#3 The Token Economy

The Internet of Value

I’d like to thank every person who kindly gave their input on this article prior publication.

As you have probably noticed by now, this is already the third article and I cited the word “crypto-currency” only once. By doing so, my target was to show you that Crypto-currencies are just one kind of Token. You understood by now that DLT and Blockchain are far more than what we hear about them. So, we are going to deep dive in this alternative economy and try to understand its potential to disrupt businesses.

It all begins with an ICO…

Those ICOs (“Initial Coin Offering”) represent a new way to raise money for companies whatever the industry. Operationally similar to the IPO (“Initial Public Offering”), but with less constraints in terms of regulations, less complexity in terms of processes but does not offer any equity in a particular company.

How does it works? Companies issue a unit of value, called token, to self-govern their business model, in exchange of money. Depending on the kind of token, the users can access a service or a product, or facilitate the distribution and sharing of specific rewards to all its stakeholders.

Thus, ICOs empower a decentralized economy, thanks to the various token that are issued. They represented 6,2B $ since the beginning of 2018, and 3,3B $ in 2017(Coinschedule).

They are mainly used by start-ups to break free from the investors influence but listed companies also use them. Indeed, Kodak, for example, launched the “KodakCoin”, which increased the Kodak valuation by 300% in the stock market. Note that, nearly 50% of companies that did an ICO in 2017 do not exist anymore, whereas those ones raised approximately 104M $. Hence, there are still a lot of scams in the market, so an extreme care must be paid and advice must be sought before any investment is made. .

It’s not all about Bitcoin

Currency Tokens / Crypto-currencies / Payment Tokens:

The reason why there is so much confusion with the different kind of tokens, is because the first token ever was Bitcoin (a programmable money) and it was created as digital currency or crypto-currency. Therefore, it is a value of exchange that is only determined by the supply and demand. Exactly like fiat money, the crypto-currencies have value and liquidity only if it is used by a lot a people But a lot of people will use it only if it has value and liquidity. (Don’t get a headache ! It’s called the “Chicken and egg problem”). This is why it took many years for Bitcoin to gain value and also explains the volatility that still remains a big challenge to overcome.

There are other crypto-currencies with different attributes and goals: some generate faster transactions (BitcoinCash), others more anonymity (Zcash).

Also, it is considered a “Digital Gold”. Do you know why ? Simple, think about Gold : at t=0 There is a limited stock (S) of gold on earth, and no gold ever extracted. As gold is extracted, S decrease and therefor there is less and less gold to extract which make it more and more rare and thus hard to extract. Its exactly the same with Bitcoin. Whereas Utility Tokens like Ether, at t=0 they were 0 bitcoin, and each time a transaction is validated by the network (this process is called “Mining”), some bitcoin are created as a reward for miners. Over time, less bitcoin are created for each transaction. Making it scarce. Therefore, bitcoin is deflationary like gold while having the transactional benefits of Inflationary currencies like cash. Note that cash is inflationary because central banks print fiat money as they need it, which does not make it scarce like Gold.

Utility Tokens / Service Tokens:

Utility tokens are the tokens that everyone refers to as crypto-currencies. Even though some of them gain so much traction that they are used as a currency like Ether (ETH), their original purpose was different. They were supposed to be used as a “currency” but not the way we imagine. They are closer to the “gift card” or “loyalty points” than what we imagine as currency. Their purpose was to provide a unit of value to pay for a service, in the case of ETH, it is to access the Ethereum network to build easily smart contracts. Thus, they are not only backed by the supply and demand for the token, but also and mainly by the demand for the product or service (You got it, it is a new asset class not backed by any tangible or intangible asset…). Therefore, this token can be used as a speculative instrument, depending on your trust in the underlying project and the team in charge of it. This is the class of token that was subject to most frauds.

Here are some quick guidelines for your Due Diligence :

- Make sure the token answers an economic problem

- Read carefully the “Whitepaper”

- Check reviews, community sources and forums

- Check in which extend the token is compliant with local regulation

- What about cybersecurity?

Moreover, government-backed currency token (let’s call it a “Crypto-Euro” for example), will not have this problem because government can enforce the usage, by creating demand. Those currency tokens are the most likely the kind of “Utility Token” to become mainstream due to the enforcement.

Security Tokens / Equity Tokens:

Security Tokens (a programmable ownership) are my favorite. Exactly as traditional securities (fungible financial instrument), they give to the owner of the token, a stake, that in a private company is referred to as a share(traditionally, publicly traded stocks), or a bond or an Option. This ownership entitles you to various rights and obligations like dividends, revenue share and/or price appreciation. This token is nothing less than an investment contract. (And guess what ? Distributed Ledger Technology is the best you can find for contracts, but you know that by now).

On the US side, the SEC already acknowledges that some tokens can be indeed considered as securities. They have passed the Howey Test (a 3 check points test to decide whether or not the instrument belongs to the securities class). As a matter of fact, this token falls exactly in the same legal boundaries than traditional securities.

On the European side, no legal milestone has been reached yet since there was no security token issued in EU. However, in the most recent transcripts of consultations from the French Autorité des Marchés Financiers (AMF), a token has to fall within the scope of articles L211–1 and L213–0–1(equivalent of the Howey Test) of the Financial and Monetary code to be referred to as Securities. According to European Securities and Markets Authority (ESMA), the following guidelines for Europe in terms of legislation are compiled in the Rule 600/2014 and directive 2014/65/UE of May 15th, 2014 are applicable. They forbid this market to tokenize listed companies shares.

In Asia, countries like China and South Korea prohibited the use of crypto-assets for a long time (respectively, to keep the control of capital and because of the speculation) before allowing them again, very recently.

The precursor country is definitively Switzerland. They defined very attractive rules like taxation laws and possibility to create non-profit foundations for the “Crypto-Space” (Ethereum foundation settled there, as well as Tezos and many more). They are also at the forefront to design a specific taxation around them to foster their development.

Their issuance is called ETO for Equity Token Offering or STO for Security Token Offering.

Whereas ICOs have no regulation, those tokens have a legal framework and again, they are backed by a real asset. They are a bit like fiat operationally because Ethereum (for exemple) can issue tokens for money (if they want), exactly like central banks. So much for the “DAO” (Decentralized Autonomous Organisation)

Asset Tokens / Investment Tokens:

Asset Token is probably the most ingenious class of tokens. It provides a direct ownership to an asset (Physical or Digital). It can be a piece of art, a house or even your DNA. What is pretty handy here is that, since the token can be divisible and fungible, without necessarily spliting the asset, it can be owned by multiple persons, easily. Applying those tokens to funds is perfect by tokenizing General Partnership (GP) and give those tokens to your Limited Partners (LPs).

This answers two pain points in Finance :

The first one is that it avoids undervaluation of some assets, in real estate for exemple.

For example, imagine that you want to sell the Eiffel Tower! You can’t because it is way too expensive! But if you Tokenize it, a very big group of people could, in theory, buy it or have rights on it… (I really hope we never come to this though!).

Here you would probably say: “Yes, but we can already buy in groups !” and I would answer : “Can you do it faster, cheaper and in a more secure way than with tokens ?”

Secondly, it offers a solution to the huge lack of liquidity in the Real Estate industry.

If you tokenize your asset (Remember DLT is perfect for transaction), they can be licensed to others very easily in a secondary market (provided that there would be an Alternative Stock Exchange, dedicated for this kind of Token. ;) I would love to call it The European Token Exchange!) blurring the lines between some asset class that had specific markets.

Hence, the Asset Token becomes what we commonly call a security. By forth, they fall within the same legal boundaries as a security token. We will denote by “Digital Securities”, the bundle of security token and asset token. Thus, a STO (Security Token Offering) is also the way an asset token gets created and issued.

Token Offering or Digital Private Equity

Advantages of token offering:

- It allows more flexibility in the process of raising money. You do not have to ask banks anymore neither to wait for VCs. (Changing the process of raising money and killing debt)

- Anyone with an internet connection and a (KYC/AML compliant) ID can invest.

Main issues:

- Token offering needs specific regulations for each class of token. A set of rules (too many ICO with just a conceptual “whitepaper”) and taxation that is attractive to entrepreneurs and investors. In France, the PACTE law is far than comprehensive enough for France’s ambition to become leader in DLT.

- Insurance companies should work tokens

- We should rethink Valuation and Financial statements Standards

Some figures to keep in mind:

The current total value of existing assets is approximately $389 Trillion(including gold, stocks, real estate…) I personally sized the market.

Note that, most of those assets are illiquid today, physically difficult to transfer (in comparison with the Blockchain settlement) and not subdivisible. Of course, some are still transacted via paper trail. I will offer a deeper review of that subject in the next article called: The Digital Age of Capital Markets.

I estimate the market capitalization of Digital Securities as of 7 Trillion by 2022. (and I’m underestimating it here… + remember the “exponential growth”).

So, you understood that tokens open the way to an entirely new field of studies, the ? Tokenized Ecosystem ?. Anyone can understand that, starting from the principle that DLT is made to exchange Value, Nobody said that Currency was the only value you can send on the distributed ledger. It was just the first use case.

This technology has the potential to literally destroying all barriers to entry in Finance and Capital Markets). Between us, It was about time to change that.

This will start as an alternative economy that could overtake the actual one sooner than we think. However, not every item on earth shall be tokenized. It needs to have a “long” life cycle in order to increase the holding time of the token, otherwise we will not have long term demand. But it is not the only threat. They are different classes of tokens and each of them can be programmed differently. Make sure you understand what you are getting into and this include a meticulous research and smart contract auditing.

Computational Law is the next big trend in Legal advisory.

Meanwhile, have fun until the next article. We will talk about the Digital Age of Capital Markets on both the operational and conceptual side. I also like to call this part The Uberization of Capital Markets, for the economic and social change unabled by DLT and Crypto-Assets.

Recap :

• Payment token : Digital Gold
• Utility Token : Digital Fiat
• Security Token : Digital Assets/shares or Digital Securities

“I served 21 years at the US justice department and it’s not fair to say that there is a greater amount of crime with cryptocurrencies. In fact, I would strongly disagree with that.” Former US Federal Prosecutor, Mary Beth Buchanan

The views and opinions expressed in this article are those of me and do not necessarily reflect the official policy or position of any agency.

Happy to discuss further.

Peace.