IOSG Ventures: How can Web3 games dance on the edge of the SEC?
Original author: Simon, IOSG Ventures
Ever since its inception, the electronic gaming industry has always been high-risk and high-reward. The global gaming market has reached 350 billions and is still growing rapidly, attracting countless practitioners. In the traditional gaming field, the dynamic game between underage addiction prevention and gambling definition, as well as the adaptation between the industry and regulation, has always been the thin line of industry development.
For web3 games, with the addition of more financial elements and the involvement of SEC regulation, practitioners will inevitably face more complex issues. When facing regulation, there will be more to do.
This article starts with the entry point of web3 games and discusses the points to pay attention to under the US regulatory system from aspects such as product design, business model construction, operation, and distribution:
The following are not financial/investment advice, but it is recommended for founders and teams to discuss and research.
What are Securities & Why Do They Matter?
Compared to other products, the development cost of games is high. In the traditional gaming industry, common financing methods for game developers include: financing from publishers, selling equity to VCs, and financing from angel investors. Web3 allows game developers to finance from the general public outside of crowdfunding platforms through the sale of tokens/NFTs.
The new financing methods bring new paradigms, providing new living space for small and medium-sized developers, but they also bring new troubles for financing. For example, many crowdfunding platforms and distribution platforms have previously avoided digital assets, the applicability of various securities definitions to tokens, and various concerns of other traditional game investors about web3 games under various uncertainties.
Howey Test
If a game's token is classified as a security, it will fall under SEC jurisdiction. Who they can sell these tokens to and how much they can sell will be directly restricted by relevant regulations. The most direct impact on tokens is that they cannot be traded on compliant centralized exchanges in the United States. The definition of securities cannot be mentioned without mentioning the Howey Test.
The Howey Test is the test that the SEC uses to determine whether a cryptocurrency should be classified as a security. The regulation will judge from the aspects of investment of money, common enterprise, and expectation of profits. Specifically, it is to score a project, and the higher the score, the closer the nature of the token is to a security. Once it is deemed a security, it means that the token needs to be subjected to the same strict regulation as securities. The threshold for issuance is much higher, and if the issuer does not meet the qualifications, they will also face serious legal risks.
Most blockchain projects, including Ethereum, are actively avoiding risks and avoiding getting high scores in the Howey Test to prevent the issued cryptocurrencies from being classified as securities.
The Howey Test primarily scores based on the following 4 factors:
(1) Investment of money;
(2) Investment in a common enterprise;
(3) Expectation of profits;
(4) No direct participation in the operation, only relying on the efforts of the promoter or a third party.
It should be noted that the Howey Test has not been directly adopted by the courts and is only used as a reference. Some blockchain projects claim to have passed the Howey Test, which typically means they score low and are not considered securities, and the project complies with US laws. Finally, the project's claim of passing the Howey Test is generally an action taken by law firms, not a recognition from the US courts.
Game projects often use the method of setting up different entities to ensure compliance. The establishment of a coin issuance entity and an operating entity in the US offshore, for example. However, having independent entities does not completely avoid regulatory risks. In practice, the SEC considers all active participants in securities issuance and includes all third-party affiliated entities. Setting up different operating entities and coin issuance entities does not escape the SEC's jurisdiction. Since this kind of deception is not advisable, let's face the problem head-on. From the perspective of the Howey Test, what are the specific risk points?
#1: An Investment of Money
This is the simplest and easiest condition to meet. If game coins, game assets, game content are sold to players, or simply airdropped/gifted to players. As long as the project benefits directly/indirectly (for example, through a promotion email asking recipients to follow the game's Twitter account in exchange for a game discount code), it meets the requirement of an investment of money.
#2: In a Common Enterprise
An investment in a common enterprise refers to whether the interests of participants are tied together, which usually means:
1. Commonality of interests among investors (horizontally)
2. Commonality of interests between investors and the issuer (vertically)
1. Commonality of interests among investors (horizontally)
To meet this requirement, it usually requires investors to pool their investments together, with shared profits and losses. As for games, some may argue that NFTs in games are unique assets and their ownership belongs to a single investor. The profits/losses of investors who invest in two different pairs of shoes in StepN are independent of each other, using this as an argument to refute that NFTs in games are not securities. However, in the case of Dapper Labs, the regulators stated that the NBA Top Shots NFTs were actually aggregated into a collection by the issuer, attracting more attention and more buyers in the form of this collection. In practice, as long as the floor price goes up, all investors in this collection of NFTs benefit collectively, and vice versa. Therefore, the argument that there is no commonality among the investors of NFTs does not hold.
2. Commonality of interests between investors and developers (vertically)
In Web3 games, there is also a vested interest alliance between investors and project issuers. Even after purchasing NFTs, their relationship remains intact. Most game NFT issuers benefit from royalties in the secondary market. When the price of NFTs is driven up, the issuer's profits increase, sometimes even surpassing the primary sales revenue. Many game projects also have their own marketplaces and collect fees from them. The same is true for NBA Top Shot, where developers not only receive royalties but also benefit from fees collected by their own marketplace. As a result, any price increase in the collection directly benefits Dapper Labs.
The game developers/NFT issuers continue to profit from the sale/issuance of assets.
#3: With The Expectation of Profit
This criterion is relatively ambiguous. Do game players expect to profit from purchasing assets? Has the project explicitly designed a mechanism for generating income? Regulations generally assess product design, marketing information, player profiles, purchase motives, and investment costs. It is crucial to emphasize information such as "play to earn," "play-to-earn," and "future dividend rights" in marketing and promotion. Additionally, the profile of the purchaser and the reasonable quantity of assets sold are also taken into consideration.
"What? Someone spent 1 million buying 80% of the skins in your game, and they're not even a player of your game?" This is very suspicious. In the case of Telegram, many holders of Grams Tokens were not their potential users (of course, how to define this is also ambiguous) but VCs and other speculators.
It is worth noting that:
1) Asset appreciation itself, rather than explicit income-generating mechanisms, is not considered as expecting profit. For example, the recent surge in CS:GO weapon skins' prices does not lead to profits (e.g., dividends), and the profits from reselling on the secondary market cannot be counted as expecting profit.
2) If the purchaser benefits from the asset through their own efforts, this criterion can be avoided. For example, if Xiaohong independently rents out Stepn's sneakers to Xiaoming outside the game, it is not a project's income-generating design.
NFT royalties, marketplace fees, game revenue sharing, and NFT mining are common basic operations for many GameFi projects, used to attract Web3 users. However, many projects overly emphasize these features during the fundraising stage, almost waving a sign to regulators, indicating that we are securities issuers.
#4: From the Efforts of Others
Finally, as mentioned above, regulators will also consider the degree of dependence of buyers on the issuer for profitability. In other words, the more the price of NFT depends on the success or failure of the project's operation or game, the more it resembles a security. In the context of the game, this point can be said to be crucial.
In addition to the regular dependence of token prices on the project, the price of game props is highly dependent on the utility provided by the game. In many cases, even at the time of token issuance, the game itself has not yet been developed or launched, and in such cases, the price of assets can be said to be 90% dependent on the project rather than the individual efforts of users.
But from this perspective, we can think of some countermeasures that game teams can use:
Including but not limited to making users pay more personal efforts before making profits: participate in "staking" before making profits, complete certain tasks or growth goals in the game, etc.
Or avoiding premature token issuance and issuing tokens during the maturity of the game.
Or increasing the utility of assets in other cases: for example, they can be used in games by other companies. These measures can to some extent reduce the dependence of asset buyers on issuers.
By the way, having a sufficiently decentralized fully on-chain game is also a potential solution.
However, developers don't need to be overly cautious. The conclusion of Houbi's test is based on specific cases and events, which means that the results of the Houbi test only affect the qualification of a token for a particular asset issuance and do not affect other tokens of the same type. If someday $GMT is determined to be a security, it does not mean that all governance tokens of the dual-coin model are securities.
"Starting with a compliant token model" and "avoiding the issuance of tokens that could be classified as securities" are highly cost-effective for issuers. But if you want to choose a safer financing method, you can directly design a financing structure according to SEC guidelines. These guidelines specify how many times a company can issue securities, how much money can be raised, who can sell and how much, disclosure obligations, and obligations related to protecting investor rights, etc.
Source: www.sec.gov/education/smallbusiness/exemptofferings/exemptofferingschart
Dancing on the Edge: Pitfalls to Avoid When Designing Tokenomics
Fungible Tokens (FT)
Let's briefly review the common design of FT tokens in the industry: web3 games usually use a single-token model or a dual-token model.
In a single-token model, the unique token has two utilities: governance and in-game consumption.
In the dual-token model, governance/utility tokens are allocated to two different tokens. Governance tokens usually have a fixed supply and theoretically give owners some degree of decision-making power in game development/operations. Utility tokens, on the other hand, typically have no fixed limit and are used as in-game currency for circulation and pricing of goods.
However, before deciding how many tokens/supply to issue in the dual-token model, developers should carefully consider the practical functions of each token/NFT and how value capture and distribution in the project will be achieved.
Designing token economics purely based on ease of manipulation will only expose the project to more regulatory risks.
The project needs to re-examine, among other things:
What is the necessity of each token's existence?
Are the buyers of these tokens consumers/real players in the game?
Although the issuers of both tokens are the same, utility tokens and governance tokens often have completely different test results, as discussed in the previous Huobi test. If the core design of the game can bypass some sensitive regulatory aspects and the project can function without dual tokens/issuing tokens, why add risk to the project?
Governance tokens are generally sold to retail investors through private sales/IEOs, while utility tokens are obtained by players in the game after completing certain in-game tasks. Under the requirements of the Huobi test, utility tokens and their holders are generally less like securities. However, is it enough to simply design the tokens as utility tokens?
Unfortunately, in order to regulate the lifecycle of the economy and prevent gold farmers from excessively exploiting the value of utility tokens, development teams often have to step in and adjust gameplay mechanics after the game is launched, affecting the production and consumption of tokens to maintain price stability. This clashes with the last criterion of the Huobi test: "From the Efforts of Others".
Choosing between token models from the past is not enough to face the pressures of current regulations.
Non-Fungible Tokens (NFTs)
NFT applications are also very common in web3 games, from characters and skins to land and buildings that mimic real-world assets. On the surface, these digital assets are very different from securities. As analyzed above, the non-fungible nature of NFTs gives them a certain level of resilience in the Howie test. However, it is still important to note that for certain series, individual NFTs can still be highly fungible, such as repetitive materials found in certain games (mahjong, poker NFTs) which could be considered a common enterprise by regulators. With the development of NFTFi and the fragmentation of NFTs, NFTs are gradually becoming more fungible, which further attributes securities-like characteristics to NFTs.
Another point worth mentioning is that in the first generation of Gamefi, many games treated NFTs as a barrier to entry, a pay-to-win tool, where players needed to purchase Axies or running shoes (incur certain costs) to experience the game.
This upfront investment adds an investment attribute to the act of buying NFTs, making the inclination of buyers to expect profit more evident. Instead of using NFTs as barriers to entry, like Limitbreak, it is preferable to make the game appearance as free-to-play/free-mint as possible.
Another viable design is to give NFTs in the game a lifespan - with time/usage, they wear down in value, or periodically reset the game's economic system. In games like Tarkov, Battlestate Games periodically reset the game's economy, and in Zelda, most weapons wear down with usage. These designs can alleviate the inclination of buyers to expect profit.
Further Discussion
SAFTs
SAFTs are a common financing method for projects, and game projects are no exception. When combined with the Howie test, the situation of SAFTs becomes ambiguous.
In theory, in SAFTs, the purchase of tokens is divided into two steps. Investors first receive an agreement that allows them to purchase tokens in the future, and then after the TGE, investors receive the tokens. Therefore, at first glance, there is reason to believe that the tokens themselves are not securities.
However, in practice, referring to the case of Telegram, the court would consider that the Howie test should be applied at the time of signing the SAFT, not at the time of the TGE. In other words, all agreements related to the token signing would be taken into account.
Utilizing tokens issued in the market
The Securities Act of 1933 and the Securities Exchange Act of 1934 regulate companies that have assets exceeding 10 MM and 500+ shareholders. So, can Web3 game companies find a token issued by a private entity that does not meet the above requirements and use it as their own token?
Maybe this operation can allow web3 companies to avoid becoming securities issuers. However, the cost is that game companies need to trust the compliance capabilities of third parties while giving up some of their value-capturing abilities. Therefore, it is recommended to conduct the most detailed due diligence on the token issuer.
Insights
1) Game project teams should pay attention to regulatory risks. Dealing with regulations in the future will be the norm in the industry. As a product with a large user base targeting the consumer market, games will always be under scrutiny. It is better to leave room for maneuver in product design rather than issuing tokens just for the sake of it.
2) Pay attention to the decentralization of the project's economic system and product operations. This is not just a marketing gimmick or a story for the community, but also a security cushion for the project when facing regulation.
3) From any perspective, Game-fi seems to be a high-risk business now. Game-fi may be a proven model but is not suitable for the current environment. If possible, even though it may be more difficult, focus on more interesting innovations.
