Houston, we may have a problem . . .
The heyday of the crypto boom (pre-2022) featured hundreds of on-chain projects promising trustless utility, pie-in-the-sky autocompounding interest rates, and the wishful possibility of investing in a native coin that might moonshot with a 100x to 1000x increase in value.
The depths of the crypto winter (2022-?) features the collapse of several of the main players in DeFi, with the likes of Terra, FTX, BlockFi, and many more crashing out. In addition, small and large projects alike who minted and listed their own coins are dying off like its a crypto plague. All one has to do is check the CoinMarketCap to see that out of the 9124 listed cryptocurrencies (at least at the time of writing), very few have managed to avoid the dreaded “flatline” of value — from a peak in investment to being a complete zombie.
While there are many reasons for failure in the crypto space, a central component interlinking these reasons is how cryptocurrencies are conceptualized as vehicles for speculation that sit too closely to being like equity securities.
In this article, I’ll run through
- the different ways coins have been launched in the past,
- why this is problematic, and
- what the future of coin launches might look like.
Coin Launches for Every Season: ICO, IEO, and IDO
As usual, I will use the terms “coin” and “token” interchangeably even though in the crypto landscape they have distinct meanings. We don’t need to get so fine-grained for our purposes. Instead, let’s just begin with a problem the various coin launches try to resolve.
How do you raise capital for a new business venture? If your business requires growing a community of active subscribers or members, how do you attract users to your site or platform?
ICOs, IDOs, and IEOs are all tactics to address the problem of “bootstrapping” start-up projects. The main idea is that you offer a cryptocurrency at a lower price to attract buyers who are incentivized by the potential value growth of that coin. This tactic was quite popular during the early days of blockchain start-ups (prior to mid 2022). And now?
Well, we’ll come back to this question.
Let’s start that with which most people are familiar — namely, the idea of an Initial Public Offering (IPO).It’s a way for companies to raise capital by offering shares of ownership in the company which then confers such benefits as dividends, voting rights, and value growth.
ICOs, IDOs, IEOs operate under the same idea, except that in most cases the business in question will be decentralized, involve a DAO, and therefore not offer ownership rights by virtue of buying the coin. Buying cryptocurrencies under an initial offering is much more limited. It’s basically getting the perk of growth in value without ownership.
ICO: Initial Currency Offering
ICOs are the closest to an IPO and can be used for non-profit and for-profit companies. ICOs gained popularity in 2017 as investors looked for potential moonshot investment opportunities by buying coins directly from a project. While some projects did rise in value, the frenzy also created an environment for two persistent problems in the immature and volatile crypto space — namely, Ponzi schemes and early token dumps.
When tokens are sold to investors, the project then seeks to list the token on crypto exchanges in order to drive sales and value in the token. Early token dumps can occur when early investors wait for the value of the token to rise sufficiently — either through genuine value growth or pump and dump schemes — and then sell their tokens. When the amount sold is large enough, this causes the value of the token to plummet.
As a result, projects tend to use two strategies to mitigate early sales: require investors to lock the tokens for a certain amount of time; and control the emissions schedule for token minting.
The role and popularity of ICOs seems to be declining. According to one academic study:
“the ICO model has raised $90 million USD in 2016 from 29 ICOs, more than $6 billion USD in 2017 from 875 ICOs, and a yearly market high of more than $7.5 billion USD in 2018 from a total of 1253 offerings10. In 2019, the market showed its first YoY decrease in terms of volumes and offerings have raised $370 million USD from 109 operations.”
Much of this has to do with the 2022 downturn in the economy (less liquidity available) and the change in the securities regulatory environment (in the US and Europe).
IEO: Initial Exchange Offering
An IEO occurs on a centralized exchange — such as Coinbase or Binance. Because such exchanges are centralized, there is a vetting process to ensure that projects offering tokens have sufficient liquidity to back their token value and amount. Otherwise, if there is a run on the token, the project could collapse. It’s also a way to ensure projects are not Ponzi schemes.
Under centralized exchanges, the smart contracts related to a project’s token will be managed by the exchange. Because there tends to be more accessibility and trust in the coin vetting process of centralized exchanges, IEOs have the main advantage of greater outreach and marketing. (N.B. central exchanges do poorly on security and solvency.)
IDO: Initial Decentralized Offering
An IDO is similar to an IEO in all features except the degree of control exercised by the DEX (decentralized exchange). While there is a vetting process, DEXes may have less stringent requirements, especially with respect to liquidity backing. As a result, there tend to be more exotic tokens available on DEXes.
Smart contract management of a project’s token involves both the DEX and the project team.
And Now, Why Aren’t ICOs and Company “De Rigeur”?
As mentioned above: For reasons relating to potential security regulation and a downturn in the economy, start-ups are forced to find different ways to raise money and/or conceive what a cryptocurrency might be about besides a lucrative increase in speculative value.
In addition to concerns about the securities regulatory landscape — where projects might be charged with selling securities (tokens) without the proper financial qualifications — questions about sustainability of projects based on real (as opposed to speculative value) are being raised. Instead of offering quick yet volatile pathways to profit, tokens may be better designed with respect to offering holders real utility within a project.
A pure utility coin does not need to be listed on an exchange since its main purpose is to sustain value within an ecosystem. On this view, the role of ICOs, IEOs, and IDOs would change radically and perhaps lend more stability to the persistent liquidity issues for exchanges that have arisen in 2022. A more radical view is that the failures of 2022 had mainly to do with centralized exchanges and how they reiterated the bad or risky practices from which DeFi is moving away and allegedly from which its more protected.
Why Is Being a Security a Problem?
Generally, a security is a financial instrument that is fungible (and therefore negotiable) and represents some monetary value. (This definition is expanded in the next section). So what’s all the worry about?
Exchange of securities is complicated since it requires knowledge of investment and banking principles, an awareness of macro- and microeconomic laws and states, and assessment of counterparty risk.
A regulatory body in the U.S. called the Securities and Exchange Commission (SEC) was established in 1934 to protect investors, maintain fair, orderly, and efficient markets, and help with the formation of capital. Without the likes of the SEC, trading securities and investing is, as the saying goes, like the “Wild West”.
So it would seem that for cryptocurrencies to count as securities, well that would be a good thing since it means protection for investors and less market volatility???
In principle, yes. However, in practice it means the kinds of things that enticed the creation of many of the crypto projects and their respective investors would not have happened.
This is because to be regulated by the SEC also means having to go through a bonafide process of licensing, which also means being held accountable for any bad or fraudulent practices. Certainly, things that occur quite frequently in the crypto space — like pump and dumps and front running — would be penalized.
So, if cryptocurrency coins are being launched and sold by unlicensed people and projects; and if they count as securities, then it’s bad news for the issuer of the coin and the investor.
Without proper licensing, then the project is basically illegal and will be fined and shut down. By extension, this is bad for the investor since the investment essentially goes kaput.
So how does one tell if a coin qualifies as a security?
Enter the Howey Act and the Howey Test
The Howey Act arose from the court case SEC v. W.J. Howey Co., 328 U.S. 293 (1946) in which an offer of units in a citrus grove development would have resulted in the net proceeds going to the purchaser (or investor). According to the Securities Act of 1933, this was defined as an investment contract and hence as an investment in securities.
An interesting fact about the Howey Act is that it involves investment in land as a means to profit for investors. Typically, this type of activity would be pejoratively labeled under the term “rent seeking”, which occurs when someone attempts to profit from an investment without contributing in any way to productivity. In other words, they may contribute money but only as means to gain from the labor and expenditure of capital of the enterprise in question.
This case famously set out the four criteria for what counts as a security, now referred to as “the Howey Test”. Per the US Supreme Court:
“For purposes of the Securities Act,
- an investment contract (undefined by the Act) means a contract, transaction, or scheme whereby a person invests his money
- in a common enterprise and
- is led to expect profits
- solely from the efforts of the promoter or a third party,
it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise. Pp. 328 U. S. 298–299.”
[bulleted format not in the original; done here for purposes of emphasis of the four criteria]
The last point is a bit oddly worded and involves the labor of another party to generate profits. In the case of land, this is quite clear. An investor gains from the labor of those who work the land without adding anything to productivity. With cryptocurrencies, this revenue is generated from the activity of the native protocol and those using the protocol. Obviously, the success of the protocol leads to an increase in the value of the native token, which can be sold for profit.
To make this test more user-friendly, you can simply ask:
- Is there an investment?
- Is the investment in a common enterprise, or “business arrangement in which two entities decide to enter into a relationship in the pursuit of some type of common goals” (Thanks, Malcolm Tatum!)?
- Is the investor led to expect profits from the investment?
- Does the resulting profit derive from the labor of others and not the investor?
Asking these question is essentially turning the Howey Act into the Howey Test to see if something qualifies as a security.
Furthermore, what is relevant to cryptocurrency ICOs, IDOs, and IEOs is that the offering party is liable even if no one invests in the enterprise (or signs a contract!). It’s the fact that that which qualifies as a security has been offered.
At the moment, the conventional wisdom is that most (if not all) cryptocurrencies are securities because, well, most coin launches are backed by a common enterprise, are offered on the basis of investors making money by contributing no labor of their own.
Caveat: At the time of writing, the SEC lawsuit against Ripple (XRP) has not been decided. If the case concludes in favor of Ripple, then there may be more leeway for crypto coin launches, etc. But in my mind, this does not solve the problem of financial boom and bust that we saw in 2022.
Indeed, cryptocurrencies do not have to be like securities at all to work well (for the common good). Rather, their current state is the result of historical circumstance. Their respective designers simply modeled them on the motive of speculative financial gain.
This article originally appeared on Medium and is a part of the Crypto Industry Essentials educational program presented by The Art of the Bubble.
Though this article is credited to me, it contains some written material by Sebastian Purcell, PhD from his The Art of the Bubble education series on cryptocurrencies.
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