Is the United States at risk of falling behind the rest of the world in cryptocurrency regulations? Are we missing an opportunity to become the leaders in initial coin offerings (IOCs) and other disruptive ideas? Will the flood of capital and crypto innovation move permanently overseas?
The “father” of the JOBS Act, David Weild IV, believes that the US still has time to act without missing any long-term prospects in the crypto space. Weild, the founder of investment banking firm Weild & Co., made these remarks at an event called The Future of Exchanges – Securites & Tokens in 2018, which was sponsored by BlockHous.
The US still has the world’s largest capital markets, Weild insisted, which is very attractive for any company looking to raise money. The former vice chairman of the Nasdaq stock exchange also noted that the US markets are the most transparent and our legal system offers the best fraud protection that is unavailble overseas. Considering that almost 10% of all the funds raised in ICOs has been lost or stolen, having strong legal recourse will be important to the many US investors that new ICOs will want to reach.
Utility Token Bootleggers
But what about all of the crypto activity that US citizens have been engaged in up until now? Could any of their actions be considered illegal retroactively once regulations are passed?
Ralph Daiuto, Jr., COO and General Counsel for tZero, who was also on the panel, warned that the SEC will consider most ICOs to be securities, even though the companies selling them claim they are just utility tokens. He used the exmple of a company that was running an arcade and selling tokens to use in it. If the arcade actually exists, then they are utility tokens. But if the company is relying on the sale of tokens to raise the necessary funds in order to build the arcade, then they are actually securities and the issuance and secondary trading of these tokens must be compliant with federal securities laws, he concluded.
Weild compared US citizens who buy ICOs or trade cryptocurrencies to bootleggers from the 20’s and 30’s who illegally brewed their own whiskey and were always on the lookout for government agents. Fast forward almost a century and we now have digital bootleggers all hoping for the repeal of Prohibition, he described.
Agreeing with Daiuto’s opinion on ICOs, Weild added that any firm selling tokens to finance their development was “dead on arrival” if they do not register them as securities with the SEC. These could be any of the approved options under the JOBS act, he explained, including Reg A+ or provisional S-1.
You could also try and find an exemption from registration such as Reg D 506(c), which allows selling securites to accredited investors, he noted.
A lawyer in the audience, who asked not to be named, explained that while there are theoretical and technical reasons that cryptocurrencies are not securities, the SEC has not weighed in on the matter. They recently refused to say definitively that the most popular cryptocurrencies, such as Bitcoin, Ethereum or LiteCoin, are not actually securities. But if they are securities, then who is the issuer?, he asked. You can not call Satoshi if you have a problem with Bitcoin!
Weild pointed out that none of the online exchanges that people are using to trade cryptocurrencies are sanctioned by either the Commodity Futures Trading Commission (CFTC) or the SEC, which means that they are operating outside the US legal framework.
And it is not just the CFTC and the SEC that you need to worry about, Weild noted. It will not be easy to avoid prosecution from the 50 state regulators. They’re just getting warmed up, he believes, and they have a strong incentive to make an example out of any offerings where investors lose money.
The law of large numbers, there are a lot of firms to choose from
What will enforcement pattern look like? To better understand this, you need to put yourself in the regulators shoes, Weild suggested. They have to pick their targets carefully since Congress appropriates their budgets and they don’t want to be brought before a committee to have to explain their actions. Regulators are risk averse, he stated.
The most agregious offenders will get hit first, Weild proposed. if you perpetrated a fraud, if you induce people because there are material ommissions, you’ll b eon the receiving end of an enforcement act.
Not adequate information and discussion of risk factors in white paper of your ICO ends badly and people lose money.
What is the difference between a company raising money on Kickstarter and one raising money on tZero through an ICO? Should the SEC shut down Kickstarter? Why is selling a digital object prohibited but selling a physical one alllowed?
Companies on Kickstarter are not selling anything that could be characterized as a security, Daiuto observed. Since Kickstarter is a platform for companies only to sell physical objects, the regulators will probably give them a pass, Weild agreed.
Just last week, Switzerland’s regulatory authority introduced a new set of cryptocurrency regulations. The Swiss Financial Market Supervisory Authority (FINMA) has classified the crypto regulations into three broad categories:
- Asset tokens are the crypto version of stocks and bonds where the tokens represent “assets such as participations in real physical underlying, companies, or earnings streams, or an entitlement to dividends or interest payment”.
- Payment tokens are the actual cryptocurrency, which can function as a store of value and a medium of exchange.
- Digital tokens are “intended to provide digital access to an application or service”.
According to another member of the audience, the financial authorities in Israel are going to leverage the FINMA rules for their own crypto regulations. Why is the US so slow to define token categories? Will the smart money move to Switzerland and Israel?
There are over $30 trillion of equity assets in the US capital markets, Weild pointed out, and this massive asset pool needs to be protected. Our regulators are not worred about being first with new regulations, they are worried about being right and minimizing risk, he emphasized.
Gibralter has already rolled out an exchange with an accredited process, stated another lawyer in attendance. But will they get into the security token business? For American investors, 80% of the ICOs this year are going through the SAFT process.
There will be an Enron moment at some point over the next 18 months, the lawyer predicted. An ICO that raises $100 million or more will run straight into a wall and collapses with all of the funds being lost. And that’s when regulation will step in.
SAFE vs SAFT
If you launch your ICO utility token using a SAFT would it be safe from the SEC?
It depends on the issuance, since it would be a security to start and some people believe it could become a utility token at the end of the process. Weild disagreed and stated that using money from investors who have an expectation of profit will be treated as a security. Just because you have a SAFT doesn’t “cure” your utility token or save you from SEC regulations, he advised.
Weild does not see SAFTs as being particularly novel from a securities standpoint.
Once crypto securities are approved by US regulators, it will result in new questions regarding different the settlement times between traditional securities and crypto.
One issue raised was regarding securities issed by tZero. These include a traditional equity issue as well as preferred stock along with their own blockchain-based security which is a rights offering that allows investors to purchase additional preferred shares.
Will there be arbitrage opportunities between traditional (also referred to as analog) securities that settle T+3 and crypto securities that can settle immediatrely (T+0)?
Daiuto explained that in the case of Overstock’s crypto security, the trade is the settlement, so it clears and settles the same day without requiring the DTCC to be involved. Overstock, which was one of the first online retailers to accept Bitcoin payments, launched their token as a rights offering which trades on the tZero platform and is not fungible. Their preferred stock trades on the OTC market, so there would not be any arbitrage because they are not interchangeable securities, he insisted.
Could the rights offering be traded on a secondary market? Would it be possible to get an aftermarket exception to Blue Sky rules?
Such securities could trade in the OTC market if they receive an exception using the original distribution, but only if the orders are unsolicted, Weild proposed. But they would not be exempted in any aftermarket exchanges.
tZero vetted this offering with FINRA, according to Daiuto, and they believe there are no issues with it. There seems to be some confusion, at least among the audience for this panel, as to the differences between Overstock’s analog and digital blockchain-based preferred shares.
Since the blockchain-based shares are not fungible, you cannot directly trade them for other securities, Daiuto responded. They must first be sold and then the prioceeds can be used to purchase analog securites, he stated.
How will tZero compete with international exchanges that have better regulatory guidance?
tZero is running a concurrent Reg S offering for investors outside of the US, Daiuto noted, and they are also licensing their technology to strategic partners. tZero expects to help shape international crypto exchanges, he predicted.
The company says their offering will allow shareholders to purchase shares of its preferred stock, including shares to be traded exclusively on the registered alternative trading system (ATS) using the t0 issuance and trading platform.
Is there any opportunity for ICOs of utility tokens?
Weild believes there will be opportunities for utility tokens, as long as the company is not selling them to raise capital. He gave the example of company he is working with that is building a digital marketplace for advertising. If they built their platform using non-ICO investments, they could distribute utility tokens to strategic partners who could then make use of them in the marketplace.
An anonymous source at the SEC had informed one of the attorneys in the audience that so many people are trying very hard to find novel ways to conclude that their tokens are not securites. What they should be doing, he proposed, is instead trying to find ways to be compliant.
Crypto Transfer Agents?
Do securities that trade on a blockchain require a transfer agent?
All physical securities that trade on a national exchange require a transfer agent according to the regulations.
What does a transfer agent do besides demonstrating and protecting the chain of ownership of securities? Weild asked.
Does Overstock have a transfer agent that can integrate with a digital wallet? This would be required if they have over 2,000 shareholders.
In December 2016 Overstock launched a public issuance of a digital security with Compushare as their transfer agent. There were only 1,000 investors who put in around a $1 million of notional value out of a $11-12 million offering. However, Daiuto claimed that the dollar amount didn’t matter since the security proved that their ecosystem worked with regulatory guidance around it.
SEC vs CFTC
Historically, the various US financial regulators have not cooperated and often clashed over jursidiction, Weild explained. But we have seen examples of how crisises can bring them together.
It took the 2015 Flash Crash to force the SEC and CFTC to begin a more constructive relationship, Weild commented.
While the CFTC is clearly in charge of futures, derivatives and commodities (including currencies), the SEC is in charge of securities. Regulators will work together to divide up enforcement responsibilites for cryptocurrencies, Weild believes.
A member of the tZero compliance team worked at the CFTC for 15 years and was head of enforcement during the Financial Crisis, Daiuto noted, and they believe that the agency is planning to regulate all cryptocurrencies as commodities, he stressed.
The Future of Custody?
Many of the larger institutions will not enter the custody market without a exemption for state Blue Sky laws, Weild believes. This is required to help shift some of the $30 trillion in US equity assets into tokens, he stated. Otherwise, average investors will be too afraid to invest in cryptocurrencies.
Large custodians banks are wary of crypto since their custody spreads are very thin and they don’t understand the technology.
The custody issue will resolve itself over time, Daiuto proposed. Many firms will dip their toes in the water to provide custody. There are some transfer agents that believe they would be a good custody location for digitial assets. To support their own custody and clearing, Overstock purchased a 25% stake in Pro Securities LLC, a New Jersey-based broker-dealer.
No institution wants to be first crypto custodian, Daiuto emphasized. There will be a consortium of banks and insurance companies and other firms will get involved, he stated.