Are Most Cryptocurrencies Doomed to Collapse — because they’re “ICO-issued”?

Cryptocurrencies that were issued via an ICO^* might be doomed to waterfall collapse.

I will explain in detail that this is because illegally issued investment securities are illegal to trade (even on registered exchanges). Or even if legally issued, it’s illegal to trade legal securities on unregistered (including decentralized) exchanges, thus (eventually) rendering every “ICO-issued” cryptocurrency (including Ethereum, NEO, Qtum, Dash, NEM, Stratis, IOTA, Lisk, Waves, EOS, Steem, PIVX, Tezos, etc.) non-fungible, effectively not legally tradeable, and thus (eventually) not plausibly functional for use as decentralized cryptocurrencies! 😲

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UPDATE: 2 days after this blog was published the collapse was imminent and has now begun as China has declared ICOs illegal and all funds raised thus far must be refunded, with the SEC expected to follow!

As well South Korea, Russia, Hong Kong, and Canada also announced warnings or enforcement against ICOs. The UK is also contemplating regulating ICOs.

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Then I’ll posit an idea (other than proof-of-work) for how to issue tokens which avoid securitization. I’ll also debunk some of the illogical theories that claim fungible ICO-issued token sales aren’t investment securities.

Note in the past, I had started afaik the original and most detailed discussion thread about whether ICOs are investment securities.

^* _{The SEC wrote, “…offers and sales of digital assets by "virtual" organizations are subject to the requirements of the federal securities laws. Such offers and sales, conducted by organizations using distributed ledger or blockchain technology, have been referred to, among other things, as ‘Initial Coin Offerings’ or ‘Token Sales’.”.}

Warning Shot Across the Bow

From August 28 to 30 the price of NEO plummeted 15% within a “few hours” (and -20% overall), presumably because it was announced that they wouldn’t be issuing tokens to Chinese citizens due to tightening regulations on fundraising in China and the possibility of an executive order suspending ICOs in that country.

However, speculative investors apparently aren’t totally spooked yet, because they probably (incorrectly) presume that the (unregistered?) issuance of NEO tokens in other jurisdictions can be traded on exchanges ongoing.

UPDATE: apparently enforcement warnings have already begun in the USA! And China is reportedly very close to taking action.

SEC’s “Hidden” Warning

I believe the SEC has foreshadowed upcoming enforcement actions and already warned about their methodology.

As quoted below, the SEC has reminded and cautioned that even legally issued (i.e. registered with the SEC or exempt from registration) securities must be sold only on exchanges which are duly registered or have an exemption; and illegally issued securities may not be offered for sale nor sold. Hence I presume decentralized exchanges of securities will be always be illegal, because afaics a decentralized system (i.e. which no one controls) can’t register itself and comply with the SEC — yet cryptocurrency tokens which aren’t securities could in theory be legally traded on decentralized and unregistered exchanges.

I presume based on the following SEC quotes that enforcement will include freezing on centralized exchanges, the tokens which were (thus illegally) issued as unregistered, non-exempt securities. And possibly also highly publicized prosecutions of individuals (especially the market makers who provide the liquidity required for exchanges to function well) who have (thus illegally) traded (legal or illegal issued) securities on (thus illegal) unregistered (including decentralized) exchanges:

SEC’s report on the DAO investigation wrote on page 2:

In addition, any entity or person engaging in the activities of an exchange must register as a national securities exchange or operate pursuant to an exemption from such registration.

And wrote on page 10:

Thus, both Sections 5(a) and 5(c) of the Securities Act prohibit the unregistered offer or sale of securities in interstate commerce. 15 U.S.C. § 77e(a) and (c). Violations of Section 5 do not require scienter.

And wrote on page 11:

DAO Tokens Are Securities

And wrote on page 16:

Because DAO Tokens were securities, The DAO was required to register the offer and sale of DAO Tokens, unless a valid exemption from such registration applied.

Moreover, those who participate in an unregistered offer and sale of securities not subject to a valid exemption are liable for violating Section 5 … “The prohibitions of Section 5 … sweep[] broadly to encompass ‘any person’ who participates in the offer or sale of an unregistered, non-exempt security.”

Section 5 of the Exchange Act makes it unlawful for any broker, dealer, or exchange, directly or indirectly, to effect any transaction in a security, or to report any such transaction, in interstate commerce, unless the exchange is registered as a national securities exchange under Section 6 of the Exchange Act, or is exempted from such registration.

The SEC decided to take no action against The DAO or its tokens on exchanges, “but rather to caution the industry and market participants”, presumably because as they wrote on page 9, the tokens were reverted to ETH and The DAO disbanded (analogous to the resolution of the SEC’s investigation into Erik T. Voorhees after he agreed to return all the investments):

On July 20, 2016, after a majority of the Ethereum network adopted the necessary software updates, the new, forked Ethereum Blockchain became active. The Hard Fork had the effect of transferring all of the funds raised (including those held by the Attacker) from The DAO to a recovery address, where DAO Token holders could exchange their DAO Tokens for ETH.

And as stated in footnote ¹ on page 1 and ³⁸ on page 14, the examination of whether The DAO was an “investment company” and whether its participants were “investment advisers”, wasn’t pursued because the funding operations of The DAO never commenced.

My stance is that now the SEC has warned everyone. Thus anyone who continues to offer for sale or sell ICO-issued tokens (unless the tokens were legally issued and are only ever^* traded on an exchange registered with the SEC or if the individual is not a US citizen then exchange registered with regulators in his/her jurisdiction) is willfully (even arrogantly) violating the clearly advertised law and can be culpable to retroactive enforcement action in the future.

Tl;dr: never hold nor touch ICO-issued cryptocurrencies. They can destroy you.

^* _{Thus the lineage of the trading of the tokens destroys fungibility because it would need to be recorded in the lineage which registered exchange each token spend was made on, because every spend was potentially an exchange until it is proven it was a spend for goods or services. IOW, the implication is that ICO-issued tokens (even if legally issued) can’t legally function plausibly as decentralized cryptocurrencies! Yikes! 😲}

Multi-Pronged Enforcement

In the prior section, I explained that the SEC has provided a warning about the applicable law and the possible enforcement actions that may be coming.

They also stated that the enforcement actions they may undertake will not necessary recover funds for all the afflicted investors:

_{Law enforcement officials may face particular challenges when investigating ICOs and, as a result, investor remedies may be limited. These challenges include:}

• _{Tracing money. Traditional financial institutions (such as banks) often are not involved with ICOs or virtual currency transactions, making it more difficult to follow the flow of money.}

• _{International scope. ICOs and virtual currency transactions and users span the globe. Although the SEC regularly obtains information from abroad (such as through cross-border agreements), there may be restrictions on how the SEC can use the information and it may take more time to get the information. In some cases, the SEC may be unable to obtain information from persons or entities located overseas.}

• _{No central authority. As there is no central authority that collects virtual currency user information, the SEC generally must rely on other sources for this type of information.}

• _{Freezing or securing virtual currency. Law enforcement officials may have difficulty freezing or securing investor funds that are held in a virtual currency. Virtual currency wallets are encrypted and unlike money held in a bank or brokerage account, virtual currencies may not be held by a third-party custodian.}

So the above can be interpreted as a warning that when in an enforcement action the SEC freezes illegally issued cryptocurrencies on centralized exchanges and files illegal trading cases against some who traded the afflicted tokens, the resultant collapse in the price can impact investors who hold the afflicted fungible tokens in private wallets and exchanges outside the SEC’s enforcement reach. IOW, the SEC can cause a conflagration in the global market price for afflicted cryptocurrencies, even though the SEC can’t freeze every private key and exchange in the world.

And indications are the SEC’s action will be eventually matched by similar enforcement in China, Russia, Europe and other jurisdictions such as Japan, Singapore, the Philippines and Canada, which are also advancing their securities law and/or exchanges regulation ostensibly in preparation for G20 coordinated actions. Analogous to how the USA was able to effectively force the FATCA, KYC, and AML regulations to be applied globally, similar results will likely be achieved in enforcement of securities regulation. G20 governments won’t willingly relinquish their regulation power over capital controls, seigniorage, money issuance, and finance.

Many cryptocurrency speculators think they’re outside the reach of TPTB of the G20, yet I predict their hubris will be shattered as always for those whose flippant middle finger is more active than their rational due diligence and pre-frontal cortex.

ICOs Are Securities

Every token ­— issued in exchange for something of value paid to the issuer,^* wherein the issuer is involved in the ongoing managerial or entrepreneurial duties which provide for the investors expectation of profit — is an investment security as so defined in the Supreme Court’s Howey Test:

• Investors in The DAO Invested Money
  …
• With a Reasonable Expectation of Profits
  …
• Derived from the Managerial Efforts of Others
  …
  ^{The central issue is “whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.”}

Another summarized it was follows:

1. It’s an investment of money
2. There is an expectation of profit
3. The investment of money is a common enterprise
4. The profit comes solely from the effort of the seller or third parties

Another explained that marketing arguments about “use value” are irrelevant obfuscations of the economic reality:

“With the expectation that they would earn a profit solely through the efforts of the promoter or of someone other than themselves,” the purchasers of Howey’s citrus-laced acres entered the hazy territory of investment contracts … As such, the ruling birthed the Howey test, a simple criterion to determine the purview of SEC jurisdiction over securities. “If that test be satisfied,” wrote Justice Murphy, “it is immaterial whether the enterprise is speculative or nonspeculative, or whether there is a sale of property with or without intrinsic value.” What matters is whether “the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.” A security has been sold, in other words, when the value of one’s transaction hinges on another’s work.

The term ‘security’ applies because the investors depend (i.e. are secured by) on the ongoing management or entrepreneurial duties of those who were funded by the value transferred to the issuer; thus, forming an implicit “investment contract”. Given there are humans securing an expected outcome, there’s opportunity for fraud and scams which deceive those investors’ expectations. This is why the governments are tasked with regulating the issuers of investment securities, because investors do eventually get defrauded and complain, e.g. The DAO.

The only way to avoid cryptocurrency tokens being classified as investment securities is if at least one of the following applies:

• No seigniorage for those who have managerial or entrepreneurial duties that fulfill the expectation-of-profit, i.e. no privileged participants funded by transfer of value to issuers.^*

• No expectation-of-profit by buyers of tokens for some (not yet invented) reason. Note that issuance on registered crowdfunding sites doesn’t necessarily eliminate the expectation-of-profit, e.g. the Rimbit scam issued on Indiegogo.

Tokens issued by competitive proof-of-work aren’t investment securities, because there’s no seigniorage on issuance transferred to those who have some managerial or entrepreneurial duties that fulfill the expectation-of-profit.

But sneaky (e.g. Dash, Bytecoin’s houdini scam, NEM’s scam airdrop, Decred’s scam airdrop, Byteball’s scam airdrop, etc) or stealth mined (e.g. Steem) issuance which is intentionally non-competitive, is just an obfuscation of the economic reality that tokens are then sold by this exclusive group to investors as securities because the expectation-of-profit depends on that exclusive group’s ongoing managerial or entrepreneurial duties! Sorry but I just realized that Dan Larimer was likely mistaken and STEEM tokens are probably investment securities. Yikes! 😲

More explanation is here explaining in detail why sneaky insta- or stealth proof-of-work mining distribution such as Dash, Steem, etc are investment securities. Additionally, Dash’s masternode scam (also in PIVX) by compounding of the initial pre-mine scam and the ongoing distribution of a significant proportion of block rewards to masternodes, enables the insider group to maintain control over the money supply and thus are effectively administered centralized-control ledgers.

Baseball cards aren’t securities, but ICOs are.

^* _{Issuers who — also redeem tokens or transmit monetary value in exchange for issuance instead of either spending the issuance on goods and services and instead of trading the issued tokens on a registered exchange — are classified as “money transmitters”; thus, are required to register with FinCEN unless an exemption applies. Yet this fact is orthogonal to whether tokens are investment securities.}

_{Afaics, the FinCEN guidelines here and here don’t require an individual to register as a money transmitter when the individual employs unregulated (including decentralized) exchanges to trade between tokens that weren’t “ICO-issued”. In the centralized virtual currency case (e.g. all “ICO-issued” tokens), the individual trader (thus acting as an exchanger who must register as a money transmitter and the unregulated or decentralized exchange by definition didn’t do it for him) sells his own virtual currency and is defined with the prerequisite of a centralized administrator (group) doing issuance. Whereas, in the decentralized case the exchanger is defined as facilitating trade between two other parties. This money transmitter issue is separate from other implications of tokens being investment securities as discussed in this blog.}

Pre-mine Without Securitization

Whether a pre-mine is obfuscated (e.g. by a sneaky or stealth proof-of-work) or not, what makes it an investment security (per the Howey Test) is that the tokens are sold to investors who have an expectation-of-profit which depends on ongoing managerial or entrepreneurial duties funded by those who are selling the tokens. I thus logically posit that if the tokens were held back and not sold (i.e. not issued to investors) until the expectation-of-profit no longer relies on such ongoing centralized managerial or entrepreneurial duties, the sold tokens wouldn’t qualify as an “investment contract” and thus not classified as investment securities.

But if the developer needs funding early and can’t wait, I suggest a non-profit corporation could be constituted with shares issued in exchange for investment. The shares (not the eventually pre-mined tokens) are investment securities that may or may not need to be registered depending on if an exemption applies.

The said corporation would develop the software, launch it with a pre-mine of tokens, and hold the pre-mined tokens until the ecosystem became sufficiently diversified such that the investors’ expectation-of-profit no longer depended on the corporation’s ongoing managerial or entrepreneurial efforts. At that point, the corporation could sell the tokens (pay any CGT) and issue the proceeds as a dividend to the investors holding its shares. I thus posit those tokens wouldn’t be investment securities because the tokens were never held by investors with an expectation-of-profit. The investors were dependent on the managerial or entrepreneurial efforts of the said corporation, and they held shares as investment securities for the investment contract. They received as a dividend the profit from the activity of the company.

Note as aforementioned in a section footnote, in an applicable regulatory jurisdiction (e.g. FinCEN), the company would be regulated as a money transmitter if selling those tokens directly (for monetary value instead spending them on goods and services) and instead of trading them on an exchange which is registered as a money transmitter.

Additional tokens to the pre-mine could be issued with some competitive, objective form of proof-of-work (or equivalent), and these shouldn’t be investment securities nor be subject to regulation as money transmitters. If the said corporation was able to earn these tokens as payments in the ecosystem (presuming there’s no coercion), these earned tokens could be distributed to shareholders as dividends without causing them to become investment securities.

Note afaics the said company would not be classified nor regulated as an “investment company” per Sec. 3. Definition of Investment Company on page 17 of the Investment Company Act of 1940.

Refutations of Some Incorrect Logic

Haonan Lin opined:

Contrary to common opinion, this could be good news for the ICO market. The SEC are not trying to kill the ICO model, but rather trying to apply regulation to players in the market that are exploiting consumer ignorance, or launching coin offerings with no intentions to deliver on the promises made.

As I already explained, the problem with that rosy interpretation is that (legally issued) securities can only be legally traded on regulated exchanges.

A token (UTXO) which is a security must have all its trading lineage documented to be sure it doesn’t have illegal trading history that could cause the tokens to be frozen or seized on an exchange by SEC (or securities regulators in other jurisdictions) enforcement action; which is the antithesis of fungibility and ameliorates the cardinal feature of a cryptocurrency: the freedom to transact and spend decentralized without all transactions passing through a regulated exchange. Thus, ultimately (when the SHTF) I can’t see how any token which is classified in law as an investment security can function properly as a cryptocurrency.

Most of the tokens being sold in ICOs today are similar to virtual products. These tokens are designed as a “permission slip” for the use of a protocol. Unlike a pure investment, they have literal functions … Participating in these tokens sales is similar to supporting your favorite program on Kickstarter. These ICOs are less likely to be classified as securities because they are more like selling a virtual product than promoting an investment plan.

Some have incorrectly argued that tokens marketed as only having use value won’t (significantly) have this expectation-of-profit, but the free market of speculators will expect appreciating value for tokens. Any token which the purchaser assumes will become traded on exchanges has an implicit speculative expectation-of-profit regardless of any marketing to the contrary. And since there are 100s if not 1000s of shitcoins that trade on a plethora of exchanges, it’s afaics impossible to reasonably argue that purchasers of blockchain tokens aren’t doing so for speculative expectations of profits. Even if the tokens were sold on a crowdfunding site to people who didn’t know about virtual currencies speculation, the savvy speculators (always scouring for a “hiding” opportunity to buy low and sell high) will find that crowd-sourced ICO and speculate on it.

The second type is purchasing certificates for the future expectation of a functional app coin. The only effort made by the coin’s team is to make sure that the whole network is operating properly. The team did not spend any effort on creating profit.

This is almost analogous to what I proposed in my prior section, but only if the “app coin” is not transferred until after the coin’s team (the issuer) has stopped/completed doing development efforts (or those efforts diluted by ecosystem participation) which the market depends on for the expectation of profit on the appreciation of the “app coin”. And I argue the “app coin” must be sold by the non-profit company which is doing those development efforts only after stopping/completing its development efforts (or so diluted as previously state); and then distribute the proceeds of the said sales as dividends. Transferring the “app coins” directly as dividends instead of selling them may convert them to securities.

After a purchase of NEO tokens through the ICO, a certain amount of NeoGas (app coin) is sent to the designated blockchain address.

As I explained, that doesn’t meet the requirements for not being an investment security.

BitTrust summarized Coinbase’s securities framework document:

The upshot of this framework is that blockchain tokens, if designed properly, should be deemed as a simple contract, equivalent to a franchise agreement. By this measure, the analogy is fitting: holders of blockchain token are granted rights to contribute to a larger system, “rather than through a passive investment interest.” The advantage of classifying Dapp tokens as a simple contract disentangles token ownership from the legal complexities of holding a security.

Tokens which are under some form of contract (e.g. “franchise agreement”) are subject to regulation on disclosures, and will be required to trade on regulated exchanges so that regulators can enforce that the disclosures have been made. This then ruins the fungibility for these tokens as I already explained. That is the antithesis of a cryptocurrency, which much be allowed to transact decentralized when it is spent.

Besides regardless of the intended agreements, speculators will speculate on an expectation-of-profit.

I will react to a few quotes from that framework’s paper:

A white paper defines the network and its use cases. It is critical for buyers to be able to understand the characteristics and functionality of the token they are buying, the challenges and risks of development, and the benefits of using the network.

Irrelevant. Fulfilling disclosure requirements for securities, doesn’t impact the 3 aspects of the Howey Test which determine whether the tokens are investment securities.

A clear development roadmap gives buyers confidence that the proceeds of the sale will be properly used for the project and that the network will be launched, meaning that they will be able to use the tokens as intended.

Ditto irrelevant.

Enabling real and meaningful participation in the network from a diverse set of independent parties may also strengthen the arguments against the second and third criteria of the Howey test, because participants are less reliant on the initial developers.

Agreed, but unless the initial developers cease their efforts to prove otherwise, the presumption is the speculators would have much lower expectations of profit if the initial developers exited. Unless reasonable observers appraise that the ecosystem is sufficiently diversified.

Decide on the percentage of the total token supply that represents a fair reward for the work of the development team and advisors.

Can’t be objectively measured. There’s no way to prove how much of the ICO was insiders buying from themselves.

Principle 6: Avoid marketing the token as an investment

Smoke & mirrors don’t change the economic reality, as I already explained. The Supreme Court stated in the Howey Test decision, that any obfuscations of the economic reality are irrelevant.

We generally believe that a Blockchain Token with one or more of the following rights likely should not meet the definition of security (nonsecurity Blockchain Token):

Tokens which are under some form of contract (e.g. “franchise agreement”) are subject to regulation on disclosures, and will be required to trade on regulated exchanges so that regulators can enforce that the disclosures have been made. This then ruins the fungibility for these tokens as I already explained. That is the antithesis of a cryptocurrency, which much be allowed to transact decentralized when it is spent.

Besides regardless of the intended agreements, speculators will speculate on an expectation-of-profit.

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_{Disclaimer: IANAL so readers shouldn’t interpret this blog as legal advice. This is my opinion shared as creative endeavor for your entertainment and to stimulate discussion.}