price is volatile, this will be almost impossible, and this factor will greatly reduce the use case for any given token that is listed on an exchange and is purchased by investors with the expectation of capital gains; each party’s interests are in conflict: the development team cannot grow the price of the token and the user base without one being benefited more than the other. The investors are buying with the intent of obtaining capital gains, and don’t care what the token costs to the users to fuel the platform. The users want the token to remain as cheap as possible so that their use of the platform can remain steady and predictable. Natural market forces are unlikely to provide a mutually beneficial solution for all parties involved.
The conclusion to be drawn from this flawed system is that a utility token cannot function as a security and should not be traded on an exchange, which would obviously reduce the capital inflow and possibly not permit the platform to be developed. So where would the funding to create the platform come from?
A potentially reasonable solution is that a single project team should issue two kinds of tokens: one utility token would go to users through an auto-pay and auto-issue mechanism, and one security token issued under securities laws would go to what would likely be accredited investors (until an offering is approved under Reg A or goes public). The security token would be freely traded on exchanges and would hopefully increase in price, as might any other security (or possibly drop to zero). The utility token would cost a set amount to the users and provide a revenue stream to the issuer, which would presumably be reflected in the correlated price of the security token. The more uses of a true utility token the greater the revenues to the platform, and the greater the capital gains to the holders of the security token. To be sure, the utility token price may be lowered for early adopters and would gradually increase the more popular a given platform may become, thereby increasing revenues to the platform.
The above would be a more solid business model that should eliminate the various conflicts of interest and ensure legal compliance with U.S. securities laws. All tokens actively traded on exchanges for the purpose of capital gains should in essence be regarded as “securities”, regardless of the Howey test analysis. “Utility” tokens should not be traded on exchanges, but sold as a product to customers of the platform. Demand for one should drive the price of the other. One potential route to take may be the creation of crypto-exchanges that cater only to accredited investors who qualify to access such exchanges under Reg D 506(c).