Volatile cryptocurrencies require regulation, but regulators face many questions about how to do so.
History may not repeat itself, but it clearly does rhyme. During the dot-com bubble, Board of Governors of the Federal Reserve System Chairman Alan Greenspan famously observed that investors were the victims of “irrational exuberance.” This observation is evidently the case with cryptocurrencies today.
A recent study suggests that the “vast majority” of initial coin offerings (ICOs) are in fact fraudulent schemes. But where stocks are regulated by the U.S. Securities and Exchange Commission (SEC), and commodities by the U.S. Commodity Futures Trading Commission (CFTC), cryptocurrencies lack an effective regulatory body. This absence suggests the need for new institutional governance that properly understands the technical and economic issues driving cryptocurrencies.
As the range of ICOs has broadened and deepened, many new and established companies have begun exploring opportunities for using ICOs as a means to fundraising. Indeed, the main driver of ICOs has been global access to investor funds. Consider, for example, that the messaging app Telegram raised $1.7 billion in March of this year. The capacity to tap a liquid market without the need for intermediaries has provided a wide range of new and established companies with deep pools of capital.
Regulating ICOs. Market valuations of cryptocurrencies remain wildly erratic. The price of bitcoin, for example, recently increased to almost $20,000 only to quickly fall to less than $7,000. With the rise of ICOs, the SEC has signaled its concern about the potential for fraud, a logical conclusion given the enormous growth of coin-related ICOs over the past two years. Five years since the very first ICO, coin offerings have raised close to $6 billion. In fact, the total market capitalization of crypto assets currently stands at about $221 billion.
The most pressing concern for the majority of regulators is eliminating the use of ICOs for money laundering and terrorism. Although critics debate the legitimacy of these concerns, governments nonetheless struggle to author guidelines for regulating the use of cryptocurrencies. Most government regulators are concerned about precisely how to classify ICOs and therefore how to govern and tax them.
On the enforcement side, there are an increasing number of class action lawsuits brought against companies involved in ICOs. Tezos, for example, raised $232 million last year only to face allegations of securities law violations and investor fraud. Selling unregistered securities can mean significant fines and even prison sentences leading some companies to bypass the U.S. market altogether.
The challenge for regulators lies in properly classifying the range of cryptocurrencies that exists. Many analysts argue that cryptocurrencies represent an entirely new asset class. This classification may be true of tokens that function like securities, but it is clearly true of so-called utility tokens. Broadly speaking, utility tokens are defined as having some utility apart from or in addition to their value as an investment. The main argument supporting utility tokens is that they do not qualify as securities under the Howey test because they do not qualify as a common enterprise based upon an expectation of profits from the efforts of others.
The problem with strictly classifying all tokens as securities is that they can simultaneously function across multiple categories: as currencies, as instruments for betting or voting, or as traditional securities. In fact, multiple agencies view cryptocurrencies differently. Although some regulatory agencies define cryptocurrencies as monetary equivalents, others define them as digital goods or commodities, or even taxable property. To be sure, a global legal vacuum exists around cryptocurrencies because they do not always precisely fit the traditional definition of an “investment contract”.
Diverging Regulation. Forecasting future SEC guidance in the United States is difficult, but the common view is that the vast majority of ICOs are subject to U.S. securities laws. A sporadically aggressive posture by the SEC has served as a red flag to early-stage companies that might seek to raise funds through the sale of tokens. Although it is true that a legal framework for overseeing ICOs is slowly starting to take shape, most governments are not entirely sure how to manage the space.
One growing fear is that overregulation will undermine innovation by suppressing risk-taking. The rapid ascendancy of ICOs and their ability to raise funds for budding start-ups has radically democratized access to capital in new and innovative ways. This suggests the need for a different set of regulatory obligations specifically designed to allow smaller cash-poor companies to raise funds from a wide range of funders.
Currently, there are roughly three broad types of regulatory systems overseeing ICOs: closed, like in China; open and strict, like in the United States; and open and liberal, like in Switzerland. For many governments around the world, the emphasis is on consumer protection while at the same time enabling legitimate businesses to flourish. Gibraltar, for example, licenses some crypto-companies, while France is working on a system of voluntary licensing.
Although various governments around the world hold widely divergent views on ICO regulation, the writing is on the wall: The broad shift from hard cash to digital currencies is a long-term global trend that neither financial institutions nor government regulators can simply ignore.
The Blockchain Revolution. The truth is that the blockchain technology undergirding cryptocurrencies is revolutionizing many parts of the banking and financial sectors. The value of the blockchain is that it provides a distributed ledger, enabling guaranteed access to an identical copy of encrypted ledger data. Many early-stage companies around the world are now vying to leverage distributed ledgers to streamline public sector functions, including identity management, health care, and real estate.
In fact, the World Bank and the Commonwealth Bank of Australia have recently issued public bonds exclusively through blockchain technology. Indeed, Estonia has emerged as a global leader in leveraging blockchain to digitize governance. Estonia’s digital infrastructure is built on an open-source backbone, which the country first instituted in 2001.
The Future of ICO Regulation. Despite attempts at regulation offered by governments around the world, the rise of cryptocurrencies remains a problem. The U.S. approach to regulating the industry has been to work with its current laws rather than introduce new ones. This approach has been arguably short-sighted. The vacuum in effective regulation has ensured that market manipulation remains a very real risk. Without some degree of protection for investors, for example, this has meant that institutional investors remain on the sidelines, limiting the size of the market.
Many entrepreneurs remain afraid of punishment by the SEC for naïve mistakes. Meanwhile, regulatory uncertainty limits the kinds of investors pursuing cryptocurrencies. This trend may be changing, but it will require some creative solutions to regulate the market. These solutions include better policing to reduce the number of phony ICOs, developing effective regulations through coordination between government and industry, developing proper assurance systems to protect investors against fraud, and creating institutional grade custody solutions to safeguard crypto assets.
Going forward, we can be sure that ICOs and the cryptocurrency market as a whole will be increasingly subject to regulation. This is a very good thing. Regulating cryptocurrencies will mean that the herd-driven volatility exciting the market will decrease even as the value of cryptocurrencies continues to expand. Nonetheless, the current non-scalability of blockchains means that there remains significant work ahead. Add to this concern the fact that most cryptocurrencies have no intrinsic value beyond speculation, and this leaves room for tremendous disruption ahead.
