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This practice note is the ninth in a series exploring the legal and regulatory aspects of cryptoassets.
In this edition, we’ll take a look at social tokens – exploring what assets they are, the different types that exist, and the regulatory challenges that arise from them.
What are social tokens?
Social tokens – also known as community tokens – are one of the newest innovations in the crypto space and have grown significantly in recent years. They are essentially a new form of cryptocurrency that is linked to a company, organization or person.
The definition of social tokens covers tokens created by companies, organizations and people in a wide range of sectors, including:
- art;
- content;
- culture;
- design;
- playing games;
- music; and
- sports.
Direct rewards for owning social tokens are generally determined by the designer or issuer of the token. These vary significantly across sectors, but can include benefits such as early access to new content, “money can’t buy” experiences, discounts, management rights and decision-making influence. Owning a token brings with it other, indirect, benefits such as status within the community and growth in value.
Are there different types of social tokens?
There are three main classifications of social tokens:
- personal tokens;
- community tokens; and
- social platform tokens.
Personal tokens
Personal tokens – also known as “creator tokens” – are issued and controlled by a primary individual. Creators are often high-profile celebrities, entrepreneurs or artists. Personal tokens generally allow holders to redeem them for services provided by their creators.
An example of a personal token is the “RAC” token issued by DJ and Grammy Award-winning artist RAC (André Allen Anjos). The token gives fans access to various benefits and exclusive content.
Community Tokens
Community tokens are issued and controlled by a group often governed by a decentralized autonomous organization (DAO). These tokens generally have all the benefits of personal tokens with added DAO management rights, along with influence and prestige in the niche community. Benefits may also include the right to income from property owned or leased by the community or payments for services provided by the community. One example of a community token is the “kit” token.
The whale community is a DAO and is supported by rare and valuable NFTs primarily in the blockchain, gaming, digital art and virtual real estate sectors. Therefore, the community token is backed by unique digital assets; or in other words, replaceable means behind which stand irreplaceable ones. The token offers its holders the opportunity to rent NFTs from the “vault”, buy exclusive NFTs, participate in liquidity mining, buy exclusive digital products and participate in the decision-making of the DAO.
Social Platform Tokens
Social Platform Tokens represent control over the platform that facilitates the issuance and exchange of Social Tokens. Token holders can often become involved in managing the social platform and use the tokens to pay fees for transactions on the platform.
In addition, since the tokens have a monetary value, those who speculate that they will increase can hold them as investments. Some tokens can also be staked where the token is allocated to validate transactions in the proof-of-stake blockchain. Investing generates rewards for the token holder.
The “Rally” token is one of the main social platform tokens in the market and is the governing token of the Rally network, which supports all “creator coins”. They allow individuals and businesses to receive payment for services and are essentially an individual type of cryptoasset.
One of the most famous examples of platform tokens in the sports sector is the fan engagement platform Socios.com and its Chiliz (CHZ) token. Socios allows property owners to buy fan tokens tied to their favorite soccer team.
Team-related tokens are minted and exchanged on a permissioned sidechain to the main Chiliz blockchain and allow holders to participate in official sports team polls – thereby influencing club decision-making – and unlock exclusive club rewards. The sidechain is used because it is less computationally intensive than the main Ethereum network, and also allows Socios to reduce and manage gas costs on that network.
Social Token Terms and Conditions
Unlike many older cryptoassets like Bitcoin, social tokens and related platforms generally have an identifiable person or entity behind them which means there is more likely to be a set of terms and conditions and/or white paper governing the use of the platform. and token(s).
The terms and conditions currently in the market tend to exclude liability as much as possible for the token issuer. Participants or token holders should expect a number of unfavorable terms, including extensive disclaimers for various types of risks – from hacking to lack of market liquidity – and unlimited indemnification provisions in favor of token issuers.
The choice of applicable law and jurisdiction will likely be governed by where the individual, entity or platform is domiciled. HX Entertainment Ltd (the entity behind the social platform token Chiliz) is, for example, a company registered in Malta and as such the terms and conditions of the Chiliz token are governed by Maltese law. Rally Network, Inc, on the other hand, is a company based in California and is governed by the US state of Delaware.
Where English law applies, the extent to which consumer law will protect buyers of cryptoassets such as social tokens is something of a gray area. A Financial Conduct Authority (FCA) consumer survey found that 89% of cryptoasset buyers were aware that they were not subject to regulatory protection.
Currently, such customers appear to be relatively sophisticated. The technical challenges for the newcomer in terms of setting up wallets, acquiring cryptocurrencies and acquiring tokens also helped to ensure a degree of sophistication among customers. However, those technical challenges are quickly being eased and this is likely to lead to increased market access for less experienced or less knowledgeable individuals. Therefore, the application of consumer protection will become an increasingly prominent topic over time. This issue is of particular importance in the field of social tokens, which are quite widely used in the context of entertainment and celebrity culture.
Interaction of social tokens with smart contracts
Social tokens are bought and traded on platforms that use smart contracts to manage the transaction. These contracts are generally quite simple, setting out an agreed purchase price for the transfer of tokens to a new owner, perhaps along with certain other limited information. Smart contracts using the ERC-20 standard, for example, will also include information such as the total number of such tokens in circulation and the current balance of the tokens in the account. It is rare to find very complex smart contracts because, as well as the complexity itself making problems with the contracts more likely, the cost of gas to process them can be prohibitive.
Most of the functionality of social tokens as perceived by the end user of the token, such as providing real-world benefits, is managed off-chain rather than through smart contracts. For example, if an influencer or brand wants to produce a closed Instagram Live session exclusively for token holders, that right to that benefit does not exist on-chain or within the token or any smart contract. Rather, it is simply a real world contract or arrangement between an influencer or brand and a token holder.
Regulatory challenges in the UK
As with many digital assets in the blockchain sector, social tokens do not fit perfectly into the existing regulatory framework. The FCA has identified two types of regulated tokens in the UK:
- e-money tokens; and
- security tokens.
Social token issuers who wish to ensure that their tokens are not subject to FCA regulation will be keen for their tokens to avoid any of the attributes of an e-money or security token.
Within the category of unregulated tokens, the FCA has specifically identified the following two types of tokens:
- utility tokens; and
- token exchange.
Many of the social tokens mentioned in this article are likely to be considered “utility tokens” under current guidance and, as such, would not be covered by existing FCA regulations. When tokens are used in a payment context, they can be exchange tokens. Although such tokens are themselves unregulated, certain payment activities in which they may be used may potentially be regulated by payment services regulation.
However, token issuers should exercise caution when assigning rights to tokens that could be interpreted as similar to the characteristics of a stock, debt instrument, or other type of financial instrument.
Platforms and exchanges should also be careful that their activities do not constitute “investment activity” on behalf of token holders, potentially opening up the classification of a platform or exchange operating a “collective investment scheme”. This is a particular risk when the token entitles holders to income from ownership/management of assets/businesses.
The FCA’s cryptoasset registration regime for AML/CTF requires cryptoasset exchange providers and custodian wallet providers to register with the FCA and meet various anti-money laundering and anti-terrorist financing requirements. It is possible that a social token platform or exchange could be covered by these requirements.
Any token issuer or platform/exchange considering launching in the UK should seek expert legal advice as soon as possible.
By Nick White and Matthew Blakebrough (Charles Russell Speechlys LLP).
In the next practice note in this series, we’ll take a deep dive into smart contracts.
Click here for Part One, Part Two, Part Three, Part Four, Part Five, Part Six, Part Seven, and Part Eight series.
This practice note is based on the original Law Society document ‘Blockchain: Legal and Regulatory Guidance’ and has been reformatted with kind permission. You can access the original report in its entirety here.
Regulation of DeFi Financial Services
