Are new regulations slowing down ICOs?
Initial coin offerings (ICOs) function in two capacities: they are used as a way for companies to raise capital and as investment opportunities for individuals. ICOs are relatively new, with the first ICO occurring in 2013. Initially, ICOs were not regulated by the Securities and Exchange Commission (SEC) and there were no restrictions on who could invest. In July 2017, however, the SEC released an investigative report determining that a particular coin was a security and, therefore, subject to federal securities laws. Despite new regulations and increased SEC scrutiny, ICOs continue to grow.
ICOs are a hybrid between an initial public offering and a crowdfunding campaign. (Paul Vigna, Shane Shifflet, and Caitlin Ostroff, The Wall Street Journal). A company looking to raise capital will create a digital token and sell the tokens to the public. These tokens will have value to the purchaser, either as an investment stake in the company or as access to products or services. ICOs are an attractive way for companies to raise money for two reasons. First, regulations of ICOs have been minimal or nonexistent. Moreover, investors are generally not granted an ownership stake, which means the current owners of the company will not dilute their ownership interests. (Lukas Schor, Medium).
ICOs are changing how companies raise capital. The amount of funding raised by ICOs in 2018 continues to grow, despite changes in regulation. According to the Wall Street Journal, ICOs raised $11.8 billion from January to May 2018, which is more than double the amount raised in offerings during 2017. While a few offerings account for a large amount of 2018’s ICO volume—Telegram raised $1.7 billion and Block.one raised an estimated $4 billion for its EOS network—the fundraising for the first half of 2018, even excluding those two funds, tops all of 2017. (Vigna et al., Wall Street Journal).
According to the SEC, some ICOs may be considered securities and are regulated under federal securities laws. Whether a token is considered a security depends on the specific facts; the SEC takes a “substance over form” approach. The name of the token does not prevent the token from being a security. Rather, the SEC looks at how investors use the token. Structuring a token to provide some utility does not make it exempt from federal securities laws. (Lucas Schor, Medium). The SEC advises companies to determine whether securities laws apply before marketing the offer and sale of tokens, and additionally cautions investors to research offerings before making an investment.
In December 2017, SEC Chairman Jay Clayton released a statement On Cryptocurrencies and Initial Coin Offerings. He warned main street investors to be careful when choosing to purchase ICOs and discussed the potential future of regulations. Clayton requested the SEC vigorously continue to police cryptocurrencies and ICOs and recommended enforcement against companies that conduct ICOs in violation of the federal securities laws.
While the United States continues to increase ICO regulation and enforcement, countries such as Switzerland are adopting policies encouraging ICOs. These policies have led companies to move their offerings overseas or exclude U.S. investors altogether. U.S. based startups, however, continue to lead the market. (Vigna et al., Wall Street Journal).
The uncertain future of ICO regulations has prompted some companies to take precautionary measures, such as (1) requiring customers to submit personal information to participate in offerings; (2) limiting offerings to accredited investors; and (3) trying to be more transparent by delivering additional information to investors. (Vigna et al., Wall Street Journal). Praetorian Group, for example, became the first company to file an ICO with the SEC. Although the company realized that their tokens may not constitute a security, they decided to preemptively seek SEC approval in light of future regulatory uncertainties. (Renaissance Capital, Nasdaq).
Despite an increase in regulations, the number of ICO offerings and the amount of capital raised has increased drastically in 2018. While the surge of growth in the ICO market may taper due to future regulations, ICOs will likely continue to grow due to their attractive characteristics for both companies and investors.