And the Regulators Arrived: from SEC’s Ruling to the PBOC’s Ban of Initial Coin Offerings

Over the past months, the cryptocurrency market has remained in the spotlight not only for the fluctuations in the major coins’ interest rates (Bitcoin, Ethereum), but also for the emergence and consolidation of a new way of raising capital in the digital token world: Initial Coin Offerings (ICOs).

The reason leading to the launch of an ICO is simple: the need to raise initial or additional funds to start or continue the development of a blockchain-based technology. This funding method consists in issuing a certain amount of digital tokens in what seems increasingly to be a sort of Initial Public Offering: tokens are sold in an auction to investors in exchange for ethers or bitcoins or other cryptocurrencies, or rarely for fiat money as dollars or pounds.

The first example dates back in 2013, with the pioneering Mastercoin’s ICO collected over $7 million, followed by the more famous Ethereum’s in 2014. A significant surge has been observed during this year. In 2017, there has been over 90 ICOs with an overall funds collection of $1.25 billion. For the first time ever, in June the amount of funds raised through ICOs overtook the total early stage Venture Capital funding for companies of the same type. And so also in July.

Regulatory Vacuum

Launching an ICO is a very convenient method to raise funds since it does not require any kind of disclosure obligations or regulatory compliance, and it allows to avoid most of the costs linked to more traditional funding methods such as venture capital. Up to July of this year, promoters of ICOs have been able to operate in the absence of clear and strict regulatory provisions regarding investor protection or market fairness and integrity: for instance, there are no rules establishing which type of investors can put money into an ICO, and thus so fare anyone has been able to participate.

It is also often not very clear what investors gain from participating in an ICO as the investment in most cases does not lead to the acquisition of shares in a company. In the majority of cases, these tokens are directly connected to the project, and are considered necessary to facilitate access to the network and the use of services it promises to offer once fully implemented. Their use can range from buying storage space on a new hosting and e-mail management platform based on blockchain, to ordering products on the company online store.

Although the apparently modest or absent level of usage outside the closed environment of the issuing company, digital tokens often turn into new currencies, which are then traded for cryptocurrencies or fiat money in online platforms, thus giving rise to a secondary market in the full sense of the term. The more the underlying project receives support from investors and market operators, the more its tokens’ exchange rate rises, starting a spiral of tensions and financial speculation mechanisms that often end up not reflecting the effective market fundamentals.

The SEC’s Ruling in The DAO’s Case

The SEC’s Ruling

On July 25th, the U.S. Securities and Exchange Commission (SEC) decided to step in, and released a Report and an Investor Bulletin on The DAO’s ICO, after investigating whether the offering promoted by the organization had violated federal securities laws.

The DAO was a “decentralized autonomous organization”, a virtual entity without a common legal status, run and managed under rules encoded in computer programmes – called smart contracts –  hosted on a blockchain (often, the Ethereum’s one). It operated as a decentralized venture fund, promoting an ICO that resulted in one of the largest in the industry. Started in April 2016, The DAO’s ICO raised approximately $150 million ethers, the cryptocurrency running on Ethereum’s blockchain. More than 11.000 people decided it was worth investing their money in this project.

But on June 17, some hackers exploited a code problem and drained funds from the platform, for a total of 3.6 million ethers (approximately $70 million at the time).

The investigation pursued by the SEC’s Enforcement Division started straight after these events, with the aim of verifying if The DAO, when launching its funding campaing, was subject to the Commission’s jurisdiction amd then must comply with its provisions. The assessment of whether there was such an infringement ended with the conclusion that The DAO tokens were indeed securities, and therefore their sale was subject to federal securities laws. Specifically, the report reads that “Based on the investigation, and under the facts presented, the Commission has determined that DAO Tokens are securities under the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”)”.

Digital Tokens as Securities

The applicability of U.S. federal securities laws does not depend on the corporate form or the organization type of the issuing entity, but is based on “the particular facts and circumstances, without regard to the form of the organization or technology used to effectuate a particular offer or sale”. And in the case of The DAO, in fact, were the “particular facts and circumstances” that gave the Commission the legal certainty that The DAO Tokens presented specific features of securities, and more specifically investment contracts.

The Howey Test

The principle at the basis of this classification of The DAO Tokens as securities derives from a definition established in 1946 in the case SEC v. W.J. Howey Co. Under the Howey Test, whether an investment instrument is a security requires a substance-over-form analysis. Obiouvsly, a stock or bond is a security, but the definition of “investment contract” can be ambiguous, lending itself to different interpetations. The Commission, building on the Supreme Court’s case-law and interpretation, clearly restates that, in deciding whether something is a security, “form should be disregarded for substance, and the emphasis should be on economic realities underlying a transaction, and not on the name appended thereto”. Even if The DAO defined its ICO as a “crowdfunding campaign”, it did not possess the afore-mentioned requisites for being exempted according to the regulations in force.

Scope of the SEC’s Ruling

The SEC has deemed it appropriate to report exclusively on the legal status of The DAO Tokens. This means that in the future not all ICOs will be immediately brought under its jurisdiction and within the federal legal framework. It will be “the facts and circumstances, including the economic realities of the transaction” to determine whether an ICO involve the offer and sale of a security. Where it is established that these conditions are fulfilled, that ICO must be conducted pursuant to US federal securities laws, with the possibile consequence entrepreneurs looking to raise funds through this avenue that compliance costs associated with the ICO may outweigh the benefits of raising money through this funding method.

The Chinese Ban and Other Positions in Europe and Asia

Shortly after, another authority decided to give new emphasis to the issue. On September 4th, The People’s Bank of China (PBOC), the Chinese central bank, declared ICOs illegal, simultaneously banning any similar funding initiative. The decision came after a long investigation. According to PBOC’s statement, Inital Coing Offerings are a serious disturbance in the economy of the country and in its financial market integrity, and therefore must be considered illegal. Consequently, online platforms trading digital tokens are required to stop conversions between coins and fiat currencies, while banks are prohibited from offering financial services related to ICOs. Companies that received money through an ICO will be required to reimburse the funds (this is approximately $766 million). China, with this statement, has become the first country to ban ICOs.

After the PBOC’s move, several other governmental and financial authorities defined their position on Bitcoin and Initial Coin Offerings. Central banks of Indonesia and Ukraine has highlighted that bitcoins will no longer be considered and accepted as a means of payment. The Deputy Chairman of Ukraine’s central bank said at the Ukrainian Financial Forum that global regulators are not taking action moved by fears regarding cryptocurrencies’ growing volume, regulators are instead concerned only with the fact that people can lose money investing in cryptocurrencies. The conclusion of the Ukrainian official was that Bitcoin cannot even be considered a currency, due to the fact that it is not issued by any government body; thus it can’t be used and legally recognized as a means of payment.

Similar observations were made by the Bank of Indonesia: the Indonesian authority stated that Bitcoin transactions are not legally allowed under the Service Provider of Payment System legislation.

The Singapore Monetary Authority and the Hong Kong Securities and Futures Commission took a more open position, stating that under certain conditions ICOs may fall under securities laws but not taking any excessively strong position.

Long-Term Scenarios

After the entry into the field of global regulators as new, active players in the ICO space, it is difficult to predict what could be the likely future scenarios in ICOs and the cryptocurrencies’ market.

The SEC did not await to draw up a complete regulation before addressing the matter. Its decision to circulate some preliminary statements on ICOs in relation The DAO’s case can be interpreted as an early signal given to the market: the SEC’s intention is in all likelihood that of developing a comprehensive legal framework on the issue. A path, however, that might be gradual and targeted to specific occurrences.

The actions taken by the PRC’s central bank on the contrary take a much firmer standpoint on the matter.

An explanation to this strong and drastic decision is offered by Stefano Tresca in an article published on Tresca is an entrepreneur, founding member of Canary Wharf’s Level39, Europe’s biggest Fintech accelerator. First of all, Tresca draws a clear distinction between Bitcoin and Ethereum: while bitcoins can be mined in a limited amount, at the opposite ethers – the cryptocurrency of the Ethereum ecosystem – can be issued with no maximum limit. An explanatory comparison could be made between gold and fiat currencies: gold is a finite resource, and owes its value from this feature, while central banks can issued much more dollars or pounds than they can guarantee.

According to Tresca, once this fact has been assimilated, we should answer these two questions: where do the most important miners live? And where is the largest amount of bitcoins in the world located? In both cases, the PRC. By banning ICOs, the PRC – as we’ve just said a fundamental country in Bitcoin geopolitics – obtains two results at the same time: avoid chaos and further instability in its financial market – which has been growing fast already for some years – and prevent the issuing of several new Ethereum-based digital tokens from companies launching ICOs, thereby favouring Bitcoin, the other cryptocurrency where the country is the worldwide market leader. In the short-term, the PRC’s ban has resulted in a sharp fall in Bitcoin’s exchange rate: despite new ICOs lead to the issuance of new Ethereum-based tokens, in fact, these tokens can be bought using bitcoins, pushing up its demand and the already high exchange rate. But in the long-term, the PRC’s ban – together with the SEC’s decision to regulate ICOs in the next future – may generate a positive effect.

The future is uncertain but what is certain is that cryptocurrencies and raising capital through Initial Coin Offerings is increasingly becoming an important way of financing for companies. This means that regulators worldwide will need to find a way to thread this into their rules, and in the long term this might provide a boost for entrepreneurship.

Each country should therefore consider how it can accept, perhaps regulate this space in order to allow it to thrive in safety for market operators and investors, carving out a place for itself on the market.


foto giacomo b




Stefania Lucchetti and Giacomo Bocale

© 2017. For further information Contact the Authors

Articles may be shared and/or reproduced only in their entirety and with full credit/citation.  This post is for information only and is it is not to be considered legal advice.




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