"I believe every ICO I've seen is a security," said Securities and Exchange Commission chairman Jay Clayton on February 6th.
Since then the crypto currency community has been on notice. For months leading up to the testimony, founding teams have been reassuring themselves and anyone who would listen “no our token is a utility token not a security so this ICO isn’t in violation of securities laws.”
All along it appears these teams and chairman Clayton may have been two ships passing in the night.
The founding teams have been overly focused on the application of the Howey test and how it pertains to the token that will one day be used. It appears this piece of the puzzle is far from the forefront of the SEC’s mind.
In my opinion Clayton’s intention from his February statement doesn’t mean a token on a functional network can’t be a utility token. Instead it is his assertion that any token sold to the public in the manner of a traditional ICO and at the time of the sale is in violation of securities laws. The difference here is complex and minute, but critical.
When a token is sold before there is a functional network to the market that is more often than not being done to fund the development of the network. Let’s use an off-chain example to conceptualize this.
No one would question that if you go into Chuckie Cheese and buy tokens to play games those tokens are a utility token and not a security. But now imagine if Chuckie Cheese was a concept, an un-open business. The founder of Chuckie Cheese decided to sell those game tokens to fund the construction of the store.
In the first example, the person purchasing the tokens knows exactly what they are getting - a ticket to play games at an open business. In the second example, the purchaser may one day be getting a ticket to play, but there are no certainties. The founding team must deliver on their vision. The purchaser is relying on the action of others for their token to ever have its potential value. This uncertainty is the difference; the second purchaser is accepting enterprise risk that the Chuckie Cheese founders will successfully launch their business so they can one day accept the tokens.
Under the laws we have established, there are rules about who is capable of assessing enterprise level risk. The decision that has been made is this is not the appropriate risk for retail investors to be bearing. This has been left to what the government deems to be more sophisticated accredited investors.
The SEC has a 3-pronged mission statement. They are mandated to protect investors, maintain fair, orderly and efficient markets and facilitate capital formation.
In my opinion, Clayton’s issue is not as to whether or not a token will one day have utility. His issue is transferring enterprise risk to retail investors as traditional ICO’s have done is an unacceptable practice that investors must be protected from.
Last week Clayton seemed to clarify this as his intention when he said "Just because it's a security today doesn't mean it'll be a security tomorrow, and vice-versa."
I believe what Clayton is telling us here is that once Chuckie Cheese has opened its doors the tokens that were once securities can now be treated as utility.
The Goal of an ICO
In order to understand and apply the message to the future of ICO’s, we must think about what the goal of an ICO is.
To me there are two critical components on an ICO. Capital raising and the dissemination of a token to the community that will use and support it.
The traditional ICO has connected these goals at the hip and that seems to be the issue.
Cryptocurrency markets move faster than most and their process of self-regulation to attempt to comply with the SEC’s guidance has been impressive. The community has digested the information and come up with the following framework: a two-part event which separates the capital raising function from the function of token dissemination.
The capital-raising component is now almost exclusively done through a SAFT (simple agreement for future tokens). A SAFT is being sold to accredited investors after thorough KYC/AML practices have been done to verify this status. In thisframework, the SAFT is a security with an exemption from SEC registration. A successful SAFT round achieves the goal of fundraising for the project as was previously accomplished during the ICO process. The difference in the SAFT to the ICO is who bears the enterprise risk.
The second event is that when a network is completed and some amount of time has passed, the community seems to believe 6 months, than the token is issued. This token goes to the SAFT holders and is also somehow disseminated to the community who will use it. The SAFT holders hold most of the issued tokens and the community has what it needs to use for utility. There are a number of ways in which the token can be distributed to the community. Secondary token sales, airdrops, faucets, fair launches or bounties are some examples of concepts being used or discussed to achieve this second objective.
Decentralization: Is it a reality, a goal or a pipe dream?
One of the many appealing and beautiful concepts introduced to the world by the advent of block chain and crypto currency is that of decentralization.
Through the application of incentives, economic game theory and cryptography,the security and control of a network has been placed in the hands of the world’s computers.
Much of the original adoption by the early crypto currency community was due to this decentralization of power, the promise of freedom from governments and the banking system.
The original structure of the ICO fit into this. The traditional banking powers that had controlled capital raising for decades were left out if it. Further,governments had no control over who could participate in and benefit from the process.
In a world were only accredited investors can be a part of this funding, many of the rags to riches stories brought by the crypto currency boom of 2017 would never have occurred. To the community, the opportunity of ICO investing where anyone could turn $100 into $1,000 was a piece of the decentralized vision.
Albeit a risky proposition, ICO investing offered this to the masses and the process of self-regulation has largely stripped this opportunity. One can call it collateral damage of compliance.
Does the Self-Regulation Go Far Enough in the Eyes of the SEC
While this two-event framework is clearly an improvement from the past ICO sales in terms of securities laws, it is still unclear from the prospective of the SEC if it goes far enough.
Time will have to pass and further guidance or enforcement actions will come out that will shed light onto the commissions view.
The creation and evolution of the ICO market have happened faster than any market that I have ever experienced and it will take time for the SEC to digest the changes.
There is little doubt in my mind that the attempt of the crypto-community to self regulate based on the statements of the SEC has lead to the institutionalization of the ICO market.
This is a step forward in the maturity of the market while at the same time a loss of decentralization.
The crypto currency community has changed from the early days and will continue to change. The presence of people like me, and the funds I represent are a part of that institutionalization.
A fully decentralized world governed by incentives created by economic game theory and open source code is a great dream, but for many reasons is not currently a reality.
For this dream to be realized, there needs to be widespread adoption by the world. The world is not only made up of people, but also businesses and governments.
I believe what we will see next are some intermediate steps towards decentralization. Both the crypto currency purest and the traditional powers that are out there may not like this.
It has been my experience in life that sometimes the best deals are the ones that leave neither side happy. It is my hope that the evolution of the ICO market, whatever that may ultimately look like, turns out to be a long thriving example of that.