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IOSG Ventures: How do Web3 games dance under the knife of the SEC?
Author: Simon, IOSG Ventures
Since the birth of the industry, video games have always been high-risk and high-reward. The global game market has reached 350 billions and is still growing rapidly, attracting countless practitioners to follow. In the field of traditional games, the dynamic game and mutual adaptation between the industry and supervision have always been the grass snake gray line of the development of the industry, from the prevention of minor addiction to the definition of gambling.
For web3 games, with the addition of more financial elements and the intervention of SEC supervision, the problems that practitioners need to face and face will only become more complicated. In the face of supervision, there will only be more to be done.
This article starts from the entry point of web3 games, and discusses the points that need to be paid attention to under the US regulatory system from the aspects of product design, business model construction, operation and distribution:
None of the following is financial/investment advice, but it is recommended that founders discuss and research with the team.
What are Securities & Why Do They Matter?
Compared with other products, the development cost of games is high. In the traditional game industry, common financing methods for game developers include: financing from publishers, selling equity to VC, and financing from angel investors. Web3 allows game makers to have a way to raise money from the general public outside of crowdfunding platforms: selling tokens/NFTs.
The new financing method brings a new paradigm and provides a new living space for small and medium-sized developers, but it also brings new troubles for financing. For example, many crowdfunding platforms and distribution platforms avoided digital assets earlier, the applicability of various securities definitions to tokens, and under various uncertainties, other traditional game investors have many concerns about web3 games.
Howey Test
If a token of a game is recognized as a security, it will be brought under the jurisdiction of the SEC. To whom and how much these tokens can be sold will be directly restricted by relevant regulations. The most direct impact on tokens is: these tokens will be Not to be traded on US compliant centralized exchanges. As for the definition of securities, Howey Test has to be mentioned.
The Howey Test is a test used by the SEC to determine whether a cryptocurrency should be classified as a security. The supervision will judge from three aspects: investment currency, joint venture and expected profit. In terms of specific performance, it is to score a project. The higher the score, the closer the nature of the token is to securities. Once it is recognized as a security, it means that the token needs to be subject to the same strict supervision as securities, and the issuance threshold is much higher, and once the issuer does not meet the qualifications, it will face serious legal risks.
The vast majority of blockchain projects, including Ethereum, are trying their best to avoid risks, avoid getting too high scores in the Howey Test, and avoid issuing cryptocurrencies from being recognized as securities.
The Howey Test score is mainly judged from the following four elements:
(1) Capital investment;
(2) invest in a common cause;
(3) looking forward to making profits;
(4) Do not directly participate in the operation, but only rely 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 court and is only used for reference. Some blockchain projects claim to have passed the Howey Test, which usually means that the score is not high, will not be recognized as a security, and the blockchain project meets the requirements of US law. Finally, the so-called passing of the Howey Test by the project party is generally a corporate behavior of a law firm, rather than being recognized by a US court.
Game projects often implement compliance by setting up different entities. Set up the currency issuing and operating entities (mkt, R&D, operations, etc.) of us offshore. However, independent entities cannot completely avoid regulatory risks. In practice, the SEC will consider all active participants in securities issuance, and all Third party affiliates are taken into account. The establishment of different operating entities and currency issuing entities cannot escape the jurisdiction of the SEC. Since this kind of deception is not advisable, let's face the problem directly. From the perspective of the Howe test, what are the specific risk points?
#1: An Investment of Money
This is the simplest and easiest test condition to satisfy, if you sell game currency, game assets, game content to players, or just airdrop/gift these things to players. As long as the project party benefits directly/indirectly (such as a promotion email asking the recipient to follow the game twitter in exchange for a game discount code), it meets the capital investment requirements.
#2: In a Common Enterprise
Investing in a common cause refers to whether the interests of the participants are tied, which usually means
Common interests among investors (horizontally)
Common interests of investors and issuers (vertically)
Common interests among investors (horizontal)
Satisfying this rule usually requires investors to put their investments in the same pool and share gains and losses. For games, some people may say that the NFT in the game is a unique asset, and its ownership also belongs to a single investor. The gains/losses of investors who invest in two different pairs of shoes in stepn are independent of each other, refuting that in-game NFTs are not securities. But in the case of Dapper Labs, the regulator said that the NBA top shots NFT was actually collected into a collection by the issuer, and in the form of this collection, it attracted more attention and attracted more buyers. In this kind of practice, as long as the floor price rises, all NFT investors in this series will benefit together, and vice versa. Therefore, the thesis that there is no commonality among NFT investors does not hold.
In Web3 games, there is also an alliance of interests between investors' investors and project publishers. After purchasing NFT, the interest relationship between the two still exists. Publishers of most game NFTs can benefit from royalties in the secondary market. When the price of NFT is inflated, the publisher's income will also increase, even more lucrative than primary sales. Many game projects are also designed to open their own marketplace and draw money from it. It is also an example of NBA top shot. Developers not only collect royalties, but also benefit from the pumping water of their own marketplace. Therefore, any price increase of this collection will directly benefit Dapper Labs.
Game developers/NFT publishers will continue to benefit from the assets sold/issued.
#3: With The Expectation of Profit
This one is relatively ambiguous. Do game players expect to profit from it when they buy assets? Has the project party clearly designed the interest-generating mechanism? Supervision generally judges comprehensively from product design, marketing information, game player profile, purchase motivation and input cost. It is very important to emphasize whether information such as "play earning", "p2e", "follow-up dividend rights" and so on are emphasized in the marketing promotion. In addition, whether the buyer's profile is reasonable and whether the amount of assets sold is reasonable will also be taken into consideration.
"What? Someone bought 80% of the skins in your game for 1 million, and he is not a player in your game at all?" This is very suspicious. In the case of Telegram, many Grams Token holders are not its potential users (of course how to define this is also very ambiguous) but VCs and other speculators.
It is worth noting that,
Compared with the clear interest-bearing design, the value-added of the asset itself will not be regarded as expecting profit. For example, the gun skins of CS GO have been hyped recently, but owning gun skins does not make a profit (such as dividends), and the profit from reselling in the secondary market cannot be counted as expecting profit.
If the buyer is relying on his own efforts to benefit from this asset, then this article can also be circumvented. For example, Xiaohong rented Stepn's running shoes to Xiaoming outside the venue by herself. This is not the project's interest-bearing design.
NFT royalties, marketplace pumping, game distribution dividends, and NFT mining are all basic operations common to many gamefi projects to attract web3 users. However, many projects are undisguised, overemphasizing these functions during the financing stage, as if holding a sign to announce to the regulators that we are the issuer of securities.
#4: From the Efforts of Others does not directly participate in the operation, but only relies on the efforts of the promoter or a third party
Finally, as mentioned above, regulators will also examine how dependent buyers are on asset issuers in order to make a profit. In other words, the more the price of NFT depends on the operation of the project party or the success/failure of the game, the more it will be like a security. In the background of the game, this can be said to hit the nail on the head.
In addition to the regular dependence of the token price on the project party, the price of game props is more highly dependent on the utilility provided by the game. Even in many cases, when the token is issued, the game itself has not yet been developed/launched. At this time, the price of the asset can be said to be 90% dependent on the project party rather than the individual efforts of the user.
But starting from this, we can think of some countermeasures that game teams can use:
Including but not limited to allowing users to make more personal efforts before making a profit: participating in "staking" before making a profit, completing certain tasks/growth goals in the game, etc.
Or avoid issuing tokens too early and release them at the mature stage of the game.
Or improve the utilility of assets in other cases: for example, it is also useful in other companies' games. These can more or less reduce the dependence of asset buyers on issuers.
Digression: A fully decentralized fully onchain game is also a potential solution.
However, developers don’t have to worry about everything. The conclusion of the Howey test is based on case & event. That is to say, the result of passing the Howey test only affects the quality of a certain token in a certain asset issuance, and affects other tokens of the same type. The token has no effect. If one day $GMT is judged as a security, it does not mean that all the governance coins of the dual-currency model are securities.
"Design the token model in compliance with the regulations at the beginning" and "avoid the issuance of tokens that may be characterized as securities", which is extremely cost-effective for issuers. However, if you want to choose a safer financing method, you can design the financing structure directly in accordance with the SEC guidelines, which stipulate in detail how many times a company can issue securities, how much money it can raise, who it can sell to, how much it can sell, and information disclosure obligations Obligations related to the protection of investors' rights and interests, etc.
Source:
How to dance on the tip of the knife: those pits that should be avoided when designing tokenomics
Fungible Tokens (FT)
Let’s briefly review the common FT token design in the industry: web3 games usually adopt a single-currency model or a dual-currency model.
In the single currency model, the only token has two utilities for governance/in-game consumption.
In the dual currency model, governance/in-game consumption of two utilities are allocated to two types of tokens. Governance tokens generally have a fixed supply, and theoretically owners can participate in game development/operation decisions to a certain extent. The utility token generally has no fixed upper limit and is regarded as the currency of in-game circulation/valuation goods.
However, before adopting the dual-currency model as a matter of course and deciding how many tokens/supply to issue, developers should carefully consider the functions that each token/NFT actually performs, and how the value capture of the project will be realized and distributed.
Designing the token economy purely from the perspective of ease of trading will only expose the project to more regulatory risks.
The project party needs to re-examine, including but not limited to:
Governance tokens are generally sold to retail investors through private sales/IEO and other financing activities, while utility tokens are obtained by players in the game after completing certain in-game tasks. Under the requirements of the Howe test, relatively In other words, the issue method and holders of utility tokens are not like securities. However, is it enough to simply design the token as a utility token?
Unfortunately, in order to regulate the life cycle of the economy and prevent gold diggers from excessively draining the value of utility tokens, the development team often has to step-in to adjust the gameplay mechanics after the game is launched to affect the output and consumption of tokens Keeping the price stable with the volume - this hits the last From the Efforts of Others of Howe's test again.
A simple trade-off of past token models is not enough to face the pressure of today's regulation.
Non-Fungible Tokens (NFT)
The application of NFT is also very common in web3 games, from characters, skins to land and buildings that mimic real world assets. On the surface, these digital assets are far from securities. As analyzed above, the non-homogeneous characteristics give NFT a certain ability to resist under the Howey test. However, it should still be noted that for some series, there is still a high degree of homogeneity between individual NFTs. For example, certain repetitive materials (mahjong, poker NFTs) that exist in large quantities in some games may be regarded as one by the regulators. Common enterprise, even for a single NFT, and with the development of NFTFi, scenarios such as NFT fragmentation also make NFT gradually homogeneous, which makes NFT more securities.
It is also worth mentioning that in the first generation of Gamefi, many games used NFT as a threshold to enter the game, a shovel for gold, players need to purchase axie or running shoes (with a certain cost) to experience the game.
This kind of pre-investment increases the investment attribute of buying NFT, and makes the buyer's tendency to expect profit more obvious. Compared with using NFT as a threshold, like limitbreak, it is more advisable to try to make the appearance of the game free 2 play/free-mint.
Another feasible design is to try to make the NFT in the game as long-lived as possible - over time/use, the value is worn out, or the economic system of the game is reset periodically. Like in Tarkov, Battlestate Games resets the game's economy periodically, and in Zelda, most weapons wear out with attacks. These designs can alleviate the buyer's tendency to expect profit.
Extended Discussion
SAFTs
SAFT is a common financing method for projects, and game projects are no exception. Combined with the Howey test, the SAFT situation also becomes very ambiguous.
Theoretically, in SAFT, the purchase of tokens is divided into two steps. Investors first get an agreement to purchase tokens in the future, and then investors get tokens after TGE. Thus, at first glance, it is reasonable to assume that tokens themselves are not securities.
But in practice, taking the Telegram case as a reference, the court will think that the Howey test needs to be applied when signing the SAFT, not when TGE. That is, all agreements signed around the token will be taken into consideration.
Use the tokens issued on the market
The Securities Act of 1933 and the Securities Exchange Act of 1934 govern corporations with over 10 MM assets and 500+ shareholders. So, can Web3 game companies find a token issued by a private entity that does not meet the above requirements, and then use it as their own token?
Perhaps such an operation can save web3 companies from becoming issuers of securities. But the price is that game companies need to rely on the compliance capabilities of third parties and at the same time transfer part of their value capture capabilities. Therefore, it is recommended to do the most detailed due diligence on the token issuer.
Insights
The game project party should pay attention to the risk of supervision, and dealing with supervision in the future will be the norm in the industry. As a c-end-oriented product with a large number of users, the game will definitely be on the cusp. Try to leave enough room in the product design instead of issuing coins for the sake of issuing coins.
Pay attention to the decentralization of the project (economic system and product operation). This is not just a marketing gimmick or a story to tell the community, but also a safety cushion for the project in the face of regulation.
Game-fi seems like a high-stakes business right now, by any measure. Game-fi may be a proven model, but it is not suitable for the current environment. If you can, even if it's harder, focus on more interesting innovations.