Regulating ICOs

The regulators of money and securities are facing a new challenge with the emergence of crypto-currencies like Bitcoin. Not only do crypto-currencies live in cyberland computers usually outside the jurisdiction of the regulators, their mere existence is a challenge to the modern notion that only nation-states have the right to issue fiat currencies.

Recently the Securities and Exchange Commission has entered the fray. It used to be said the securities regulators could be divided between the philosophy of the states and the philosophy of feds. The states were adherents to the central government control view (called “merit review”) believing that the staff of the Department of Financial Institutions (DFI) in Olympia knew what was good for investors and would be the appropriate gate-keepers for the investing public. For example, when Apple Computer went public, DFI would not approve its IPO stock for sale in Washington (it was too risky) so Washington investors had to purchase post-IPO stock at a substantial premium on the national public markets. The SEC was said to hold to a view that anything could be sold if there was full disclosure. Over time, the positions modified. The SEC is now known to make it difficult or impossible to register an offering its employees do not like. Recently the SEC insisted on applying traditional stock trading and Investment Company Act of 1940 rules to registration of crypto-currency ETF-like funds which were designed to allow investor speculation in a basket of crypto-currencies¹Staff Letter: Engaging on Fund Innovation and Cryptocurrency-related Holdings, January 18, 2018.

In a typical government “catch-22”, now that the SEC had held it currently impossible, it gave the following pronouncement from the Divisions of Enforcement and Trading and Markets of the Securities and Exchange Commission in a “Statement on Potentially Unlawful Online Platforms for Trading Digital Assets on March 7, 2018. It said in part: “A number of these [online cryptocurrency trading] platforms provide a mechanism for trading assets that meet the definition of a “security” under the federal securities laws.  If a platform offers trading of digital assets that are securities and operates as an “exchange,” as defined by the federal securities laws, then the platform must register with the SEC as a national securities exchange or be exempt from registration.”²https://www.sec.gov/news/public-statement/enforcement-tm-statement-potentially-unlawful-online-platforms-trading))

At this point the SEC takes the position that crypto-currencies are not securities but money. However they can be used in Investment Contract offerings (including those that are securities under the holding of Securities and Exchange Commission v. W. J. Howey Co.³328 U.S. 293 (1946) . As far as I have ascertained, the actions taken in creating crypto-currency does not in itself become the reliance on the actions of others for purpose of the Howey test in the SEC view.

Those promoting cybercurrencies seem to frequently cross the line between a pure currency play and issuance of securities. For example, see the SEC report on The DAO.

It is said that public markets cycle between fear and greed. There is plenty of both in the crypto currency markets.  In early April 2013, the price per Bitcoin dropped from $266 to around $50 and then rose to around $100. It is currently around $8,000 which is frightening to those who are students of market bubbles.

This amazing rise of value has attracted promoters, as well as entrepreneurs and its share of fraudsters. Often the pitch is in the form of an Initial Coin Offering (ICO).

The posterchild for a successful ICO that was profitable for early investors is the distributed ledger cryptocurrency called Ethereum which has “Ethers” as its coin tokens. In 2014, the Ethereum project was announced and its ICO raised $18 million in Bitcoins or $0.40 per Ether. The project went live in 2015 and in 2016 had an ether value that went up as high as $14 with a market capitalization of over $1 billion.⁴https://www.investopedia.com/terms/i/initial-coin-offering-ico.asp

The posterchild for a failed ICO might be Modern Tech, a cryptocurrency headquartered in Vietnam which conducted an ICO for two cryptocurrencies, Ifan and Pincoin. It is said to have raised 15 trillion Vietnamese dollars (US$660.79 million) from 32,000 people before going silent (as an apparent fraud) on April 8,2018.⁵https://tuoitrenews.vn/news/business/20180409/vietnamese-cryptocurrency-scam-allegedly-deceives-thousands-to-swindle-660mn/45001.html

ICO offerings have received different regulatory treatment around the world. China shut them down (as well as cryptocurrency exchanges) on September 5, 2017.⁶https://www.coindesk.com/chinas-ico-ban-a-full-translation-of-regulator-remarks/)) European countries have been more open to ICOs. European Commission vice president Valdis Dombrovskis has been quoted a pointing to a possibility of future regulation:

“This depends very much on the facts and circumstances around specific crypto-tokens.

Based on the assessment of risks and opportunities and the suitability of the existing regulatory framework for these instruments, the Commission will determine if regulatory action at EU level is required.((Remarks by Vice-President Dombrovskis at the Roundtable on Cryptocurrencies Brussels, 26 February 2018 On 22 January 2018, South Korea adopted a regulation that banned anonymous trading of bitcoins by requiring all bitcoin traders to reveal their identity.

On April 2, 2018, the SEC brought a civil action against a services start-up alleging a fraudulent ICO that raised more than $32 million from thousands of investors. It falsely claimed to provide a debit card backed by Visa and MasterCard that would allow users to instantly convert cryptocurrencies into U.S. dollars or other legal tender. From the press release:

“As we allege, the defendants relied heavily on celebrity endorsements and social media to market their scheme. Endorsements and glossy marketing materials are no substitute for the SEC’s registration and disclosure requirements as well as diligence by investors.”

The SEC has placed an ICO warning page on its website((https://www.sec.gov/ICO