SEC’s Warning Shots Over ICOs

This article was written by Adinah Brown from Leverate.

The recent spate of initial coin offerings (ICOs) has drawn the attention of the US financial industry’s regulatory body FINRA, warning about the potential risks to anyone that purchases the coins.

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A bulletin from the Securities and Exchange Commission (SEC) highlighted the issue in the following terms. “Investing in an ICO may seem like an exciting way to be a part of the virtual currency and blockchain startup markets, but buyers should use caution when considering these complex investments,” said Gerri Walsh, FINRA’s Senior Vice President for Investor Education.

“ICOs involve new technologies and products that are highly technical and can be used by con-artists as an opportunity to dupe investors”. At the core of the issues is the structural issues associated with ICOs. Whilst an IPO is registered by the SEC, an ICO provides no such protection.

Investor protection, or lack thereof 

A second critical issue is that it can be unclear what the ownership of the coin purchased confers. For an IPO, the person who makes the purchase is taking ownership of a share of the company. This provides a tangible and more importantly, quantifiable stake. The ownership is backed by a physical share certificate that is registered in a share registry.

A purchase of a coin via an ICO does not necessarily give the holder of the coin ownership rights, although this can often be the nature of the purchase. However, it can often simply be seen as a method of funding, whereby the ownership of the coin itself is the value, similar to how money works.

However, with actual currency, there is a market where the money can be used to purchase goods. The amount of coins are controlled by a central bank which is tasked with maintaining inflation and the ongoing strength of the economy. With a crypto-coin, although usually considered de-centralized, the de-centralization of the coin is more in relation to the users of the coin, rather than the issuing entity.

Generally the coin is monitored by a single entity, usually whichever entity that established the ICO (albeit, its creators, or miners are internationally dispersed). Unlike a central bank whose purpose is to maintain a steady control over inflation, the purpose of ICOs is to raise funds. Therefore, as long as the sale of coins have a market, the issuers will have an interest in selling them, potentially diluting the value.

‘Smart’ contracts

That is not necessarily the case with all cryptocurrencies, as many have an inbuilt maximum designed to give the coins a continued value, with Bitcoin a prime example. However, the more recent issues of cryptocurrencies are not necessarily designed to mimic a financial system like Bitcoin.

Ethereum for example, has been created to allow ‘smart contracts’, effectively to create an efficient system of ownership transfer. Whilst maintaining the value of Ethereum coins is important, it is not essential.

There are a few other aspects that add risk to the purchase of coins from an ICO. Many of the ICOs are tokens issued by startup companies to help fund their own cryptocurrency software. since ICOs are  related to a product and a company, a deep understanding of the company would help the purchaser know the long term prospects of the company and software.

Since these companies are generally not listed as a public company, they are not subject to public disclosure requirements, making the research process challenging. Since the ICOs do not confer ownership this is less of a concern, but should a company not develop the software, the tokens will be useless.

Issues of cybersecurity should also be at the forefront of the minds of those purchasing coins. It is possible that the company has poor cybersecurity, meaning that the coins are easy to steal, or worse, allow attacks on your personal information.

Issues surrounding how to get your money back, what rights are conferred with the coins and how the coin issuance is structured are key elements that also need to be investigated. In most cases there is no requirement for an ICO to address any of these issues, since there is no process for financial regulation.