Ready For Exchanges & Launchpads: Essential Token Classification For Compliance

1. Introduction

With the rise of blockchain-based fundraising, token launchpads and cryptocurrency exchanges and launchpads have become essential platforms for projects looking to raise capital, enhance liquidity, and expand their user base. However, one of the most critical legal challenges projects face is determining whether their token qualifies as a utility token or falls under the category of a security token—a distinction that carries significant regulatory implications.

A misclassification can lead to regulatory enforcement, trading restrictions, and compliances under securities laws. While security tokens represent investment contracts and are subject to stringent regulatory frameworks, utility tokens—if performs correctly, can stay outside the scope of regulatory compliances for security tokens. However, it is imperative that the utility token functions solely as access tools for products or services rather than investment vehicles.

This article provides an overview of key regulatory frameworks in the United Kingdom and the United States, and offers practical insights to guide projects in ensuring their tokens are classified as utility tokens, thereby facilitating compliant listings on launchpads and cryptocurrency exchanges. This article does not venture into classification of cryptocurrency as property which is purposefully kept out of the scope of this article.

2. Overview of United Kingdom Legal Framework

In assessing the token as a utility token, we reference the Financial Conduct Authority's (FCA) classification framework for crypto assets, along with relevant guidance papers, policy statements, and applicable laws, including the Financial Services and Markets Act 2000 (FSMA), the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (RAO), the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017, the Electronic Money Regulations (EMR) 2011, and the Payment Services Regulations (PSR) 2017.

2.1. Token Classification

According to the FCA, crypto assets are cryptographically secured digital representations of value or contractual rights that utilize distributed ledger technology (DLT) and can be transferred, stored, or traded electronically. The FCA¹ and HM Revenue & Customs² provide a framework for classifying crypto assets, defining different types of tokens based on their attributes and regulatory requirements, which are as follows:

1. Security Tokens: Security tokens fall within the scope of a "Specified Investment" under the FCA's Regulated Activities Order (RAO) if they confer financial rights such as ownership, entitlement to profits, or repayment of specific sums. They include tokens that grant holders some, or all, of the rights conferred on shareholders or debt-holders, as well as those tokens that give rights to other tokens that are themselves specified investments. For these tokens, compliance with applicable securities regulations is mandatory, as they fall under the FCA's regulatory perimeter.
2. E-money Tokens: Defined under the Electronic Money Regulations (EMRs), e-money tokens represent a claim on the issuer and are issued at par value, allowing for redemption on demand. Since these tokens function similarly to traditional electronic money, they are subject to regulatory requirements and oversight under the EMRs³.
3. Utility Tokens: These tokens provide holders with access to a current or future product or service but do not confer rights equivalent to those associated with specified investments. While utility tokens are generally not classified as specified investments, they may, in certain cases, meet the definition of e-money or any other types of tokens. In such instances, activities involving these tokens may fall under regulatory oversight.⁴ The Cryptoassets Taskforce, in its final report, defined a utility token as one that can be redeemed for access to a specific product or service, typically delivered through a DLT platform.⁵

One of the primary distinctions between utility tokens and security tokens under the FCA guidelines is the presence of financial rights. Security tokens typically grant ownership rights, profit-sharing, dividends, or other financial entitlements, making them subject to regulatory oversight as specified investments.

2.2. Financial Services and Markets Act 2000

The FSMA establishes a comprehensive regulatory framework governing financial services and markets in the UK. This legislation is crucial for maintaining market integrity and protecting consumers, as it sets out the legal framework within which financial services operate. Among its key features are provisions defining "regulated activities", which require entities to obtain authorization and adhere to specific compliance standards.

According to the FSMA, a range of activities qualifies as regulated if they relate to investments, financial standing, or claims management services. Section 22⁶ specifically outlines these regulated activities, making it clear that certain criteria must be met for any activity to fall under this umbrella.

2.3. Electronic Money Regulations, 2011

The Regulation 2⁷ and Regulation 3⁸ of EMRs is a critical aspect of financial services legislation, aimed at ensuring the integrity and safety of digital financial transactions. According to Regulation 2 of the EMRs, "electronic money" is defined as electronically stored monetary value that represents a claim on the electronic money issuer, is issued upon receipt of funds for the purpose of making payment transactions, is accepted by a person other than the electronic money issuer and/ or is not excluded by Regulation 3. These exclusions under Regulation 3 include scenarios where the stored monetary value is restricted to limited use cases, specific networks, or small-value transactions under specific conditions.

2.4. Payment Services Regulations 2017

Under the Payment Services Regulations 2017 (PSRs), "payment services"⁹ are defined by a list of specific activities outlined in Part 1 of Schedule 1, which a business must perform regularly to be considered a payment service provider. These services include activities like enabling deposits and withdrawals from payment accounts, executing payment transactions (such as direct debits and credit transfers), money remittance, issuing payment instruments, and providing account information services. Each of these activities is intended to cover traditional financial services where funds are transferred between parties or stored with providers for future transactions, thus covering services that typically require regulatory oversight to protect users.

A "payment service provider"¹⁰ encompasses any entity engaged in offering payment services, which include a range of classifications such as authorized payment institutions, small payment institutions, registered account information service providers, electronic money institutions, credit institutions, and governmental entities. Each of these categories operates under specific regulations designed to ensure compliance and consumer protection within the financial services sector. The role of payment service providers is to facilitate monetary transactions, manage electronic money, and provide essential banking services to individuals and businesses.

In contrast, Part 2 of Schedule 1 lists activities explicitly excluded from being classified as payment services, even if they involve funds in some way. Exclusions cover transactions that are inherently limited in scope, such as cash-to-cash currency exchanges, transactions carried out entirely within closed systems (e.g., between payment providers in settlement systems), and activities within closed networks (e.g., specific payment instruments used in limited settings). Particularly relevant is the limited network exclusion (Part 2, Section 2(k)), which applies to instruments restricted to a single issuer's premises or a defined group of service providers. This exclusion allows tokens used solely within a specific ecosystem to prevent the regulatory requirements of payment services, provided they are limited in application and do not serve as general payment instruments.

In the United Kingdom, the FCA's comprehensive framework, coupled with legislation like the FSMA, EMRs, and PSRs, provides a structured approach to token classification. The distinction between security, e-money, utility, and exchange tokens hinges primarily on the presence of financial rights and the token's functional role. By adhering to these guidelines and understanding the nuances of regulated activities and payment services, projects can navigate the UK's regulatory landscape and ensure compliant token offerings.

3. Overview of United States of America Legal Framework

Under U.S. law, the Securities and Exchange Commission (SEC) has provided important guidance regarding the regulation of coin/token issuances in its "Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO" (Release No. 81207, July 25, 2017)¹¹. The SEC has affirmed that existing federal securities laws are sufficient to regulate such issuances. Crucially, the SEC emphasized that not all coins or tokens qualify as securities, and this classification must be determined on a case-by-case basis. To assess whether a coin or token constitutes a security, the SEC applies the "Howey Test".¹² The SEC's stance indicates that U.S. securities laws apply to anyone offering or selling securities to U.S. citizens, irrespective of the jurisdiction where the issuing entity is incorporated or located.

3.1. Token Classification

Under U.S. Securities laws, there are generally three types of coins/tokens issued through Initial Coin Offerings (ICOs): Equity, Security, and Utility coins/tokens.

1. Security Coins/Tokens - These tokens are digital assets that represent ownership or rights to an underlying asset, such as equity in a company, debt instruments, or other financial assets. These tokens are issued through a Security Token Offering (STO) and are subject to federal securities regulations, including those enforced by the SEC. The primary purpose of a security token is to record ownership of an underlying asset on a block-chain, allowing investors to access investment opportunities within regulated markets.
2. Utility Coins/Tokens - Utility tokens do not meet the criteria outlined in the Howey Test. These tokens provide holders with access to a product, service, or both within a specific platform or ecosystem. Utility tokens function as a contract for the provision of goods or services that can be redeemed either once or continuously. The value of a utility token is determined by the value of the underlying service or product it represents.

3.2. Securities Act, 1933 and Securities Exchange Act, 1934

From a U.S. legal standpoint, the regulation of "securities" is governed by Section 2(a)(1)¹³ of the Securities Act of 1933, which defines securities as including any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in a profit-sharing agreement, investment contracts, or generally any instrument commonly recognized as a security, including temporary certificates, receipts, guarantees, or warrants. Additionally, Section 3(a)(10)¹⁴ of the Securities Exchange Act of 1934 further defines what constitutes a security under U.S. law. Both provisions help clarify the scope of securities regulation, which is vital for determining whether token falls within the regulatory framework of Securities.

The U.S. Supreme Court has established that the term "investment contract" is legally synonymous with "security." Consequently, the U.S. definition of "security" includes "investment contracts," which are defined as "an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others," as articulated in SEC v. W.J. Howey Co., 328 U.S. 293 (1946).

3.3. Understanding Howey Test

The Howey Test, derived from the U.S. Supreme Court case SEC v. W.J. Howey Co¹⁵., is the key standard used to determine whether a financial instrument, such as a token or coin, qualifies as a "security" under U.S. law, particularly under the Securities Act of 1933. The test is designed to assess whether an investment is an "investment contract" and, if so, whether it falls under the regulatory framework for securities.

The Howey Test originates from the Supreme Court case SEC v. W.J. Howey Co. in 1946. The SEC intervened because Howey failed to register the transactions with the regulator. The Supreme Court ultimately ruled that these leaseback arrangements constituted investment contracts. This decision led to the establishment of four key criteria for identifying an investment contract. An investment contract is:

1. Investment of Money
2. Common Enterprise
3. Expectation of Profit
4. Efforts of Others

The SEC explains that the "investment of money" requirement is usually straightforward to satisfy in cases involving digital assets, as these transactions typically involve the exchange of fiat currency or other digital assets, such as cryptocurrencies. This indicates that the buyer is committing something of value in the hope of gaining a return. Similarly, the "common enterprise" requirement is often easily met, as most digital asset projects pool resources or contributions from multiple participants, tying their fortunes together. The more complex determination lies in whether the buyer has an "expectation of profit" that is dependent on the "efforts of others." This is often the key factor in deciding whether a digital asset qualifies as an investment contract. If the value of the digital asset or the success of the project relies heavily on the actions, management, or expertise of the project's backers or developers, it is more likely to meet this part of the test.

For instance, the purchasers of a digital asset may be relying on the efforts of others if they depend on the project's backers to launch and scale the digital platform (especially during its formative phases), rather than these tasks being carried out by an independent, decentralized community of users. The "efforts of others" test is also satisfied if the project's backers take active measures to sustain or influence the value of the digital asset, such as establishing incentives or creating artificial demand through controlled token distribution. Additionally, if the backers continue to play a significant managerial role in the project, the test is further met. These examples, among others highlighted by the SEC, illustrate that when the success of a project hinges on the sustained involvement of its backers, purchasers of the associated digital asset are likely relying on the "efforts of others."

The US Courts recently had the opportunity to determine whether tokens are securities under the relevant laws. In the SEC v. Terraform Labs PTE, Ltd¹⁶. case, the U.S. District Court for the Southern District of New York applied the Howey Test to determine that several digital assets offered by Terraform Labs, including LUNA, MIR, and UST tokens, qualified as securities under U.S. law. The court found that purchasers invested money to acquire these tokens, satisfying the first prong. Regarding the second prong, the court identified a common enterprise, noting that the fortunes of investors were closely tied to the success of Terraform Labs' ecosystem. For the third prong, the court emphasized that Terraform Labs' promotional materials and public statements led investors to reasonably expect profits from their token purchases, primarily driven by the company's efforts to develop and maintain its platform, thus enhancing the tokens' value. This expectation of profit from the entrepreneurial and managerial efforts of Terraform Labs was a critical factor in classifying these tokens as securities under U.S. law.

4. Conclusion

The global regulatory landscape for digital tokens necessitates a nuanced understanding of jurisdictional differences, yet common threads persist. Whether in the UK's FCA framework or the US's Howey Test, regulators emphasize substance over form, prioritizing investor protection and transparency. Projects must conduct thorough legal analysis, ensuring their tokens clearly define utility rather than investment rights.

Ultimately, successful token launches hinge on a proactive approach to regulatory compliance. Projects must prioritize clear utility definitions, robust KYC/AML procedures, and continuous adaptation to evolving regulations.

Footnotes

1. Financial Conduct Authority. (n.d.). Cryptoassets: Our work. Retrieved from https://www.fca.org.uk/firms/cryptoassets

2. HMRC internal manual Cryptoassets Manual, CRYPTO10100 - Introduction to cryptoassets: what are cryptoassets available at https://www.gov.uk/hmrc-internal-manuals/cryptoassets-manual/crypto10100

3. Supra at 1

4. Guidance on cryptoassets: Feedback and final guidance to CP19/3. Financial Conduct Authority. Retrieved from https://www.fca.org.uk/publication/policy/ps19-22.pdf

5. UK Government Cryptoassets Taskforce. (2018). Cryptoassets: Consultation paper. https://assets.publishing.service.gov.uk/media/5bd6d6f0e5274a6e11247059/cryptoassets_taskforce_final_report_final_web.pdf

6. 22. "regulated activity" (1) An activity is a regulated activity for the purposes of this Act if it is an activity of a specified kind which is carried on by way of business and—

(1A) An activity is also a regulated activity for the purposes of this Act if it is an activity of a specified kind which is carried on by way of business and relates to—

(1B) An activity is also a regulated activity for the purposes of this Act if it is an activity of a specified kind which—

(2) Schedule 2 makes provision supplementing this section.

(3) Nothing in Schedule 2 limits the powers conferred by subsections (1) or (1A).

(4) "Investment" includes any asset, right or interest (including where an asset, right or interest is, or comprises or represents, a cryptoasset).

(5) "Specified" means specified in an order made by the Treasury.

(6) ...

(6A) For the purposes of subsection (1A)(c), "benchmark" has the meaning given by Article 3 of the EU Benchmarks Regulation 2016, and "administering" a benchmark means acting as an administrator of that benchmark within the meaning of that Article.

7. Regulation 2. - "Electronic money" is defined as electronically (including magnetically) stored monetary value that is represented by a claim on the electronic money issuer, which:

1. is issued upon receipt of funds for the purpose of making payment transactions.
2. is accepted by a person other than the electronic money issuer.
3. is not excluded by Regulation 3.

8. Regulation 3 - For the purposes of these Regulations, electronic money does not include:

1. Monetary value stored on specific payment instruments that can be used only in a limited way and meet one of the following conditions:
   
   1. Allow the holder to acquire goods or services only on the issuer's premises.
   2. Are issued by a professional issuer and allow the holder to acquire goods or services only within a limited network of service providers that have direct commercial agreements with the issuer.
   3. May be used only to acquire a very limited range of goods or services.
   4. Are valid only in the United Kingdom, provided at the request of an undertaking or a public sector entity, and regulated by a national or regional public authority for specific social or tax purposes to acquire specific goods or services from suppliers with which the issuer has a commercial agreement.
2. Monetary value used to make payment transactions resulting from services provided by a provider of electronic communications networks or services, which includes transactions between persons other than that provider and a subscriber. This applies where those services are provided in addition to electronic communications services and the additional service is:
   
   1. For the purchase of digital content and voice-based services, regardless of the device used for the purchase or consumption of the digital content, and charged to the related bill.
   2. Performed from or via an electronic device and charged to the related bill for the purchase of tickets or for donations to organizations recognized as charities by public authorities, whether in the United Kingdom or elsewhere, provided that the value of any single payment transaction does not exceed £40, and the cumulative value of payment transactions for an individual subscriber in a month does not exceed £240.

9. PART 1

Payment services

1. Subject to Part 2, the following, when carried out as a regular occupation or business activity, are payment services—

(a) services enabling cash to be placed on a payment account and all of the operations required for operating a payment account;

(b) services enabling cash withdrawals from a payment account and all of the operations required for operating a payment account;

(c) the execution of payment transactions, including transfers of funds on a payment account with the user's payment service provider or with another payment service provider—

(d) the execution of payment transactions where the funds are covered by a credit line for a payment service user—

(e) issuing payment instruments or acquiring payment transactions;

(f) money remittance;

(g) payment initiation services;

(h) account information services.

10. "Payment service provider" refers to any entity engaged in the provision of payment services, including the following categories:

(a) Authorised payment institutions: These are entities authorized by a regulatory body to provide payment services, ensuring compliance with relevant regulations.

(b) Small payment institutions: Similar to authorized payment institutions, but typically smaller in scale and subject to different regulatory requirements.

(c) Registered account information service providers: Entities that provide services for retrieving and aggregating account information from various financial institutions with the consent of the account holder.

(f) Electronic money institutions: These include organizations that issue electronic money and provide payment services linked to this issuance, including branches in the United Kingdom of such institutions headquartered outside the UK.

(g) Credit institutions: Traditional banks and other financial entities authorized to accept deposits and provide credit.

(h) The Post Office Limited: The UK postal service, which provides certain payment services.

(i) The Bank of England: The UK's central bank, except when acting in its capacity as a monetary authority or performing other public functions.

(j) Government departments and local authorities: These entities provide payment services outside their public function scope.

11. Securities and Exchange Commission, Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Release No. 81207, July 25, 2017, https://www.sec.gov/files/litigation/investreport/34-81207.pdf.

12. SEC v. Howey Co., 328 U.S. 293 (1946)

13. Section 2.(a)(1) of Securities Exchange Act of 1933,Defines: The term ''security'' means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ''security'', or any certificate of interest or participation in, temporary or interim certificate for, receipt for, Guarantee of or warrant or right to subscribe to or purchase, any of the foregoing

14. Section 3(a)(10) of Securities Exchange Act of 1934, Defines: "The term ''security'' means any note, stock, treasury stock, security future, security-based swap, bond, debenture, certificate of interest or participation in any profit-sharing agreement or in any oil, gas, or other mineral royalty or lease, any collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting trust certificate, certificate of deposit for a security, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or in general, any instrument commonly known as a ''security''; or any certificate of interest or participation in, temporary or interim certificate for, receipt for, or warrant or right to subscribe to or purchase, any of the foregoing; but shall not include currency or any note, draft, bill of exchange, or banker's acceptance which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited."

15. SEC v. W.J. Howey Co., 328 U.S. 293 (1946)

16 SEC v. Terraform Labs PTE, Ltd. and Do Hyeong Kwon, No. 23-cv-1346-JSR (S.D.N.Y.), 12.06.2024.

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