The Securities and Exchange Commission’s concern about “initial coin offerings” is understandable. There are significant problems in the ICO marketplace, but new markets always have issues. Unfortunately, the SEC’s recent restrictions defining the tokens sold through such offerings as “securities” completely miss the point and once again will constrain the ability of startups to raise much-needed capital without having to go to a bank or venture capitalist first.
The SEC’s recent investigative report targeted specifically the offering linked to the DAO, but its effect will be felt by ICOs across the spectrum. In a press release, the SEC said the agency concluded that “tokens offered and sold by a ‘virtual’ organization known as ‘The DAO’ were securities and therefore subject to the federal securities laws.”
The SEC is on a slippery slope going after cryptocurrency-powered offerings since the agency does not have direct authority over currencies. But more to the point, the agency’s dictum is yet another affront to the efforts by fledgling companies to raise funds. As we note in a recent report, ICOs are simply a new tool for doing what Title III of the JOBS Act should have done by providing capital to innovative startups in an efficient way. Title III allows all companies with less than $1 billion in sales to raise up to $1 million in equity or debt. It was designed, as the University of Georgia’s Usha Rodrigues described, to serve as an "IPO on-ramp," thereby easing "regular companies’ path to going public."
However, by regulatory delay and overreach, the SEC made sure Title III did not work as well as it could have. Title III has, in aggregate, generated slightly over $50 million in committed capital since 2016. We note that so far in 2017, ICO issuers have raised over $1 billion.
An ICO is a process by which firms raise money through the issuance of “tokens,” money created with the assistance of innovative encryption techniques that both generate units of currency and validate transaction records without the need for a central bank. (The network is the central bank.) With digital currencies and blockchain technology serving as vehicles, ICOs have features that resemble crowdfunding, venture capital and IPOs.
The SEC’s action suggests that central banks, regulators and large financial institutions are still frightened by the decentralized nature of this new market and instrument. Digital currencies and the blockchain they run on represent a new threat to the hegemony of more mainstream financial services entities. The SEC may have legitimate questions about the classification of ICOs, but the potential negative effects of the report on offerings by startups simply feed the perception that regulators are protecting entrenched social and financial interests from a new financial technology (blockchain) with great potential.
This perception is only amplified by the SEC’s apparent unwillingness to crack down on those entrenched companies for bigger crimes. Institutions that facilitated significant legal violations during and after the financial crisis paid only the smallest of fines and endured the lightest of sanctions relative to their size. For example, Wells Fargo has been among the big banks crafting civil settlements with the government; there have been no criminal proceedings. With regard to the scandal over Wells’ creating 2 million fake accounts, if the SEC were actually concerned about protecting the public, Wells would have faced charges immediately for violating securities laws over its allegedly falsifying disclosure documents.
In many respects, the popularity of digital currency, decentralized structures and new ways of raising capital is a result of the lack of trust toward traditional institutions following the financial crisis, as well as the lack of meaningful (as in jail time), rational and effective post-crisis regulatory enforcement. As the organization that failed to protect investors in the recent financial crisis, which cost U.S. citizens $17 trillion, the SEC might be considered lacking in trustworthiness. People are looking for financial vehicles they can trust.
Over the long term, I do not expect the SEC's attempt at regulation to work. Markets will, as they always do, figure out a way around these restrictions. Given the SEC's lack of jurisdiction over currency, many potential ICO issuers are redesigning their offerings.
The nature of blockchain is such that this technology — not regulators — will win in the long term. It would be better for the SEC to recognize this and to put in place common-sense, rational and meaningful safeguards that protect the public, not financial institutions. Trying to smother the newborn ICO industry in its crib is not the right approach.