Blockchain ICOs: This is the year regulators will validate security and utility tokens
Trevor Koverko, CEO of Polymath, takes stock of the 'Cambrian Explosion' of ICOs.
The term "Initial Coin Offering (ICO)" became the buzzword in 2017, second only to the blockchain industry's use of the term "Cambrian Explosion" when describing growth over the past two years. Yet while it can be convenient to slap the ICO label on every new token emerging from developer teams, not all token sales (or distributions) are alike. And this distinction is becoming increasingly important for the blockchain industry as a whole, especially from a regulatory perspective.
For most casual observers, ICO elicits an image of what we call a "utility token." Utility tokens allow for access to blockchain code or software, functioning much like a software license and gateway to a network's applications. Companies that have conducted –or are planning to conduct– such utility token sales include Atari, Telegram, Kik, and others.
In addition to utility tokens, there's also "security tokens," which do exactly as their name implies- they tokenize assets. Stocks, bonds, venture capital, private equity, equity, LP shares, and share units can all become programmable, Know Your Customer (KYC)-aware tokens. This means these tokens can provide investors with the same rights that shareholders have in the traditional financial securities world, and companies will have obligations to these token holders in the same way they do to present shareholders.
This distinction is important, because for all the coverage supporting the narrative that the blockchain industry is the "Wild West," major regulatory authorities do not see tokens existing outside the purview of current regulations. Notably, during the recent U.S. Senate hearing on cryptocurrencies, the U.S. Securities and Exchange Commission Chairman (SEC), Jay Clayton, fired this warning flare for the whole industry to see: "I believe every ICO I've seen is a security. Merely calling a token a utility token or structuring it to provide some utility does not prevent the token from being a security." Of course, if Chairman Clayton's words weren't enough to convince observers, the SEC's recent wave of ICO subpoenas leave little to the imagination on how seriously regulators are taking the market.
The SEC had already warned investors that ICOs have fewer investor protections than traditional securities. And should investors lose money in an ICO, such as in an exit scam where the organizers simply "run off" with funds raised, the prospect of recovering funds is dismal. Some cases, such as the recent Prodeum scam, may be much smaller in scale than many headlines would lead you to believe. However, that doesn't mean real money isn't often at risk- as the now infamous PlexCoin scam and its $15 million raise demonstrates. When the amounts raised keep increasing, it is only a matter of time before regulatory authorities have to act.
So what can blockchain entrepreneurs and developers do? Obviously, there will be those who continue forward- whether out of malice or hubris- with calling their ICOs "utility tokens" in the hopes they'll somehow evade regulatory oversight. And while security tokens may have the benefit of existing securities law and legal precedent to serve as guidance, genuine utility token teams are nervously floating in a legal grey-area right now. Even in such a young industry, despite its massive growth trajectory, leaders need to continue working with regulators to ensure the full potential of blockchain technology can be achieved.
Fortunately, we're starting to see real progress when it comes to collaboration between the blockchain industry and regulatory authorities. Japan, for instance, was host to what was nearly an industry-killing event in the Mt.Gox hack in 2014. However, rather than stifling the growth and evolution of the industry, Japanese authorities have taken a measured approach to it. They have encouraged the development of blockchain-enabled payments and services in Japan while still focusing on consumer protections and mitigating illicit applications of the technology. Switzerland, which has openly embraced blockchain technology development for many years, also recently released ICO guidelines for "Payment," "Utility," and "Asset" ICOs- which could serve as inspiration for other international regulators looking to promote more formal guidelines in their markets.
Similarly, U.S. regulators and legislators are starting to set the foundation for a more concrete regulatory guidance. It's not perfect, but New York's BitLicense framework- for blockchain companies operating in the state- indicates a good start for the industry to which regulators can model from and improve upon in other states. Similarly, the recent blockchain bills that were introduced and approved in the Wyoming House could signal a new era of regulatory certainty for utility tokens, providing issuers with clear "rules of the road" to follow (and potentially setting up Wyoming as a new capital for utility token providers). At the federal level this past-September, Representatives Jared Polis (D-CO) and David Schweikert (R-AZ) introduced the Cryptocurrency Tax Fairness Act- part of their work as the "Blockchain Caucus" in congress, advocating for more federal-level leadership on the transformative industry. While the bill was ultimately left out of the tax reform legislation last year, we can reasonably expect it to come back in 2018 as more members of congress realize how many of their constituents are directly impacted by the lack of federal level legislation.
2017 marked a pivotal year for the blockchain industry globally, with the wildfire growth and awareness of ICOs making the technology the story of the year- and 2018 is poised to continue this momentum. Increasing crackdowns from Chinese authorities on miners and cryptocurrency traders has been disconcerting to see, and both German and French officials have expressed a desire for the G20 to take a stronger regulatory stance on cryptocurrencies via international coordination. However, it's clear looking at the recent regulatory momentum in countries like the U.S., Japan, and Switzerland that officials understand the vast potential of both security and utility tokens. And I hope that both industry and government officials will continue to collaborate on regulatory guidance that provides certainty for both, while protecting users and investors alike.
