It has been a while since the name “Bitcoin” first appeared on mainstream media in 2011.[1] As the first distributed digital currency in the world, Bitcoin quickly attracted public attention for redefining the conventional notion of “currency.” Suddenly, everyone who owned a computer and had access to the Internet appeared to be mining (“Mining” is the term of art used to describe the process of earning bitcoins by contributing your computer power to solve computational puzzles in the bitcoin system, where new bitcoins are released to reward your participation[2]). Bitcoin became so popular that you might have heard of someone you know joining the game and becoming a miner. As the digital currency market continues to grow rapidly, there are currently over 800 kinds of digital currencies in existence.[3] Their functions have evolved from buying a piece of pizza[4] to fundraising.[5]
The means by which digital currencies are fundraised is called the initial coin offering (“ICO”).[6] The idea is similar to an initial public offering (“IPO”): the firm offers assets of the company in exchange for investment.[7] The difference with an ICO is, unlike an IPO, buyers do not receive shares of stock for the money they pay; instead, they receive digital coins (also called “tokens”) that the company issues, which will appreciate in value if the company is successful.[8] If you think someone would have to be crazy to invest money in something that has neither intrinsic value nor a tangible form, you will be surprised by the reality of the digital currency world. Many start-ups have found ICOs to be a preferable alternative for business financing than traditional equity funding.[9] As of August 2017, the cumulative ICO funding has hit $17.8 billion.[10]
Despite the absurdity suggested by this number, there is a rationale behind the skyrocketing popularity of ICOs. Digital currencies, including Bitcoin, are based on an underlying technology called blockchain.[11] A blockchain is a cryptographic account that records every transaction carried out with digital currencies.[12] As the parties freely trade in the system, a blockchain is automatically generated and becomes a permanent, irreversible record that serves to prove the legitimacy of the transaction.[13] Transactions are visible to everyone in the system, which adds to the transparency of the market.[14] In addition, blockchain eliminates the middleman, such as a bank, which is usually required to facilitate the transaction in traditional currency markets. Eliminating the middleman also helps to eliminate high transactional costs.[15] Thus, the nature of digital currency ICOs produces a few advantages: speed, security, and low-cost.
However, there are concerns about ICOs. Blockchains only record the transaction, but not the personal information of the parties behind it.[16] People who trade digital currencies are hidden behind a pseudonymous address.[17] Because of this personal identity protection, ICOs seem to be the perfect soil from which financial crimes can grow. Given the huge amount of capital circulating in the market, the results of a lack of regulatory oversight are conceivably severe.
Luckily for ICO investors, the Securities and Exchange Commission (“SEC”) has decided to place the ICO market under its jurisdiction.[18] On July 25, 2017, the SEC announced that ICOs, although in a different form from traditional shares of stock, are nonetheless securities and subject to the federal securities laws.[19] To match its actions to its words, on September 29, 2017, the SEC brought its first charges against a company engaging in ICO fundraising.[20] Two companies were charged with violating federal securities laws for selling unregistered securities that were represented to buyers as being backed by assets that did not exist.[21]
The market, however, did not seem to appreciate the heightened standards that the SEC imposed. After the SEC’s announcement on July 25, 2017, the prices of many ICOs were down 20% to 30%.[22] 46 of the top 50 coins by market value were in the red.[23] The fact that the SEC is strictly enforcing its regulations regarding ICOs should alert companies who are utilizing the ICO fundraising model: It is time to play by the rules.
[1] See Timothy B. Lee, Five Years of Bitcoin in One Post, Wash. Post (Jan. 3, 2014), https://www.washingtonpost.com/news/the-switch/wp/2014/01/03/five-years-of-bitcoin-in-one-post/?utm_term=.f6f56902614a; See also, Jerry Brito, Online Cash Bitcoin Could Challenge Governments, Banks, Time (Apr. 16, 2011), http://techland.time.com/2011/04/16/online-cash-bitcoin-could-challenge-governments/.
[2] How Bitcoin Works, Investopedia: Bitcoin, http://www.investopedia.com/terms/b/bitcoin.asp (last visited Sept. 30, 2017).
[3] See Moe Adham, Digital Currency Indexes Are Coming, Forbes (June 26, 2017), https://www.forbes.com/sites/forbesfinancecouncil/2017/06/26/digital-currency-indexes-are-coming/#7d6a0d5948a3.
[4] See supra note 1.
[5] See Yuliya Chernova, Who Needs Venture Capitalists When You Have Initial Coin Offerings?, Wall Street J. (Sept. 14, 2017), https://www.wsj.com/articles/coin-mania-forces-vcs-to-sidelines-on-cryptocurrency-1505388633.
[6] See Initial coin offering, Article, Wikipedia, https://en.wikipedia.org/wiki/Initial_coin_offering (last visited Sept. 30, 2017).
[7] See Mike Orcutt, What the Hell Is an Initial Coin Offering?, MIT Tech. Rev. (Sept. 6, 2017), https://www.technologyreview.com/s/608799/what-the-hell-is-an-initial-coin-offering/.
[8] See supra note 6.
[9] See Tomio Geron, How Blockchain and ICOs Are Changing the Funding Game for Startups, Wall Street J. (Sept. 24, 2017), https://www.wsj.com/articles/how-blockchain-and-icos-are-changing-the-funding-game-for-startups-1506304861.
[10] See supra note 5.
[11] See supra note 7.
[12] Id.
[13] See Sloane Brakeville & Bhargav Perepa, Blockchain Basics: Introduction to Distributed Ledgers, IBM, https://www.ibm.com/developerworks/cloud/library/cl-blockchain-basics-intro-bluemix-trs/index.html (last updated Aug. 21, 2017).
[14] See id.
[15] See What Are the Advantages and Disadvantages of Bitcoin?, Coinreport, https://coinreport.net/coin-101/advantages-and-disadvantages-of-bitcoin/ (last visited Sept. 30, 2017).
[16] See id.
[17] See id.
[18] See Jeff John Roberts, SEC Says Digital Tokens Are Securities, Warns of Fraud, Fortune (July 25, 2017), http://fortune.com/2017/07/25/sec-says-digital-tokens-are-securities-warns-of-fraud/.
[19] See id.
[20] See Nikhilesh De, SEC Charges ICO: US Agency Takes Action Against Alleged Token Scammer, Coindesk (Sept. 29, 2017), https://www.coindesk.com/sec-charges-promoter-two-icos-fraud-says-recoin-no-real-estate/.
[21] See SEC Exposes Two Initial Coin Offerings Purportedly Backed by Real Estate and Diamonds, S.E.C. (Sept. 29, 2017), https://www.sec.gov/news/press-release/2017-185-0.
[22] See Paul Vigna & Dave Michaels, SEC Says It Will Patrol Red-Hot Virtual Coin Offerings, Wall Street J. (July 25, 2017), https://www.wsj.com/articles/sec-says-it-will-patrol-red-hot-virtual-coin-offerings-1501017684.
[23] See id.