Crypto Thoughts - Sec directive on ICOs & Tokens
Key excerpts from the SEC investor bulletin and their investigation report on the DAO hack-
"The DAO sold tokens representing interests in its enterprise to investors in exchange for payment with virtual currency. Investors could hold these tokens as an investment with certain voting and ownership rights or could sell them on web-based secondary market platforms. Based on the facts and circumstances of this offering, the Commission, as explained in the Report, determined that the DAO tokens are securities."
"Sponsors involved in an exchange of something of value for an interest in a digital or other novel form for storing value should carefully consider whether they are creating an investment arrangement that constitutes a security. The definition of a security under the federal securities laws is broad, covering traditional notions of a security, such as a stock or bond, as well as novel products or instruments where value may be represented and transferred in digital form. A hallmark of a security is an investment of money or value in a business or operation where the investor has a reasonable expectation of profits based on the efforts of others."
"A market participant engaged in offering an investment opportunity that constitutes a security must either register the offer and sale of the security with the Commission or structure it so that it qualifies for an exemption from registration. Market participants in this area must also consider other aspects of the securities laws, such as whether a platform facilitating transactions in its securities is operating as an exchange, whether the entity offering and selling the security could be an investment company, and whether anyone providing advice about an investment in the security could be an investment adviser. Structuring an offering so that it involves digital instruments of value or operates using a distributed ledger or blockchain does not remove that activity from the requirements of the federal securities laws."
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Although some of the detailed aspects of the federal securities laws and regulations embody more traditional forms of offerings or corporate organizations, these laws have a principles-based framework that can readily adapt to new types of technologies for creating and distributing securities."
"Before investing in an ICO, ask whether the virtual tokens or coins are securities and whether the persons selling them registered the offering with the SEC. A few things to keep in mind about registration:
If an offering is registered, you can find information (such as a registration statement or “Form S-1”) on SEC.gov through EDGAR.If a promoter states that an offering is exempt from registration, and you are not an accredited investor, you should be very careful – most exemptions have net worth or income requirements.Although ICOs are sometimes described as crowdfunding contracts, it is possible that they are not being offered and sold in compliance with the requirements of Regulation Crowdfunding or with the federal securities laws generally. "
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International scope. ICOs and virtual currency transactions and users span the globe. Although the SEC regularly obtains information from abroad (such as through cross-border agreements), there may be restrictions on how the SEC can use the information and it may take more time to get the information. In some cases, the SEC may be unable to obtain information from persons or entities located overseas."
"Section 21(a) of the Exchange Act2 to advise those who would use a Decentralized Autonomous
Organization (“DAO Entity”), or other distributed ledger or blockchain-enabled means for
capital raising, to take appropriate steps to ensure compliance with the U.S. federal securities
laws. All securities offered and sold in the United States must be registered with the
Commission or must qualify for an exemption from the registration requirements. In addition,
any entity or person engaging in the activities of an exchange must register as a national
securities exchange or operate pursuant to an exemption from such registration."
"This Report reiterates these fundamental principles of the U.S. federal securities laws and
describes their applicability to a new paradigm—virtual organizations or capital raising entities
that use distributed ledger or blockchain technology to facilitate capital raising and/or investment
and the related offer and sale of securities. The automation of certain functions through this
technology, “smart contracts,”3 or computer code, does not remove conduct from the purview of
the U.S. federal securities laws.4 This Report also serves to stress the obligation to comply with
the registration provisions of the federal securities laws with respect to products and platforms
involving emerging technologies and new investor interfaces."
My thoughts
This report and the following advisory and the sec press release was published on 25th July 2017 helps to clarify the stand of SEC a key regulatory body on the issue of ICO. And though there can be many questions asked why it took SEC over a year to come up with this investigation report and also on the hard handed approach in dealing with ICOs. But the truth is that is was long coming and the wild wild west of ICO investment was always known to be a big bubble which can bust any time.
And there was a lengthy debate in many forums at length as to what these directives mean for the whole Crypto currency industry as a whole and ICO as a medium of raising capital. From an investor point of view and also from a regulations friendly crowd this was a boon given that this now states the right of an investor viz a viz tokens sale and also setting obligations to all the participants in the ecosystem like the investors, the exchanges, the token issuers and even advisors. And bringing all of them under the preview of the US securities and incorporation laws. Which while many do not know or understand partially is a whole a lot bigger beast.
And thanks to some of the inputs from a lawyer friend I got lot more deeper insights as to how big the impact on ICOs and the various participants and entities in ICO can have.
So here is what I think:
Currently most of the securities are traded in formal exchanges and to list securities there you have to go register via SEC (for US entities). Next depending on your capital requirements either you can ask for exception or go via a crowd funding rout. But in crowd funding in US the maximum capital that can be raised is approximately 1 million which is OK for small projects but not for sizable fintech enterprises.
Another rout if you want to raise capital is through EU where without prospectus you can raise capital of 5 million euros per year which is good enough to start out for many start ups as seed capital.
But lets say your startup has a capital requirement then the above then you have to raise it via capital market via issuing securities and conducting an Initial Public offering which gives certain rights to the investor in return of share in profits and right in decision making via voting rights. And these are some of the corporate actions that are tracked and have to be published in all major media methods and duly notified in prospectus and also clearly mention the risk of such investments. Once IPO is over it is traded in secondary markets or share markets by listing them in stock exchanges. And are regulated by SEC in US and various other market bodies in other countries.
Now how ICO work, they are known as token sale or crowd sale and for some fearing the interpretation by law enforcement use words like token swap or fund raiser. But all at the end of the day share a digital or Crypto token (instrument) that is perceived to have a speculative value. And that is traded against an established Crypto currency like Bitcoin or ether. Many of them use ethereum platform to issue the tokens where they are mostly erc20 tokens. And are managed by smart contracts which is mostly written in solidity language. Again though the vulnerability in the slock.it DAO created the huge hack and the subsequent chain split which again was a erc20 token and is the basis of the SEC investigation erc20 is the preferable mode of issuing the tokens as many exchanges have standard operating procedure developed for listing erc20 tokens.
Now let's come to how can such tokens or in the Coinmarketcap terms assets can be traded in exchanges. Now depending as to if they are a token in a DApp or a virtual currency in a new Blockchain they can be listed as a token/asset or a currency. And many of these exchanges have a standard operating procedure as to how to list such currencies and tokens and in many cases either the exchanges can be centralized or decentralized. Now for many centralized exchanges the keys of your wallet is with the exchange. So while you may need a special wallet like (MYEtherWallet) to get tokens and send ether to a smart contract address. You may not need such setup while trading the tokens in exchanges.
Now let us look at the ICO issuers, after reading many white papers and having spend some time in many chatrooms I can say that many of the people entering ICO business are either super geniuses or imposters of worst kind. Reason being many of the icos do not even have a Proof of concept ready. Many are napkin ideas and the facts and figures given to substantiate their claim are mostly untrue. Even worst is that their roadmap , investor advice or even their token proposal are so arbitrary and that its very difficult for an investor to make an informed decision if the ICO is genuine or is it fake. Mostly its only the reddit, Bitcointalk and the chatrooms so so many rumors or community alerts that make you aware if a project is genuine or scam.
And then coming to the ICO ecosystem. After 1.6 billion raised in first 6 months of this year and from late last year many people are leaving their well paid jobs and trying to jump into the ICO craze. There is a huge FOMO both for investors and even for those who want to make some bucks. And that is why many sites, bloggers like me, youtubers and even lawyers and advisors are part of this ecosystem. And a very new phenomenon is that of bounty hunters. If you go to Bitcoin talk market place you will see many icos advertising for bounty which is nothing more than offering tokens in exchange for promoting for the ICO. Even I tried but somehow did not feel right.And according to me in no way it is bad but it is actually very good. Many may not understand the pain of running an ICO but it is a very stressful job for any founders and many genuine team have to stop their product development and have to ether sit in chat rooms or support the social media campaign or take flack from angry investors who either get hacked or the ethereum network is clogged with transactions. And at these times the support of such bounty hunters is very important.
But at the end of it the SEC ruling puts a hard blow all of it that is happening now. Because most tokens are sold with a proposition that they will have a speculative value and when they are traded they will either appreciate and give some profit. Also to entice many investors had incorporated the concept of community voting and dividends . Hence based on the latest advisory all of such token which constitute 95% of the icos today of DApps will come under the preview of SEC directive. Also many major exchanges that trade such token will also have to get a license for SEC to trade securities which is not easy task. Hence with this it remains to be seen how the speculative value of tokens will remain. Even the bounty hunters and bloggers are impacted as they have to be registered with SEC to advice any securities. Also the advisors that are pictured in the Whit papers and have some profit from the token sale will be subjected to securities and capital gains laws.
Many may think by registering in another country their risk of exposure to US regulations is minimized but that is not true. Every bank that we transact with also are exposed to US regulations as for any USD transactions they use ether an intermediary or have their branches registered in us. And by preview of FATCA regulations dealing in securities or such intermediary in any part of the globe exposes you and the entities to AML and KYC norms as set my FATCA regulations and other securities related laws. Even for mutual funds that is not of us or even if I am not a us citizen I am obligated to us regulations and have to fill those forms.
Also other regulators round the globe see to US as a template to implement their regulations and the stringent stand will make the life of both Crypto investors, Crypto startups and even exchanges a lot more difficult. And we are forgetting that Russia is legalizing ICOs it means now many of the Russian Financial institutions and individuals who are Sanctioned by EU and US can also invest in these ICOs which will expose all the players in the ICO ecosystem to even more stringent scrutiny by Governments and regulators alike.
Finally
As some believe cryto currencies will weather this storm and will shine bright. Many are already searching for more anonymous options like Monreo or Dash. But only time will tell how safe they are. Also despite the risk of Aug 1 hard fork and all the dampening by the SEC ruling still many ICOs are raising huge capital. So while its very important that we stay vigilant. But it is also true that we should be the Crypro dreamers and Crypto warriors who are ready to invest I the next promise and next Crypto dream like we have now as Bitcoin or Ethereum. And to be more safe do your own research and if you like anonymity then use TOR or VPN and trade in decentralized exchanges all at your on risk.
Reference:
https://www.sec.gov/news/press-release/2017-131
http://www.sec.gov/litigation/investreport/34-81207.pdf
https://www.sec.gov/news/public-statement/corpfin-enforcement-statement-report-investigation-dao
https://www.investor.gov/additional-resources/news-alerts/alerts-bulletins/investor-bulletin-initial-coin-offerings
