It’s a cryptic world to navigate when the Securities and Exchange Commission (SEC) believes that initial coin offerings (ICOs) should be under their purview, but not a single one has ever registered with the regulatory body.
But cryptocurrencies are here to stay, even if their metamorphosis isn’t complete, and the SEC isn’t sure how it’s going to regulate them yet.
For potential investors, it’s a murky world at best—and one for which risk has never been higher.
Over the past few months, SEC Chairman Jay Clayton has put crypto regulations at the top of his agenda. The goal? To eventually regulate them just like they regulate traditional markets. And ideally, the regulation would be global.
The SEC has also hinted at a crackdown on ICOs, specifically.
The simplistic view is that ICOs are the cryptocurrency version of initial public offerings (IPOs)—but this view can get investors in trouble. ICOs are an alternative means of raising funds, and startups love the opportunity because it’s easier than chasing down traditional venture capital.
Using ICOs, startups create their own digital ‘tokens’ and sell them on the secondary market through crowdfunding. Basically, it means that anyone with a white paper can do an ICO, and investors aren’t digging deeply enough to determine if they’re legitimate.
In 2017 alone, ICO proceeds increased almost 40-fold, from $96.3 million to just under $4 billion. More than 180 new ICOs are scheduled to launch this year, and they’ve already flown past the SEC radar.
Testifying before the Senate Banking Committee last month, Clayton said that cryptocurrency markets in the US require a coordinated regulatory scheme, and that the feds may need more power to enforce the rules.
When Committee Chairman Mike Crapo asked Clayton if he thought the SEC might need additional legislative powers to get the job done, it was a resounding ‘yes’.
The SEC has been slow to this party, but now it’s getting serious. In recent weeks, the regulatory body has sent subpoenas to dozens of tech companies and individuals involved in cryptocurrency. The targets of the subpoenas include companies that have launched ICOs.
But they’re just skimming the top of the barrel here, and in the meantime, investors—many of them woefully unaware of the risk—are being set up to lose, and to lose big.
“Folks somehow got comfortable that this was new and it’s OK, they’re not securities, that they’re just another way to raise money, but I disagree. ICO promoters and other participants are not following our security laws. Some people say that’s because the law isn’t clear. I do not buy that for a moment,” Clayton said at the hearing.
Following Clayton’s testimony, only one ICO bothered to register.
At the same time, the SEC has provided some guidance for investors before engaging with ICOs.
Here’s are 5 things the SEC wants you to know about ICOs:
#1 You Are Not Protected
Because ICOs aren’t registering themselves with the SEC, the SEC cannot provide investors with protection in the event of fraud. You’re pretty much on your own at this point. This is not the traditional market. If anyone tries to tell you that their ICO is SEC-approved, run for the hills.
#2 Few ICOs Will Pass the ‘Howey Test’
When it became clear earlier this year that the SEC was looking at ICOs, some companies rushed to define their offering as “utility tokens.” ICOs, or more specifically tokens, can be called whatever someone wants to call them, but at the end of the day, it’s the same thing. Simply changing the name of something to include “utility”, or even structuring it to provide some ‘utility’, does not mean it’s not a security.
The ‘Howey Test’ is one way to determine if a ‘token’ is a security—and if it is a security, and it’s not registered with the SEC, anyone involved in it may have a problem.
Because this is a very gray area still, a case study from the SEC best describes what it would determine a security that needs to be registered:
The DAO is a for-profit entity created by Slock.it and Slock.it’s co-founders. Through an ICO, The DAO offered “DAO Tokens” to investors in exchange for ether, a digital currency connected to the Ethereum blockchain. Each DAO Token granted the holder voting rights and an entitlement to “rewards” in exchange for their investment. The investors remained “pseudonymous,” meaning that the investor’s Ethereum blockchain address functions as their only identifying information. Following the ICO, persons could buy or sell DAO Tokens on the secondary market through digital asset exchanges. The DAO’s primary form of business was investing in projects submitted by “Contractors” who received a majority vote from DAO Token holders. Generally, only project proposals given the green light by The DAO’s “Curators” were voted on.
The SEC determined that the DAO Tokens offered by The DAO through an ICO are unregistered and non-exempt securities. The SEC applied the Howey test (first articulated in a 1946 Supreme Court decision) to reach a determination on the regulatory status of the tokens. In that case, the Court considered whether the offering of units of a citrus group development coupled with a contract for cultivating, marketing and remitting the net proceeds to the investor constitutes an “investment contract,” a form of security.
Few ICOs will pass the Howey Test with any level of confidence.
#3 There’s No Such Thing As An SEC-Approved Crypto ETF
The SEC also has not to date approved for listing and trading any exchange-traded products (such as ETFs) holding cryptocurrencies or other assets related to cryptocurrencies. In fact, in late January, the SEC killed the idea of crypto ETFs for the time being when it rejected such plans by two Wall Street trade groups. So, again, if anyone tells you they’ve got a crypto ETF, they’re lying. There is no such thing. ETFs are regulated by the SEC. Period.
#4 Your Money May be Traveling Far and Wide
Investors should recognize that these markets are global and borderless. Your invested funds may quickly travel overseas without your knowledge. Risk is thus increased many times over, and protection is even further from the SEC’s reach.
#5 ICOs Make it Easy to Manipulate Investors
Because there are no rules in this game, those behind ICOs have no legal incentive to provide information to potential investors, and investors are not doing enough due diligence before taking the plunge. ICOs often lack detailed product descriptions and detailed information on who is promoting the product, what their backgrounds are and whether or not they are licensed to sell the product. Or, indeed, if they have been paid to promote it. Investors are at a severe informational disadvantage on this playing field.
By Michael Kern for Savehaven.com
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