By Dave Weisberger, November 10, 2017
The Wall Street Journal published an article yesterday with the headline trumpeting “SEC Chief Fires Warning Shot Against Coin Offerings.” It quoted SEC Chair Jay Clayton making sense by saying “I have yet to see an ICO that doesn’t have a sufficient number of hallmarks of a security.”
It is very important to understand, however, that there are two major things that Mr. Clayton did NOT say. First, he did not say that ICOs would need to be treated the same as securities listed on the National Market System. The disclosure requirements and financial standards for OTC securities, for example vary widely. At the top end, in markets such as the OTCQX market run by OTC Markets, the disclosures and financials are relatively strict, but at the bottom end of the market, in the “pink sheets,” the requirements are relatively lax. It is hard to understand why ICOs should have problems meeting those standards, depending on the size of the offering, so it is hard to see why this should cause a huge uproar. (Perhaps the security regulations requiring that initial investors and founders need to hold newly issued securities for 12 months is troubling, but should not be a problem considering that it is early stage investing.) This is particularly true considering Mr. Clayton’s past commentary on his desire to preserve innovative methods of investment.
Second, he did NOT say that all ICOs are EQUITY securities, which is a good thing, since that would not have been accurate. In fact, many ICOs represent something quite different than an equity, as they do not represent stakes in an operating business. That was the distinction made by the DAO release, and it is correct. There are at least two types of ICOs that should be allowed, but do not fit the equity model. First, are use or “utility” tokens that are essentially a method for a company to “pre sell” their products or services. In this type of token, it can either be consumed upon use, or exchanged back to the company for goods or services. As an example, imagine for a moment that Amazon, in 1999, did not have access to the convertible bond market to finance their distribution network. If ICOs were an available financing method at that time, however, they could have offered “prime tokens” for $40 each that would entitle the holder to redeem them to Amazon for a year of Prime. Now, in this hypothetical, time travelling example, Amazon was better off by raising $2 billion and then charging $69 a year for Prime, but it is easy to see examples of companies who would be willing to do this. More interesting, however, are ICOs based on the value of a NETWORK instead of a company. Before delving into the specifics of this, note that the following example is based on a network that I am currently building for CoinRoutes, and does not represent all or even the majority of ICO network projects.
The phrase “network effect” is well understood to be defined as enhanced performance for clients of a network created by the growth and utilization of the network itself. Many industries have examples of businesses that strive to achieve “network effects” where their customers get better value, pricing, or service levels because of the information value in the network that company built. Now imagine a situation where a company, that built the best network realizes that it can only extract a finite percentage of value from it due to the impossibility (and illegality) of achieving a monopolistic 100% market share. They would also realize that despite a superior network design, it will be limited based on its lack of access to competing networks. As a result, they decide to monetize the value of their network instead, by offering its competitors access, in the form of tokens sold in an ICO. This allows them to both monetize the value of the network, and to participate in the appreciation of network value, if they hold onto some of the tokens. In that case, everyone wins. The company monetized the value they created, competitors get the benefit of offering services on a better network, and consumers gain the benefit of superior service, all without the “cost” of a monopoly. This can be accomplished by leveraging the blockchain “proof of stake” technology. This new paradigm would work by requiring that competitors “lock up” a large number of tokens while they utilize the network to establish their own offering. In this way, network effects can be maximized, and companies would be rewarded for it.
The downside to this model is that securities laws are not ready for it. In this case, the network is not an operating corporation, has no individual board of directors or others to regulate, so the equity rules don’t apply well. That should not matter, since a unique value of this concept is that the network can self-regulate. Pre-determined rules are encoded into “smart contracts” that execute on the blockchain. These rules may contain voting and other governance mechanisms, but the key point is that violation of those rules by network participants that are using the network to offer services could subject them to loss of the tokens they locked up for “proof of stake” that enabled them to act as privileged gateways on the network. Certain equity-like rules still make sense, such as those against fraudulent representations of the network by the ICO sellers, but financial reporting requirements or individual operating accountability rules will require adjustment. The best approach, therefore, for regulators to take, is to focus on rules to improve transparency and disclosures in a cost- effective manner. This is true for ICOs, and for OTC equities, crowdfunding, and most other investment vehicles. What would be truly sad is if overzealous regulators created artificial barriers to innovation, based on fear of the unknown, or worse, the lobbying of those that become disintermediated.