The SEC Will Leave Good ICOs Alone
(Bloomberg Opinion) -- Ether is not a security.
William Hinman, the Director of the Division of Corporation Finance at the Securities and Exchange Commission, gave a smart and nuanced speech yesterday declaring that Ether—the cryptocurrency of the Ethereum network—is not a security and so is not subject to the requirements of U.S. securities law. People had wondered. I think there is a reasonable view that, when it was first launched—when it was closely held and then sold to investors to raise funds to develop the Ethereum network—it might have been a security, but it’s not now, and, you know, water under the bridge, whatever. That is not a particularly solid legal analysis or anything, but it does seem more practical than going back and bothering Ethereum about what it did before the SEC was paying attention. Also it is literally what Hinman said (emphasis added):
And putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions. And, as with Bitcoin, applying the disclosure regime of the federal securities laws to current transactions in Ether would seem to add little value.
Ehh, by the time we got around to it, it was fine.
So that’s a relief for Ethereum. (And Bitcoin, which Hinman also said is not a security, though we kind of knew that.)
But the speech is much more interesting than that. More broadly, Hinman suggested that, at least in limited cases, the SEC agrees with the notion that cryptocurrency startups can raise money by selling tokens (or token contracts) as securities early on before launching their network, but then flip into non-security “utility tokens” once their networks are running and the tokens are usable:
“Can a digital asset that was originally offered in a securities offering ever be later sold in a manner that does not constitute an offering of a security?” In cases where the digital asset represents a set of rights that gives the holder a financial interest in an enterprise, the answer is likely “no.” In these cases, calling the transaction an initial coin offering, or “ICO,” or a sale of a “token,” will not take it out of the purview of the U.S. securities laws.
But what about cases where there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created? I believe in these cases the answer is a qualified “yes.”
There have been reports that the SEC is skeptical of the idea that crypto startups could sell tokens packaged in security wrappers in limited offerings solely to accredited investors, with the promise that those tokens will eventually be unwrapped and usable by everyone. Hinman’s speech suggests that the SEC has gotten over that skepticism.
Or not quite. There are, I think, two sorts of crypto-token use cases, two kinds of initial coin offering. One kind—represented by Ethereum, and a few other projects; Filecoin is often mentioned—involves a vision of a decentralized ecosystem not owned by anyone. The point of an ICO, here, is to raise enough money for a small group of founder-visionaries to build the basic infrastructure, but once they have done that their role melts away. The system—like Bitcoin—becomes self-maintaining; it is not owned by an entrepreneur who profits from it but collectively by the people who use it. The tokens allow people to use the system—to pay for computing power or file storage or whatever—but also create decentralized incentives to maintain it. It is a genuinely new way of organizing economic activity.
The other kind is just, you start a company, and you think up a product, and you raise way too much money for your company by pre-selling that product in the form of tokens that also have a speculative component. It’s like airline miles or Starbucks gift cards, if those were also somehow incredibly volatile get-rich-quick schemes. The company never gives up control of the ecosystem. A lot of the half-baked branded ICOs that you read about—KodakCoin is a silly one we talk about a lot around here—look like this. Kodak is never going to melt away from KodakCoin; it will always be a centralized network run by and for the benefit of its sponsors, though they will say “blockchain” a lot to confuse you.
Hinman’s speech suggests that the SEC, confronted with a genuinely new way of organizing economic activity, concluded: Yes fine that is not a security. Seems right! Arguably—almost certainly, really—there should be some sort of regulatory framework for cryptocurrencies, some set of rules about transparency and disclosure and manipulation and fraud. But plausibly those rules shouldn’t be—perhaps shouldn’t even start from—the rules regulating securities. You can’t make a decentralized network’s chief executive officer certify its audited financial statements, or demand that people deliver a prospectus every time they spend a currency. True decentralized cryptocurrencies are a new thing, and demand a new regulatory paradigm.
But the other thing, where companies raise money by selling speculative things with no ownership rights to investors hoping for a quick profit, and then say “what? It has no ownership rights! It can’t be a security!”—that thing is very squarely in the SEC’s wheelhouse. You can definitely make those companies deliver financial statements, and prospectuses, and require their tokens to trade on exchanges, and apply all of the rules to this form of speculative corporate fund-raising that you apply to other forms of speculative corporate fund-raising.
And that seems to be Hinman’s view. “Primarily,” he says, “consider whether a third party – be it a person, entity or coordinated group of actors – drives the expectation of a return.” And:
Does application of the Securities Act protections make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset?
Loosely speaking, then, ICOs that seek to fund the construction of decentralized open protocols should still work under the SEC’s rules. (Though they’ll probably have to do securities offerings limited to accredited investors—using a SAFT structure—to raise money: They’ll only become non-securities when the protocols have actually been built and the founders have walked away.) ICOs that are just fundraising schemes for companies will be treated like securities and require the usual disclosure requirements, which can't really be a surprise.
But there is a third category. The interesting implication is for genuine utility tokens—tokens that can really be used to buy and sell stuff—in ecosystems that are owned and run by companies. (The obvious exercise for the reader is: Ripple.) If you start a company, and issue tokens in an ICO, and use the proceeds to build a real useful product ecosystem, and the tokens can be used to buy or sell stuff in that ecosystem, but your company remains in charge of maintaining that ecosystem and makes a profit from running it (or from selling more tokens), then it is a closer question. If it is a pure utility token, it might be fine. Hinman notes that “there are contractual or technical ways to structure digital assets so they function more like a consumer item and less like a security.” But his list of factors—“is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment”; “is the asset marketed and distributed to potential users or the general public”; etc.—seems pretty challenging for many ICOs. If the central enterprise doesn’t melt away, then the investment purpose of the token has to. For most tokens, that seems very far away.
The SEC’s view is effectively that decentralized-network tokens don’t require securities regulation because there is no company to regulate, no enterprise with financials to disclose, no central counterparty to coordinate transactions. But if there is a company, and it raises money by issuing a token to the public, it has the same securities-law obligations it would if it raised money by issuing stock or bonds.
Hinman’s speech, to me, suggests that the SEC accepts and supports the idea of ICOs as a fund-raising tool for building decentralized open protocols, but is more skeptical of them as a way for companies to raise money by effectively pre-selling products. The former is a much more interesting, compelling and potentially transformative use—but it is also probably a relatively limited one. The world only needs so many open protocols. The latter is much less interesting—there are lots of other ways for companies to pre-sell products, without building a token on the blockchain—but quite possibly a bigger market. Unless the SEC shuts it down.
Are banks tech companies?
I wrote the other day about how banks are becoming software companies, not only in the sense that they are developing software for clients to use, but also in the sense that they can make money on that software by using it to advertise their financial services. They’re … almost … ad-supported tech companies? Obviously ad-supported tech companies are controversial these days, not least for how they are constantly giving you free stuff in exchange for taking your data and using it in murky and unsettling ways. Anyway here’s a story about how banks are tracking their clients’ usage of sell-side research—“they can typically see in real-time exactly what pages are being read, for how long, and by which users”—and how the clients are worried about how that data will be used:
It is also a sensitive topic at a time when banks are exploring new data products. Some bankers said that hedge funds have asked if they can see a stream of aggregated research data, such as what notes are the most read, or longest read, but also that their banks weren’t selling that information, people familiar with those requests said.
The amped up data-tracking has rankled some customers, who worry that even anonymized readership habits, if shared with other clients, could allow rivals to get ahead of their trades. Some liken it to the maelstrom surrounding social-media behemoth Facebook Inc., which has faced intense criticism for its handling of user data.
I admire the hedge funds for asking. If you run a certain kind of hedge fund these days, you spend much of your time pondering what alternative sources of data might give you an edge, and then going out and trying to get access to those data sources. Often this is hard, because the data is genuinely hard to collect, or because the people who collect it are not keen on the idea of selling it to hedge funds. But if banks already have some niche data—Longest-Read Research Notes—that they don’t make public but that might be market-moving, then, you know, why not ask? Banks are certainly in the business of selling stuff to hedge funds, and now they are increasingly in the business of selling technology stuff to hedge funds. It seems very natural to ask whether they’d sell this particular byproduct of their technology infrastructure.
We talked yesterday about Goldman Sachs Group Inc.’s use of a machine-learning model to predict the winner of the World Cup, and what it might tell us about the use of machine learning in finance. Here is a story about a group of German professors who constructed a “random-forest” machine-learning model to predict the World Cup winner, and what they found:
Interestingly, the random-forest approach allows Groll and co to include other ranking attempts, such as the rankings used by bookmakers.
Plugging all this into the model provides some interesting insights. For example, the most influential factors turn out to be the team rankings created by other methods, including those from bookmakers, FIFA, and others.
I mean … okay? In a sense, if you tell a robot “go figure out how to rank soccer teams,” and it goes out and thinks about the problem and comes back and says “the best way is to cheat by copying how humans rank soccer teams,” then, you know, good job, smart robot. That answer is plausibly correct and probably pretty easy: Why spend a lot of time and effort finding, compiling and analyzing data when you can just go find a list that someone else made and copy that? On the other hand, if your goal in building machine-learning systems is to supplant human intelligence, to build a perfectly rational system that analyzes more data than a human ever could, and is free from human biases and blind spots, then this does seem like a bit of a disappointment. You haven't gotten rid of the dependency on humans; you’ve just wrapped it up in a random forest.
I suppose there are implications for investing. Like if you build a stock-picking machine-learning algorithm, and what it comes up with is “call Warren Buffett up and ask him what stocks to buy,” then I guess that would be a little cool.
Should Michael Milken be pardoned?
You know, if you had asked me that two years ago, I would have said sure, why not. Not just because of Milken’s track record as a philanthropist since his conviction for some frankly arcane securities-law violations 28 years ago, but also because, as an admirer of financial creativity, I think that Milken’s innovations in junk bonds—which allowed companies to finance themselves in the capital markets in ways that they couldn’t before, and which created a more competitive market for corporate control—were basically good, and were certainly interesting, and have been overshadowed for decades by his tangentially related criminal conviction. The result is that the general public associates those innovations with that criminal taint, and thinks “oh, junk bonds, aren’t those slimy and semi-legal things used by criminals?” (Fine, the name doesn’t help.) That seems like the wrong reading of his legacy.
Also of course I endorse Tyler Cowen’s view on pardons. (“I don’t even firmly believe that punishment is justified morally,” he says, and: “If I were a president, I’d consider just only pardoning people and then resigning.”)
The idea of a Milken pardon is being supported by Anthony Scaramucci, the financier who briefly directed White House communications; Treasury Secretary Steven Mnuchin; and Trump son-in-law and senior adviser Jared Kushner, the people said. Another advocate is Rudy Giuliani, the onetime federal prosecutor whose criminal investigation landed Milken in jail but who later bonded with him.
Imagine if any of those wildly privileged advisers to the president advocated to use the awesome powers of the federal government to protect vulnerable people and reduce suffering, rather than just to further aggrandize their already extremely comfortable billionaire friends. Imagine looking at the immense cruelty that the U.S. government inflicts on innocent children every day and thinking that the most important injustice you can address is clearing Michael Milken’s name for stuff he pleaded guilty to three decades ago. What a sad lot of moral nullities these people are.
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