On July 25th, the SEC released an alert (https://www.sec.gov/oiea/investor-alerts-and-bulletins/ib_coinofferings) on the latest blockchain craze: “ICOs” or initial coin offerings. To understand what this ruling means we can first look at what an ICO is, where this ICO craze has spawned from and then onto what this alert actually means.
What is an ICO?
ICOs are a new method of fundraising capital to finance the development of an early stage project. In return investors are given ‘coins’ or ‘tokens’ which resemble a share in a company. These tokens in theory allow the holder to use the network/application that is being built. The investment principle is that these tokens will go up in value due to scarce supply and unwillingness to sell from investors. This increased value gives the developers more money to develop with. This creates a better product that will encourage more users and thus increase the demand for the token.
One could draw similarities between IPOs (Initial Public Offerings) which is a traditional method of raising capital. However, the are some key differences between the two and it is best to look at these to understand what an ICO actually is. An ICO is almost like a VC/IPO/blockchain hybrid which takes some of the principles of VC and IPOs and combines blockchain platforms to create an entirely new model.
From an investor perspective, they offer high risk and high returns and actually the ability to easily invest in early stage projects. An exemplary ICO it is designed to improve the relationship between investors and entrepreneur. Both have skin in the game and as a result the community driven growth in ICOs is a large part of their success. A good project without a community is not worth much and unfortunately a bad project with a well organised and engaged community can be worth more than it arguably should. As an ICO holder you don’t get the same rights as you would with an IPO and there isn’t an official dividend distribution of profits. You also don’t have the ability to vote in the direction of the company, unless it is a DAO (Decentralised Autonomous Organisation). Where tokens allow holders to vote on the decisions the DAO should make. The first DAO which raised around $150 million dollars (the largest crowdsale ever at the time) went down in flames when a hacker drained over $70 million in Ethereum from the DAO smart contract. Since then DAOs have been largely untouched, however a few have started to emerge and projects such as Harbour DAO are trying to build what would arguably be the first working model of a DAO. Another attribute of ICOs is that they are liquid soon after the ICO close, tokens are typically listed on exchanges in minutes to weeks after the ICO. In comparison equities take far longer to become liquid on markets in some cases up to 10 years (http://www.angelblog.net/Venture_Capital_Exit_Times.html ). This creates a liquidity premium which in turn has opened the door to ‘scalpers’ who look to sell their token soon after the ICO to skim profit from what has been a very strong market. This has fed into the potential bubble we are seeing right now.
From an entrepreneur’s perspective ICOs are attractive because it is a fast and effective way to raise capital without having to go down the long and arduous path of pitching to thrifty VC’s. Blockchain platforms such as Ethereum and Waves makes it very easy to launch an ICO from a technical perspective. The regulatory burden is much lighter as the approach has generally been to hold back and wait to see this model develop. KYC and AML regulations are much less stringent and in some cases absent.
Currently the friendliest ICO environments are Switzerland, Gibraltar and Singapore. One of the hot topics is whether an ICO is a security and therefore can an ICO in Gibraltar raise capital from investors in the US using Bitcoin or Ethereum? We will now get into the SEC ruling and what it means for this space.
Data from Cryptcompare shows that the ICO market is highly exuberant with % changes since ICO price varying from -90% with over 28 ICOs generating over 1000% returns. This sort of volatility is starting to get notices especially as significant money is being invested in this market. Currently the figure stands at just over $1.4 Billion. So it is only a matter of time before the regulators start to move in… enter SEC.
How does the SEC ruling fit into all this?
Remember that ICO called “The DAO” that was mentioned earlier? Yep, the one that raised $150 million. The DAO invited people to purchase tokens which would be used to automatically invest in projects. The token holders can vote on projects and create a democratised investment plan. If these investments make profits then the ‘rewards’ would be distributed to token holders. Almost like dividends… which made it unsurprising that the SEC concluded the tokens were classed as securities.
The report only focused on the DAO however it is the first concrete judgement from the SEC and at long last it has shed light on the SEC’s stance on ICO’s. Interestingly, the SEC spoke of “Virtual organizations or capital raising entities that use distributed ledger or blockchain technology to facilitate capital raising” in other words, most ICO’s. They described these organisations as a “new paradigm” and the
“automation of certain functions through this technology, ‘smart contracts’ or computer code, does not remove conduct from the purview of the U.S. federal securities laws.”
The SEC has essentially covered all bases and made it crystal clear that most ICOs could be classed as securities. In the US only ‘Accredited investors’ can participate in equity sales. Unfortunately for the 90% of the public they do not meet the requirements for having greater than $1 million in net worth. Luckily for the creators of the DAO the SEC said they wouldn’t take action against the DAO. It is not clear why they choose to do this, perhaps because it is such a unique and new case that a heavy-handed approach would achieve nothing and stifle innovation. The announcement does have some other benefits in the sense that it removes a lot of ambiguity for upcoming ICOs but could potentially create a serious issue for past ICOs as they will need to start explaining their way out of selling securities to US investors.
It is clear that in some way shape or form “ICOs” will be here to stay. The attributes listed above make it too compelling a model for investors and entrepreneurs alike. However, it is likely that this SEC alert is the first step in the transition from what can be seen as the ‘Wild West’ of fundraising to a more regulated and sensible token distribution model. For that to happen there must be more research and better communication and guidance from regulators. It is important to get the delicate balance between helpful vs stifling regulation as the possibilities of blockchains and their fundraising capabilities have only scratched the surface of what is possible.