Regulators Zero in on Brave New World of Initial Coin Offerings

Amy Cortese | February 6, 2018


The SEC has spoken: ICOs are securities and should be regulated like them.

In a wide-ranging hearing convened by the Senate Banking Committee on Tuesday, the heads of the Securities & Exchange Commission and the Commodities Futures Trading Commission gave their opinions of cryptocurrencies, Initial Coin Offerings (ICOs), blockchain and their regulatory oversight—or lack thereof, as has more often been the case.

These innovative new technologies have the potential to reshape not just financial services, but industries of all kinds and government itself, for better or worse.

The hearing comes as regulators have begun (belatedly) cracking down on the issuance and trading of tokens and cryptocurrencies. At the same time, the value of Bitcoin and other digital currencies have plummeted in recent days from their lofty heights.

The ongoing discussion could have far-reaching consequences for capital markets and beyond.

A New Fangled IPO

An estimated $4 billion has been raised through ICOs to date. In an ICO, individual investors help fund a venture by buying into an offering. But unlike an IPO, they don’t buy a share of the company; instead they receive a digital asset labeled as a coin or token.

ICO issuers have skirted securities laws by claiming these “utility tokens” can be used in the future to transact on the company’s system—sort of like paying in advance for a product as you might on Kickstarter. Yet, these tokens and coins have been promoted as investments that could soar in value and be traded on an open market, generating speculative buying.

“You can call it a coin, but if it functions like a security, it is a security,” said SEC chairman Jay Clayton told lawmakers at Tuesday’s hearing.

The definition of a security, he added, is when you give another party money with the hope of a financial return—what lawyers call the Howey test.

SEC Chairman Jay Clayton (Wikimedia)

Clayton also had harsh words for the lawyers and other professionals who have encouraged and enabled the ICO craze. “I don’t think the gatekeepers we rely on to make sure our rules are followed are doing their job,” he said, noting that not a single ICO to date has been registered with the SEC.

Although officials expressed skepticism about digital currencies, they had nothing but praise for the blockchain, the distributed ledger technology the underlies Bitcoin and other cryptocurrencies.

The blockchain is a distributed ledger system that records transactions in an open, secure and tamper-proof way. By divvying up the verification and record keeping among a network of crypto-enhanced computer nodes, there is no need for a central authority, such as a bank or stock exchange or credit card company.  The blockchain can work in conjunction with smart contracts, mini-software programs that execute instructions, such as what event triggers a payment.

Bitcoin and other digital currencies are just one application that sits on top of a blockchain.

Blockchain for Good

The technology has profound implications for everything from cross border payments and global trade to identity systems and governance. A “Blockchain for Good” movement has arisen to apply the technology to pressing social issues.

For example, 2.5 billion people around the world that don’t have access to banking services could be helped by blockchain technology, said J. Christopher Giancarlo, chairman of the Commodities Futures Trading Commission. He also suggested that, had distributed ledger technology been in use in 2008 before and during the financial meltdown, regulators would have had a clear view of bank counter-party risk in real-time, allowing for more precise policy interventions.

Rethinking Disclosure

Blockchain systems are being developed and tested today across a wide range of industries. In the meantime, regulators are grappling with how to reign in the unwieldy cryptocurrencies it has spawned and protect Main Street investors from unscrupulous players.

At least one lawmaker expressed skepticism about the SEC’s longstanding doctrine of disclosure, which relies on companies issuing securities to publish lengthy legal documents that detail financials, risks and other material information. These disclosure documents run hundreds of pages and cost tens of thousands of dollars to prepare. Yet hardly anyone reads them, as Senator John Kennedy of Louisiana contended—and Giancarlo sheepishly agreed.

“What’s the point?” asked an exasperated Kennedy. “You can extend the disclosure to Bitcoin, but you have to have disclosure that makes sense.”

It’s too early to say whether the SEC will rethink or reform its disclosure requirements. For now, investor protection seems top of mind.

Building on earlier warnings, the SEC’s Clayton sounded a note of caution. “We should embrace the pursuit of technological advancement, as well as new and innovative techniques for capital raising,” he said. “But not at the expense of the principles undermining our well-founded and proven approach to protecting investors.”


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