Immediately preceding the Munchee's ICO shutdown last month, SEC Chairman Jay Clayton produced a report offering surprisingly sound advice on cryptocurrency investments that even veterans in the space would agree with. In this article, we're going to go through Clayton's report point-by-point, analyzing the effectiveness of his claims. Ultimately, it boils down to due diligence leading to calculated risk-taking and decision-making.
Be wary of guaranteed returns, zero accountability and trust-based investments
As with any other type of potential investment, if a promoter guarantees returns, if an opportunity sounds too good to be true, or if you are pressured to act quickly, please exercise extreme caution and be aware of the risk that your investment may be lost.
The ICO market is rife with tiered bonuses dependent on how early you bought in and how much you bought in for. Adding to Clayton's words here, one should be extremely wary of ICOs that pressure investors to buy-in quickly. Investments should always be made in a deliberate and calculated manner, always do your own research.
Recognize that these markets span national borders and that significant trading may occur on systems and platforms outside the United States. Your invested funds may quickly travel overseas without your knowledge. As a result, risks can be amplified, including the risk that market regulators, such as the SEC, may not be able to effectively pursue bad actors or recover funds.
To the cypherpunk and crypto-anarchist, unregulated markets is the boon that cryptocurrencies offer. To the layman getting involved with altcoins and ICOs to "get rich quick", this will come in as an unpleasant shock when an investment goes wry. Semi or full-anonymity paired with permissionless global transactory power means that buying into an ICO is a highly risky affair. A bad actor in sheep's clothing can and will run away with the funds if due diligence isn't done.
Notice: It's important not to conflate the risks involved with Bitcoin in contrast to ICOs and the vast majority of altcoins. Bitcoin is a decentralized and entirely bootstrapped technology with substantially increased life expectancy due to the Lindy effect. As Jimmy Song noted, "The main advantages of Bitcoin are network effect and proven security. Both are nearly insurmountable advantages." This is in addition to Bitcoin's proven use case a store of value, with secondary functionality as digital cash, soon to be improved with adoption of the Lightning Network.
ICOs and altcoins, on the other hand, start off with minimal network effect and zero proven security. It's important to understand that any discussions of a "tulip mania" or "bubble popping" event occurring are more applicable to unestablished altcoin & ICO markets moreso than Bitcoin. There's certainly major gains to be made, but it's important to factor the above into one's risk-to-reward preferences.
ICOs can be "effective ways for entrepreneurs and others to raise funding, including for innovative projects."
Clayton acknowledges the power of ICOs to raise funds in a legitimate way, albeit with the expected disclaimers:
However, any such activity that involves an offering of securities must be accompanied by the important disclosures, processes and other investor protections that our securities laws require.
He also goes on to dismantle the commonly cited argument for ICOs not being securities:
A change in the structure of a securities offering does not change the fundamental point that when a security is being offered, our securities laws must be followed. Said another way, replacing a traditional corporate interest recorded in a central ledger with an enterprise interest recorded through a blockchain entry on a distributed ledger may change the form of the transaction, but it does not change the substance... Merely calling a token a “utility” token or structuring it to provide some utility does not prevent the token from being a security.
If it walks like a duck, talks like a duck and smells like a duck, it doesn't matter whether or not you call it a dog - it's a duck.
Later on, Clayton accurately acknowledges the advantages of cryptocurrencies, despite the fact that the SEC is generally perceived as archaic and out of touch with emerging technologies:
... Proponents of cryptocurrencies highlight various potential benefits and features of them, including (1) the ability to make transfers without an intermediary and without geographic limitation, (2) finality of settlement, (3) lower transaction costs compared to other forms of payment and (4) the ability to publicly verify transactions. Other often-touted features of cryptocurrencies include personal anonymity and the absence of government regulation or oversight.
While certainly not an endorsement, this showcases that the SEC, or at least Chairman Clayton has ceased to reduce cryptocurrencies' perceived utility to illicit uses.
How to verify?
Clayton concludes his piece with a useful list of questions that should be asked and verified before investing into an ICO. I have highlighted the most relevant ones below with personal annotations in bold:
- Who exactly am I contracting with? [Establishing that a known figure in the space is backing or spearheading the project is a positive, but not sure sign of a legitimate investment opportunity]
- Who is issuing and sponsoring the product, what are their backgrounds, and have they provided a full and complete description of the product? Do they have a clear written business plan that I understand? [Any ICO with a half-assed whitepaper is a major red flag. The only excuse is when more resources are pooled into building the platform rather than marketing material]
- Who is promoting or marketing the product, what are their backgrounds, and are they licensed to sell the product? Have they been paid to promote the product? [Be wary of popular Twitter and social media influencers shilling a product. Oftentimes they will be paid extra specifically NOT to disclose that this it is paid promotion. In cases like this, you can be certain that the marketing efforts backing the ICO are far greater than the fundamentals of the platform]
- Where is the enterprise located? [To add: is there an established legal entity backing the ICO in the first place? This will help you understand the level of accountability that the ICO will hold in the case of unforeseeable events]
- Where is my money going and what will be it be used for? Is my money going to be used to “cash out” others? [ICOs seek to raise exorbitant amounts of money in relation to the platform they're attempting to build and the size of their team. The whitepaper almost never provides a satisfactory amount of detail on where the invested funds will be used. You are encouraged to get the full picture here - and be even more wary of ICOs that have unreasonable limits.]
- What specific rights come with my investment? [What will the token issued to you entail? Oftentimes, there is no specific link between the growth of the token's value and the growth of the platform backing the token, leaving investors hanging high and dry]
- How, when, and at what cost can I sell my investment? For example, do I have a right to give the token or coin back to the company or to receive a refund? Can I resell the coin or token, and if so, are there any limitations on my ability to resell? [Similar to the point above]
- If a blockchain is used, is the blockchain open and public? Has the code been published, and has there been an independent cybersecurity audit? [Be wary of any ICO that has yet to show any kind of coding competence backing their platform lest you're buying into long-term vaporware.]
- Has the offering been structured to comply with the securities laws and, if not, what implications will that have for the stability of the enterprise and the value of my investment? [Read: most ICOs are unregulated and based entirely on trust and your own due diligence. Even with verifying the information presented to you, it still presents a risky venture]
- What legal protections may or may not be available in the event of fraud, a hack, malware, or a downturn in business prospects? Who will be responsible for refunding my investment if something goes wrong? [Same as above]
In summary, the SEC continue to push their regulatory framework onto ICOs within their jurisdiction, but also acknowledge its effectiveness as a form of fundraising. The question of whether the derivatives resulting from them can produce real returns (read: outside of speculation) that live up to their valuations is yet to be seen. In the meantime don't trust, verify.
For those who have been burnt in the past:
“Sometimes you're flush and sometimes you're bust, and when you're up, it's never as good as it seems, and when you're down, you never think you'll be up again, but life goes on.”
― Fred Jung
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