Op-Ed: Cryptocurrency Investment Series Part 4: ICOs, Securities, and Intrinsic value

Executive Brief

The last year has seen the ICO become the preferred means of capital acquisition in the crypto industry, with more than one billion dollars of funding raised. While many praise ICOs for their easier access to capital, the SEC has a differing opinion to the many proponents who claim ICOs should be exempt from securities laws that require additional regulatory oversight. Generally ICOs do not issue rights to any equity or future earnings from a project or organization, which begs both a question about intrinsic value, and what mechanism beyond speculative trading could make ICO tokens fairly considered an “investment” or “asset” at all.

Read the full story below. 

In case you've missed them, here are parts one, two, and three of this series: 
Part One - Op-Ed: The Cryptocurrency Investment Series
Part Two - Op-Ed: How Do Cryptocurrencies Become Valuable?
Part Three - Op-Ed: Mitigate Your Risk – How to Invest for Success

The ICO: The latest trend for raising capital

An Initial Coin Offering (ICO) allows organizations to acquire capital more rapidly and easily than selling equity or borrowing to facilitate growth - all at no cost to the raising organization. Instead of issuing ‘stock’ in a company, the issuing organization creates tradeable ‘digital tokens’ and sells them for real money. These tradable tokens allow the purchaser to participate in the economy of the organization's project in some way, and may appreciate in price at a later date.

Proponents of ICOs praise their ability to democratize capital markets by making funding available for innovative projects that otherwise wouldn’t be possible through more traditional VC routes, and for allowing everyday people to invest without meeting minimum wealth and income levels required by law to invest in VC. ICOs have proven popular as a result, with more than $1 billion dollars in funding raised through them this year. In ICO land, getting Series C level funding in the seed round is commonplace, and tens of millions of dollars in crypto are frequently being given to organizations offering little more than a couple of statements regarding what they might to do in the future.


ICO as a security?

Many ICO proponents and issuers consider them the blockchain ecosystem’s ‘kickstarter’ or crowdfunding vehicle for businesses, and that by being ‘donations’, ICOs do not meet the Security Exchange Commission’s (SEC’s) classification as a security - but the SEC disagrees. Late last month the SEC clarified that Decentralized Autonomous Organizations (DAOs) like the one that raised $150 million on the ethereum network last year are securities, and that all other ICO operators should be mindful that the SEC is watching.

The SEC uses the Howey test to classify whether a money transfer counts as a security, each of them can be reasoned without much difficulty.

Howey test:

     1. It is an investment of money [or other investments]
     2. There is an expectation of profits from the investment
     3. The investment of money is in a common enterprise
     4. Any profit comes from the efforts of a promoter or third party

Points one, three, and four should be pretty straight forward in the affirmative, but many hold the view that point 2 fails because the tokens bear no claim of equity nor future profits from the project or organization, and that this makes an ICO a crowdfunded ‘kickstarter’ that alleviates reasonable contributor expectations for “gain”. This would sound reasonable were the Howey test about the reality of the product delivered rather than the intention of the investor - but more than 1 billion dollars has been funneled this year into just a handful of ICOs, and this makes ‘purchaser’ intentions pretty clear. Individuals are making very large bids for these tradable tokens, and nobody throws down 100+ thousand dollars, or even a thousand dollars worth of anything just to see a project that they will likely never use come to fruition. ICOs are investments for gain; it is difficult to make the case that any ICO is not a security.


A security without intrinsic value.

The argument that ICOs are ‘donations’ further begs the question regarding what value many ICO tokens may have. The industry standard for ICOs is to have clear statements within Terms and Conditions like [sic] “No Ownership, Revenue or Governance Rights” are awarded to its “investors” - which makes classification of the tokens as an “equity” incorrect, and as an “asset” with any sort of intrinsic value difficult to advocate. Without a claim to future earnings or equity, there is no direct intrinsic mechanism by which an ICO token appreciates in response to a project’s successful development.

For example: a company issues a token that bears no claim to equity in the company, nor against its future earnings. Later, the same company issues a financial report that reveals record profits, and the release of a new R&D project. By what rationale, or intrinsic mechanism should the token also rise in value?

The answer appears to be little more than name association, speculative trading, and sometimes a modicum of increased token usefulness on an issuer’s platform. One issue with service tokens (ones that must be spent to power services on platforms the same way gas is used in a car) is that if they rise in value, the platforms they’re created for become more expensive to use without an adjustment of the network’s fee.


So why invest?

ICO tokens have a speculative value in the same way that cryptocurrencies like Bitcoin do, meaning they have potential to be traded for significant profit at a future date. But caution must be exercised - ICO tokens are usually issued at a fixed price that could be wildly different to its price when later traded on the open market. In contrast, currencies like Bitcoin and Litecoin are purchased a fair ‘market price’. The absence of this price discovery in many ICOs, combined with a lack of intrinsic value from equity and profits and potential retrospective legal issues from the SEC can make investing in ICO tokens very risky.

It is still early days in the ICO and blockchain industry, and many best practices have yet to be established. The SEC’s recent ruling may put a damper on the fast and easy money being taken by ICO issuers, but it will likely bring forward more professional outfits making use of ICOs as a viable capital raising vehicle that will at least consider real value for their investors through equity backed tokens.

Author: Timothy Goggin

Timothy Goggin is an economic analyst with an interest in the application of moral philosophy and decentralized systems. He studied economics at the Business School at Victoria University of Wellington, New Zealand. His area of research is the consequential and moral dimensions of implementing digital currencies and the resulting synergies for consumers in the trading environment.

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