Crypto Regulations and Strengthening the Blockchain Ecosystem

There’s been a lot of discussion in the blockchain community about an Investigation Report released yesterday by the US Securities and Exchange Commission. It concerns the digital tokens issued by “The DAO” and concludes that they were securities, and are subject to federal law regulations. This is the SEC’s first official regulatory intervention of the ICOs so its impact is significant.

There is an increased interest in Estonia among blockchain entrepreneurs because of the country’s e-Residency programme so it’s imperative I looked at the report. The main points are the following:

  • DAO tokens were qualified as securities because i) they allowed participation in anticipated earnings of DAO projects investment and ii) they were traded on the digital asset exchanges that supported secondary trading. The DAO failed to meet the requirements of the “crowdfunding contract” because it was not a broker-dealer or a funding portal registered with the SEC and FINRA.
  • SEC warns that sales and offers conducted by organizations using blockchain technology (ICO or Token sales) are subject to requirements of the federal securities laws and must register sales unless a valid exemption applies.
  • Not only the organizations issuing tokens, but also participants in unregistered token sales may be liable for violations of the securities laws. However, the SEC specified that the application of the laws will depend on the facts and circumstances of the transaction which include the economic realities.
  • Securities Exchanged trading in tokens must also register unless a valid exemption applies. This is done to ensure that all proper disclosures are available to investors, to protect their holdings and to make fully informed decisions.
  • While the SEC hasn’t pressed the charges at this point, they encourage the market participants to engage with them and continue to investigate the effects and risks of the distributed ledger transactions. Investor.gov also issued a bulletin educating investors about ICOs.

This had obvious ripples in the global blockchain community. As troublesome as it may sound at first, the SEC’s intention to regulate ICOs bears signals of a positive development for the blockchain markets:

  • Regulations may reduce the risks of financial bubbles and result in the most credible and less volatile token offerings to remain.
  • Crypto may get recognized as an eligible financial instrument in capital markets (for example, could be used as collateral).
  • Blockchain ecosystem may become stronger, more transparent and investor friendly.

However, while it is important to recognize SEC’s intention to regulate ICO issuances in a highly volatile and mostly unregulated token market, it is also necessary to make a distinction between two types of tokens the organizations are issuing:

1. Asset backed tokens that have one of the following characteristics: i) equity claim, ii) anticipated earnings participation and iii) voting rights. This type of tokens is much closer to being recognized as securities, while the holders are more likely to be recognized as investors and be protected by the investor regulations. Example: DAO.

2. Tokens that give access to the future services and products of the organization. This type of token has the characteristics of the unearned or prepaid revenue and are recognized on the income statement when the actual service is provided and tokens are exchanged. The holders of tokens are more likely to be characterized as customers with a claim on the future product.

While these tokens do exhibit the characteristics of securities, by being traded on the secondary markets, they in a way similar to iTunes prepaid cards, or Walmart gift cards being traded on classifieds websites.

As a very new and open territory, ICO markets carry higher risks for token holders mostly due to mass speculations on the token value and there is a great need for accurate valuations, forecasting and analysis of the products or services being offered. That said, it is essential to recognize ICOs as the future of capital raising as a more efficient, faster, less convoluted instrument that fosters innovation and technology advancement. We just need better risk and assessment instruments to distinguish the good players from the bad, as well as reliable security mechanisms to ensure safe transaction environments.

On the other hand, the SEC doesn’t recognize that ICOs are global by nature, being built on decentralized networks, what makes them very hard to be controlled by a centralized regulatory framework. The applicable framework might come down to being a law of the country where the ICO issuing organization is established, pushing the companies to search for friendlier sovereign environments. It is possible that EU might become such a territory, although there is still no commonly accepted regulatory framework, nor common judgement on ICOs across the European Union. Until the clear EU wide regulatory framework is established, the local members’ approaches dominate, and the smaller, fast-moving countries might have an opportunity to be on a cutting edge of fostering this development.

At e-Residency, which is powered by the Republic of Estonia, we are developing an innovative, safe and transparent environment for the global business community, including blockchain companies, and we are working with all constituents involved to stay up to date with the cutting edge development and work out the solutions that fit. E-Residency already provides the ability for everyone in the world to start and run a business in EU, regardless of their physical place of residence. With the understanding of both technology and legal implications, our goal is to build a new framework for the digital society and its global business environment by fostering innovation while protecting the interests of the investors.

You can apply for e-Residency at e-resident.gov.ee or read more about how Estonia welcomes blockchain entrepreneurs here: Welcome to the blockchain nation