For the first time in centuries, the economic mould has been disrupted with the launching of Bitcoin in 2009. Ethereum and other altcoins started to emerge. With the emergence of new tokens came a new problem: How to raise capital. This is because the philosophy of cryptocurrency is diametrically opposed to the central dominion of modern economics, regulations. Initial coin offerings (ICO) were created in order to over come this problem for cryptocurrency startups. However it became clear that this was not going to be tolerated by authorities. Some countries embraced cryptocurrency others banned it. However those who allowed ICOs want regulatory compliance. The issue of “regulation compliance” was, and is, a thorn in the side of cryptocurrency because it is the antithesis of regulations and middlemen. Will security token offerings (STO) be the solution and next big revolution in economics? Are STOs a synthesis cryptostartups have been searching for? Disclaimer: this is not financial nor legal advice and no product, mentioned or not, is endorsed by this article.
Payment Tokens, Assets, and Securities
There are 3 basic categories that cryptocurrency has been divided into that is relevant for the understanding of this discussion, namely, payment tokens, assets, and securities. Very briefly, and simply, a payment token (which is also sometimes referred to as cryptocurrency) is a cryptocurrency that is used to pay for goods and services and any other purposes fiat currency would be used for, an asset would be a token that is used as any other asset would be used, and finally a security token would be any token where the person invests in the token in order to make a profit from the token bought. These 3 use cases are vitally important because they face different legal implications and need to be registered, or dealt with legally, in accordance with their specific category.
IPO
An IPO is a form of capital raising by a company that goes back several centuries. Typically a private company would undergo a process of transforming itself into a public tradable company by selling a large percentage of its shares to the public in a process that is now known as an IPO. An IPO is a securities offering. Therefore it is subject to the regulations of the US Securities and Exchange Commission (US SEC) in the United States, the Financial Conduct Authority (FCA) in the United Kingdom, the Australian Securities and Investments Commission in Australia, the Securities and Futures Commission (SFC) in Hong Kong, the Financial Services Agency (FSA) in Japan, the Federal Financial Supervisory Authority (BaFin) in Germany or the equivalent financial regulatory authority in any other country or territory. These regulatory bodies form part of the middlemen that cryptocurrencies dream of eliminating and that is how ICOs were born.
ICO
An ICO is where a startup cryptocurrency company raises capital by selling cryptocurrency tokens in exchange for either cryptocurrency, such as Bitcoin or Ether; or fiat currencies, such as the US dollar and the Euro. ICOs then decide how they want to keep their capital raised. In other words how much capital they want to maintain in cryptocurrency and how much they want to have in fiat currency. Most companies hold at least a portion of what they have raised in either Bitcoin and/or Ethereum’s Ether.
The main difference between an IPO and an ICO is that an investor buying into an IPO is buying a piece of the company and has a share in company profits paid out in dividends, whereas an person buying into an ICO is buying the “monetary supply” of a future technology project. The idea is that the person buys cryptocurrency tokens before the technological product is created or while it is in development. Equivalent to regular startups who often presell their product before they launch it to the general public.
This is where things get tricky for cryptocurrency because unlike a product, the token could increase in value. Therefore a person who buys cryptocurrency could be buying it to make a profit, that is as an investor. This then turns an asset into a security. Here is where regulatory authorities start to get involved and start demanding compliance to regulations.
Note: it could even be that if a person buys a cryptocurrency and later, years after the launch, he trades it and makes a profit in the transaction, that that transaction is subject to security laws and needs to be reported to the relevant financial regulatory bodies.
STO
A STO is a token offering within the framework of the relevant financial regulatory bodies, such as the US SEC (United States Securities Exchange Commission) regulations that enables a company to raise capital by selling tokens that are backed by actual tangible, often multiple tangible, assets. The difference between an STO and an IPO is that an IPO issues shares that can be traded on a stock exchange whereas tokens issued by an STO cannot be traded on a regular stock exchange. However STOs can be traded on licensed security exchanges that specifically designed to trade security tokens and cryptocurrency.
Regulations vis-a-vis Cryptocurrency: The Legal Implications
The upside of an ICO is that there is significantly more flexibility than an IPO. This is why many startup companies opted to launch an ICO instead of and IPO. Its downside, however, is that the person who buys the cryptocurrency of the startup does not have an actual claim to an underlying asset. 2 important drawbacks of ICOs are that they are largely unregulated and more prone to scams and fraud without protecting the person who buys the cryptocurrency offered by the startup against any loss.
Ambiguity abounds about the legal status of a startup. This ambiguity exists because of the lack of specific legal definitions of the 3 categories of cryptocurrencies (discussed above) in government legislation and regulations. As a result of this, laws regarding ICOs involve applying existing laws and regulations that apply to financial assets and securities to different aspects of a startup. The consequence is that there are many differing legal opinions about whether an ICO is a security or not thereby leading to different legal advice for each startup. If a lawyer determines an startup is actually a security, then the startup must register with the relevant regulatory authority accordingly.
While testifying to the US Senate in February 2018, US SEC Chairman Jay Clayton stated that he would classify every ICO he has seen as a security. At the time, not a single ICO had been registered with the SEC. Surprisingly in June 2018, he seemed to contradict his February statement by saying that he does not believe that Bitcoin is a security. In his reasoning he said that he said he believes that Bitcoin’s main objective is to replace national currencies such as the US dollar, Euro, and Japanese yen. At the same time, interestingly, he did not extend that definition to alternative cryptocurrencies such as Ether and Ripple that also claim not to be securities for the same reason.
Private Placement Rules
A quick word on private placements because of its relevancy to the topic at hand. Private placement is similar to an IPO but on a smaller scale. There are significantly less legal requirements for a private placement than for an IPO. According to the SEC rule 506b for a company to qualify for private placement, there can be a maximum of 35 investors. If a private placement is to exceed 35 investors, there is automatically a requirement for the company to comply with all the legal requirements of an IPO. Thus the small number of investors is a huge problem for the cryptostartup crowd funders!
Summary
There is a lot of ambiguity in the legal handling of cryptocurrencies. This is mainly due to the lack of clear legislation. Cryptostartups are hoping that the regulatory authorities will come out with clear laws and guidelines. So that they can move ahead with confidence within the new framework. It is speculated that when these clear laws come out, STOs will sky rocket and be the new ICOs without the high risks, due to intrinsic problems, of ICOs.
Ultimately it will not be clear where the law stands until existing financial laws and regulations are properly defined, tested, and enforced in the court of law. That is why so many people, and potential investors, especially institutional investors, are waiting with bated breath to see what the US SEC and other regulators finally decide. Everything is still speculative. Disclaimer: this article is not financial or legal advice and does not endorse any product mentioned or not.
