Initial Coin Offerings: Crowdfunding in a regulatory vacuum
What began as a curiosity with the introduction of bitcoins less than a decade ago has now become a global phenomenon offering both promise and peril in the world of international finance. Bitcoin was the first innovation in digital currency to take advantage of the latest developments in financial technology enabling many types of financial transactions to take place on a peer-to-peer basis without intermediaries like banks or clearinghouses. Issued by an unincorporated software protocol, bitcoins initially enabled electronic payments directly among the participants of the bitcoin network. But bitcoins have spawned many offspring in recent years, notably the proliferation of large-scale crowdfunding for technology startup companies through so-called Initial Coin Offerings (ICOs) or sales of new digital currencies (or tokens). More than $1.6 billion has been raised through ICOs in 2017 alone.
The advantages to users of digital currencies promoted by these startups are clear. ICOs have the potential to make global capital allocation more efficient by providing new funding channels to entrepreneurs beyond those in the arena of venture capital (VC) or bank borrowing. ICOs also allow everyone, independent of location or wealth, to participate in the success (or failure) of new technologies and applications, and not just a few VCs. Some see this as a welcome democratization of capitalism. Some VCs have also started to invest directly in ICOs. Third, the amounts that can be raised is determined by the market (or a cap by the issuer) and are thus much higher than amounts that can be raised through conventional crowdfunding channels. Fourth, for the startup the funding terms are more attractive than borrowing from VC firms or banks. They don’t have to give up ownership rights nor do they have to pay interest on the tokens.
But the dangers of such a system as it grows at an exponential rate in a regulatory vacuum are equally clear. For all the benefits, these investments are high-risk. The current regulatory framework is almost certain to prove inadequate for the benefits to materialize. Restrictive investment rules in the United States and “wild west” financing in a regulatory vacuum elsewhere are not a sustainable model. A coherent international regulatory effort is needed to address issues of investor protection, taxation, money laundering, and terrorism financing inherent in ICOs. Moreover, the issuers are often "decentralized organizations" with unknown and possibly shadowy locations. They do not even have to have a bank account, because their transactions, including wage payments take place in digital currencies, evading scrutiny still further.
How ICOs Work
In an ICO or token sale, the startup receives funding in an established digital currency like bitcoin or ether. In some cases, sovereign currencies are also accepted by the startup as funding. In exchange, the startup distributes digital tokens (which is the startup’s new digital currency) to investors at a predetermined price (or exchange rate). The digital tokens have different embedded features, such as a right to future revenues of the startup. The startup uses the funds to finance the development of the company or certain projects within the company, and the digital tokens may also provide access to the platform, software, or other benefits of the project. Typically, ICO tokens are not structured as equity or conventional interest-bearing debt. In fact, with the advice of specialized law firms they are deliberately designed to avoid regulation or scrutiny by securities and banking laws. Since ICOs are not issued through an intermediary, they also are not covered by crowdfunding laws such as the US Jumpstart Our Business Startups Act (JOBS Act). After a holding period, the tokens are traded on digital secondary markets against other digital currencies.
About 120 ICOs have raised $1.6 billion in the first seven months of 2017, up from $100 million in 2016. The largest ICO was in July 2017; within two weeks $230 million was raised for a project. ICOs have now surpassed the amounts that VC firms are contributing to internet startups in angel and seed rounds.
To the investors, ICOs present their business plan in the form of a whitepaper. The whitepaper describes the project, introduces the team, and discusses the functionality of the token. Whitepapers typically also do not include revenue projections. Potential investors exchange views on a particular ICO website and discussion fora before the token is launched.
Regulators Are on the Sidelines
International regulatory bodies have been curiously silent about ICOs. ICOs are not mentioned in a recent research report on Fintech by the International Organization of Securities Commission. Neither were they discussed by the Committee on Global Financial Stability and the Financial Stability Board in a report on the risks of crowdfunding. Similarly, there is no reference to ICOs in a discussion note by the International Monetary Fund on Fintech issues. The Financial Action Task Force (FATF) has issued guidance on the obligations of digital currency exchanges to combat money laundering and terrorism financing, but it has yet to clarify its requirements for ICOs.
National regulators also have generally stayed on the sidelines and have refrained from providing clear guidance on how they are planning to deal with ICOs. Very recent exceptions are the US Securities and Exchange Commission (SEC) and the Monetary Authority of Singapore (MAS). The SEC published two documents: The first is an investigative report on a large but failed ICO “The DAO.” The second is a general investor bulletin published by the SEC's Office of Investor Education and Advocacy outlining to investors the risks that ICOs pose in the current environment.
The SEC's Enforcement Division investigated whether “The DAO,” an unincorporated organization, and the people behind it had violated the federal securities laws. “The DAO” was the first major ICO. It took place in spring 2016 and raised an equivalent of $150 million in ether. Shortly after the offering period had ended, hackers siphoned off a significant fraction of the funds paid to “The DAO” to their own accounts. As the best of all remaining bad options, the ether community then decided to annul all pay-ins to “The DAO” and return the funds to the investors. “The DAO” itself ceased to exist and never became operational.
Based on a detailed discussion, the SEC concluded that ”The DAO” tokens were investment contracts within the definition of the Securities and Exchange Act of 1933. “The DAO” should have registered its token sale with the SEC or conducted the offering in compliance with an exemption under the Securities Act, such as for an alternative trading system, which itself must register with the SEC. Thus, “The DAO” violated US securities laws. Without specifying any reasons, however, the "Commission has determined not to pursue an enforcement action in this matter."
The SEC's determination is troubling for several reasons. First, even unincorporated "distributed" organizations are subject to US laws. Second, the platforms over which “The DAO” tokens would have been traded, including brokers, should also have registered with the SEC or complied with the exemption for alternative trading systems registered with the commission. Third, not all digital tokens are securities. Without being very specific the SEC stresses that "facts and circumstances" need to be considered. An important determining factor is whether the token holder has an expectation of profit arising from the managerial efforts of others.
The SECInvestor Bulletin provides general guidance to investors about the risks of ICOs. The SEC stresses the risk of fraudulent ICOs. "Fraudsters often use innovations and new technologies to perpetrated fraudulent investment schemes.” Because the issuers may be unincorporated organizations with an unidentified location, legal options in case of fraud are also likely to be limited. "Law enforcement officials may have difficulty freezing or securing investor funds that are held in" digital tokens.
Similar to the SEC, the MAS also states that if a token offered in Singapore qualifies as a security, it needs to be registered with the MAS. The MAS does not, however, specify what criteria will be applied to this determination. In addition, the MAS indicates that it “is currently assessing how to regulate ML/TF [money laundering/terrorism financing] risks associated with activities involving digital tokens that do not function solely as virtual currencies.”
Thus, the ICO space is currently divided into two parts. In the United States, where the law defines securities in a broad way, a prudent issuer offers a digital token only to accredited investors. Outside of the United States, individual investors are contributing large sums to projects that are often no more than an idea written down in a whitepaper sketched out on a paper napkin. Major failures are bound to happen.
1 I thank Olivier Blanchard, Anna Gelpern, Patrick Honohan, Junie Joseph, Matthew Panizari, Adam Posen, Marcus Noland, Sherman Robinson, Ted Truman, Angel Ubide, Nicolas Véron, and Steve Weisman for stimulating discussions and feedback. This blog builds on a forthcoming article by Ted Truman and myself in the Georgetown Journal of International Affairs, “International Financial Regulatory Cooperation and Digital Currencies,” which discusses various challenges for international financial regulators arising from digital currencies.
2 Such technology is typically referred to as distributed ledger or blockchain technology.
3 For a description of bitcoin, see my 2017 PIIE Policy Brief 17-13, Do Digital Currencies Pose a Threat to Sovereign Currencies?
4 Heller and Truman, “International Financial Regulatory Cooperation and Digital Currencies,” forthcoming in Georgetown Journal of International Affairs.
5 Ether is the second largest digital currency after bitcoin.
6 The whitepapers for ICOs are equivalent to the pitch decks in the VC world. Instead of Powerpoint format, whitepapers are written text.
7 Since in both digital funding currencies, ether and bitcoin, the owner is identifiable only through an alphanumeric sequence, the issuers of an ICO do not know who is contributing to the token sale.
8 In the blockchain environment, this process of unwinding past transactions is called a ”hardfork.“
9 An accredited investor is a natural person with a certain net worth or wage and who is registered with the SEC. For this reason, US IP addresses are usually blocked in ICOs. Such a measure is, however, not watertight since it is fairly easy to obtain a non-US IP address through a virtual private network.