– August 21, 2017
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The rise of blockchain technology and associated cryptocurrencies is creating both exciting funding opportunities for young companies and potential regulatory battlegrounds. James Mosher recently wrote on this site about initial coin offerings and some highly successful recent examples. Most ICOs do not involve direct shares in a company, instead acting “like supermarket coupons, entitling holders to buy a product or service that a company expects to offer. If a product bombs, then the coins could be rendered valueless.”

The SEC, however, has recently taken more notice of ICOs, spurred on by an infamous example that looked a lot more like an initial public offering of stock than a coupon. Though fears of heavy-handed regulation of all ICOs have not yet come to fruition, companies will have no choice but to begin paying more attention to the regulatory landscape.

The Notorious DAO

In May 2016, a blockchain-based organization called the DAO (Decentralized Autonomous Organization) held an initial coin offering. The DAO aimed to create a democratic governance system using the Ethereum cryptocurrency, where new projects on the Ethereum network could get venture-capital-style funding. Investors would vote on proposed projects to decide which got funding and how to apportion dividends. The DAO raised over $150 million by selling voting rights in the form of tokens. However, a hacker managed to exploit a weakness in the code and siphon 3.6 million ether (worth around $70 million) from the ICO into their own account.

On July 25, the SEC rolled out its long-awaited report on the DAO. Though the SEC stated it would not be pursuing “enforcement action” against the DAO, it did argue that the DAO tokens would be considered securities and that any company looking to release tokens in the future that might resemble DAO tokens should register with the SEC. Resembling DAO tokens involves “the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.” However, the SEC did state that not all ICOs should be considered securities issuances that must register with regulators. The report stated that “whether or not a particular transaction involves the offer and sale of a security—regardless of the terminology used—will depend on the facts and circumstances.”

Combatting Fraud, but at What Cost?

The SEC left a lot of gray area in its statement, and certainly did not throw regulatory shackles onto all ICOs. This may be good news, but it does mean investors must approach these offerings with extreme vigilance, as cases of fraud have been documented.

Without SEC regulations, companies offering ICOs do not have to disclose standardized information, and investors lack traditional legal recourse. Projects looking to run an ICO do not have to disclose a proof of concept or a business plan. In early 2017, an article posted on CoinJournal.net pointed out potential red flags surrounding an emerging project, Qtum. The article spoke to the reluctance of the development team to reveal their identities and raised concerns over a lead developer’s failure to disclose his true identity, given his previous involvement in a project linked with a scheme to net thousands of bitcoins. And although the code was open source, Qtum was planning to release the code after the ICO, not allowing the public time to go over the code before the investment period.

Projects have other ways of defrauding investors too. Some projects have falsely associated themselves with well-known names, such as an environmental blockchain startup in Malaysia that was claiming to be funded or directed by the UN and even falsely used UN logos on its website.

Still, the cost of centralized SEC regulations likely outweighs potential benefits, as compliance costs are far from trivial. The SEC estimates that the average initial cost of complying with its regulations for stock offerings is $2.5 million, with ongoing annual compliance costs of $1.5 million. These costs could be prohibitive for many firms, especially small startups.

Brian Bushee (professor of finance at Wharton Business School) and Christian Leuz (professor of economics and finance at Booth Business School) studied the effects of legislation that required small firms on the Over-the-Counter Bulletin Board to register with the SEC. Their research found that the new rules had a “crowding out” effect on stocks, with nearly 75 percent of the shares targeted by the rules moving off the OTCBB to avoid the SEC. The result shows that overregulation ends up pushing many companies further off the grid, where funding may be less available. According to a piece from the Heritage Foundation, not only do these regulations overburden predominantly small and start-up companies, but too much disclosure can also “obfuscate rather than inform.” The surfeit of information can be overwhelming to investors and hide red flags.

The Need for Self-Governance

The specter of regulation has many in the blockchain field concerned. In March, cryptocurrency expert Andreas Antonopoulos said, “I’m sure there are some [ICOs] that are very interesting but at least 95 percent of the ICOs out there have none/very few of the basic fundamentals. Does that mean we should have a regulatory agency decide which ones are good or bad? No. It will require more maturity among investors in identifying Ponzis. The best way to learn which ICOs are worth it is to lose money.” However, the relative novelty of the technology and the lure of profits brings large numbers of interested investors with little to no knowledge of cryptocurrencies.

One way for companies operating in the ICO space to discourage heavy government regulation is to establish investor-education programs and trusted forms of self-governance. As a report on ICOs by the People’s Bank of China stated, “Mature markets need mature investors. Looking back on history, all kinds of asset bubbles and all previous financial crises are, to some extent, a manifestation of human weakness… ICO investor protection needs to be regulated, but in the long run, investors still need their own maturity, including professional knowledge, stable emotions, and rational decision-making.”

Berns-Weiss, a legal group with expertise in blockchain technologies, recommends that ICOs disclose a condensed version of the SEC form to potential investors even if not required to comply with SEC regulations. Berns-Weiss, along with others, recommends covering details such as the nature of the business, properties, contributors or founders, budgets, plans for distribution and running of the ICO, and governance details (bylaws, disclosure of code to auditors).

With the maturation and proliferation of cryptocurrencies, it was only a matter of time before governments began to take notice. The recent report from the SEC signals that incidents such as the one involving the DAO have alerted governments to the increasing impact of companies using blockchain technology. Companies should take proactive steps such as those discussed above to prevent future heavy-handed government regulation. The next big advancement or application in blockchain technology will likely come as a startup, and ensuring investor confidence both that future ICOs will not be overregulated and that they won’t be fraudulent could make a world of difference.

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Matthew Kehoe

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Max Gulker

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Max Gulker is an economist and writer who joined AIER in 2015. His research focuses on two main areas: policy and technology. On the policy side, Gulker looks at how issues like poverty and access to education can be addressed with voluntary, decentralized approaches that don’t interfere with free markets. On technology, Gulker is interested in emerging fields like blockchain and cryptocurrencies, competitive issues raised by tech giants such as Facebook and Google, and the sharing economy. Gulker frequently appears at conferences, on podcasts, and on television. Gulker holds a PhD in economics from Stanford University and a BA in economics from the University of Michigan. Prior to AIER, Max spent time in the private sector, consulting with large technology and financial firms on antitrust and other litigation. Follow @maxgAIER.
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