My previous post on ICOs and venture capital led to a question about how ICOs are currently regulated. I spent some time last weekend looking at the regulatory environment for ICOs. While I was bewildered by much of what I read, I managed to learn two things:
- Existing cryptocurrency regulations are primarly concerned with AML/KYC, not consumer protections.
- Regulating ICOs as securities is still nascent, with varying approaches by jurisdiction.
The Current Regulatory Environment
In most jurisdictions, cryptocurrency exchanges have to comply with existing anti-money laundering (AML) and know your customer (KYC) regulations. ICOs, as cryptocurrencies, fall under these existing regulations. Implementing these requirements can be difficult. Since tokens are transferred using generated addresses, identifying the parties in a transaction can be difficult. Other networks, like Zcash, support fully anonymous transactions, potentially obviating things like KYC.
Entities conducting an ICO may also face regulations from multiple jurisdictions that classify ICOs and cryptocurrencies in different ways. Cross-border tax implications have yet to be reconciled.
Future Regulatory Directions
In the U.S., the SEC issued an investor bulletin for ICOs. The bulletin didn’t offer any proactive advice on ICO regulations. Instead, the bulletin simply advised investors that, depending on the circumstances of a given ICO, the tokens may or may not be securities. As I understood it, tokens that return capital gains or profits back to the token holder are more likely to be considered securities.
ICOs issuing tokens that are deemed securities will face more scrutiny and overhead. Sales must be registered, as will secondary markets that trade in tokens. Local laws will also apply, which can vary in each state.
At least in the U.S., this should be seen as promising. Regulators effectively went with what they knew: securities. They didn’t overreach in their guidance to investors or ICO issuers, but they also left a number of areas yet to be defined. At least in the U.S., I believe these open regulatory areas will eventually be covered. Other jurisdictions are also actively outlining how ICOs will coexist in their markets, but this will take time.
- Investor Bulletin: Initial Coin Offerings
- Understanding Initial Coin Offerings: Technology, Benefits, Risks, and Regulations
So far in 2017, there have been 92 initial coin offerings (ICOs) that have raised over $1.2 billion. That surpasses the amount raised by startups from angel and early seed rounds. This hype has me thinking about how startups may fund themselves in the future, and what role VCs might play, if any. I don’t pretend to be an expert in either space, just interested in both.
ICOs aren’t a transfer of equity or ownership
Unlike VC funding, ICOs do not transfer company ownership from the issuing organization to the buyer. ICOs issue tokens (“appcoins”) that you can use within a project’s ecosystem, usually in the form access to some product or service that either exists or will exist at some point in the future. If the service is desirable and demand goes up, the value of the appcoin goes up due to presumably limited supply.
Holding an appcoin doesn’t allow you to influence the company or drive product direction. That’s one likely reason why startups are taking the ICO route over angel or early seed investors: why give up equity – and control – if you don’t have to?
Appcoins can be considered an asset, even if they’re completely unregulated. It’s not unreasonable that VCs will start buying and holding appcoins, hoping for appreciation. Appcoins are also more liquid than startup investments, which take several years to pay off (if they ever do). What happens if VCs start making more money from appcoin trading than from traditional venture investments? Will LPs just take their money to dedicated appcoin firms? I don’t know the answers to these questions, but the eventual answers will be interesting.
In the short term, the ICO hype will continue as an unregulated, poorly vetted source of crowdfunding. Hearing how some ICO’s are pitched by eager supporters, it feels like today’s ICOs are a shared speculative fiction largely driven by greed, without accountability for the issuer. Over the long term, my guess is ICOs will become regulated or outlawed by entities like the SEC. If regulated, launching an ICO will likely carry as much overhead as an IPO, and VCs are back in business. The People’s Bank of China (PBOC) has already banned ICOs. Additional regulatory agencies will likely follow suit.
Everyone seems to have thoughts about ICOs and what they’ll mean for the financial industry and the broader population. Let me know what you think in the comments.