A year ago, the FinTech Program published its Taxonomy of Digital Assets. In that time, there has been enormous growth and change in the digital asset space. In response to that change, we are taking this opportunity to update the terms we discussed in our previous taxonomy. While the definitions of some terms like blockchain, coin, token, and virtual currency have undergone minor changes, the terminology around crypto wallets, stablecoin, utility tokens, and security tokens is becoming increasingly relevant as efforts to legislate for crypto grow.
Crypto Wallets
A crypto wallet is a misnomer. Where a regular wallet holds cash and credit cards, a crypto wallet holds your private and public keys. These keys prove ownership and allow users to transact their digital assets stored on a blockchain. In that way, a crypto wallet is more of a key chain that unlocks a personal vault of digital assets.
According to the definition of the US Treasury, a crypto wallet is "a software application (or other mechanism) that provides a means for holding, storing, and transferring digital currency. A wallet holds the user's digital currency addresses, which allow the user to receive digital currency, and private keys, which allow the user to transfer digital currency. The wallet also maintains the user's digital currency balance."
The wallet that most consumers are familiar with is a hosted or custodial wallet. The Treasury defines these as "a person (individual or entity) that provides the software to create and manage wallets, which users can download. A hosted wallet provider is a business that creates and stores a digital currency wallet on behalf of a customer. Most hosted wallets also offer exchange and payment services to facilitate participation in a digital currency system by users."
Non-custodial wallets, according to the Congressional Research Service, are not hosted by third-party institutions. "They maintain the keys necessary to access and sign the assets for transmission to blockchains and represent the asset's location on the network. Loss of private keys renders cryptocurrency irretrievable. A non-custodial wallet user can transact in crypto without relying on a custodian." While this architecture allows users more autonomy and control over their assets, hosting service providers can be targets for cyberattacks.
An offline non-custodial wallet, known as a cold wallet, limits the risk of attack in an online wallet. The Congressional Research Service defines cold-storage wallets as "pieces of hardware that allow end users to store cryptocurrencies offline, a practice that shields them from hacking. Cold-storage wallets can be connected to the internet to perform transactions."
Non-custodial, self-hosted, and cold-storage wallets are the subject of concern for international financial regulators. The same Congressional Research Service report notes that crypto exchanges are under no obligation to verify the identity of a non-custodial wallet holder. The service warns that the anonymity afforded by these wallets can facilitate sanctions evasion, money laundering, and fraud.
The United Nations Conference on Trade and Development has called for global regulators' registration of all crypto wallets to fight financial crime in its June 2022 policy recommendations. Given the decentralized nature of non-custodial wallets and the global crypto regulatory environment, registration may be hard to achieve. This registration may happen at exchanges, the critical bottleneck between the crypto and fiat assets. Crypto exchanges in jurisdictions willing to skirt know-your-customer (KYC) requirements could become hubs for anonymous crypto conversion to fiat.
Stablecoin
Our previous taxonomy described asset- or reserved-backed stablecoin. However, this spring, algorithmically backed stablecoin garnered attention after the collapse of TerraUSD. A stablecoin is a cryptocurrency pegged to a reference asset like fiat money, exchange-traded commodities, or another digital asset.
In its report on TerraUSD, the Congressional Research Service defined algorithmic stablecoin as "an algorithm or smart contract to manage the supply of tokens and guide their value to some reference asset (for example a fiat currency, such as the U.S. dollar). Algorithmic stablecoin generally does not attempt to achieve value by holding a reserve of fiat-denominated assets with a value in a 1:1 relationship with the value of the stablecoin. Instead, algorithmic stablecoin use different mechanisms to control the supply or value of the stablecoin, including the minting or burning of coins, rebasing, and arbitrage."
Since the TerraUSD collapse, few algorithmically backed stablecoins have a sizable market cap. However, their recent instability has spurred legislators to formalize reporting standards and reserve requirements for stablecoins.
Central Bank Digital Currency
Another digital asset that has moved to the forefront of crypto conversations is Central Bank Digital Currency (CBDC). In principle, a CBDC would be a liability of the Federal Reserve (Fed) held by everyday consumers. A CBDC would differ from today's digital dollar facilitated by bank accounts and payment apps, which are liabilities held by commercial banks backed by the Fed. President Biden’s March executive order directed research into the utility of a US CBDC. This move prompted organizations like the Fed to clarify what CBDC would look like in the US.
The Federal Reserve defines a CBDC as "a digital liability of a central bank that is widely available to the general public. Today in the United States, Federal Reserve notes (i.e., physical currency) are the only type of central bank money available to the general public. Like existing forms of money, a CBDC would enable the general public to make digital payments. As a liability of the Federal Reserve, however, a CBDC would be the safest digital asset available to the general public, with no associated credit or liquidity risk."
The Fed's definition lays out what an American CBDC would look like in principle but leaves many questions about implementation, intermediation, and accessibility. More clarity may come as the research ordered by the White House is released next year.
Utility Token vs. Security Tokens
Utility and security tokens are a final set of terms we are adding to our updated taxonomy. A utility token offers its holder the ability to receive benefits. A utility token generally describes a digital token not intended to serve as an investment vehicle. Utility tokens can be separated into NFTs, DeFi tokens, and governance tokens.
NFTs can represent membership in exclusive clubs. The Board Ape Yacht Club is the most famous example of an NFT line that also straddles the world of utility tokens. An ape provides access to club spaces and events in addition to its artistic value.
DeFi tokens facilitate financial services by representing stakes in smart contracts. The tokens can facilitate loans, insurance, savings, and investment management. Yearn.finance’s YFI and Crypto.com's CRO are examples of DeFi tokens. Governance tokens enable holders to vote on changes relevant to their program, blockchain, or application. Decentralized autonomous organizations (DAOs) rely on governance tokens for decisions making.
Issues emerge when the line between utility tokens and traditional securities is blurred. In 2017, former SEC Chairman Jim Clayton stated that “merely calling a token a ‘utility’ token or structuring it to provide some utility does not prevent the token from being a security.” Current SEC Chairman Gary Gensler told CNBC, “If somebody is raising money selling a token and the buyer is anticipating profits based on the efforts of that group to sponsor the seller, that fits into something that's a security.”
Security tokens are the digital asset equivalent of traditional securities like stocks and bonds. The past few years have seen companies and startups raising capital with initial coin offerings. Security tokens could become a cost-effective alternative to other methods of fundraising. As regulatory and legislative efforts in the token space grow, we look forward to more clarity on what is and isn't a security token. We will continue to update our taxonomy as the industry innovates and develops.