A new report from European thinktank, Bruegel, titled The Economic Potential and Risks of Crypto Assets: is a regulatory framework needed?, by authors Maria Demertzis and Guntram B. Wolff, dives into Initial Coin Offerings (ICOs), Tokenization of assets, and other legal challenges related to crypto. Open investment through Equity Crowdfunding, Initial Coin Offerings, or Tokenized assets is poised to transform finance.
In July of 2018, there were over 100 ICOs that raised over 100 Million USD (Demertzis & Wolff, 2018).
ICOs and tokenized assets pose regulatory challenges because they serve different roles beyond equity. When an individual purchases equity into a company, they own part of the company or its revenues, and potentially exert voting control over the firm’s management. These limitations are codified in law.
For example, a tokenized security might provide, in addition to voting rights, an exchange function, tolls, usage fees, and security deposits (Blockgeeks, 2019). A tokenized security can act as a payment unit or provide other non-financial exchange such as rewards (Blockgeeks, 2019).
The dual nature of tokenized securities provides regulatory challenges. In response to a 1946 Supreme Court case, the SEC v. W.J. Howey Co., three definitions of define what constitutes a security (Investopedia, 2018).
For a transaction to become an investment, it must have three characteristics, or meet the Howey Test:
- An investment of money
- In a common enterprise
- With an expectation of profits predominantly form the efforts of others (Tsigulev, 2017).
The SEC provided token categories to distinguish between utility tokens and security tokens. Utility tokens provide users with a product or service as opposed to a security token, which provides ownership shares in that company (Blockgeeks, 2019). ICOs are subject to Regulation D, A+, and S security laws.
An Asset or a Utility?
The technology behind Blockchain, which in part can allow for automated contract negotiation, muddles the nature of securities law. Some companies might want to provide a reward, discount, or use of the service as an incentive to hold equity within the company or the assets of the company.
The report from Bruegel arrives at three conclusions as to whether a regulatory framework is needed. The first is that regulations may stifle innovation (Demertzis & Wolff, 2018). Second, “policy requires global coordination” due to the nature of crypto and subsequently, there is a question as to what supervisory institutions should play a role (Demertzis & Wolff, 2018).
Crypto is complex because it requires cross-national regulation. The scope of Bruegel’s recent report suggests that it could take years before intra-national regulatory agencies will be able to coordinate.
Blockgeeks. (2019). What are Security Tokens? Blockgeeks. Retrieved February 11, 2019, from https://blockgeeks.com/guides/security-tokens/
Demertzis, M., & Wolff, G. B. (2018). The economic potential and risks of crypto assets: is a regulatory framework needed? Bruegel. Retrieved February 11, 2019, from http://bruegel.org/wp-content/uploads/2018/09/PC-14_2018.pdf
Investopedia. (2018). Howey Test. Investopedia. Retrieved February 11, 2019, from https://www.investopedia.com/terms/h/howey-test.asp
Tsigulev, V. (2017). Howey test: when a token can