During the last week, cryptocurrency and ICO regulations have become a popular subject again. The debate centers on whether cryptocurrencies and tokens sold in Initial Coin Offerings (ICO) constitute securities according to the US Security and Exchange Commission (SEC).
Speculation whether Ethereum’s cryptocurrency, Ether, might be classed as a security because of its token sale in 2014 was fueled by a Wall Street Journal article claiming a SEC meeting on the subject would be held on 7th May.
This news worried many cryptocurrency community members, as the second biggest cryptocurrency, seemed to be under scrutiny.
Some doubts have been cast whether this meeting actually took place and no announcement has been made, leading to conspiracy theories on the Wall Street Journal’s intentions.
Nevertheless, the online community is currently engaging in discussions on SEC rules compliance, and it is foreseeable that at some stage, regulations will be put in place.
ICOs and their Legality
Let’s first discuss how ICOs work. The idea of a token sale is based on crowdfunding models, such as Kickstarter, and initial public offering (IPO), i.e. the process of creating a stock offering for a company, hence the name. A token is created for a project idea and sold to the public. The money raised in the token sale is used to fund the project. Investors that have bought tokens hope the project succeeds and that the token will become valuable when traded on cryptocurrency exchanges. Typically, the token will have some use in the project, such as serving as an in-app currency.
In contrast to stock investors, ICO investors normally do not receive any shares in the company and have no voting rights. Furthermore, as ICOs are a relatively new concept and are not yet regulated, they attract attention from two sides.
Scammers and con artists find great opportunities and gullible victims. Plenty of money has disappeared down the drain through fraudulent ICOs. All that is needed to run an ICO is a website and a whitepaper.
On the other side, regulators have taken interest in many jurisdictions, not just the SEC. For them, unregulated investment rounds constitute a risk.
Are Tokens Securities?
Whilst the status of cryptocurrencies is still unclear in most jurisdictions, the biggest concern for regulators currently seems to be whether tokens offered in ICOs constitute securities.
The Howey test is often quoted as a simplified process to decide if something should be classed as a security. Four key points are used to define an investment constituting a security:
- It is an investment of money.
- There is an expectation of profits from the investment.
- The investment of money is in a common enterprise.
- Any profit comes from the efforts of a promoter or third party.
This spreadsheet is based on the Howey test and is often used by the community to justify a project not being in danger of being classed as a security.
The SEC has previously issued statements, making it clear that a token can be many things, but may probably be classed as securities in most ICOs. In particular, several issues have been criticized:
Firstly, it is not clear that so-called utility tokens of many ICOs are really necessary for the proposed systems, and are not just thinly veiled security tokens, mainly aimed at attracting investors.
Secondly, tokens can be traded on exchanges. The ability to sell tokens at a possibly higher price in the future is clearly the main attraction for many investors.
Finally, most systems are not built yet. ICOs sell a promise of future development, without any guarantees, to build what they have specified. It’s enough to read the legal disclaimers included in whitepapers to realize that the project team may do anything with the investors’ money.
ICOs meanwhile are very careful with their wording. The term ICO is usually avoided these days, substituted by “crowd sale” or “token offering”. Teams are also very clear in classing their tokens as “utility token” and avoid mentioning the possibility of trading on exchanges.
It is also fascinating to observe how key players in the crypto community are very careful about how they describe cryptocurrencies. For example, Consensys founder Joseph Lubin can frequently be heard describing Ether as a commodity, highlighting its use as gas for executing transactions in decentralized applications.
What to Expect
Whether or not tokens will end up having to be registered as securities or not in the future, it seems fairly clear that Ethereum and cryptocurrencies, in general, will be covered by some form of regulation at some point.
In the meantime, all we can do is educate the public and lawmakers on this new and promising technology. There is nothing worse than decisions being made by people that don’t understand what they are trying to regulate.