I was on CryptoTrader on Thanksgiving, talking about changes in the U.S. regulatory environment for ICOs.
1) Getting it out of my system: I told you so
The American Initial Coin Offering is dead.
As I predicted, years ago. In case you’re wondering why I make predictions years in advance, such as
- my 2013 prediction that the UK’s Help to Buy scheme would end badly, or
- my 2014, 2016 and 2017 predictions that the American ICO market would come crashing down due to regulatory intervention,
I make those predictions for days like today, when they finally come true.
Today’s post to my blog is the latest, and arguably best, post in my ICO Mania series. That’s because, today, I can prove that my bear case for crypto was absolutely correct in predicting major regulatory headwinds at a scale that few other lawyers, or investors for that matter, foresaw.
I take an ultra-conservative approach when it comes to token issuances in the United States, and have done so for years. This has not been an easy position to publicly maintain for the last half-decade. The great and the good of cryptocurrency, including numerous cryptocurrency foundations and their “billionaire” entrepreneur sponsors, BigLaw partners, Coin Center (more) (more), USV, a Cardozo/Consensys joint venture, a Coin Center/Consensys/Coinbase/USV collaboration, venture capitalists talking their books, and others have all insisted, at various points, that there is some magical workaround, some way that a token becomes useful-enough, which has the result that the registration requirements of U.S. federal law no longer apply.
I was right. They were wrong.
In the instant case, the two companies that settled – Paragon and AirFox – each agreed to register the tokens as securities within 90 days, and to pay a substantial fine. The SEC concurrently announced pathways to compliance for token issuers, unregistered token investment funds, unregistered exchanges and unregistered broker-dealers. All of this follows last week’s enforcement action against a founder of the decentralized exchange EtherDelta, who no longer runs it, yet was made to pay restitution and penalties.
These enforcement actions are an earthquake that should be felt by the entire cryptocurrency and digital asset space, all over the world.
There is nothing extraordinary or particularly interesting about these enforcement actions by themselves; one could describe the orders as being mundane. It is for this reason that these orders are notable; they all but destroy a narrative that I have often heard in legal and VC circles, accepted hitherto as gospel, that US regulators will “only go after bad actors” or “the most egregious frauds,” and that strength in numbers from the startup side of things will overwhelm regulators’ ability to cope or, Uber-style, convince the regulators of the errors of their ways.
This assumption and comparison – which I have heard dozens if not hundreds of times over the last five years from investors and entrepreneurs alike – is flat wrong. VCs everywhere with no legal training, enabled by too-clever-by-half associates and advisers, failed to appreciate the meaningful difference between a municipal taxi regulation and federal law, and underestimated the intelligence and professionalism of those enforcing it. They thus failed to see what is becoming increasingly clear: the SEC intends to go after anyone in the ICO space who violates U.S. securities laws, well-intentioned or not, honest or not, technologically sophisticated or not, VC backed or not.
“But the SEC is a law enforcement agency, they don’t decide what the law is,” I hear you say. Yeah, OK. Sure. Let’s noodle on that for a second. It’s possible that, rather than roll over and die, some extremely wealthy coin promoter is going to decide to use his or her resources and a not inconsequential percentage of what time he or she has left on Earth to fight the SEC all the way up to the Supreme Court, and seek to overturn 70 years of extremely solid precedent on the basis of “because blockchain,” unlikely though that is. To the extent that unlucky entrepreneur’s scheme fits the standard mold we’ve come to expect of ICOs in the American market, I do not believe that effort will be successful, although I wish him or her the best of luck, if for no other reason than the college tuitions of the lawyers’ children for which such an action will pay.
2) So what’s next?
Companies that think they have a compliance issue on the ICO front shouldn’t panic. What they should do is convene their boards and call a lawyer, immediately.
Crucially, startups should get psychologically prepared to put in a lot of time and effort on a compliance program. What exactly this will look like for a particular startup will depend on a number of factors, e.g. whether any tokens have actually been issued or whether only SAFT notes are outstanding, whether those tokens have been listed on public exchanges, the residence of the team and investors, and the content of marketing efforts undertaken to date. Depending on those factors a number of different pathways might be available, including registering the token as a security, eliminating any U.S. touchpoints and moving the project offshore, or winding the project down and refunding investors.
Digging in one’s heels and fighting is also a possible option, but one which I would consider inadvisable for most startups.
In practical terms, for most ICO startups, the party, at least in the United States, is over. The landscape that makes ICO business practices so much more attractive than traditional capital-raising models has changed irreversibly. Much of the ease with which current coin businesses operate, including low overheads and the ease of onboarding new users, is facilitated by deficient compliance processes and absent licensure. Most existing “coin” services infrastructure accessible in the U.S. has a long way to go before it is in a position to deal in regulated products. Many coin issuers and service providers may not have the resources to achieve compliance. This includes exchanges. Overseas exchanges, based on their past performance, are unlikely to try.
At the issuer level, registration and ongoing reporting is extremely expensive, for which reason I cannot see it ever being an attractive option for seed-stage firms. Additionally, to the extent that Palley’s view is correct (it’s a fact-based determination, but I agree with his view that most ICO tokens, as they are encountered in the wild, are securities under U.S. law) this also has implications for any and all altcoin exchanges servicing U.S. customers, who will either need to register as national securities exchanges or cease servicing the U.S. For real, though, not just by easily-circumvented IP blocking.
The knock-on effects for the rest of the crypto ecosystem will be substantial, as U.S. projects wind down or register, projects that have not yet issued tokens pivot to Europe and Asia, and years of legal wrangling begins to pick up the mess engendered by a couple of years’ worth of crypto-anarchic whataboutism, Silicon Valley move-fast-and-break-things-ism and plain old bad legal advice.
In terms of assessing projects who really took the “Fat Protocol” thesis on board and are too far down the line to pivot, if I were running an altcoin portfolio for a living, today I should mark any such assets – if U.S.-based and having seriously deficient securities compliance – to zero.
None of this, of course, should come as any surprise to anybody who bothered to take the time to read the nearly 75 years of U.S. caselaw that exists on this question. Historia magistra vitae est. One wonders how many billions of dollars of value are going to be destroyed as a result of our industry’s shortsightedness; losses which might not have been, if only people had cultivated respect for legal history and the law, paid a little less attention to the salesmen, and paid a little more attention to the skeptics.
So the FCA’s Cryptoassets Task Force Report is out today. Compared to the last time the FCA chimed in on crypto, there are few surprises/not a lot to write home about.
For this reason, rather than writing a blog post, I have decided to go all “Web 2.0” on everyone by writing a Twitter thread instead.
Ethereum’s cryptocurrency, Ether, peaked at $1397.48 per coin on 14 January, 2018.
Eight months later, Ether is today at $190 per coin. Put differently, Ether has lost 87% of its value since January.
This is not something Ethereum’s promoters expected, nor is it the vision they sold, a year ago.
Buy the dream
A little over a year ago, my longtime acquaintance and philosophical opponent Vinay Gupta wrote a very well-shared piece titled “What does $100 Ether mean?” as the price of Ethereum’s cryptocurrency, Ether, blew through $100 (then $200, then $300… all the way to nearly $1,400). At the time, Vinay wrote:
Today, Ether hit $100 (update: it’s $300 now, five weeks later). I’m sure by the time you’re reading this it will be in The Guardian and the New York Times as a curiosity piece. Our market cap will approach thirty billion dollars. By all and any standards, this is a success beyond anything dreamt of when the project started, and the money raised will continue to finance technical innovation for years to come. While the impact and worth of a technology cannot be measured by money alone, on this occasion, celebration is appropriate. We have done well.
What followed was a paean to Ethereum as the future of the internet. The price of the coin, Vinay said, was the very embodiment of the hope Ethereum’s most fervent adopters; its entry into the annals of titans of world finance, like JP Morgan or Goldman Sachs, guaranteed:
I think Ether at $100 means that so many people believe in the world they think Ethereum will create, that it is becoming inevitable. I suspect that the full implementation of that vision will be a lot more humane and user-friendly than most of what people are thinking about right now…
…Regardless of how the technological details are worked out, I am more convinced than ever that the smart contract ecosystem is here to stay, because people want it, they need it, and it solves problems they face regularly. It may well be used by ordinary people 50 times a day without ever realizing they have touched it.
And how many “ordinary people” will Ethereum service? According to Vinay & co, “millions:”
It means that enough people are rallying around this vision of the future, and putting their money on the line for it, that the core development teams and entrepreneurs building that future will be funded more-or-less indefinitely. It means that there’s a massive wave of product innovation as people try to figure out how to get the millions of Ethereum users to spend their money on our products, and that evolutionary process builds further into the potential that the Ethereum system has to satisfy real human needs and desires.
Sell the news
But, of course, there aren’t millions of users; there are perhaps 100,000 active addresses on the network each day, and roughly only 5,000 or so DApp users (I stress, these are maximum numbers, and the likely number of actual users is considerably lower than this). Absent some very major technical innovations which do not as yet exist, Ethereum breaks whenever a few hundred people try to use it at the same time. Ethereum very obviously lacks the capacity to address millions of users, unless those users do absolutely nothing with the cryptocurrency except hold onto it and hope that the value will rise.
I have been aware of these limitations from the start, which is why I have long been skeptical of the Ethereum team’s claims. I remember, back in 2014, attending the very early Ethereum meetups and being told that Ethereum would become a “world computer” capable of running the entire internet on this one, fully-decentralized platform. This is a contradiction in terms, mind you, as it seems awfully centralizing to be using a single instance of a blockchain database to decentralize all the things.
But the “world computer” made for fantastic advertising. Remember the marketing? Hospitals, automobiles, groceries, identity, local government, payments, cloud storage, encrypted messaging, airplanes, power stations… Ethereum, Ethereum the World Computer, the one Ethereum that held its ICO back in 2014, that Ethereum whose coin we were all told to buy, was quite literally “the secure backbone for everything” and was going to do it all.
And you people believed it.
It was all bullshit, of course. Ethereum can barely handle the traffic it gets for a single Initial Coin Offering. But it was easier, and it apparently continues to be easier, for uncritical journalists and conferences looking to fill airtime to find some coin sellers wearing unicorn t-shirts to talk nonsense for 45 minutes than to learn who is actually building real applications with actual, working code, and ensure that those people get airtime instead.
I never bought Vitalik’s vision. Loathed the Ethereum-as-cryptoccurency vision, actually. I always thought smart contracts should be free to develop and use, as Nick Szabo first described them in 1997, rather than pairing smart contracts with an investment scheme designed, seemingly, only to extract economic rent for the benefit of early adopters at every stage of the system’s future use.
Indeed: what is now known as the “permissioned” or “private” blockchain grew out of the realization that a single, stateful Ethereum instance shouldn’t scale, doesn’t scale, and never will scale, but stateless standards for blockchains and languages, like HTML, can scale (giving rise to a codebase that lives on today as the absolutely-free-to-use Hyperledger Burrow, the Hyperledger project’s Ethereum Virtual Machine).
Practical concerns about Ethereum’s capabilities were not, last year, foremost in everyone’s minds. Making money, however, was. As Ether blew past $300/coin in September of last year, I had lunch with a private equity bod one afternoon in New Haven.
Echoing similar noises that could be heard about the housing market in 2006, the investor told me that “nobody in cryptocurrency could imagine the price of this stuff going down.” “Is that so,” I thought.
I wrote my most popular blog post ever, the Bear Case for Crypto, later that night. I recommended that people run away from Ether as quickly as they could. At the time Ether was $385/coin.
Ether is now at $190 and falling fast, with no end in sight.
I write this blog post only to put down a marker for historical purposes. My thesis in “the Bear Case for Crypto,” for those of you who do not care to read it in full, was simple:
First, cryptocurrencies are being wildly over-sold by their promoters. Technical promises – such as Zerohedge which name-checked Microsoft in an Ethereum Enterprise Alliance puff piece while repeating the garbage claim that Ethereum can process a million transaction per second (it can’t) – bore no relation whatsoever to reality. Most code-free ICOs are in the same boat: as Matt Levine put it, people selling things in crypto are “like if the Wright brothers sold air miles to finance inventing the aeroplane.”
Second, on account of this expectation/reality mismatch, the 2017 bubble was unsustainable and anyone who advised you otherwise was a charlatan or a fool, or possibly both.
Third, it was, as of last September, very likely that a crash and regulatory intervention would create a self-reinforcing feedback loop which would bring about it a catastrophic crash in the value of cryptocurrencies. I referred to this event as the “zombie marmot apocalypse.”
Re: 1, res ipsa loquitur. That’s Latin for “I am dropping my microphone.”
Re: 2, see above.
Re: 3, it is of course difficult to gauge why investors are dumping their coins, as I have not yet learned telepathy. However, if we’re selling the news, last week Shapeshift’s announcement that it was implementing basic KYC procedures (pursuant, in all likelihood, to a request from the Department of the Treasury) resulted in a 20% sell-off in Bitcoin.
Which means there is indeed a relationship between regulatory action in the U.S. and the price of Bitcoin, such that we may expect an end to regulatory forbearance to exert downward pressure on Bitcoin’s price and indeed the price of all coins in the ecosystem.
I will therefore update my prediction from a year ago. If
- a civil case and criminal charges are brought against a major ICO promoter and/or cryptocurrency exchange operator for perpetuating coin investment schemes in contravention of some provision of the Securities Acts other than obvious fraud (any day, now, SEC & DOJ, you’ve had four years);
- a major exchange is shut down for AML violations or charges of market abuse/manipulation; and/or
- Tether, the central bank of Bitcoin, implodes due either to the allegations of noncompliance or allegations of non-possession of funds turning out to be true,
you should expect drops in the value of the crypto-economy roughly on par with, if not greater than, the plunge in value we saw when ShapeShift announced its KYC policy last week.
Thus ends roughly a year of blog posts I have written about ICO Mania, which – seeing as the conventional wisdom, i.e. the Economist, has now adopted the view I have espoused consistently since 2014 (and the Economist quoted me in the process as well!) – also means that I have accomplished everything I set out to do when I started this series last August. Chiefly, I have done my part to convince the world – before the world even wanted to be convinced – that most ICOs were a pile of hot garbage.
Going forward, I am planning to redirect the majority of my writing and research efforts into other less critical, and more productive, areas of the blockchain and cryptocurrency space, like building systems that automate securities lifecycle management or figuring out thorny legal questions for clients who are developing new and interesting peer-to-peer network applications.
I may, of course, chime in from time to time on this project or that one, but will be de-emphasizing the criticism from here on out.
So, what does $100 Ether mean?
Or rather, what will $100 Ether mean, when that price level is inevitably reached once again in the next few weeks?
What Stephen said.
As a parting note, to close this series, I would encourage everyone reading this post to remember the following:
Remember the future you were sold in 2017. Remember who sold it to you. Remember the fairweather folks who were made rich by these offerings, or worked for ICO mills, but now feign disapproval as the wind blows against them. Remember how those the coin bubble enriched the most cavalierly dismiss criticism of their products’ nonperformance, now that the tide has gone out.
Remember the small cadre of skeptical voices that tried to warn you about all of this so that you did not get burned, as you have undoubtedly been burned very, very badly.
Remember to apply that same skepticism to every investment decision you make from here on out.
This is the latest entry in my ICO Mania series of blog posts.
The Shapps Incident
Speaking as one who has long waited for legislators and regulators to get serious about cryptocurrency and blockchain tech, yesterday’s alleged scandal involving Grant Shapps MP is not only shocking, but it tells me that the state of ICO regulation in the UK is years away from being what it needs to be.
For those of you who were living under a rock, Grant Shapps – former co-chair of the British Conservative Party and a member of Parliament in that country – yesterday stepped down from both a Parliamentary working group and an ICO’s advisory board after it was alleged in the pages of the Financial Times that Shapps apparently failed to disclose a $3.7 million interest in tokens issued by an ICO. Note, officers of the allegedly offending ICO itself also advised the Parliamentary working group.
That something this inappropriate could allegedly happen in such close proximity to the heart of the regulatory process shows that it is more likely than not that the British government is, currently, totally blind to the size of the issues presented by the space they are only now beginning to understand, and the extent to which they are failing to exercise their duty to the public to quickly achieve competence and work with industry to establish appropriate supervisory frameworks.
It’s time for regulators around the world to (a) get serious about learning how this technology does and does not work, (b) work with legislators to get the power to put an end to market conduct which is abusive of the investing public and (c) put those powers to use.
An exercise in futility
Over the years, I have had the privilege to speak with regulators, law enforcers, legislative aides and legislators alike, in several countries, about the danger that the proliferation of ICO, or “Initial Coin Offering,” schemes poses to the investing public. I have done so consistently and unwaveringly since 2014.
To date, warning regulators about this misconduct has been an exercise in futility.
The more money these ICO schemes make for their promoters, the less the warnings are taken seriously, not only by new entrants seeking to raise money in the space or investors doing diligence, but also by regulators who have become accustomed to coin offerings as a fact of life.
The reasons why this should be the case are clear enough to me. Cryptocurrency companies with vast marketing and lobbying budgets have sent sufficiently hip and sloppily dressed technology emissaries ’round the capitals of North America and Europe, peddling decentralization prosperity gospel to our leaders, and blinding them with the promise of “blockchain technology.”
A small but not insignificant number of the companies in “blockchain” do good, honest, and solid development work. But they are in the minority. To any half-decent engineer, most of the claims peddled by the average ICO firm these days are, transparently, garbage. So-called “stablecoins” set themselves apart as being particularly awful, but many others that don’t try to be anything other than a cryptocurrency are themselves chronically oversold. The much-vaunted Eos scheme, for example, which raised more than $4 billion, utilizes four-year-old consensus tech known as delegated proof of stake which wasn’t that impressive on the two occasions it was tried previously (Bitshares and Steemit) and remains unimpressive now, at least to anyone whose opinion I respect.
The issue, of course, is that most people in “blockchain” arrived on the scene in the last 12 months. As a consequence, they are unable to exercise the requisite levels of diligence to sift out the marketing B.S. from genuine innovation. This explains, for example, the U.S. Securities and Exchange Commission’s legally puzzling pronouncement, which appeared to borrow heavily from the logic put forth by U.S. lobbying firm Coin Center, that Ethereum, which virtually any legal professional I know will agree started its life as a security, somehow transmogrified into a non-security by the mere passage of time (despite there being no basis in the precedents I’m aware of for such an interpretation).
Or why a European Parliament subcommittee produced a breathless resolution that read like a marketing document that might be more at home on the blog of the European Commission’s “blockchain observatory” development partner, ConsenSys, than it would be as serious legislation that could be found within a library of evenhanded assessments of blockchain tech.
Those of us standing against unqualified evangelism – the half-dozen or so consistent and battle-weary public “skeptics” like myself, Izabella Kaminska, Tim Swanson, and David Gerard, who between us have $0 in marketing budget and have to earn a living without recourse to the coin-capital markets – look on with ever-increasing levels of horror as unbridled greed goes unchecked and indeed is endorsed by regulators who have been told, and in good faith believe, the lie that in order to utilize blockchain cryptography, a coin is required.
This is not to say that the entire space is a waste. I firmly believe that cryptocurrency and cryptography combined with distributed systems, which currently takes the form of blockchains, will change the world. Indeed, these things already have changed the world.
However, I also believe that ICO boom is to “crypto” what the Railway Mania was to the industrial revolution. Lasting change will come not from an infinite proliferation of instamined “shitcoins,” or by handing hundreds of millions of dollars to un-tested novices whose only objective is to drive up the price of the digital assets they sell. Distributed cryptosystems will, as with all technologies, evolve incrementally and as a result of a slow and gradual process of adoption and developer familiarity with the tooling.
There are well-worn methods for promoting innovation in cryptocurrency (see e.g. the BIP process for Bitcoin) and in blockchain-without-the-coins (see e.g. the development process utilized by the Hyperledger project). Note, in each case, that the substantial development – hundreds of thousands of man-hours – that has occurred in either project has required the sale of precisely zero coins of any description, and certainly not the excessive sums like the $1.5 billion raised by Telegram or the $4 billion purportedly raised by Eos.
This brings me to my main point. What is not required for a healthy innovation sector is the repetitive, cookie-cutter ICO industry which has been allowed to proliferate in the U.S. and the U.K. almost completely untrammeled for the last four years. Which I find problematic, which practically every lawyer I know finds problematic, and which regulators on both sides of the Atlantic Ocean have singularly failed to address directly for half a decade or more.
Parliament, in particular, should bear some responsibility for the inability of British regulators to address market misconduct occurring within the jurisdiction. Numerous coin schemes have been run out of London. Stand-out examples of regulatory inability to come to grips with “blockchain” include:
In May 2016: A “decentralized venture fund,” calling itself the “DAO,” is launched from London and Berlin. The scheme quickly raises $150,000,000 in outside capital. However, because the smart contract administering the scheme was sloppily written, the DAO was hacked and the scheme collapsed, causing user funds to be lost (although later efforts by the Ethereum Foundation ensured that some of the funds would be reclaimed). No action was taken in England and Wales; the U.S. S.E.C. wrote a “report of investigation” in July 2017 rapping the DAO scheme on the knuckles for violating securities laws in that country.
September 2016: the UK FCA warns consumers about the Onecoin Ponzi scheme while at the same doing nothing to intervene in the scheme: “This firm is not authorized by us and we do not believe it is undertaking any activities that require our authorization. However, we are concerned about the potential risks this firm poses to UK consumers.”
September 2017: the FCA, after what must have been a thorough review, confirms what many practitioners suspected when it says it has almost no statutory power to supervise cryptocurrency and ICO offerings, leaving no dedicated regulator with the remit.
January 2018: The Bitconnect Ponzi scheme, which was apparently administered by an English registered shell company, is shut down. More to the point, it is shut down after regulators in Texas of all places filed a cease-and-desist order against the company and the founders cut and run. As far as I can tell, no investigation or regulatory response ever occurred in the United Kingdom.
May 2018 – Ripple Labs states, to a committee of Parliament, that its business has no relationship with the cryptocurrency XRP despite the fact that this assertion is frequently disputed in the cryptocurrency community. Members of the Parliamentary Committee lack the competence or sector knowledge to challenge this assertion on the spot.
July 2018: Grant Shapps MP, former co-Chairman of the Conservative Party, steps down from his role in the All-Party Parliamentary Group for Blockchain tech for allegedly receiving compensation from one of the schemes he’s meant to be supervising and allegedly failing to disclose this to Parliament.
I warned in November of 2017 that failure to adequately supervise the cryptocurrency space will create levels of systemic risk which could potentially endanger the mainstream financial system. Last week we learned from the erudite Bitcoin banker OG Caitlin Long that ICO issuances were, in dollar terms, equal to 45% of IPO issuance in Q2 – with nary a prospectus or registration statement in sight.
Regulators of the world, the time for exploratory work is past. Clean house, come up with a battle plan, establish a supervisory framework, and enforce it.
It’s long overdue. There’s a real possibility it will soon be too late.