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ICO: the challenge of effective regulation

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The year 2017 was marked by a boom in ICO (Initial Coin Offering) operations in the crypto-currency market. This dynamism nevertheless raises questions in terms of governance and regulation. Responses are emerging in the United States to provide a framework for this flourishing market.
 
Aith more than $2 billion raised since the beginning of the year, 20 times the amount for 2016, the ICO market is booming. The lack of regulation is not unrelated to its success, but this situation could soon change: since the summer, several regulators, and in particular the US SEC, have been seeking to regulate these new types of public offerings, in which tokens replace financial securities.
 

Should tokens be regulated as stocks?

 
The regulation of ICOs involves a twofold challenge: on the one hand, to prevent the multiplication of empty or even fraudulent projects that have appeared on this market, and on the other hand, to improve the legal framework of the tokens resulting from these operations. It is this second aspect that raises the most interesting questions in terms of ICO governance.
 
The main question facing the US regulator at the moment is whether tokens should be considered as financial securities. At first glance, the answer seems to be no, since tokens issued at ICOs generally entitle their holders to benefit from the services of the company that issued them, in various forms. In this sense, Dapps-type tokens constitute a simple subscription or usage right, a form of prepayment from a company, as also exists in the crowdfunding market (cf. Kickstarter). Tokens can therefore assume multiple functions. For example, some tokens represent a user's reputation (Augur), others represent deposits in US dollars (Tether), or the outstanding amount of a stand-alone currency system (Bitcoin).
 
Dapps-type tokens, linked to the actual use of an application, allow us to approach a theoretical "economic perfection": the price of a company's services is valued at its marginal utility (the ultimate goal of a perfect market). The value of the firm is defined by the intensity and continuity of use of its services, and the token is the bearer of this value, much more precisely than a share listed on a regulated market.
 
Nevertheless, according to a recent assessment carried out by the Token Report site based on the analysis of 226 ICOs, only 10% of the tokens issued to date would have been used by their purchasers to take advantage of the services of the issuing company. In other words, 90% of the tokens would have been purchased only for speculative purposes, to be resold later at a higher price. From this point of view, the tokens do appear to be used by their purchasers as investment products, in particular as shares, and should therefore be regulated accordingly. This is the meaning of the US SEC's approach, the "substance over form" doctrine: a token is defined by the use made of it.
 
Curiously, the answer to this topical issue could come from the application of very old case law dating back to 1946 and referred to as "SEC vs Howey Co. In short, this legal review makes it possible to determine whether a product should be considered a financial asset by answering a set of simple questions, constituting the "Howey test". If this test proves positive, which could well be the case for many ICOs, the SEC would automatically be entitled to consider certain tokens as securities, or financial products.
 
It remains to be seen whether the SEC would apply "hard" regulation, which could be detrimental to the future development of the ICO market by reserving them for qualified investors, or on the contrary "soft" regulation, which would ensure the sustainability of this nascent market. The 11 December speech by SEC Chairman Jay Clayton seems to show that the regulator is considering a rather accommodating response. "The technology that underpins crypto-currencies and ICOs can be disruptive, transformative and effective. I am confident that the development of fintechs will provide promising investment opportunities for investors (...). I encourage investors to be open to these opportunities, but to ask good questions and use common sense," he said.

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What will be the rights of token holders in the future?

 
Another subject that is also hotly debated across the Atlantic is the question of the rights of token holders.
 
Unlike shares issued in an IPO, tokens issued in an ICO currently offer very few rights to investors, apart from being able to benefit from certain services of the issuing company. Token holders thus have no voting rights on the company's board of directors and no rights to receive any dividends.
 
For companies that raise capital through an ICO, the weak rights of investors are an important advantage, as they can raise large amounts of capital without the constraints of demanding shareholders entering their capital. However, these advantages for issuers are also disadvantages for investors. In order to make the ICO system sustainable, it will therefore be important in the future to ensure a more consistent form of countervalue to tokens, so as to make them more attractive to investors. Companies such as Aragon (digital governance) and Civic (validation of economic beneficiaries) offer solutions to support good practice in ICOs.
 
The subject of governance is clearly at the heart of the issues related to how regulators will decide to regulate the ICO market. It should be noted, however, that even if tokens are in the future associated with more rights for investors, tokens already issued should not be able to benefit from these new features retroactively.
It is clear that the regulation of ICOs and tokens is still in its infancy, but the subject is hot and will remain exciting to follow in the coming months.
 
Alexander Azoulay, president of GHS Capital
 

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