“I’m gonna make a [whole lot] of money on August 2nd on the Stox.com ICO.”
Written in July on Instagram, these words made boxer Floyd Mayweather the first big celebrity to endorse an “initial coin offering,” a form of crowdfunding that issues cryptographic coins or “tokens.” Stox, an online prediction market, went on to raise more than $30 million, some of which seems to have gone directly into Mayweather’s pocket. Other VIPs, including socialite Paris Hilton, followed suit and endorsed ICOs.
This source of easy cash may now be drying up, however. On November 1 America’s Securities and Exchange Commission warned that such promotions may be unlawful, if celebrities fail to disclose what they receive in return.
The endorsements and the SEC’s attempt to rein them in are the latest episodes of token mania. Virtually unknown a year ago, ICOs are now more celebrated than initial public offerings, the conventional way of floating a company. During the past 12 months, $3.3 billion has been raised in more than 200 ICOs, according to Coinschedule, a data provider—compared with only about $70 million in the same period a year ago.
This surge is one reason for the boom in bitcoin, a crypto-currency, which was worth around $7,500 on November 2. As Benjamin Lawsky, a former securities regulator in New York, put it recently: “Regulators have never seen a new financial product explode with the speed and velocity [of ICOs].”
Unsurprisingly regulators have stepped in. China and South Korea, where ICOs had become part of the local gambling culture, have already outlawed them. Many regulators in Western countries by now have made it clear that they consider at least some of the “tokens” distributed in an ICO to be securities, which need to be regulated as such, with all that this entails in disclosure and other requirements. Leading the pack, the SEC said in a report on the DAO, an ill-fated early ICO, that offerings of this kind need to be registered or apply for an exemption.
Big regulatory problems remain unsolved, however. The most pressing open question is what a token really represents, said Peter van Valkenburgh of Coin Center, a think tank.
Technically the answer is straightforward, at least for those familiar with crypto-currencies. Tokens are mostly entries on Ethereum, a “blockchain” or “distributed ledger,” copies of which live on many connected computers around the world—much like the one that underlies bitcoin. The Ethereum ledger, however, not only keeps track of a currency, called “ether,” but also hosts what are known as “smart contracts,” programs that encode business rules. Investors send ether to an ICO’s smart contract, which generates tokens that can be traded. The ICO’s issuer can keep the ether and use the funds to develop its project.
Legally, though, things are more complicated, according to Kevin Werbach of Wharton, a business school at the University of Pennsylvania. The SEC, for instance, argues that the technology is irrelevant: When tokens are used to raise funds, they are securities. By contrast, champions of ICOs hold that, although initially they are used to raise funds, often they also have a function in the projects they finance and hence should be treated differently. In Filecoin, an online market for digital storage that raised a record $257 million, the tokens will be used to pay for or get paid for space on disk drives.
Most issuers will have a hard time convincing the SEC and other regulators that theirs is a “utility token.” For many existing companies, such as Kik, a messaging app which raised nearly $100 million, raising funds seems to be the priority. For other issuers the problem is that the tokens they are selling are for projects that exist only on paper, and so have no other function than to bring in money. Certainly most current investors buy tokens not for their utility, but because they are betting that their value will skyrocket.
To avoid the heaviest regulation, issuers are keeping the lawyers busy. One increasingly popular legal construct in America is called SAFT (“Simple Agreement for Future Tokens”)—in effect options to buy tokens, rather than tokens themselves, thus dodging the problem posed by projects that do not yet use the tokens. As raising money gets harder, marketing becomes more important. One result is the “pre-sale,” in which early investors often get a big discount to help boost demand for the ICO.
A second big open question is where tokens will fit into the regulatory landscape. Being pieces of code, they can take on the form of any financial product.
“They collapse all asset classes into one,” said Lex Sokolin of Autonomous Research, a consultancy.
This will cause legal friction, particularly in America, where different asset classes are regulated by different agencies.
© 2017 Economist Newspaper Ltd., London (November 11). All rights reserved. Reprinted with permission.
Image credits: Karen Bleier/Agence France-Presse/Getty Images