We Need to Talk About ICOs

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Cryptocurrency experts critique the current regulation of secretive token sales.

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Once considered the financial innovation of the future, initial coin offerings (ICOs) have plummeted in popularity. And regulation may be to blame.

In a recent paper, cryptocurrency experts argue current U.S. securities laws lack the precise technological definitions necessary for effective ICO regulation. They contend that a more robust disclosure framework is needed to reduce the ambiguity surrounding tokens and make financial markets more transparent and efficient.

People often confuse ICOs with the many other assets that rely on “blockchain” technology. Despite the edgy name, blockchain simply enables financial transactions outside of traditional markets such as stock exchanges. The coauthors focus on ICOs of “utility” tokens, which carry nontraditional and nonfinancial rights and have different pricing considerations than traditional debt and equity securities—things like stocks that allow investors to share in the profits of a business. For example, one type of token may grant the purchaser access rights to digital platform or marketplace without serving as bona fide “currency” on that platform.

Regulators have increasingly sought to treat ICOs as securities. In the United States, this approach would mean regulating ICOs under the Securities Act of 1933, which governs what must be disclosed when companies offer securities to the public. In a recent paper, Chris Brummer of Georgetown Law, along with Trevor Kiviat and Jai Massari of Davis Polk & Wardwell LLP argue that the Act’s extensive disclosure requirements—even those reaching nontraditional securities—prove inadequate in the face of token economics. They contend that, under current laws, ICO issuers and promoters complying with securities regulation would not be required to disclose material information about token valuation and pricing, which would reduce investor knowledge and cripple market efficiency.

The U.S. regulatory framework did not anticipate the rise of tokens, so they present unique regulatory challenges.

Federal disclosure requirements, which outline what information companies must provide to potential investors, do not explicitly mention ICOs, and the rules governing nontraditional securities require little beyond a “brief description” of the rights involved. The rights anticipated here relate to voting, dividends, and liquidation—none of which are directly implicated in standard ICOs.

Under current laws, issuers have to disclose ICO characteristics closely resembling traditional securities, but a token’s distinguishing “utility” functions—for example, digital access rights in lieu of claims on profits or dividends—likely fall outside of the characteristics covered by existing law, say Brummer and his coauthors. Disclosure of these utility-related functions may not occur voluntarily, so a new disclosure regime would need to fill in these gaps to be effective.

The current securities disclosures that apply to ICOs often do not provide the information that ICO investors would find most relevant. Instead of detailed disclosure statements that companies must file before a public security offering, ICOs rely on explanatory documents called “white papers.” These documents outline the technology problem and related solution that a particular blockchain-backed token is designed to solve, while also serving as marketing and solicitation materials.

Unfortunately, white papers circulate almost exclusively among technologically sophisticated investors who can interpret the complex formulae and statistical models used—virtually barring unsophisticated retail consumers from meaningful participation in ICOs. In addition, tech-focused white papers often provide less company and market related information than is required by the modern U.S. disclosure regime, which captures off-balance sheet arrangements not present in white papers.  These differences make ICOs riskier and less appealing than traditional securities, note Brummer and his coauthors.

One of the major drawbacks of securities laws as applied to ICOs is that they expect companies to disclose both historical financial data and “forward-looking” information. Due to their digital nature, however, most ICOs will not have operation “histories” extending beyond a few lines of code at the time of disclosure. Unlike in regular public offerings, historical data are not nearly as widely available at the outset of an ICO and white papers often contain hyperbolic language that complicates predictive disclosure.

In addition, the extraordinarily complex nature of coding that underlies ICOs makes for a very difficult auditing process that requires careful review of even the most basic aspects of the code. This laborious task proves more challenging than reviewing a company’s macro-level financial statements in a typical public offering, which further reduces ICO appeal.

Furthermore, U.S. securities laws require extensive information about a company’s board of directors and management, the key decision-makers in a public company. For ICOs, the technologists who develop a token’s digital infrastructure and write the white paper play a far greater role than directors because they develop the code that makes up the ICO. Because ICOs are conducted to finance new, often short-term projects, a CEO or director may not be heavily involved at the time of the offering. Securities laws include a catch-all provision for these “significant” employees, but, again, such disclosures relate to their business—not technical—experience.

Most crucially, tokens do not yet trade on national securities exchanges; they trade on digital marketplaces like Coinbase that are often called “cryptocurrency exchanges.” Many digital exchanges operate in unregulated jurisdictions abroad, further limiting the reach of U.S. regulators. Domestic crypto exchanges sometimes have obligations under state laws, which can very drastically in their disclosure requirements—a matter complicated by the fact that only 31% of ICO white papers explicitly outline the relevant laws and governing jurisdiction. This potential source of confusion may discourage investors.

The statutory designation of ICOs as “securities” will not automatically place them in an efficient regulatory scheme. A flexible disclosure framework that can accommodate the rapid growth of ICOs and other digital age financial tools is needed to better protect investors and to ensure that the virtual marketplace continues to grow. Transparency and adaptability in ICO disclosure regulations will generate value for the investing public, argue Brummer and his coauthors. Demystifying the nature of cryptos may lead to their strong resurgence and to a world of economic possibilities.