Speculating on the future of initial coin offerings

First published by The Japan Times

Initial coin offerings took the world by storm last year. In total $5bn was raised, a twentyfold increase over 2016. Governments are only now waking up for the need to regulate ICOs and their related tokens. The US Securities and Exchange Commission recently launched a probe. Are ICO tokens currencies? Are they commodities? Are they securities or perhaps something else? How regulators answer these questions—there is no one global answer—will determine the future of ICOs.

Initial coin offerings are a quick way for startups to raise funds from many people on easy terms. Investment comes from evangelists of the firm’s products or services. The entire funding needs of a startup can be raised upfront in one fell swoop, bypassing the need to raise capital in dribs and drabs from traditional sources. Founders love ICOs because they don’t give up shares or control in their companies. People love them for the chance to invest in startups they otherwise would not be able to access.

In an ICO, firms sell their own newly minted virtual tokens to investors in exchange for bitcoin or alternative tokens. Issuers publish a white paper beforehand, describing the firm’s business plan, what they intend to do with raised amounts, why the token is integral to their business and the risks to investors who buy them. However, the information is often limited. Contractual obligations are not as clearly defined as with a stock or bond. Importantly, there is no clear path for legal redress when an ICO investment sours. Unsophisticated investors buying ICO tokens, often across national boundaries through the internet, assume financial risks they little understand.

Governments normally protect such people by limiting sales of regulated securities to accredited retail and institutional investors. But ICO tokens are not easily classified as securities because they lack equity-type features (like dividends). So government regulators ignored them at first.

Mainstream adoption of cryptocurrency is causing governments to re-evaluate their regulatory approach to ICOs. Each does so differently. China, Russia, South Korea and Vietnam restrict or ban virtual tokens altogether. Gibraltar, the Isle of Man and Mauritius aim to remain offshore crypto-tax havens. Most advanced economies, Japan, the United States, United Kingdom and the European Union included, seek to balance the need to protect investors against the need to innovate.

Japan’s Financial Services Agency was early to treat virtual currencies as payment methods rather than as securities, under the Payment Services Act. In lay terms, the act defines virtual currencies as electronic payment instruments (separate from fiat currencies like yen or dollars) which have financial value and can be used to buy goods or services. A second type of virtual token accommodates ICOs under the act. Almost any Japanese firm can apply for a license to mint, sell and exchange virtual tokens. While waiting for FSA approval, it can conveniently trade through a licensed partner.

Ken Kawai, a legal adviser of the Japan Cryptocurrency Business Association and a partner in the Tokyo-based law firm Anderson Mori & Tomotsune, thinks the FSA chose not to treat ICO tokens as securities to promote innovation. The FSA wants “moderate and prudent regulation in the trade of virtual tokens,” he says.

Their approach failed to prevent January’s $530 million Coincheck theft. The token exchange was operating under a grandfather provision while seeking FSA accreditation, when the heist occurred. It was the second of its kind in Japan following the 2014 Mt. Gox fiasco. The ICO industry is trying to self-regulate to prevent similar cases from occurring in the future. “If they fail to do so, harsh regulations may be imposed,” warns Kawai.

On the other side of the Pacific, U.S. firms seeking to ICO must navigate the gauntlet of multiple regulatory agencies. The Commodity Futures Trading Commission (CFTC) considers certain tokens to be commodities, while the Securities and Exchange Commission believes many ICO tokens are securities.

The SEC looks at facts and circumstances to decide if tokens are securities. The test has different prongs. If people intend to buy tokens expecting to passively profit from the efforts of others, then the SEC treats these as securities (or “securities tokens”). In contrast, if people intend to use a firm’s product or service — once it is built or becomes available — then the tokens may be treated as something other than securities. These are called “utility tokens” because the tokens are integral to the operation of the issuer’s business.

For example, if tokens are used to presell stadium seats to fans who intend to occupy them once the stadium is built, the SEC might decide they are utility tokens. In practice, however, many people who buy ICO tokens don’t intend to use the firm’s goods or services. They are speculators hoping that token prices will appreciate. When they do — for instance should stadium seat prices increase — it doesn’t necessarily mean the firm’s tokens are securities, says Eric Sibbitt, a partner in the San Francisco law firm O’Melveny & Meyers LLP. “It depends in part on the design of a token and its intended use case, how a token was marketed, expectations of purchasers and other factors,” he notes.

SEC regulators have yet to be clear about what a utility token actually is. Christopher Austin, partner at the New York Office of Orrick, Herrington & Sutcliffe LLP, explains: “U.S. regulators have said, ‘Come talk to us.’ ” When securities lawyers talked to them, one asked, “Would this qualify as a utility token?” They replied, “So you want us to tell you how to evade securities laws?” Austin believes regulators presume ICO tokens are securities and that people who try to treat them as utility tokens are in fact evading securities laws. “I think that’s been a real issue,” he says.

At first the SEC targeted firms involved in ICO fraud and theft. Then they switched, targeting firms issuing tokens with equity-like features. Later they refocused on how firms market tokens. Today, those lacking inherent utility or marketed on the basis of capital appreciation are more likely to be treated as securities. “It went from fraud, to equity-like features, to more about how tokens are marketed,” says Sibbitt.

The trend toward greater regulation will likely continue, prompted by investors’ complaints in high-profile cases of theft, fraud and speculative schemes. As regulators become more sophisticated, they will prevent firms lacking a strong use-case from tokenizing. That may take some of the speculative bubble out of tokens, but will also protect investors. It will also allow firms whose tokens are integral to the operation of their businesses to responsibly innovate.

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