Key Learnings: ICO & Crypto Market Regulation (12/20/17)

The NetForum held its final meeting of 2017 on December 20th to discuss ICOs and Crypto market regulation.
The NetForum convened against the backdrop of a peak in the value of Bitcoin, a media frenzy not seen since the advent of the DotCom era, and pronouncements by the SEC accompanied by fresh enforcement actions against ICO schemes.  Our featured guests were David Brill and Demetrios Boutris, representing the point of views of Blockchain innovators and regulators, respectively.  Also partaking in the discussion were Crypto and Blockchain investors, Blockchain technology innovators, and securities law and regulation experts.

Here’s what emerged from our discussion.

It’s the Wild Wide West

The clear consensus was that “current market conditions” were out of control, unsustainable and likely to cause some crisis that would generate blowback.  The critique was directed both at the usefulness of projects coming to market (“do we really need this”) and to the carelessness of investors.  Issuers seem to be getting away with totally egregious behavior — hubris , smarts or naivete?

The Train has Left the Station.

Token issuers in attendance called our group’s attention to the fact that Blockchain networks are being created every single day and are selling tokens in this manner all over the world — it is what it is.  If the US puts up regulatory shackles, these projects can and will avoid the US market, and will still get their funding, such is the enthusiasm for the new networks.

Blockchain Innovators Expect a New Regulatory Regime in the Name of Reducing Fund Raising Costs and Promoting Broad Access to a New Digital Asset

Raising money is too hard and too expensive was mentioned as a key driver behind the issuance of ICOs.  In fact, that simple statement is a bundle of critical assertions:

  • Assertion: There are cheaper ways to sell digital assets to people who want to buy them than securities issuances under Reg D or the like.  Taking software as an example, over the last 20 years, people have learned to how to sell software online and grant proper use permissions to the buyers.  Why not do the same for ownership rights, participation rights and other rights emanating from Blockchain networks?  I find this argument, at least in theory, compelling.  I did not hear anyone in our discussion disagreeing that securities issuances were a costly process.  Let’s remember, though, that there is a trade-off, where in exchange for the cost of regulations and their cumbersome record keeping and auditing rules, the market obtains social goods in the form of less fraud, less systemic risk, etc.

 

  • Assertion: The current rules actually don’t apply to this asset class.  This is the school of thought that is seeking to educate regulators on the difference between utility tokens and security tokens, and seeking to exempt the former from securities regulations. While not defining how to draw such a distinction, recent pronouncements by the SEC open the door to accepting that such a distinction could hypothetically be drawn.  Some of our participants were adamant that current jurisprudence could go a long way in helping resolve the question of which rules apply to which tokens.  In fine, what is regulated is and should be determined by the public interest.  If the powers that be feel the public needs protection, they will call tokens any name they need to call them to make sure they are covered by the regulatory regime.

 

  • Assertion: The current rules should not apply to this asset class.  An avowed goal of Blockchain network developers is to open participation in the networks to a broad-based public and limit the concentration of ownership by professional investors.  To achieve broad ownership they are seeking that a) suitability requirements to buy this asset be different (i.e., measuring suitability differently) from those applied to securities purchases, and b) “resale” restrictions be relaxed to allow easy transferability of tokens.  I believe that the burden of proof to change the rules in the public interest is still on the token issuers.  If it were deemed in the public interest, it would not be a difficult issue to solve, even under the current regulatory framework though I agree that tinkering may be required, especially for resale rules.
Many Issued Tokens Did Not Properly Define the Bundle of Rights they Granted

One of the oddities of the ICO market is this thing called a “White Paper.”  White Papers seem to be rather vague statements of intentions by founders.  There is no legally binding commitment that the issuers will do anything they state in the White Paper or that they can do it.  It’s not clear what claims on corporate assets token holders concretely have or what governance rights they might have if any.  But stunningly many White Paper issuers don’t know that they might be doing something wrong, as they are complying with the industry practice.

A NetForum participant, a VC actively investing in Blockchain projects, both confirmed and decried this state of affairs.  Another participant, an issuer, almost conceded all these points but told us that the White Papers are equivalent to implied guarantees that people will do what they said they would do.  Further, he reminded us that regardless of the pretty paperwork that typical startups currently peddle, what VCs really invest in are “people and ideas” and the White Paper gives you just that: it tells you what is the (current) idea and who is working on it.  It’s indeed the golden rule of VC investing: people and market potential drive investment decisions.  But, in my experience, investors always want (and get) downside protection.  There was strong push back in our discussion that vague commitments would do.  Yet, as the issuer indicated, Billions have been raised on these terms.  And another issuer confirmed, investors they have polled have a gambling mentality and don’t really care.  Let’s remember that more money was raised via ICOs for Blockchain projects than via traditional VC funding.

Regulations Arguably Exist for Good Reasons

What wrong with this picture?  Our financial markets are prone to violent cycles.  In the last big crashes, the good deals were washed out with the bad.  So, the Good Actors have a vested interest in weeding out Bad Behavior and exercising some restraint.

As our attendees understand, regulations seek to promote a variety of public interests. These include a) giving private investors the protections they expect, including access to third party adjudication to enforce property rights and contracts, b) protecting the financial system and the transmission chains between its components, c) providing good governance to enable proper allocation of capital, and d) protecting retail investors from deceptive practices, among other rights and concerns.  These rights are likely to continue to be defended by the current judicial means for the foreseeable future.

 

The Regulators are Watching.

Our discussion did not linger on the issue of whether US regulators were doing their jobs properly.  They seem to be issuing guidance from the sidelines while striking at the grotesque cases.  The group seemed to view this as a proper balance: let the market develop, but not too much, see where norms of behavior naturally settle, try to influence them with timely pronouncements and enforcement actions, and see where it goes.  This is typical behavior of US regulators, certainly on the Federal side.  State regulators, we were advised by a former regulator, may eventually take an active role in pursuing wrong doers who engage in bad behavior that harm consumers, a primary constituency for State bodies.

In closing, watch this space, figuratively and literally.  This market is developing at breakneck speed so you need to be informed and agile.  The NetForum is increasing its commitment to the Blockchain area by creating a “fork” in our curriculum.  We will now hold Blockchain related meetings every month following our regular format, while continuing our discussions on other topics of critical importance to Digital Leaders.

Thanking our participants for their contributions, and you for reading the Key Learnings!

Happy Holidays and Best Wishes for 2018!  Look for invitations to NetForum events starting in January.

Laurent

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