SEC’s Shot Across the Bow for “Initial Coin Offerings”

Yesterday, the Securities and Exchange Commission (SEC) issued a curious statement on so-called “Initial Coin Offerings” (ICOs) — that is, issuances of new cryptocurrencies (if your head’s spinning already, here’s a good intro to Bitcoin, the currency that kicked off the crypto-wave).

Credit: BTC Keychain; Flickr, Creative Commons

Although the news has broad implications for the entire cryptocurrency marketplace, the SEC focused its announcement on one particular cryptocurrency called “The DAO,” which came into existence a little over one year ago. Amidst the many ICOs over the last year, The DAO was likely the SEC’s choice for a first dip into ICO world because The DAO had the misfortune of being hacked.

Shortly after The DAO’s ICO, an attacker exploited a vulnerability in the new currency’s code and managed to steal about one-third of the approximately $150 million in assets that The DAO had raised, which was in the form of Ethereum, the hottest Cryptocurrency for ICOs. Ethereum has rapidly caught up with Bitcoin of late in terms of its share of the $85 billion cryptocurrency universe (as of today, there are 828 such currencies, according to CoinMarketCap).

Credit: Coin Market Cap https://coinmarketcap.com; July 26th, 12:15 PM EDT

So far in 2017, a little under 100 such offerings have raised about $1.25 billion — an increase of 1,200% over the $96 million raised in about half as many offerings in 2016 — and we’re only halfway through the year.

Credit: Coin Schedule, https://www.coinschedule.com; July 26th, 12:45 PM EDT

But back to The DAO, which amassed its small fortune in less than one month’s time with little more than a “White Paper” (a must for any ICO visionary), a blog, and a Slack channel. The DAO’s lofty aim? Per its founders:

“To blaze a new path in business for the betterment of its members, existing simultaneously nowhere and everywhere and operating solely with the steadfast iron will of unstoppable code.”

While their high-minded concept seemed to center on a blockchain revolution where smart-contracts using the Ethereum blockchain would automate, self-regulate, and secure a wide range of transactions, its more practical intent seems much more like an effort to create a kind of venture capital fund — using the ETH (Ethereum) that they had amassed through the ICO. So-called “contractors” could apply for an advance of ETH (e.g. a venture investment) for a project that created a new smart contract using the Ethereum blockchain. If the project went well, holders of DAO could expect to share in the success and see a return on the investment that the collective had made.

There’s more to this particular story and it’s an interesting read, but the bigger question is: what does yesterday’s announcement mean for the future of ICOs, and the explosion of cryptocurrencies, for that matter? The SEC finds in their report that:

“In light of the facts and circumstances, the agency has decided not to bring charges in this instance, or make findings of violations in the Report, but rather to caution the industry and market participants: the federal securities laws apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology.”

Even though no charges are being brought in this case, this is still big news and it reads, to me, as a signal that the SEC will be cracking down on more ICOs, particularly those that are thinly disguised Ponzi schemes. Yet the buzz in the world of cryptocurrency is mixed and, at least so far, the ICO craze soldiers on, with lots of new flavors to buy. The price of Ethereum dipped only slightly yesterday: despite a small burst of trading activity, the market appears to have settled for now.

Credit: World Coin Index https://www.worldcoinindex.com/coin/ethereum; July 26th, 11:10AM EDT

By contrast, when the 23-year old creator of Ethereum was (falsely) rumored to have been killed in a car accident, a flash crash led to a $4 billion plunge in the market value of the young currency (ETH will celebrate its second birthday on July 30th). As of today, Ethereum’s market capitalization totals about $18.7 billion. One ETH will cost you about $200 — a coin that will be one of about 94 million in circulation right now. New coins are added all the time via mining — that’s a long story so if you like, just think of it like gold and pretend it’s the year 1849.

In its statement, the SEC made clear that future enforcement actions on cryptocurrencies would be on a “case-by-case” basis and that the agency will not be assuming that every ICO is a securities offering — and thereby require boatloads of compliance, which the ICO world blithely eschews. In an interview with the FT, Silicon Valley venture capitalist Tim Draper articulates what I believe is the critical issue here, namely, that if most coin offerings are in fact issuances of new currencies, not securities, then the SEC will not be regulating them (at least, anytime soon). That means that some of the things that seem most outlandish at first blush — like SkinCoin, which aims to increase liquidity in the market for ‘skins’ (cool, unique stuff in video games that players value and will pay for) — may enjoy safer harbor, at least from the rules around issuing securities. It just so happens that I am fascinated by the SkinCoin story right now so tune in soon for Part Two of this story, with an ICO case study.

What do you think? Is there value in this new world of micro-currencies with specialized purposes that are (for now at least) outside of much of the traditional financial system?