After months of speculations, the United States Securities and Exchanges Commission (SEC) has clarified its stance on the very innovative area of tokens and ICOs in an historic speech delivered by William Hinman, Director at SEC’s Division of Corporation Finance.
The entire speech is worth reading. It boils down to SEC stating that a token can start its life as a security, but once it is fully functional or sufficiently decentralized or the network does not depend on one individual or group or information asymmetry no longer exists, then it is no longer a security and becomes something else.
Sheila Warren, Head of the Blockchain at the World Economic Forum’s Centre for the Fourth Industrial Revolution, says:
“It’s quite challenging to be in the SEC’s position, to walk the line between protecting consumers and supporting innovators.
This approach shows that the SEC has come a long way in its understanding of the digital currency landscape and is able to take nuanced positions on the subject.
It will be interesting to see if a de facto safe harbour based on decentralization is created and to see how other groups evolve their governance structures in light of these illuminating remarks.”
It was summer 2017 when we implicitly called on SEC to get involved after the industry failed to set-up a self-regulatory organization. We like to think no one cares what we say, so the DAO report that soon followed was probably a coincidence.
In our reporting of those summer days, as project after project experimented with different ways of holding an ICO, some good practices begun to emerge. One of them was limiting the amount any one individual can invest through a KYC process.
The latter part has its own problems because sending IDs to all sorts of projects obviously has privacy implications, including an increased risk of identity theft.
The limiting aspect, however, organically grew as a best practice because when such limitation did not apply bots would race each other with the ICO over in seconds. Something which caused problems due to the need for token ownership to be distributed.
But while in that area there was progress, in some other areas we eventually turned into a robot repeating the same thing over and over because no one was listening.
As we analyzed project after project, it soon became obvious that they had to reveal certain thing. We’re referring here to good, honest, projects of course. Fraud is something completely different and the business of law enforcement rather than these pages.
But just because a project is “good,” it in no way means it will succeed. To evaluate those chances, therefore, we kept asking for projects who already had a working product or a running business to reveal their revenue and profits figures.
Around the end of it some started moving in that direction, but still not to a satisfactory level for us. By that we mean they might show revenue, but not profits, or they might show the number of users, but not revenue.
Then as we looked back at projects that had already ICOed, it started becoming obvious that they need to reveal what exactly they are doing with all this money.
In effect, in some ways, we organically re-invented the Securities Act, but then when such act was actually applied we saw it as outdated.
It is outdated because SEC has probably not even looked at the process in decades. There were start-ups, who’d go to rich Venture Capitalists, then there were Initial Public Offerings with lawyers writing book length prospectuses for other lawyers.
No one cared about how any of that worked until a new business model came along which needed some of the Securities Act, but not much of it.
In analyzing all these projects, for example, there are really very few things we want to know and if they are signed under a declaration then that would be sufficient for us.
That being revenue, profit, the number of users and Venture Capital backing, if any of those aspects apply. Then quarterly financial reports or twice a year would be useful.
On the other hand, we certainly do not want to read a document that says its many risks include something like if there is a fire the office might burn down. That increases information asymmetry because you have to go through all sorts of useless statements to get to useful information.
Then what we really did not like about the Securities Act is that it prohibits us all from investing, unless you are very rich already. That goes completely against what many ICOs were working towards and achieved in the end, a method to have as wide a distribution as possible.
Now they could, arguably, file for a public offering, but why does no start-up do so? Why even Telegram, for example, which has plenty of resources, did not do so?
This space is at the bleeding edge so we’re a lot more sensitive to outdated regulations, but it is actually a general problem.
Initial Public Offerings (IPOs) have been falling for some time and there are a number of reasons for that, including around intellectual property.
“US securities law requires companies to disclose their activities in detail. But startups are wary of sharing information that might benefit their competitors,” a report says covering a paper analyzing the problem, then adds:
“If a firm is building a new plant, it is easy for it to disclose that it is doing so. Nobody can steal the plant,” write the authors. Not so for R&D. “By disclosing details of that program, a firm gives away some of its ideas. Other firms can build on what they learn.”
There has been a structural economic shift since the Securities Act was written in 1933. The economy has moved away from manufacturing to a knowledge based digital economy.
That means much of the requirements for public listing are outdated and inadequate with failure to revisit the process hurting the economy in many ways.
There needs to be a public consultation in our view or an enquiry to see how these requirements can be made fit for the 21st century.
Some of it is needed, as we’ve made clear, but a lot of it is not and its no good for SEC officials to say we’re not going to innovate for you. They do well to remember they are servants of the public, never their master.
They need to look at the process, and it may be much work but that’s their job because they are failing to promote capital formation as is their mandate and they are failing because a lot of the requirements are unnecessary or are unnecessary in certain categories.
Regulating a global mammoth, for example, should be different than regulating a start-up even if both are public companies. Requirements for physical companies might have to be different from digital companies. Tokens might perhaps need their own regulatory approach.
And we say that not just because it would be nice, but because it would be necessary. There are of course certain aspects to tokens that are no different than any other company, but some aspects are very different.
A share in a start-up or company gives you ownership of that company, while a token gives you access to a network. Concentration of ownership in a company is irrelevant. Concentration of ownership in a network is very undesirable to the point of dangerous.
A good token project, therefore, might not quite have the luxury of simply tapping into rich VCs. And here too there needs to be a public policy discussion because there are a lot of issues that have considerable effects on the economy and on the wealth of American citizens.
Why, for example, was a yearly income of $100,000 chosen as an exception? Why not $20,000 or $50,000? Why is crowdfunding limited to only sums of $1 million when all are already limited in investing only $2,000 maximum?
In UK, for example, and all of Europe, you can raise up to just under $10 million through crowdfunding exemptions. Quite a significant difference to US requirements and more in line with a viable ICO, although wisdom in this space was a cap of $20 million.
If SEC raises that crowdfunding exemption to $20 million, then it would go a very long way towards fully addressing the concerns of this space.
Otherwise a token sale that had private investors, and thus a concentration of ownership, may start to be looked down in this space when compared to EU based projects which distribute their ownership far more widely through crowdfunding exemptions.
And we focus on crowdfunding because this space started moving in that direction by itself, so it does appear from experience that limiting the amount invested by individuals would best achieve ICOs goals.
SECs further clarification that ICOed tokens might eventually become a commodity or currency or something else other than a security, is very much welcomed because it does look to us that now there can be a proper balance between satisfying the need for investors to be informed while also promoting capital formation.
We’d think that considering this huge gap between US and EU law on crowdfunding, that US will likewise move to increase that exemption or to have absolutely minimal requirements for sums up to $20 million that boil to little other than a declaration under written oath of revenue, profit, user numbers, and investors, if any applies.
As this space develops, how regulators can assist may change. From experience, for example, the need may arise for other information or perhaps for less of it or whatever it may be.
Which makes it quite important for SEC to have a collaborative approach so that they can better perform their service to the public and so that we too can benefit from their service.
Because while we understand of course that they have an enforcement aspect and we support them on that end because that’s why we pay taxes, we also understand that they are not our masters, but our servants.
There can, therefore, be here a very healthy working relationship so that they better understand the needs of the economy, and so that we too can have a healthier ecosystem.
As the digital revolution marches on, change is coming. And with tokens now potentially allowing for liquid fundraising in a regulated manner, we may well have reached a stage where the bad aspects are minimized, while the good aspects are amplified.