A new approach to fundraising by startups that uses digital currencies like bitcoin is sparking concern among lawmakers and regulators, and calls for tougher rules.
At issue are initial coin offerings, where new companies or smaller projects seek to crowdfund — or raise investment funds from the public — through crypto online currencies.
While many of these offerings are well-intentioned, others are scams and some have weak security making them susceptible to hacks.
That's led to growing calls for new regulations to protect investors and consumers.
The Securities and Exchange Commission is already taking notice.
The agency on Tuesday made public an investigation it conducted on digital coins sold by "The DAO" — an online leaderless group that used a cryptocurrency called Ethereum."
Hackers targeted the group in May of last year after one of the highest-profile initial coin offerings. That attack destroyed the group and the value of its coins, leading many to lose money.
In its report, the SEC concluded that the coins offered by DAO were securities — publicly tradable debt like bonds. And the agency said U.S. securities laws may apply to the tokens.
“Foundational principles of the securities laws apply to virtual organizations or capital raising entities making use of distributed ledger technology,” the SEC wrote.
The agency said DAO users were investing money in the coin offerings with the expectation of making profits.
The SEC held that because DAO tokens were securities, the group needed to register with the agency as an exchange.
The SEC decided not to punish DAO, given the novelty of the situation, but warned that any future attempt to sell a security, regardless of the medium or payment, needed to be registered.
“These requirements apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger Technology,” the SEC wrote.
The move highlighted how the SEC is putting the microscope on cryptocurrencies and initial coin offerings.
The agency also offered suggestions for investors to help them determine if initial coin offerings were safe and legal.
In their report, the SEC warned investors to make sure a coin offering is registered properly if it is a securities exchange, and to learn about their rights and level of control, as well as to understand potential cybersecurity threats. Investors were also warned that regulators’ have a limited ability to oversee the novel technology.
“If fraud or theft results in you or the organization that issued the virtual tokens or coins losing virtual tokens, virtual currency, or fiat currency, you may have limited recovery options,” the SEC said.
“Law enforcement officials may have difficulty freezing or securing investor funds that are held in a virtual currency. Virtual currency wallets are encrypted and unlike money held in a bank or brokerage account, virtual currencies may not be held by a third-party custodian.”
The Tuesday report marked a shift in how the SEC has publicly handled digital currencies.
The agency has had its eye on the trade for sometime, but largely stayed quiet as the two largest digital currencies, Bitcoin and Ethereum, have exploded in market value over the last year. There's also been an explosion in the number of initial coin offerings using those currencies.
The SEC has had a unit dedicated to digital currency since 2013, though originally the focus was on Ponzi schemes where victims were force to pay in Bitcoin.
Industry and advocacy groups for digital currencies have cautiously welcomed the SEC's engagement.
“They’re the right people to look at it this sort of thing, says Peter Van Valkenburgh director of research at Coin Center, a research and advocacy group focused on digital currencies. “Creating token and selling them is like selling portions of businesses.”
Valkenburgh said that his organization has advised the SEC on digital currencies and said the agency is expanding its own knowledge and research.
He thinks the next step will be for regulators to make an example of a bad actor and begin cracking down on fraudulent initial coin offerings.
“The reason to do that would be to set some ground rules,” Valkenburgh told The Hill,
But he also cautioned that while some oversight was good, he wanted to avoid over-regulation.
Initial coin offerings are also getting the attention of lawmakers on Capitol Hill, including Rep. Jared Polis (D-Co.) who co-founded the Congressional Blockchain Caucus, which focuses on policy regarding cryptocurrencies like Bitcoin and Ethereum and the technology for managing them.
“Like anything in the financial sector there’s going to be good players and bad players,” Polis told The Hill, “ICOs are becoming very widespread, which is great in that there’s new ways to make capital.”
Startups and small companies can make money from ICOs by offering digital coins. Investors purchase the tokens to help finance the project.
But how the tokens are valued varies from business to business. And the coins may not represent a share of the business in the same way as an equity stake.
In some cases, token investments are completely speculative and can grant their owners a share of the company’s future revenue. In other cases, the tokens are integral to the startup’s operations.
Coin Center says believes regulatory policies should take into account the different types of ICOs.
“[Some of these ICOs] look like people issuing debt instruments and equity, and in that case the SEC would regulate them,” Valkenburgh said.
“Some of them aren’t. If you do fit into the definition of a security you shouldn’t call it an ICO.”
The SEC's report suggests the agency is headed in that direction.
Valkenburgh and Polis are hopeful for a light regulatory touch, but still want more protections for investors.
“There’s a bit of a speculative bubble with ICO’s we should make sure that there’s real meat,” Polis said.