What CPAs need to know about 4 cryptoasset classes

Happy 10th birthday, bitcoin! You too, blockchain!

The first block of the bitcoin blockchain was created on Jan. 3, 2009. A decade later, it’s amazing to witness what has evolved from the birth of the first “genesis block.”

Where there was once one cryptocurrency, there are more than 2,000 cryptoassets.

Yes, you read that right. While you probably are familiar with the term cryptocurrency, you might not know that other classes of cryptoassets have been created during the past 10 years.

With the creation of new cryptos rapidly increasing and their intention evolving from that of a currency, such as bitcoin, to investment instruments, such as those exchanged in initial coin offerings (ICOs), it’s not surprising cryptoassets have attracted the interest of regulatory agencies, such as the SEC. Additional complexities developed as cryptoasset trading on crypto-specific exchanges, including cryptocurrency-related derivatives, emerged over the past few years. Now the Commodity Futures Trading Commission provides guidance as well.

With so much interest and with the eyes of so many regulatory agencies watching the crypto landscape, who really has oversight? The not-so-simple answer is that it depends. Regardless, it is imperative that CPAs, along with anyone working in the financial services industry, keep a close eye on the rapid evolution of the cryptoasset ecosystem, including the developing regulatory oversight. But for now, we can break down cryptoassets into four categories:

Cryptocurrencies

Being the first cryptoasset, cryptocurrency is not just the most well-known but also serves as the technological foundation of all cryptoassets. Unsurprisingly, other cryptoassets classes are often mistakenly lumped into this category.

Cryptocurrencies are digital currencies that employ cryptography for security with a fundamental purpose, like regular currencies, of being a medium of exchange and/or a store of value. As the first cryptocurrency, bitcoin was also the first application of the distributed ledger technology blockchain to eliminate the need for third-party intermediaries to facilitate transaction settlement.

Since bitcoin’s creation, countless developers have modified its software to create their own cryptocurrencies, such as litecoin and dash.

Security tokens

Security tokens, like the classic financial instruments we typically think of as securities, represent real-world assets, usually the anticipated profits of a blockchain-based business. As with traditional securities, the SEC has oversight of these security tokens.

To determine whether a cryptoasset falls into the security token category, the Howey test, established by SEC v. W.J. Howey Co., 328 U.S. 293 (1946), is applied. In the crypto world, the Howey test can be simplified by asking two questions. First, is the token being sold as an investment? Second, do the investments, and therefore the investors’ profits, rely on a single entity or a small group of entities? Again, this is an extreme simplification of the Howey test; however, if the answer to both questions is “yes” then you have a security token.

The most infamous security token launch, which ultimately drew the attention of the SEC into cryptos, was the DAO token offered by the DAO, or the Decentralized Autonomous Organization. The DAO, an investor-directed venture capital fund, set out to define a new stateless decentralized business model for organizing enterprises with no conventional management structure.

The DAO set records for the largest crowdfunding campaign of all time when it raised more than $134 million in U.S. dollars and ether, the cryptocurrency of ethereum, in May 2016. However, just a month after its historic launch, a security vulnerability in the DAO’s code was exploited by an unknown person or persons to siphon off nearly one-third of the organization’s ether, a haul valued at almost $50 million.

Utility tokens

Utility tokens entitle their owners to future access to a service or a product, much like a postage stamp allows the holder to use the Postal Service. Utility tokens are designed to provide a particular function or resource in their associated blockchain systems, and their value is based on supply and demand derived from the system that uses the token.

One of the most fascinating utility tokens is the Basic Attention Token, or BAT, which raised approximately $35 million in the first 30 seconds of its ICO in May 2017. BAT is a decentralized ad exchange platform integrated with the Brave web browser. Using BATs, advertisers purchase advertising space. Publishers receive contributions from users. Users are paid in BATs for viewing ads and can redeem rewards and services with participating merchants in the BAT ecosystem. Designed to monetize human attention on the internet, BAT matches and displays ads to users based on data stored on their local computers, removing the need for third-party ad tracking.

Digital asset tokens

The last type of cryptoasset, and probably easiest to comprehend, is the digital asset token. A digital asset token is a blockchain-based token that simply signifies that an asset exists off-chain, or off the blockchain. Once tokenized, the off-chain asset, which could be a property record or a precious item such a diamond, lives on a blockchain where ownership is immutable.

Blockchain technology, the cryptoassets associated with blockchain-based projects, and these new investment instruments continue to evolve. In fact, the ICO concept has evolved since the SEC started paying attention to security tokens. With the SEC opposed to lumping both security tokens and utility tokens into the same initial coin offering category, security token sales have spun off into security token offerings, or STO, leaving the ICO to utility tokens.

Regardless of the terminology, all these concepts will continue to progress, as will the development of and application of cryptoassets. As a result, the agencies tasked with protecting investors while maintaining financially sound markets will certainly continue to explore the cryptoassets.

Amanda Wilkie is a consultant with Boomer Consulting. To comment on this article or suggest an idea for another article, contact Jeff Drew, senior editor, at Jeff.Drew@aicpa-cima.com.