Depending on your generation, you may be shocked to learn that the movie business is dwarfed by the financial might of the videogame market. The latest Star Wars movie, The Last Jedi, has generated $1.3 billion worldwide. In the videogame world, Candy Crush Saga, a 2012 released mobile game with more than 2.7 billion downloads, is estimated to have generated more than $4 billion. It is still going strong as one of the 10 highest grossing mobile applications in 2018.

Games are as much about telling stories as movies. The Legend of Zelda series launched in 1986. The saga follows Link, a Hylian from the land of Hyrule. He attempts to save both Princess Zelda and Hyrule from Ganon, using the Master Sword which can only be found through many trials and tribulations. Through gameplay – through a series of games – we learn about Hyrule, its “people” and its rulers. And we grow to bond with Link as we follow him from childhood into his adult years.

Likewise, the use of games has become increasingly important in the field of education. By engaging students in “games” where they earn points, rewards and recognition for academic achievements, they are more likely to see improved results.

It also has spurred the growth of emerging technologies like virtual reality and augmented reality. For a few months in the summer of 2016, you couldn’t find a young person who wasn’t in an augmented reality world exploring Pokemon Go on their cell phone.

So what does this have to do with blockchain?

On November 28, 2017, Axiom Zen unleased a virtual cat game on the Ethereum blockchain. In December, CryptoKitties virtually halted transactions flowing through that blockchain for nearly two weeks. The game, which generated more than $5 million its first week, helped illustrate to a new group two key components of Ethereum. First, the transmission of value – money – through the token value of Ether could be done seamlessly, cheaply and quickly (although the last two were impacted by the very success of the game). And second, it demonstrated the ability of developers to deploy applications on the decentralized blockchain using smart contracts.

A CryptoKitty is essentially a unique playing card. Each one (described by the game producers as a “breedable Beanie Baby”) has a 256-bit unique code. The gender-fluid Kitties, when combined with another Kitty, produce virtual offspring with up to 4 billion possible genetic variations. A secondary market then values the uniqueness of the Kitty, resulting in profit based on a combination of luck and growing demand for the collectible.

A CryptoKitty sold for more than $100,000 during the first week of the game, with the average Kitty selling for “merely” $25. Every 15 minutes a new Kitty is released for the first year by the “system”. The starting price is set as the last five sold plus 50%. Remember, you need two! Some Kitties can breed every minute (that’s the characteristic that led to the $100,000 off-spring), while others must wait a full week.

CrpytoKitties aren’t the future of on-line gaming. But they do illustrate that people are interested in games with an element of gambling and financial risk. This is a truth that must be acknowledged to explain the over-exuberance in these early days of the cyptomarkets. Of course, the same thing should be said about the early days of the Internet financial markets too.

The real lesson – aside from people’s love of gambling- is that crypto is about more than moving money quickly and seamlessly using blockchain. The promise of Ethereum and so many other newer cryptocurrencies is that the chain will power decentralized applications. As a bonus explaining how the next Facebook, YouTube or whatever else will run on the blockchain is now a lot easier. And it is all because of a simple game using simple “smart contracts”.

So while today’s games – and today’s applications – are mostly run on centralized servers, the gamification of the blockchain has begun. Blockchain is about more than tokens and money. It is about the ability to utilize worldwide computing power to more efficiently breed and transact one CryptoKitty at a time.

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.

 

Some Data

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).

Why Care?

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.

Remember Steve Bannon? The leader of the alt-right, former Chief Strategist to the President of the United States and Executive Chairman of Breitbart News has a much more complicated past than most know. And one of the stops on his journey coincided with the birth and explosive growth of cryptocurrency.

After serving as a Naval Officer, Bannon made his way to Georgetown University to earn a master’s degree in National Security and to Harvard to receive an MBA. He then went to Goldman Sachs for a period of time before he started his own investment bank. As part of his compensation relating to the sale of Castle Rock Entertainment, he received on-going royalties for a handful of television shows, including Seinfeld. He produced 18 films during the 1990s. For a couple years, Bannon was the head of the Biosphere 2 project located in southern Arizona. The project focused on space colonization and under Bannon’s watch, scientific research relating to the Earth’s atmosphere and climate change.

In 2006, he convinced his old colleagues at Goldman Sachs to invest $60 million in a Hong Kong company called Internet Gaming Entertainment (IGE). And in 2007, he took over the company as its CEO.

During the 2000s, before the emergence of mobile games, the world of gaming was dominated by giant Internet games called massively multiplayer online role-playing games (MMORPG). These games allowed players from around the world to participate in competing with (and against) each other in a massive online world where completing tasks could earn you virtual currency. That “gold” was then used to purchase equipment, skills and other items that made a player’s character more powerful. The more you played the game, the more likely you were to be successful because you’d earn more gold.

The incredibly popular World of Warcraft has had more than 100 million player accounts created over its lifetime. For a monthly fee, a player can play and work hard to earn virtual gold to buy virtual goods.

IGE and Bannon hired Chinese workers, who for $4 an hour could “farm” virtual gold. This fake currency was then sold for real money for people who wanted to progress more quickly in the game. The players who couldn’t devote as much time playing the game were now on the same level – or way ahead of their fellow players. All it cost was a few real dollars to buy virtual gold. Was it a legitimate use of the free market to advance in the game or a glorified cheat?

The makers of World of Warcraft didn’t think too highly of this business model. Not only was it affecting the “enjoyment” of legitimate players (a claim in a class action lawsuit against IGE), but the makers of the game weren’t getting a cut of the money. The accounts of the “farmers” were shut down by the makers of the game. And IGE melted away.

Steve Bannon went on to become the head of Breitbart News in 2012. His involvement with the alt-right news site led to his involvement with Donald Trump. And he helped coin the term “fake news” to describe mainstream news sources.

The founder of IGE, who convinced Steve Bannon to help raise money from Goldman Sachs and take over the company was a former child actor, Brock Pierce. He was best known for his work on Mighty Ducks and its sequel. IGE grew to more than $250 million in annual revenue selling virtual gold for real money.

Brock Pierce has also found something else to do. While Bannon went to work for Breitbart and Trump, Pierce became chairman of The Bitcoin Foundation. Modeled on the Linux Foundation, Pierce is focused on guiding the development of the Bitcoin blockchain and public policy relating to Bitcoin.

Mobile apps embraced the IGE business model. While a player can earn tokens through gameplay in many mobile games, a player can also advance by purchasing tokens directly through the app for real money.

At the same time, players are no longer limited to using real money to buying game tokens. Now they can use Bitcoin or other cryptocurrencies to buy the “fake” money. Which begs the question: what is “real” when fake money is used to buy fake tokens to buy fake virtual items?