The question of whether the blockchain will end up as nothing or everything continues to be asked with no definitive answer as of yet. With the price of Bitcoin bouncing around US$10,000, and the mass media moving on from breathlessly covering the issue, it may not be obvious to readers whether the revolution may have stalled. Initial coin offerings (ICOs) are a good lens through which we can view the issues challenging regulators and market participants.

ICOs are digital tokens, typically based on the blockchain technology underlying Bitcoin’s functionally similar but more versatile cousin Ethereum (the Ethereum protocol, which is distinct from the Ethereum network and Ether cryptocurrency). ICOs typically function as a “smart contract” application layer — essentially a small piece of code prescribing certain rules governing the ICO’s existence — on top of an existing blockchain network. Entrepreneurs sell these ICOs to investors in exchange for cryptocurrency, typically Bitcoin or Ether, as these are the most liquid cryptocurrencies.

To-date, ICOs have typically not conferred any rights or claims against assets or revenues, as is the case with traditional debt or equity securities. In his article “Initial Coin Offerings: The Top 25 Jurisdictions and Their Comparative Regulatory Responses,” Wulf Kaal describes the motivation behind ICOs, which “allow promoters to avoid sacrificing equity for financing.” Because ICOs offer no interest or principal repayment, his description implies that ICOs are something closer to a speculative donation rather than an investment. At this point, a tech optimist would say that investors are paying to come along for the ride, while a tech cynic might say they are being taken for one.

In many cases, not granting ownership rights is done to simplify the issuance process by avoiding the need to satisfy securities regulations (with mixed success). Instead, the tokens act as bearer instruments, which either offer no recourse to the assets or income of the issuer, or confer some privileges relating to accessing the product or service being developed by the issuer (so-called Appcoins, which function in a manner similar to the crowdfunding of a project). The Swiss Financial Market Supervisory Authority (FINMA) provides a useful taxonomy of tokens:

1. Payments tokens — similar to cryptocurrencies — are used for purchasing goods or transferring value and give no claims on the issuer.
2. Utility tokens — also called app tokens — are designed to facilitate access to an application related to the token (e.g., Filecoin).
3. Asset tokens — tokens that promise a share of future earnings or a claim on capital — include tokens trading on a blockchain but representing off-chain assets (e.g., tokens representing real estate holdings).
4. Hybrid tokens are tokens that have a combination of the features listed above.

SAFT, But Not SAFE

The taxonomy described above is now somewhat out of date, with the initial ICO concept of hiding behind technology to regulation coming to an end. Matt Levine’s article, “Crypto Offerings Slowly Grow Up,” provides more on what has happened here. Essentially, by trying to operate outside the scope of any regulators, what ICOs have paradoxically achieved is to attract the attention of all regulators, even ones only tangentially related to capital formation. An example of this is seen in the US Treasury Financial Crime Enforcement Network’s (FinCEN) recent statement that it considers developers issuing ICOs to be operating as money transmitters who must comply with anti-money-laundering and anti-terrorism regulations. Levine notes that because a company issuing stock would not be considered by anyone to be operating a money transmission business, this would make ICOs more regulated than IPOs. Further souring the experience of first-generation ICOs are mis-selling lawsuits. The Polsinelli issue brief, Cryptocurrency Class Action Lawsuits: A New Frontier, provides a list of class-action lawsuits against ICO issuers, which includes some well-known defendants.

Some ICOs have sought to tread a kind-of middle ground, through the use of the Simple Agreement for Future Tokens (SAFT) framework, inspired by the venture capital world’s convertible-note innovation: the Simple Agreement for Equity (SAFE). The SAFT structure sees an issuer typically offering coupons to accredited investors using a private placement for the subsequent purchase of tokens to be issued publicly in an ICO once the product or service has been developed. Clearly, coupons that can only be traded among accredited investors in perpetuity are not likely to be useful to build a network. For this reason, the SAFT converts these securities into nonsecurity utility tokens during the ICO once the service is up and running. In this way, the coupons serve to separate the venture capital/investment/speculative phase of the ICO from the subsequent use-case phase of the ICO.

The US SEC has issued dozens of subpoenas to ICO issuers in the last year, possibly in relation to misuse of the SAFT structure, whereby the public utility token ICO is launched immediately after the presale, allowing near-immediate secondary trading of tokens in contravention of the intent of the SAFT structure. It has been noted many times, including by CFA Institute, that most financial problems are caused by unethical human behaviour and are not going to be solved by technology. With the writing on the wall for laissez faire ICOs, the important questions shift to how they will be regulated.

The Swiss Crypto Valley

In recent months, Switzerland has made a big effort to style itself as a “crypto-nation,” a phrase coined by economics minister Johann Schneider-Ammann. This is perhaps unsurprising, given the comparative advantage Switzerland has historically enjoyed in banking privacy and its entrepreneurial attitude to financial services. To be more geographically specific, the canton of Zug is trying to become a “crypto valley,” and is the home of the eponymous Crypto Valley Association, an industry association for startups in this space.

In mid-February 2018, FINMA released its guidelines for an ICO regulatory framework, reinforcing its status as one of the leading jurisdictions for progressive fintech regulation.

The FINMA guidelines answer the question of when a token can be considered a security and therefore require compliance with relevant securities regulations. In brief, FINMA does not consider payment tokens (and cryptocurrencies) to be securities; utility tokens are also not considered securities as long as their sole purpose is to establish access rights to software or a service. Asset tokens, on the other hand, are considered securities, as are the pre-financing/presale claims (e.g. SAFTs) that are often seen during the pre-ICO phase, as long as they are standardised and suitable for mass trading.

An interesting dynamic is that while FINMA is considered to be one of the more progressive fintech regulators, the traditional Swiss banking scene often feels that FINMA is practicing regulatory overreach, and a motion to separate the regulatory and supervisory powers of has recently passed the lower house of the Swiss parliament.

EU’s David vs. Switzerland’s Goliath?

Other jurisdictions are also competing to attract ICOs, but data on ICO issuance, including that in Wulf Kaal’s article cited above, confirms that Switzerland is punching above its weight. Some of the more interesting descriptive statistics presented by Kaal include the share of global ICO issuances in 2017. Ranked by number of ICOs, the list of countries and regions is as follows: United States, United Kingdom, Russia, Switzerland, and Singapore. However, when ranked by the amount raised, the picture shows Switzerland in first place, followed closely by the United States and then, at a significant distance, Israel and Singapore. A similar ranking presented in the Financial Times shows Switzerland a close second to the United States, with Singapore and Russia following at a significant distance.

Depending on which ranking you believe, the first EU-27 country by number of ICOs or amount raised is either France, Estonia, or Lithuania, all outside the top five. The United Kingdom ranks above the EU-27 along both metrics. These data suggest that the EU’s just-released Fintech Action Plan, intended to help the EU leapfrog ahead of other markets, and become, according to Vladis Dombrovskis a “global hub for fintech,” is quite optimistic. This is especially so considering that the Fintech Action Plan, by design, avoids legislative measures before Q2 2019.

The Fintech Action Plan seems to be designed in large part to ensure fintech remains a priority for the next European agenda (the current European Commission’s term ends in 2019). It is possible that the EU will enjoy a second-mover advantage and be able to cherry-pick best practices developed elsewhere, possibly just as the real, economically valuable second-generation ICOs start to be launched.

Capital Formation: The Death of Equity, the Birth of ICOs?

Commentator Preston Byrne argues in “The American ICO is Dead” that second-generation ICOs will have to (1) be platforms that acknowledge in a realistic way their regulatory status, and (2) offer a proposition to both issuers and investors that is based on the competitive advantage of decentralisation (the reality of this advantage is yet to be determined) rather than regulatory arbitrage.

The case against the hype of blockchain’s superiority over centralised systems is made rather eloquently by Nouriel Roubini and Preston Byrne in “Bitcoin is Based on the Blockchain Pipedream.” The basic argument boils down to whether the efficiency disadvantage of distributed systems (which by definition have many redundant nodes performing the same verification task) is a price worth paying for the censorship-resistance (and consensus-generating) superiority of distributed systems (again, due to the many redundant nodes having copies of the true state of a given database of information).

Whether the capital formation process is amenable to distributed ledger technology will be seen in the next few years. Byrne argues that it may be one of the spaces where it makes sense, because currently this process is not centralised, but rather “multiplecentralised” with an inefficient use of redundant silos often repeating verification work already done by other parties.

CFA Institute is interested in the issues surrounding capital formation, particularly given the secular* decline in the number of IPOs and listed companies in the last 10 years. ICOs are an interesting new approach that simultaneously solve some challenges to capital formation while raising new issues for regulators and market structure. With the crowdfunding industry struggling to make an impression after years of hype, it will be interesting to see whether ICOs can leave behind their speculative origins and turn into a more durable tool for capital allocation.

* Secular in the economics sense – (of a fluctuation or trend) occurring or persisting over an indefinitely long period.

If you liked this post, consider subscribing to Market Integrity Insights.
Photo Credit: ©Getty Images/Photographer is my life.