The sun may be setting—or at least dimming—on a Wild West of blockchain-powered finance.
The Securities and Exchange Commission on Tuesday released an investigative report concluding that initial coin offerings, or ICOs, must comply with federal securities laws, just as if they were issuing shares of stock, unless they can find a valid exemption.
An ICO is essentially a special type of crowdfunding campaign, "like a Kickstarter on steroids," according to Andreessen Horowitz board partner Balaji Srinivasan. Entrepreneurs raise capital by selling blockchain tokens, giving investors a stake in the protocol, platform or service being built. The tokens then trade online as a liquid asset.
Because of how easy they are to launch and how liquid the investment capital is, ICOs have been growing in popularity for months. Dozens of projects have raised a total of $1.3 billion through ICOs so far in 2017, according to Autonomous Research.
While critics have accused the market of being a bubble, technologists have claimed that such token sales represent the future of funding for startups and new internet protocols, which, in turn, could change the global economy.
The SEC's report could put that at risk.
The agency made it clear that federal securities laws would apply to the offer or sale of securities in the United States, regardless of whether or not the "issuing entity" was a traditional company or a decentralized organization and regardless of whether or not those securities were issued through blockchain technology.
While the SEC implied that it would treat token offerings on a case-by-case basis to determine how they should be classified, it did single out one entity, the DAO, as having crossed the line.
The DAO launched last year with the intent to be a sort of decentralized investment fund. Investors bought into the DAO with Ether, the native cryptocurrency of the Ethereum network, in a crowdsale that raised more than $100 million.
But before it could get going, a thief exploited a flaw in the DAO's code to steal tens of millions of dollars worth of digital currency. The DAO collapsed, and the founders of Ethereum created an entirely new version of the network in order to roll back the theft.
On Wednesday, the SEC said that the DAO's crowdsale had constituted the sale of unregistered securities.
"The innovative technology behind these virtual transactions does not exempt securities offerings and trading platforms from the regulatory framework designed to protect investors and the integrity of the markets," Stephanie Avakian, co-director of the SEC's enforcement division, said in a press release.
The SEC has chosen not to bring charges against anyone involved in the DAO, however, nor to find them in violation of any laws.
Like much of the regulation surrounding digital currencies and blockchain technology, the SEC's new report is something of a square-peg-in-a-round-hole job. Blockchain tokens function like a strange hybrid of securities and currencies.
In its press release, the agency leaned hard on the need to protect investors from unscrupulous speculators and outright scammers.
"Investors need the essential facts behind any investment opportunity so they can make fully informed decisions," William Hinman, director of the SEC's division of corporation finance, said in the release.
Some firms have been prescient about regulations. When the San Francisco venture capital firm Blockchain Capital decided to raise $10 million of its latest fund through a token sale in April, it was clear from the outset that the token should be considered a security. As a result, the firm restricted its ICO in the U.S. to a limited number of accredited investors.
The restriction doesn't seem to have hurt Blockchain Capital's fundraising. Its token sold out, and the firm reached its funding goal in a mere six hours.
But the SEC's report also took a hard line on the trading of such tokens after the initial crowdsale. As it stands, online exchanges make it possible for people all over the world to buy and sell tokens such as Blockchain Capital's.
But if a particular token is deemed to be a security, the SEC said in its report, then any online exchange that facilitates the trading of that token will have to register as a national securities exchange.
The consequences could be devastating for the market in these new digital assets, should exchanges choose to bar American users or drop some tokens altogether instead of complying with U.S. securities laws.
There are good arguments to be made that not all blockchain tokens should be classified as securities, particularly if the token serves some function on the software platform with which it is associated.
In a statement, the advocacy group Coin Center argued that the SEC's determination regarding the DAO should not be extrapolated to all tokens.
"We believe that applying the same facts and circumstances test to other tokens will mean that some do not fit into the definition of securities, particularly tokens with an underlying utility rather than a mere speculative investment value," Peter Van Valkenburgh, Coin Center's director of research, said in the statement. "We hope clear guidance from the SEC to that effect will be forthcoming."
It remains to seen whether the SEC will bring enforcement actions against any token issuers and whether any token entrepreneurs will rethink their approach before forging ahead with an ICO.
While members of the media and even some industry insiders play fast and loose with the nomenclature, lumping cryptocurrencies such as bitcoin together with the blockchain tokens issued in ICOs, there are important differences. Cryptocurrencies are distinct in the method of their issuance —cryptographic "mining" versus public offering—and by virtue of possessing their own distinct blockchain network, whereas tokens sit atop existing blockchains, such as Ethereum's.
The Commodity Futures Trading Commission previously ruled that bitcoin and other cryptocurrencies of its ilk are commodities.
Token sales are a global phenomenon, and the SEC alone cannot stop the trend. But the U.S. is the world's deepest pool of capital, and by late Wednesday afternoon the SEC's report was sending shock waves through social media.
Upon seeing the news, Barry Silbert, the founder and CEO of Digital Currency Group, which has invested in dozens of blockchain startups, tweeted: "The SEC has just put every potential ICO issuer on notice. From here on out, nobody gets a free pass."