With the rise of initial coin offerings (ICOs) over the past two years, the U.S. Securities and Exchange Commission (SEC) has signaled that it is increasingly focusing on policing ICOs within the crypto space. An aggressive posture by the SEC has served as a red flag to early-stage companies who might seek to raise funds through the sale of tokens. This stands to reason given the enormous growth of ICOs over the past year. In December, the total market capitalization of crypto assets reached $370 billion, surpassing the value of JPMorgan, the largest bank in the United States.
Governments around the world have been struggling to regulate cryptocurrencies because they appear to represent an entirely new asset class. This is obviously true of tokens that function like securities. But it may equally be true of so-called utilities tokens in the future. In China, for example, the government has simply outlawed ICOs altogether. While in the United States, the SEC has been under criticism for not providing clear direction in managing cryptocurrency regulation.
So where is this all going? Forecasting future SEC guidance in the U.S. is difficult but the common assumption is that a nascent crypto asset class is subject to U.S. securities laws. In December, the SEC’s new Cyber Unit filed a complaint against Montreal-based PlexCorps and the company’s founders, freezing the company’s assets. The SEC alleges that the founders raised $15 million in a fraudulent and unregistered offering of securities.
What seems clear is that the SEC has made it a priority to target fraudulent exploitation of investor enthusiasm. As SEC Chairman Jay Clayton explains, “prospective purchasers are being sold on the potential for tokens to increase in value — with the ability to lock in those increases by reselling the tokens on a secondary market — or to otherwise profit from the tokens based on the efforts of others. These are key hallmarks of a security and a securities offering”.
For regulators, the overarching concern is that digital tokens sold during ICOs may eventually be redeemed for goods and services. Tokens serve as currency, but they also function as an instrument for betting or prediction mechanisms as well as traditional securities. Tokens sold during ICOs, for example, may be traded on secondary markets, making them securities and subject to SEC oversight.
A larger concern for regulators has been the rise of virtual currencies as Ponzi schemes. ICOs have been criticized as unregulated instruments for fundraising that simply bypass the rigorous capital-raising requirements mandated for venture capital and banks. However, the larger issue for legitimate ICOs is whether there is an assumption of profit based upon a shared investment contract.
The underlying question is the distinction between securities tokens and so-called utility tokens. Broadly speaking, utility tokens are defined as having some utility apart from or in addition to their value as an investment. The main argument supporting utility tokens is that they may not qualify as securities under the Howey test. That is to say, they do not qualify as a common enterprise based on an expectation of profits to be derived from the entrepreneurial or managerial efforts of others.
What we do know is that that the exact regulation needed to differentiate between security tokens and utility tokens is not readily apparent. The Canadian approach to ICOs, for example, appears to apply the established regulatory system for securities so that issuers who distribute coins or tokens may require dealer registration. Of course, neither the Canadian Securities Administrators (CSA) nor the SEC has categorized all cryptocurrency as a security. But instead both government bodies have simply chosen to rely on regulatory precedent.
In December, Clayton issued a public statement providing some guidance on cryptocurrencies and ICOs, emphasizing two points:
(1) Promoters need to either (a) demonstrate that the currency or product is not a security, or (b) comply with securities laws.
(2) Brokers, dealers and other market participants that accept payment in cryptocurrencies and/or use cryptocurrencies to facilitate securities transactions should exercise caution and not lose sight of anti-money laundering and “know your client” obligations.
Going forward, the vast majority of analysts believe that regulators are likely to take a harder stance on cryptocurrencies in the future. In practice, however, governments seem to be settling for one of two alternative positions: (1) either waiting to see how regulations work out before acting, or (2) banning some or all cryptocurrency exchanges altogether. What we can assume is that the torrent of investigative activities by Canadian, U.S. and other governmental securities regulators will continue.
One growing fear is that unnecessary regulation will undermine innovation by squelching risk-taking. The rapid ascendancy of ICOs and their ability to raise funds for start-ups has democratized access to capital in new and innovative ways. This suggests the need for a different set of regulatory obligations specifically designed to allow smaller cash-poor companies to raise funds from a wide range of funders.
What is clear is that there is significant confusion when it comes to ICOs, in part because governments around the world have taken such widely divergent positions. While some countries have decided to ban ICOs (China), others (Singapore, Switzerland, Estonia) have thrown their full support behind them. Nonetheless, the writing is on the wall. The broad shift from hard cash to digital currencies is a long-term global trend that neither financial institutions nor government regulators can simply ignore.