Since the invention and release of bitcoin in 2009, distributed ledger technology, and the use of it to issue cryptocurrencies, has endured trials, tribulations, triumphs, and immense growth. According to a market study conducted by Castle Island Ventures, within the past five years alone, the industry has seen a massive boost in popularity—with digital assets worldwide having a market capitalization of nearly $249 billion.
Cryptocurrency’s high demand and sudden surge to fame has created a need for a funding mechanism to raise money for such crypto ventures. Although these mechanisms, referred to as “Initial Coin Offerings” (ICOs), can be legitimate investment opportunities, the nuances of the regulations (or lack thereof) surrounding these assets can be confusing, and there are major risks associated with ICOs that can be detrimental to investors if the necessary precautions are not taken.
What are ICOS?
An ICO refers to the offer and sale of digital asset tokens. The seller of the ICO token offers the investor a digital token in exchange for something of value (such as another token or fiat currency). The seller usually produces an ICO whitepaper that describes the proposal detailing the terms and conditions of the deal and explaining how the funds will be used. The seller will then deliver the token to the investor’s digital address on the relevant blockchain.
Security vs. Commodity
Determining whether a token is considered a security or a commodity can be extremely difficult, and the answer can dictate the amount of legal protection allotted to the investor.
The U.S. Securities and Exchange Commission (SEC) only protects assets that are considered securities and meet the filing requirements of a security registered with the SEC. A security is defined as the investment of money within an enterprise with reasonable expectation for profits to be derived from the entrepreneurial or managerial efforts of that enterprise. A token is deemed a security by the SEC if it meets the standards of the W.J. Howey rules (which came to fruition after the U.S. Securities and Exchange Commission v. W.J. Howey Co. Supreme Court case, which established the general applicability of the federal securities laws).
If the asset meets the requirements of the Howey rules, then it is officially considered a security and falls under the jurisdiction of the SEC, meaning that the components of the asset are more regulated, lending more protection to the investor.
If the token is advertised more for its functionality over potential profit, then the asset is less likely to satisfy the elements of the W.J. Howey rules and would likely be defined as a commodity. The SEC warns against the heightened risk of investing in this industry due to the infancy of the technology and the wafer-thin line between regulated and unregulated ICOs. If an ICO is not deemed a security and instead considered a commodity, it will lack the regulatory oversight of the SEC—leaving investors vulnerable.
Although the SEC has specifically identified a limited number of cryptocurrencies (e.g. bitcoin and ether) that it does not consider securities, these two cases have been exceptions, and the SEC has generally taken the view that the vast majority of tokens are securities and should be subject to SEC oversight. So, if you are dealing with a token issuer who is indicating that their token is not a security and not subject to SEC regulations, you should be very skeptical.
Risks Associated With ICOs
ICO crypto has been dubbed the “Wild, Wild West” by start-ups, investors, and regulators alike due to the many unregulated actors in the field.
In the first six months of 2019, a total of $4.26 billion in investment losses were seen in the crypto sector due to thefts, scams, and fraud, according to CipherTrace’s Q2 2019 Cryptocurrency Anti-Money Laundering Report.
The barrier to entry to the ICO investment market is exceptionally low. It is remarkably easy to set up an ICO website, draft a whitepaper, and offer a token—so easy that almost anyone can do it, and many scammers have.
To exhibit how easy it is to concoct an ICO scam, the SEC set up their own fake ICO website demonstrating all of the alarming “red flags” that can signal an ICO risk to investors. The site manifests these red flags and prompts investors to be wary of:
1. Guaranteed high investment returns
2. Overarching themes of “get-rich-quick”
3. Complicated jargon
4. Unlicensed sellers
5. Offers sounding too good to be true
6. Unsolicited offers
7. Pressure to purchase immediately
Oftentimes, fake ICO websites have very little disclosure about who actually runs the company behind the digital asset, how the company is using the funds received, what the company’s qualifications are, or what exact product they are offering.
The ease of creating a fraudulent ICO site combined with the lack of protection surrounding ICOs leaves investors of crypto susceptible and exposed. Extreme caution should be taken before deals are made and assets procured.
Crypto ICO Exchange Theft
The asset is at its most vulnerable during not only the initial offering exchange from the ICO seller to the investor, but also during any transfer of the digital asset between two parties via a blockchain network.
If you purchase an ICO token and then wish to trade that asset for profit, you will need to transfer the token to an exchange. Exchanges may not comply with the rules of the SEC, meaning that they are not protected by the Commission’s sanctions, leaving the exchange severely vulnerable to manipulations.
The SEC also urges caution when entering into deals with ICOs sanctioned in foreign countries. When dealing with foreign actors in this space, investors may not receive protection under U.S. law.
Before purchasing tokens in ICOs, take a step back. Analyze the company in question and the token being offered. Do your best to verify the truth of each and every statement made by the seller. The individualized, one-on-one nature of the transactions in this field leads to an inherently unregulated transaction process—so ensure that you are aware of all the risks associated with ICOs.
The information above was compiled from an event recently hosted by the U.S. Securities and Exchange Commission (SEC)—Crypto: Blockchain, Bitcoin, and Beyond, discussing ICOs and the potential risks at play in the field. For more information, please refer to their articles surrounding Initial Coin Offerings, fraudulent digital asset sites, and Ponzi schemes surrounding digital currency.