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The SEC and the ICO
Traders Magazine Online News, October 3, 2017
Some people are making real money investing in cryptocurrencies. Just this year, Bitcoin has gained 300%. Another cryptocurrency, Ethereum, is up more than 2,300%.
An increasingly common use of these currencies is the initial coin offering, or ICO. Companies are using ICOs to raise funds by offering investors the chance to buy into a new venture using a cryptocurrency in exchange for virtual tokens instead of stock in the company. The tokens grant investors access to a product or service to be offered by the token issuer. Sound confusing? Here’s how Kevin Roose illustrated the process in a column in the New York Times:
Imagine that a friend is building a casino and asks you to invest. In exchange, you get chips that can be used at the casino’s tables once it’s finished. Now imagine that the value of the chips isn’t fixed, and will instead fluctuate depending on the popularity of the casino, the number of other gamblers and the regulatory environment for casinos. Oh, and instead of a friend, imagine it’s a stranger on the internet who might be using a fake name, who might not actually know how to build a casino, and whom you probably can’t sue for fraud if he steals your money and uses it to buy a Porsche instead. That’s an ICO.
In recognition of the likelihood of abuse, China’s Central Bank, the People’s Bank of China, has recently put an end to ICOs there, claiming they are rife with fraud, pyramid schemes and other criminal activity. Chinese ICOs scheduled to launch this month have been put on hold.
The SEC, perhaps because it lacks the sweeping powers of China’s Central Bank, has taken a more measured approach in warning potential ICO sponsors and online platforms that support trading of tokens that they might be subject to US securities laws, which they have pretty much ignored to date. The SEC picked on one particular ICO, which called itself The DAO, which stands for Decentralized Autonomous Organization, a term used to describe a “virtual” organization embodied in computer code and executed on a distributed ledger or block chain.
The concept of a DAO entity is memorialized in the document known as a “White Paper.” This one would use “smart contracts” to solve governance issues it described as inherent in traditional corporations. The DAO’s website explained its intended purpose this way: “To blaze a new path in business for the betterment of its members, existing simultaneously nowhere and everywhere and operating solely with the steadfast iron will of unstoppable code.” (Seriously?)
The token issue sold out. However, before The DAO could commence funding projects, an attacker exploited a flaw in its code to steal approximately one-third of The DAO’s assets.
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