If it acts like a duck, quack likes a duck; it’s probably a duck…

“…the reality of it, the market today has a lot of scams and I think there’s a lot of securities laws that are being violated by the ICO phenomenon right now…” Peter Smith, Blockchain Co-Founder & CEO [1]

The lines between cryptocurrencies and securities continues to blur making it hard for governments, regulators and market participants to understand the functional differences between them and how they should be ultimately treated. Traditionally, a security was a physical document (nowadays electronic) that showed an individual’s ownership in a company’s stocks, bonds or other financial instruments. The characterization of a cryptocurrency is not as straightforward and that’s a result of the different use cases and motivations for companies issuing virtual coins or tokens. Unlike traditional IPO’s where investors receive shares that represent ownership in the underlying company, Initial Coin Offerings (ICO’s) involve the sale of virtual coins or tokens that are based on blockchain technology that are unique to the issuing company or its network. The virtual token represents some arbitrary value that’s based on the value of the company’s network or the investment value of that open protocol. [4] One thing is clear, in certain cases particularly around the use of ICO’s by companies to raise money, market participants are operating in a regulatory grey area.

On July 15^th 2017, Tezos (a smart contracts platform) raised ~232M through an ICO making it the largest sale to-date. To put that into context, the average IPO in Hong Kong this year was around $31M and the average IPO globally was around $91M. [2] The ICO market has arguably hit an inflection point with funding raised via ICO’s to-date (~1.25B) and the monthly run-rate (~601M) exceeding the monthly run-rate of funding raised via early stage venture capital (~550M) in June. [3] One of the main attractions for firms to raise money via the ICO market is because cryptocoins bypass traditional middle men such as banks and venture capital firms minimizing fees and offering faster access to capital. The drawback is that traditional checks and balances as well as consumer/investor protections are non-existent. Growth of money raised via ICO’s was ~1,585% in 2016 and is already up 570% YTD.

The libertarian aspirations of decentralized cryptocurrencies is being encroached by governments and regulators around the world, though it’s been difficult for these entities to keep up as innovation and the tech community move a lot faster than governments. It’s also hard for regulators to have an isolated policy response to the phenomenon that’s happening on a global cross-border scale. On March 25^th 2014, the United States Internal Revenue Service (IRS) ruled that bitcoin and similar cryptocurrencies will be treated as property (digital assets) for tax purposes as opposed to currency. This means that cryptocurrencies will be subject to capital gain tax. [5] The latest news on the regulatory front was announced on July 25^th 2017, the Securities and Exchange Commission (SEC) weighed in saying that companies which raise money through the sale of digital assets (cryptocurrencies) must adhere to federal securities law. This development is significant because it illustrates that the SEC does not distinguish whether the issuing entity is a traditional company vs. a decentralized autonomous organization, whether those securities are purchased using fiat currencies (USD) vs. virtual currencies and whether they are distributed in certificates vs. distributed ledger technology. [6] It’s important to note that the SEC did not go as far as to say that all virtual coins or tokens are securities and each case would need to be evaluated independently.[7] The Howey Test, a test created by the Supreme Court to determine whether certain transactions quality as “investment contracts” and if those transactions are considered securities, is the legal standard that would be used to define whether tokens are securities.

The recognition by governments and regulators of cryptocurrencies should not be seen in a negative light as this reinforces the reality that these technologies are moving into widespread adoption. Regulatory bodies like the SEC and the rules and regulations they enforce around disclosure requirements and consumer protections were created for a reason, let’s not forget that the functions of the capital markets once operated in a regulatory grey area. It’s unclear what happens to past ICO’s that have already taken place as the SEC has signaled they will likely be flexible with previous issuers. Going forwards, issuers, investors and people buying ICO’s will need to ensure that whatever they purchase will be compliant with US securities laws or risk potentially being liable for activities further down the road.

References

1. https://www.bloomberg.com/news/videos/2017-05-31/looking-for-a-bubble-in-bitcoin-s-recent-bounce-video
2. http://www.ey.com/Publication/vwLUAssets/ey-global-ipo-trends-q1-2017/$FILE/ey-global-ipo-trends-q1-2017.pdf
3. https://medium.com/@wmougayar/has-ico-cryptocapital-exceeded-early-stage-venture-capital-funding-yes-b0500d5fbe8
4. https://www.bloomberg.com/news/articles/2017-07-25/bankers-ditch-fat-salaries-to-chase-digital-currency-riches
5. http://www.nasdaq.com/article/3-reasons-the-irs-bitcoin-ruling-is-good-for-bitcoin-cm339333
6. https://www.bloomberg.com/news/articles/2017-07-26/what-s-next-for-crypto-coins-as-sec-tames-wild-west-of-finance
7. https://www.bloomberg.com/news/articles/2017-07-26/what-s-next-for-crypto-coins-as-sec-tames-wild-west-of-finance