3 Ways to Safely Design Utility Tokens
When designing a utility token, picking a proper legal framework is an essential step in the token design process for web3 founders that want to create their own token.
In this article we will explore three common legal approaches token creators take today, and provide 3 helpful tips for making sure utility tokens don't break federal securities laws, present themselves as an investment contract, or tick off the securities and exchange commission.
3 Ways Token Creators Approach Legal Frameworks for Tokens
There are three mainstream thoughts about legal in the web3 community; two of which are not recommended, and one that is best, but rarely followed.
1. SEC is NGMI! Crypto rules the world! GM anons!
The most popular but reckless prevailing sentiment is that the securities and exchange commission (SEC) is not gonna make it (NGMI), and crypto will be an exemption to the rules because the industry, blockchain technology, and the decentralized future is arriving faster than the SEC can regulate it.
However, there are dozens of court cases where the SEC found legal issues with digital assets that were sold (either to investors or as ICOs) and violated the securities exchange act of 1934.
In these cases, the SEC saw the digital asset as an investment, and penalized the company hard.
You have to follow the law.
Period.
2. Let's sell digital securities and avoid regulatory paperwork because security laws are ambiguous
99% of the time this approach will fail.
Token creators can hire a couple of attorneys for a $5-10k legal opinion, but because each case is investigated thoroughly and on it's own accord, judges consider the actual underlying economic relations, not just the formal paperwork.
3. Perform thorough legal research to determine whether to to create a security token (investment contract) or a utility token.
This is the rarest approach in crypto, but it is the best way to design a token. Two of the most common reasons why this approach is rare is that:
- It is expensive to complete the legal research
- It is slower to get to market
While performing thorough legal research about your tokenomics is slow and expensive, if you want to build a strong foundation for the future of your community, it is essential work.
Why are utility tokens better than security tokens while working within federal securities laws?
A token is a security if it creates expectations to receive profits derived from the efforts of others, and anything outside of this legal definition would be considered a utility token. A utility token is safer than a security token and they're also more convenient because they:
- Have way less legal expenses
- Require no extra reporting
- Garner no attention from regulators
- See 100x more trading and DeFi venues
- Forgo KYC/AML for token holders
3 Ways to Design and Market Utility Tokens to Reduce Securities Risk
Here are some examples of marketing a token so it is treated as a utility and not a security.
1. Don't sell tokens, let investors earn them
Token sales are a red flag for the SEC's watchdogs, but there are plenty of examples of successful tokens that were not sold, but rather minted: BTC, Axie Infinity, airline miles, etc.
It's impossible to apply securities regulations where there's no single issuer and the investors or token holders have to do some work to get the reward.
Four Ways People Can Mint Tokens
New utility tokens are launching all the time that sidestep common snares of the Howey Test simply by distributing them through mints or rewards without holding a token sale.
- Run - StepN empowers you to mint tokens for walking and running.
- Play - Axie Infinity allows people to mint tokens for playing their blockchain game.
- Provide hardware - Chia Network pays participants that loan their excess processing hard drive space. Bitcoin, the most famous example, pays miners BTC for excess computation.
- Fly - Airlines pay airline miles for using an airline credit card or for flying with a particular airline. These airline miles are rewards that have a cash value when redeemed for airfare.
Trying to raise money through Initial Coin Offerings (ICOs), especially for tokens that are not registered, is risky, and finding creative ways to distribute tokens are numerous.
2. Don't pay dividends, assign bonus points
If you want to organize payouts to your token holders, it is safer to structure them as bonus points instead of paying out what could be considered dividends.
These bonus points (i.e. tokens) could provide holders with benefits like:
- A discount on your services
- A key to unlock extra features
Two Examples of Utility Tokens that Use Bonus Points
Lofty.ai, a tokenized real estate investment app, allows people to stake their tokens and earn rewards such as VIP access to deals, unique NFTs, and more. Lofty's token follows 100% utility behavior, which doesn't fall under securities regulation.
If Lofty designed their token to pay staking dividends in fiat money or cryptocurrencies — it would be treated as a security.
Another example is Braintrust, a decentralized version of Upwork, that is owned by freelancers and employers. A person can mint a BTRST token for inviting people to the decentralized network of freelancers and completing peer-to-peer (P2P) vetting.
People can redeem BTRST utility tokens for special perks like free and discounted software, products, career resources, and other rewards.
3. Don't create expectations of profits
The main mistake a majority of web3 token projects commit is "moon talks."
The probability of getting penalized by federal regulators is growing each time a community leader or a team member publicly declares these kinds of remarks that create an expectation of profits from the work of the common enterprise:
- Invest in our coin.
- Buy our coin, and it will 3x next year.
- Stake our coin and get a 200,000% APY.
- The listing price at a new exchange will be X.
The average investor doesn't have a lot of financial or legal education, and they are susceptible to excessive expectations based upon these baseless claims.
Conclusion: creating utility tokens are safer than security tokens
Issuing and trading a security token is much more expensive and riskier for web3 projects than creating a utility token with real benefits to the holder.
There are many legal frameworks for designing a utility token, but they all could be simplified to one test: members have to do some work to earn tokens and get benefits from it.
Disclaimer: the author strongly believes everyone should follow the law. This article shares how serious securities regulation is and how to legally design your utility token's tokenomics.
