ICO Market Watch: What’s Happening with Regulation?

Part 2 of 2 (Have you checked out Part 1?)

Co-written by Mick Emmett

Photo Credit: Bjorn Rudner

In the movie Speed, an L.A. city bus is careening down the freeway without braking because, if the speed drops below 50 mph, a bomb onboard will explode. If you can get past the ridiculous concept of ANY vehicle going more than 20 mph on an L.A. freeway — never mind 50! — then it’s a highly entertaining movie. The conflict that needs to be resolved is that there are passengers on the bus, so eventually something has to be done to defuse the bomb and stop the bus safely. That’s pretty much where we are with initial coin offerings (ICOs) and regulation in the United States.

You know things aren’t all buttoned up when you’re reading a Forbes article about cryptocurrencies and just a few paragraphs in an editor’s note appears dead center of the screen:

[Ed note: Investing in cryptocoins or tokens is highly speculative and the market is largely unregulated. Anyone considering it should be prepared to lose their entire investment.]

Not as harsh as a cigarette pack warning label…but not exactly comforting either.

In Part 1 of this article we went into detail about what exactly ICOs and tokens are. Here in Part 2 we’re focusing on ICOs and regulation — where there is a lot of confusion and tension. Good times!

Like Two Boxers Warily Eyeing Each Other from Across the Ring

As we discussed in a recent article about FinTech and regulation, the tension between FinTech companies trying to innovate, traditional financial institutions like banks and insurance companies trying to keep the status quo, and government regulators trying to…um, “regulate” has created a messy and confusing landscape. Some financial institutions (like Credit Suisse and their blockchain-based syndicated loan product), and some regulatory entities (like the US Commodity Futures Trading Commission, aka CFTC, and their innovation lab) have taken a forward-thinking approach. Others, like JPMorgan Chase and the Securities and Exchange Commission (SEC), are wading in slowly and carefully before committing to any significant changes. And some still wish it was 1955.

With a market cap of $165B as of this writing (per CoinMarketCap), cryptocurrencies like bitcoin, ether and 1,000+ others are not chump change. All those billions attract a lot of attention, especially from regulators — not to mention institutions and individuals who are looking to ride the momentum to profits.

Welcome to the Jungle

Once you get past the foregone conclusion that ICOs are eventually going to face more regulation and start venturing into the legal weeds, well, let’s just say that things get real complex real fast. And that’s where cryptocurrency and ICO legal experts like attorney David M. Otto come in. They’re the kind of experts who not only know what “SEC v. Howey, 328 U.S. 293 (1946)” is, but also why it’s important to what’s going on with ICOs today.

David recently laid out the challenges of the current situation in an article co-written with Andrea K. Louie:

“The recent rise in the use of initial coin offerings (“ICO”) to raise capital compels an evaluation of the legal, structural, and operational issues impacted by this relatively new form of financing. Initial coin offerings, or crypto-equity financings, are outpacing the establishment of comprehensive, clear, and relevant guideposts under U.S. securities laws. As a result, every crypto-equity financing must be independently evaluated to ensure compliance with securities laws. This evaluation is impacted by various factors, such as distributed autonomous organizations, smart contracts, token functionality, and built-in rights for the cryptocurrency holder, such as managerial or voting rights.”

The key phrase here is “Initial coin offerings, or crypto-equity financings, are outpacing the establishment of comprehensive, clear, and relevant guideposts under U.S. securities laws.” Outpacing…you know, sort of like the bus in Speed flying past all those commuters on the freeway.

What’s happening here with ICOs — as it has with numerous other financial instruments over the years — is that securities laws passed decades ago like the Securities Act of 1933 are still in force. This despite the fact that there’s no way future changes in financial services could have been predicted. So there’s a lot of catching up to do by the SEC and other regulatory bodies. In the case of Howey, defining what exactly constitutes an “investment contract” is one of the key issues.

With the CFTC the big issue is also classification. In their case, tokens are considered commodities and within their jurisdiction. So, given all the alleged and documented cases of fraud and other illegal activity with ICOs, where are all the stories about CFTC punitive actions? Not even an old-school bust or anything? Well, it has to do with the agency’s primary focus, which is the derivatives markets, and less so the immediate delivery, buy and sell transactions that fuel commodities trading. So they’re watching and they have some regulatory muscle behind them — which is nice — but don’t look for any law and order fireworks just yet.

What Makes a Token a Security vs. an Asset?

The short answer: hire an attorney who specializes in cryptocurrencies. Answering this question is complicated, and is a situation tailor-made for an attorney who specializes in cryptocurrency issues like ICOs because he/she will ensure that fly you under the radar of the SEC and other regulators. Sure, you could do this yourself, but let’s just say that is a risky approach that could lead to fines, jail time and other extremely unpleasant outcomes.

Without going too deep into this subject, there’s a legal precedent called the Howey test that is used as a guide to determining whether or not a financial instrument (like a token) is a security. And based on previous SEC actions, some — but not all — ICOs have been deemed securities based on the Howey test. In a broad sense, if there’s an investment of “money” with the expectation of a profit, then there’s your security.

What makes a token an asset, as opposed to a security, is removing the expectation of profit. Instead, the focus is on the inherent use and value of the token. The user/investor deploys the token in some way and receives some kind of value that is not necessarily profit.

Every ICO will need an expert assessment to determine whether it is a security or asset. Trust us — hire an attorney who knows this stuff inside and out. It will be money or bitcoin or whatever well spent.

A Fraudster’s Paradise?

The biggest knock against ICOs is fraud. Depending on who you read or talk to, ICO fraud runs from “rampant” to “a big problem” to “an issue that needs to be dealt with.” In fact, just a few months ago in a “Just doing our job, ma’am” initiative, the SEC issued a warning on ICO fraud risks. The gist of the warning: fraudulent ICOs could be using “the lure of new and emerging technologies to convince potential victims” to invest in ICO-promoting companies. In the same warning they also cautioned investors against “pump and dump” scams.

We thought we might not hear from the SEC again on this topic for a little while, and then, just a couple weeks ago (after we had already drafted this article), came news of a new “Cyber Unit” to police ICOs and other Distributed Ledger Technology (DLT) violations. According to the announcement, the cyber unit will go after “misconduct perpetrated using the dark web” and also market manipulation and the theft of sensitive information. Expect more actions like this.

In a related story…a recent Bloomberg article aptly titled, “Go Ahead, Try to Stop Initial Coin Offerings” (subhead: “The Fraud-ridden market could make us appreciate regulation”), writer — and blockchain engineer — Elaine Ou poses the critical question: “How can any government control a phenomenon that transcends national borders and rules?” The is particularly relevant in light of China banning ICOs earlier this month. The short answer: not easily, if at all.

Fraud is impossible to measure with ICOs. It’s clear that it’s out there, and it’s also clear that there’s a LOT of it going on. We won’t bore you with all the stories; they’re easy enough to find. It sure seems like investing is the old dog, and ICOs are the new tricks, doesn’t it?

Walkin’ the Tightrope

In the opinion of Realm Labs, the ICO market is walking a tightrope. It’s a precarious time. Some unexpected waves from regulatory bodies like the SEC, or some competing IPOs, or a number of other threats could send the whole ICO market careening off the tightrope — without a net. And, if the issuers play fast and loose with fraudulent activities and ICO structures, then fines and jail time are also in play.

That’s one side of (bit)coin. The other side is the cool side. The disruptive side. The side with really smart people and innovative applications (like smart contracts) coming together to build new ecosystems.

The big question is: how does the ICO market avoid greed taking it — and everyone associated with it — down.

We’ve thought a lot about this question here at Realm Labs. Here’s what we advise:

  1. Play it conservative. Do a private offering, not an ICO
  2. Hire an attorney. Someone (or some firm) with expertise not only with ICOs, but with local and federal financial regulations also. Yes, it’s expensive. Yes, it’s a lot more work. But it’s worth it.
  3. Build out your team. Bring in people on the business side and development side. This type of talent is almost impossible to source after the fact — especially the developers.
  4. Put real time and effort into the white paper. Sounds like common sense, but have you seen some of the ICO white papers out there? Trust us — there’s some scary, shoddy stuff out there.
  5. Have an operational plan in place. Not the pieces of a plan; a researched, vetted, written plan.
  6. Ask your team: “Does a blockchain solution here make sense?” Again, sounds like common sense. But…
  7. Put some source code on GitHub. It will make your offering stand out.
  8. Don’t wait until you’ve raised a ton of money to do all of the above!

The potential of ICOs is immense. They are a fascinating and forward-thinking way to build totally new economies to incentivize things that are important but not obvious profit generators. Things like clean water and basic health needs. That’s why we’re in this game. But we also don’t lose sight of reality. Neither should you.

[you can check out Part 1 here]

— — — -

DISCLOSURE: We wrote this article ourselves, and it expresses our own opinions. We are not receiving compensation for it. Views shared here are our own and cannot, under any circumstances, be interpreted as an official account of any companies we are associated with — currently or in the past.

Like what you read? Give Nathan Martinez a round of applause.

From a quick cheer to a standing ovation, clap to show how much you enjoyed this story.