Initial Coin Offerings Require New Regulations
The term “initial coin offering” (ICO) has entered the lexicon to describe the method used by thousands of individuals and businesses to raise more than $3 billion in bitcoin and other digital currencies to fund new enterprises and products. Regulators across the globe are struggling to assess the risks and potential for fraud posed by this promising phenomenon. Their challenge is to balance the benefits of new classes of investors who are funding innovative ideas and turning them into workable products against the traditional goal of investor protection. To reach that balance, regulators should consider moving away from the usual dichotomies of domestic versus foreign or accredited versus nonaccredited investors. Eligibility could instead become more self-selected, considering suitability based on engagement and expertise, which are more relevant for the hybrid, frontier nature of many of these projects.
An ICO raises money by selling a newly minted digital currency or “token” instead of selling equity or debt to fund development of a new idea or organization. (See this earlier article for more details.) These tokens and their proposed forms are used in varying ways. Some are meant to be digital representations of assets like stocks or real estate. For example, one token could correspond to one share of a company. These tokens would logically be regulated as securities. Other digital currencies are similar to a payment instrument (for instance, bitcoin), simply allowing transfer of the token among participants in a network created for this purpose, following a set of rules laid out in computer code.
Other tokens entitle the holder to use resources provided by other participants in the network or to purchase products and services on a network. For example, Filecoin tokens allow the holders to purchase cloud storage through a network. This blog post focuses on this last group, often called “utility tokens,” because they have the greatest potential for innovation while raising the most challenging questions for regulatory regimes overseeing securities and commodities.
First, some misconceptions about ICOs of utility tokens should be clarified. These should not be viewed as general-purpose fundraising mechanisms comparable to equity or debt, which are time-tested ways to raise money for startups in any industry. Rather, this type of ICO can be sensible for blockchain startups trying to create marketplaces that are “decentralized,” meaning the marketplace is owned by the participants of the network, e.g. holders of the tokens. Instead of a company managing pricing, supply, and further development decisions in a centralized way, the developers aim to organize a community of suppliers, users, and developers who interact according to protocols spelled out in computer code. Those who add value to the network by contributing resources like computing power or file storage space are compensated with tokens, and those who use these resources can pay for them in tokens. Tokens can also be traded for cash or other digital currencies on exchanges. A key advantage for these tokens is that they enable large amounts of small “micropayments” between participants that would be expensive and slow to process in the traditional financial system. Since the value of this type of marketplace depends heavily on network effects, it makes sense to reward early adopters (in particular those who invest in the ICO) with tokens as incentives to help grow the network.
But the story is not all positive. The hybrid, technically complex nature of ICOs and their current, crazed boom make them prone to abuse. Without the kind of decentralized model described above, there tends to be little reason to issue an ICO, except as a marketing ploy to ride the wave of easy money and (probably illegally) dodge reporting and compliance requirements. If investors buy into ICOs that are issued by unknown or undisclosed entities, they may be used for nefarious purposes like money laundering and tax avoidance. Without proper regulatory safeguards, there may be no legal recourse for victims of fraud if issuers simply run off with the money and never build what they promised.
ICOs Build on Established Crowdfunding Models
The ICO model can be considered a subset of online crowdfunding, which has existed to fund new products for years. In product crowdfunding, a person or company proposes a product idea with a listing on an online platform like Kickstarter or Indiegogo. Kickstarter reports that 136,000 projects and $3.4 billion have been raised on its platform to date. Contributors are entitled to rewards like delivery of the proposed product if it is successfully produced. The crowdfunding model has enormous advantages for small product ideas. Banks do not tend to lend funds needed to produce the first batch of products to small entrepreneurs with unproven ideas, but crowdfunding can provide these funds upfront. A crowdfunding campaign also generates more valuable information than typical fundraising. It gives the entrepreneur a sense of the demand for the product and time to tweak the design based on feedback from contributors before investing in production, reducing the risk of wasted time, money, and effort on a product no one wants. Regulations for this type of crowdfunding have been relatively light, with most of the rules being self-imposed by the platforms concerned with the reputational risk that frauds or incomplete projects pose. In the United States the Securities and Exchange Commission (SEC) issued Regulation Crowdfunding in 2015, which sets out some rather basic requirements for crowdfunding platforms and their users. There are rare Federal Trade Commission cases against individuals who have used crowdfunding contributions for personal expenses, but these are the exception rather than the rule.
By contrast, crowdfunding to raise equity or debt has recently been allowed in the United States, but it has been rarely used and faces far more regulation than product crowdfunding. Despite caps limiting the exposure of individuals to any crowdfunding offering, the Securities and Exchange Commission is concerned with the potential for fraud.
This dichotomy of vibrant product crowdfunding and almost nonexistent financial crowdfunding stems from the sharp discontinuity in regulation between the two, a determination that is much more difficult to make for ICOs that combine elements of both. If ICOs are all regulated like financial crowdfunding, communities may not be able to form and share resources the way product crowdfunding allows, strangling potential innovation by being overly protective of potential investors whose risk is already limited by existing exposure limits.
ICO Regulation Needs Coordination
Effective regulatory responses to ICOs are both imperative and difficult. Several cases of ICO fraud have become public, and more are sure to follow. Also, banks have become reluctant to provide accounts to startups that have been funded through ICOs, afraid of possible reputational damages from doing businesses with “crypto companies” or fearing that these transactions violate "know your customer" (KYC) and anti–money laundering laws. Singapore, Switzerland, and some other countries have been permissive so far, though they may release more concrete regulatory guidance down the road. Regulators in some countries, such as China and most recently South Korea, have banned ICOs. The SEC has hinted repeatedly that registering ICOs and imposing disclosure requirements like those for securities offerings would be prudent, as would allowing only accredited investors to participate. Showing an awareness of the significant legal risks, some users of ICOs have proposed frameworks for self-regulation.
Because ICOs are being carried out around the world, regulators in different countries need to cooperate and coordinate their efforts. Within the United States, the problem of regulation is compounded by a fragmentation and rivalry among regulators themselves. The SEC claims jurisdiction if the tokens are viewed as a security, the Commodities and Futures Trading Commission (CFTC) does if they are viewed as a traded commodity, and the Federal Trade Commission (FTC) is responsible for consumer protection when the tokens are used to buy products and services. But what if a token is all three? A "wild west" with no regulation could easily lead to fraud. But even worse would be continued regulatory uncertainty that chokes off innovation, making issuance too risky for innovators. Legal uncertainty in the United States has led to US companies and investors being mostly excluded from the ICO market, for better or worse, with many ICOs excluding investors from the United States.
US regulators should seek a balance between protecting investors and consumers on the one hand, and encouraging innovation on the other. This balance is always hard, but it is even more difficult to achieve for digital tokens, which can combine aspects of a security, a commodity, and a product/service. In the case of a utility token, the mix of these aspects can also change over time as the marketplace is established. What started off as a risky investment in an unproven marketplace could function more like gift cards or frequent flyer miles once it is established and running. As the nature and magnitude of the risk changes, so should its regulation. Different regulatory treatment as commodities or a sort of ongoing product crowdfunding, rather than securities law, may be a better fit once the network has been launched successfully and is growing. The lack of clarity from regulators so far creates problems for legitimate startups aiming to raise funds with an ICO, like unexpected legal liabilities and being unable to qualify for the common avenues that startups use to raise funds without triggering the kind of onerous obligations large corporations face. Some promising workarounds have sprung up, but these are untested legally and have restricted participation to investors with substantial wealth or income.
In the United States, regulation of ICOs should build on already existing provisions for startup companies, taking into account the global nature of this new field of financing. Such regulation should include, for instance, a requirement of the network to incorporate in the United States, disclosure and ongoing audited reporting requirements, a limit to the capital raised, and individual investment limits. They should not limit participation to only accredited, e.g. already wealthy, investors. Also, all investors would need to be identified in line with standard “know your customer” rules. However, there should be no or only limited restrictions on foreign participation in the ICO.
Such regulation, if carefully designed and effectively communicated, can reduce legal uncertainty for innovative fundraising methods of startup companies based in the United States. It would also make more issuers comply with the rules, allowing for more experimentation in governance mechanisms and a wider base of potential investors, all while maintaining necessary protections for investors and consumers.
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1. These include exemptions from full SEC reporting requirements for securities, including Regulation D and others that are part of the Jumpstart our Business Startups (JOBS) Act of 2012. These include Regulation Crowdfunding and the Revised Regulation A.
2. One workaround is the Simple Agreement for Future Tokens (SAFT), which uses Regulation D to issue securities to accredited investors who can then use the securities to obtain tokens later. Tokens are only issued once the network is operational, when issuers hope they will not be considered securities. This is a somewhat convoluted process, and it is not guaranteed that the arrangements are compliant under current law.