Tokens, ICOs, and Blockchain: Regulatory Challenges (Note)

Summary:

• The rapid development of ICOs has led to a need for regulation by various national financial authorities.
• This same regulation has created barriers to entry into this new market, both legal and economic.
• However, if properly implemented, regulation can contribute to the development of blockchain technology and related innovations such as ICOs, decentralized applications, and tokens, while protecting less experienced investors.

This article aims to familiarize readers with the concepts of ICOs and tokens, while offering a reasoned analysis of the issue of regulating these financial and technological innovations.

Although the world of cryptocurrencies has grown in popularity in recent years, it was not until 2017 that the general public took a massive interest in them, due in particular to the spectacular rise in the price of bitcoin, which was itself fueled by media coverage. Google searches containing the term « blockchain » peaked in December 2017,while the Twittersphere was buzzing with 80,000 tweets a day referring to Bitcoin.

This interest in the famous cryptocurrency and the technology that enables it to exist, blockchain, somewhat overshadowed another equally important phenomenon, namely the explosion of ICOs (Initial Coin Offerings), whose name is reminiscent of Initial Public Offerings (IPOs), which refer to a company’s initial public offering. To illustrate the growth of ICOs in 2017, simply look at the following graph:

We can see the spectacular growth of this phenomenon throughout 2017: between April and September, the cumulative funds raised by ICOs increased more than sixfold, reaching nearly $2.4 billion.

Tokens, at the heart of the ICO process

Unlike an IPO, which involves a company issuing shares to investors in exchange for cash, an ICO involves a company selling tokens.

Tokens are digital assets that can be used in an application registered on a blockchain and can perform functions predetermined by their creators. The attractiveness of tokens is determined primarily by their future usefulness within the project, but also by speculative objectives. The creator of an application may, for example, choose to issue votingtokens (the more you have, the more votes you have in policy votes[3]), tokens that allow the service produced to be consumed ( the Waba.network token, WNT, for example, enabling town halls or associations to use a platform that allows them to set up alternative or local currencies based on blockchain) or even  » reputation »tokens , which allow users to be evaluated—similar to the review system on Airbnb or Blablacar—and which are issued automatically, for example, when a co-contractor is satisfied with the service provided through the application. The possibilities are virtually limitless, which is precisely one of the great advantages of blockchain and a guarantee of its future development.

Tokens are inseparable from blockchain. Blockchain is their medium, and thanks to its characteristics, it allows them to be exchanged in a decentralized manner while replacing the trusted third party, just like the most traditional cryptocurrencies, which can also be classified as  » tokens. »This makes them susceptible to pump and dump phenomena, just like the most well-known cryptocurrencies.

In summary, an ICO is an innovative way to quickly raise funds in a decentralized manner through the issuance of digital tokens. Their rapid and somewhat chaotic development has led to a need for supervision and regulation, often demanded by investors themselves in order to prevent fraudulent transactions while offering certain fundamental guarantees. However, as highlighted in the France Stratégie report dated June 21, 2018, dedicated to the challenges of blockchains, the regulatory process is still in its infancy and is currently contributing to competition between jurisdictions at the international level to attract new ICOs to their territory. The funds raised are often correlated with the credibility of the jurisdiction where the fundraising takes place and the potential investments to which it legally gives access. On the other hand, regulation sets registration fees accordingly, which has the effect of creating barriers to entry into this new market: the days when anyone could raise funds through an ICO are over.

There are many issues at stake: states are seeking to attract ICOs by offering them favorable regulation. On the other hand, ICO promoters have an interest in registering theirs within a jurisdiction for at least two reasons: on the one hand, it reassures investors; on the other hand, if they do not do so, they expose themselves to the risk that their token will in fact fall under a given jurisdiction and be classified in a category whose characteristics they will have to comply with or face legal proceedings. This point will be developed further below.

It is therefore worth considering the relationship between the development of ICOs—and, by extension, blockchain technology —and the regulatory process to which they are subject: does this process represent a hindrance or a step forward for their development?

From the token gold rush to the intervention of the Securities and Exchange Commission (SEC)

In December last year, funds raised by ICOs reached nearly $2.4 billion, but many of these ICOs ended in failure. According to Nessim Ait-Kassimi, economic journalist at Les Echos, « out of a panel of 902 ICOs in 2017, 142 (15%) failed to raise the hoped-for money, and 276 (31%) subsequently failed because they were scams or due to a lack of interest from investors. Another 113 operations did not reach critical mass and fell into oblivion. In summary, 59% of ICOs were failures to varying degrees. »[7]

The proliferation of ICOs was a cause for concern for the SEC, the US financial regulator whose main mission is to protect American investors. It was necessary to attempt to impose an initial classification of the assets issued during ICOs, the famous tokens, which automatically fell under US jurisdiction if at least one US citizen invested at least one dollar in an ICO and if the ICO was not registered under any other jurisdiction. By defining the status of the token, the SEC exposes its issuer to penalties if the asset, treated as a security, does not comply with the regulations applicable to securities. The SEC’s intention was clearly stated by Jay Clayton, its current chairman:  » I believe that all the ICOs I have seen are offers of securities. You can call it a coin or a token, but if it functions as a security, it is a security. Furthermore, just because you invest in an ICO does not mean you are investing in a blockchain-based service. « 

The SEC considers—almost systematically—that tokens issued during ICOs are securities, in other words, transferable securities conferring standardized rights, implying that these crypto-assets must include a financial consideration, or more precisely,« a reasonable expectation of profits derived from the entrepreneurial activity or managerial efforts of a third party. » The France Stratégie report on blockchains notes that « it should be noted that the SEC in the United States relies on the Supreme Court’s Howey case law to characterize an instrument or right as a ‘security.' » However, one of the key criteria for distinguishing a  » security » (which is very broadly defined in US law) from another asset or right is the financial consideration granted to token holders in the form of dividends or income or the promise of income, in other words, the existence of a financial return (a criterion also used in France to characterize an « atypical asset »).[10]

This can be a problem for ICO promoters who do not want their token to fall under US jurisdiction and be classified as a security, as they do not want to be penalized if it does not generate a capital gain. Let us imagine that the promoter of an ICO does not register it in any jurisdiction, that a US investor uses dollars to buy tokens from them,[11] and that the price of these tokens quickly collapses because, for example, they have no future use in the operation of the project they are used to finance. In this specific case, the promoter of this ICO will have to comply with North American regulations and bear the consequences. It is therefore in their best interest to protect themselves by choosing a more accommodating jurisdiction depending on the nature of their token and the use they intend to make of it: if the token is not intended to increase in value, then its promoter must avoid it being classified as a security.

Is regulation a hindrance?

However, the need for regulation translates into a higher barrier to entry. According to Sebastian Valdecantos, former economist at ECLAC, « it currently costs around $500,000 to launch an ICO. On the one hand, jurisdictions are very expensive. To register an ICO in Estonia, for example, which is one of the cheapest, you have to pay $70,000 […] in the US, the cost becomes prohibitive for a startup. On top of that, there are the costs of hiring a lawyer and advertising the project, maintaining the website, paying the salaries of the full-time team […] and the list goes on.« [12] In other words, to have a chance of attracting investors, the entry ticket is half a million dollars, which is enough to discourage a multitude of smaller projects that still had a chance of raising funds through this means last year.

Even if a significant barrier to entry allows regulators to weed out less savvy investors (small investors), this raises the question of the impact of excessive regulation on the development of ICOs, but also on the blockchain that makes them possible. If legal standards become too restrictive, important innovations may never see the light of day. This would greatly limit the flow of capital into the crypto-application and blockchain technology sector, limiting the sector’s growth potential.

The development of blockchain is also threatened by attempts by governments to regulate the legal validity of transactions. This technology is supposed to guarantee the transfer of assets in a decentralized, peer-to-peer manner, in a completely secure way thanks to the use of cryptography. Blockchain thus seems to make possible the libertarian dream of eliminating the trusted third party, which necessarily implies the existence of a central entity. In the context of contract law, for example, the validity of contracts is ultimately guaranteed by a judge. This is not the case with smart contracts or crypto asset transfers, as blockchain is sufficient in itself to guarantee their security and validity: the trusted third party is replaced by trust in technology and in the decentralized and pseudonymous aspects of the validation process (on this point: Bitcoin, altcoins, and blockchain: speculation or revolution? BSI Economics 02/01/2018).

If, for example, the legislative power of a state considered that transactions carried out on the blockchain did not have legal validity in themselves, but that this had to be guaranteed by a judge, this would effectively reintroduce the trusted third party that the promoters of this technology are trying to do away with. In other words, if regulation is not tailored to the characteristics of the asset it governs, it could slow down the development of blockchain and the innovations that depend on it.

… or a guarantee of future development?

The issue of ICO regulation is therefore central. In addition to the barriers it raises to entry into this emerging market, if it is not carried out with discernment, it risks limiting what could be a major technological revolution.

However, regulation is ambivalent in nature. While it may sometimes limit individual initiative in the short term, it often enables the success of a system at the collective level, which in turn makes individual success possible in the long term.

In the case of ICOs, regulation can also be beneficial. It forces token issuers to build solid projects with a higher chance of success than unregulated ICOs, thereby helping to create a virtuous circle: if it is necessary to meet criteria predefined by the jurisdiction chosen to launch an ICO, this will reassure investors and therefore enable the issuer to raise sufficient funds to carry out their project. In other words, if investors believe that the project will succeed, they will finance it, which will enable the project to succeed, their confidence being partly due to the fact that the tokens are « certified » by the financial authority that regulates the chosen jurisdiction.

In addition, the half-million-dollar mark (which is an average value) also constitutes a kind of « quality label »: to exceed it, the promoters of an ICO—which is generally carried out in two stages—must raise funds during a pre-sale, i.e., by exchanging their tokens for other cryptocurrencies in over-the-counter transactions, obviously at a very low price and with the promise that they will be issued in limited quantities. This encourages investors to buy quickly, making them early adopters, which in turn stimulates the initial fundraising. Passing the $500,000 mark means that the project has already gained the confidence of investors, which is an incentive for others to invest.

Conclusion

If the regulation of ICOs boosts investor confidence, they probably have a bright future ahead of them. However, it must respect traditional incentive mechanisms so as not to stifle the development of a technology that could well place pioneers at the forefront of the race for technical progress, which is essential to ensuring the long-term growth of developed economies (Guellec and Ralle, 2003). In this race, the United States, Russia, and the United Kingdom are in the lead, as shown in the following graph:

Source: medium.com

These three countries alone account for more than 40% of all ICOs worldwide. However, they face competition from Switzerland and Singapore, two countries that were quick to establish a legal framework in which ICOs can operate. France, on the other hand, seems to be slow to legislate and runs the risk of never being able to occupy the privileged position that comes with having been quick to adopt a promising technology. Indeed, by failing to offer a legal framework favorable to investors, France risks seeing highly promising innovations develop elsewhere and finding itself in the paradoxical situation of technological dependence on other, less developed countries such as Estonia and Poland.

Bibliography

Articles and books

Ait-Kassimi, Nassem., « Factors contributing to the success and failure of ICOs, »Les Echos, March 8, 2018

https://www.lesechos.fr/08/03/2018/lesechos.fr/0301386757259_les-facteurs-de-succes-et-d-echec-des—ico–.htm

Guellec Dominique, Ralle Pierre, Les nouvelles théories de la croissance(New theories of growth), Paris, La Découverte, 2003, 128p.

Thomas G., « United States: Senate hearing on the regulation of the cryptocurrency sector, » Le journal du Coin (02/09/2018)

Statistical sources and reports

– Coin Dance https://coin.dance/stats/blockchain

– Crypto France, Bitcoin figures https://www.crypto-france.com/bitcoin-chiffres-statistiques/

– France Stratégie, Reporton the challenges of blockchainshttp://www.strategie.gouv.fr/publications/enjeux-blockchains

– SEC report: Statement on Cryptocurrencies and Initial Coin Offerings

https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11

-Waba, Waba.network white paperhttps://waba.network/wp-content/uploads/2018/06/WABAnetworkWhitePaper.pdf