Presently, 21 national securities exchanges are registered with the Securities and Exchange Commission. The primary way to legally and easily trade a registered security in the United States are through a national securities exchange. Yet, no exchange is dedicated to the rapidly growing issuance or sale of cryptographic assets, like cryptocurrency.
The explosion in tradeable cryptocurrencies has predictably raised eye-brows of the SEC. In July 2017, the SEC issued a cautionary report to inform potential issuers of initial coin offerings (ICOs) that cryptocurrencies, which functionally act as securities, must be registered or fall under an exemption prior to being sold – just like any other security. Likewise, the SEC noted that any company engaging in exchange activities must register as a national securities exchange or operate under an exemption from registration.
There is no question that several of the thousands of this year’s ICOs or those in the pipeline are in fact securities. SEC observers know it is only a matter of time until the SEC takes strong enforcement action to shut down the illegal system that funded over $3,350,667,608 into ICOs during 2016 and thus far in 2017 alone. But the sheer volume of transactions and the overwhelming success of selling investment opportunities on the blockchain lead to one inevitable conclusion. Over the next several years, more and more issuers will want to offer their securities using blockchain’s distributive ledger technology and allow their resale in secondary markets. And the SEC already made it clear, only a registered exchange is permitted to act as the conduit for trading securities.
There are several structural reasons why the existing registered exchanges like NASDAQ and the NYSE are going to be reticent about changing their centralized exchange into one that functions on the blockchain. Challenges exist because of technological hurdles and entrenched political issues with stakeholders, including the broker-dealer network and transfer agents that a blockchain based exchange threatens to displace. On the other hand, the creation of a blockchain exchange is inevitable.
During Q2 2017, issuers used ICOs to raise approximately $729 million, compared to the only $235 million raised from venture capital groups. In addition, there is hundreds of billion of market capitalization. ,
For perspective , 2017 has seen roughly $52.6 billion in U.S. venture capital-backed deals – which were surpassed by ICO raises in June and July of 2017. Issuers raised $51,207,390 under Regulation Crowdfunding between May 16, 2016 and October 23, 2017. In the first 18 months post effectiveness of the Regulation A amendments, issuers have raised about $1.8 billion. There is practically no market for resale for any of those offerings (although a small handful is in fact available for trading).
Obviously a great deal of excitement was generated by the confluence of the Bitcoin explosion with a white-hot pent-up demand for investment opportunities normally only open to venture capital groups. Pent-up demand exists because small and mid-size businesses historically avoid selling investments in their company – or else afoul of securities laws.
Instead, these companies are now selling cryptocurrencies best described as “utility tokens.” Determining how this differs from a “security token” has frankly resulted in a lack of clarity. One thing is clear, however. Stringent enforcement actions face unwary token issuers in the coming months and years.
An Analogy to Help Understand What’s Happening
Imagine that an entrepreneur has come up with the engineering design for a self-driving semi-truck truly capable of moving goods across the country without a driver. The prototyping and semi-truck building is highly capital intensive, so off goes the entrepreneur to raise money. Certainly if he attempts to raise money for the company by selling equity, he will need to comply with securities laws. Those laws are complicated to the uninitiated and slow and cumbersome to the eager entrepreneur. Instead of selling ownership in the company, our entrepreneur friend decides to announce that the self-driving semi-truck won’t run on regular gasoline. Or diesel. It will use special fuel.
Now instead of selling interests in his company, he sells barrels of special fuel to investors. And these investors can either store the special fuel or start buying and selling it right away. And although that special fuel isn’t actually used by the semi-trucks that haven’t been designed yet, the investors happily partake in the effort to fund the company and to have special fuel that they can immediately sell. Depending on the market conditions, they can make a lot of money on the idea that soon the entrepreneur’s semi-trucks will run on special fuel. The entrepreneur finally gathered money necessary to startup his semi-truck business- despite that many challenges beyond raising capital (product risk, market risk, regulatory risk) remain forefront.
But here’s the glitch. If you asked those investors what they’d prefer: special fuel or an equity piece in an exciting company that was creating a new mode of driverless transportation – we already know the answer. Moreover, those investors faced with the choice of a six month (or indefinite) holding period or instant liquidity, hands down will pick liquidity. In short, investors want the best elements of a utility token (the fuel that runs a product) – the ease of purchase and liquidity. At the same time they want to own a piece of the action.
Securities law won’t change overnight. But we must recognize that millions of people are putting billions of dollars into utility tokens because we have somehow failed. Securities law is about transparency. It isn’t about regulating something making it too expensive, daunting, slow and, thus, useless.
The gap between JOBS Act crowdfunding and what has happened in the ICO market is wider than any ocean. We must recognize that while the power of the blockchain will revolutionize the Internet, our ability to fund companies cannot be sustained while we sell imaginary fuel instead of an upside of investment in a high-growth enterprise.
The blockchain will evolve slowly over the next few years. As we begin to see the enforcement ramp up to stop fraud, we cannot forget that our regulatory scheme must adjust to honor the opportunities that investors demand.
*A special acknowledgement to Amanda Salvione, Esq. at Radix Law for her input and assistance.