The breakneck speed at which initial coin offerings have taken off — raising about $2 billion so far — has left regulators in the dust and put at risk masses of speculators, some of whom are willing to go into debt on the off chance they make it big.
With regulation uncertain, last month, decentralized protocol company Protocol Labs in conjunction with AngelList, announced CoinList, a platform for holding token sales that limits the offering to accredited investors and offers its investors a security called a SAFT (simple agreement for tokens) that later converts to coins when the network is launched.
Ironically, the super-compliant CoinList’s first sale (for Filecoin, which Thursday raised $200 million in one hour and has raised more than $250 million by press time) ended up being decried by a venture capitalist and author of The Token Economy newsletter, Stefano Bernardi, as having some of the worst investment terms in a post he titled, “The Analysis Filecoin Doesn’t Want You to Read.” (His main critiques: They gave friends and associates who got in early a much sweeter deal than other investors and they are raising more than a pre-product endeavor merits.)
Whether or not his analysis on Filecoin was correct, the dust-up demonstrated that, as with a stock, just because a token sale is compliant with securities regulations doesn’t mean it’s a good investment — or that even if it is a good investment, the structure of the token sale is fair. To that end, some businesses, professional initiatives and grassroots efforts to guide ICO investors have sprung up even in places such as Reddit forums and Twitter. Most are trying to codify some common sense financial wisdom and keep investors from throwing away their money and stop token issuers from preying on the naive — while others are again exploiting the uncertainty to make dubious recommendations, and in some cases, charge for them. What is clear from these efforts is that both for tokens that are securities and for tokens that aren’t, evaluating them requires a new set of skills because they are fundamentally a technology.
Jerry Brito, executive director of blockchain advocacy group Coin Center, analogizes the trend of standardizing evaluations and investment analysis to the traditional capital markets, in which the government requires certain disclosures from issuers and then, “you’ve got investment advisors and analysts taking that information and other information in the world and rating a stock based on subjective criteria and the market demand for the thing. So I think today, what we’re seeing in the community is people trying to get disclosure of information from the issuers and doing that rating.”
ICO investors and issuers were not much fazed a couple weeks ago by the Securities and Exchange Commission’s first report on crypto assets. Referencing a 1946 court case, SEC v. W.J. Howey Co., it concluded that one coin, called the DAO token, was a security, which was to be expected because it was a tokenized share in a venture fund. But it said that whether any other coin is a security depends “on the facts and circumstances, including the economic realities of the transaction,” so many tokens could ultimately not be deemed securities.
But just because some token sales won’t have to register as securities (which then requires them to make disclosures about the company’s business and management and release independent, audited financial statements), that doesn’t necessarily mean buyers of those token sales will be worse off. “The degree of transparency and disclosure we get from fully compliant and regulated public corporations when they do an issuance of stock is less than what we get from some of the better token sales,” says Peter van Valkenburgh, Coin Center’s director of research. “In a really well run token sale, with a product that’s already up and running, … if it’s smart contract-run and an ERC-20 token” — the most common type of token smart contract — “we know exactly how it operates. And if we can see on the blockchain how many tokens there are, they can’t secretly dilute the existing owners by creating new shares or selling more shares than they’ve already sold.”
Since not everyone is able to read code or analyze blockchain data, that does leave room for other initiatives to have an impact, says Bernardi, who wrote the post critical of the Filecoin sale. “The regulators will have an immensely harder job than anything they’ve tried to regulate before, because it’s digital assets and anyone can create them in literally a second and sell them to anonymous people all around the world without using any state infrastructure or any regulated infrastructure like the banking system,” he says. “I think there will be a lot of need for grassroots and more institutionalized due diligence efforts.”
But that begs a couple questions: For the services, how to evaluate the information, and for the investors following advice, whose evaluations to trust. Various efforts are taking different approaches. Community-owned investment group Neufund out of Germany created a site called ICO Transparency Monitor that evaluates projects (at the request of community members, not the projects themselves) mainly on how much trust a buyer must place in a person vs. a smart contract. As they explain, “We are not looking at teams, token models or their ecosystem impact. We also are not doing a typical code review that looks for bugs. We are looking for the following: Breaches in trustless trust, where essential terms are controlled by a person, not a smart contract.”
Because of the specific way in which they evaluate projects, they view the Filecoin offering, and therefore the SAFT model, as non-transparent, since user protection isn’t governed by a smart contract but by a legal agreement. As business operations manager Agnieszka Sarnecka wrote via email, “It is a very trust-based agreement.” Noting that buyers might trust Filecoin based on facts such as that Andreessen Horowitz and Union Square Ventures backed the token, “Nonetheless, the subscriber has no other choice than to trust that the company issues Filecoins or returns money.” (Protocol Labs, the company behind Filecoin, was not available for comment.)
One early-stage effort that grew out of a discussion on a Reddit forum called ETHtrader (for Ethereum trader) created a set of ICO rating review criteria on a points scale. “Early on when the [subreddit] was smaller, you got a feeling that more of the community understood what would make a token have value, but now you get a sense people are coming in just to make a buck,” said Carl Larson, the moderator of Subreddit, adding “if we educate people more, they’ll demand more, and we’ll all get a better deal.”
Some of the group’s review questions are more subjective than easily quantifiable — for instance, “To what degree does the concept benefit from blockchain or smart contract functionality?” or “Does the document contain high rate, well-reasoned, publishable content and tech; or is it largely subpar, amateur marketing ‘fluff’?” Larson said since they may crowdsource the answers, “It’s okay to have more subjectivity, because you’ll ask the question to lots of people and average their responses. So it’s like an IMDB for ICOs.”
Then there are the questions of how issuers should structure their sales. In an analysis by Vitalik Buterin, the founder of Ethereum, in a June blog post, one suggestion that sparked interest was for teams to do multiple raises in a structure that resembles a series of venture capital rounds, in which teams raise more capital as their projects mature and reach new levels of success.
One band of crypto insiders formed via Twitter has begun a series of salons on token ethics for issuers. Led by Christopher Allen, principal architect of Bitcoin company Blockstream, a group of almost 20 people met in San Francisco at the end of July, with participants including Angus Champion de Crespigny of Ernst & Young (who was participating in his personal capacity), Linda Xie of Coinbase and Spencer Bogart of Blockchain Capital. Allen says people can discuss individual token sales or projects, but, “I wanted to rise above the fray of specific tech problems or various U.S. regulatory [issues] to, why are we doing this and how can we do it in a responsible fashion?”
The group, which has launched a website, brings in academic approaches, for instance, analyzing token marketing through psychologist Margaret Thaler Singer’s Taxonomy of Levels of Influence, which puts persuasion into a spectrum ranging from education (limited consensual relationship; logical thinking is encouraged) to thought control (authoritarian, hierarchical, without target awareness, for indefinite time). They also considered how economist Elinor Ostrom’s design principles for the management of common resources could apply to decentralized blockchain networks, i.e. who has the right to use the common resource and how can everyone affected by the resource participate in all related decision-making.
Some of the best practices they agreed upon prize transparency, honesty, and communication with the community: “Provide enough information to support informed decisions,” “Represent your token honestly and accurately,” and “Detail how the token will be used in the network.” They also encouraged a fundraising model similar to venture raises in rounds, rather than one big raise, which is the current ICO model.
In fact, a lot of these best practices aren’t too different from established practices in traditional finance. And that may be why the SEC’s DAO token report hinged on the 71-year-old Howeycase. Coin Center’s van Valkenburgh says, “When we look at evaluating factors within the community — how the thing was developed, how it was publicized, whether the code was open — it matches up with what you’re supposed to be looking for in the Howey test. People think the law and technology are far apart here, but actually, they’ve got similar standards.” Only time will tell if regulators view it that way as well.Source: Forbes