April 20, 2018

In 2017, $5.6 billion was raised for blockchain-based development projects through a new funding mechanism dubbed an ‘ICO’ or Initial Coin Offering. By comparison, $240 million was raised by the same method in 2016, while it’s estimated $1 billion has already been invested in the first two months of 2018. There is a rush for digital gold and with it comes a hefty dose of snake oil. Ethics takes a back seat in the dash for cash as the authorities scramble to keep pace. How can regulatory policy protect the unwary without stifling innovation?

Hold on, what IS blockchain?

Much of the world is still blithely ignorant of blockchain and cryptocurrency, so let’s take a step backwards and look at the landscape in a little more detail. Back in 2009, the first working cryptocurrency, Bitcoin, arrived on the scene. The system, devised by the pseudonymous Satoshi Nakamoto, was the realization of decades of theoretical work which sought to solve the problems of double spending, money creation and security for a purely digital asset. Worth only a few dollars to those who were willing to exchange them, Bitcoins were seen as largely experimental and used predominantly in online gaming. In those early days, U.K. singer Lily Allen was offered an estimated 200,000 Bitcoins for an online gig on the Second Life platform. She declined.

Bitcoin seemed to be a novelty to the casual observer, but a lot of attention was being paid to the tech beneath the coin, known as distributed ledger technology (DLT). The concept of a chain of immutable, transparent and decentralized transactions immediately caught the attention of developers and service providers. To what processes other than the transfer of a unit of cryptocurrency could blockchain technology be applied?

Wherever there are multiple stakeholders (such as auditors, regulators, registries, buyers and sellers) and a clear set of rules for every stage of a transaction, a blockchain can take the strain. There are plenty of projects in progress at the highest levels of global society. Representing the drive for social impact, leading NGOs and the United Nations are subscribing to the concept. The World Food Programme’s Building Blocks project started in 2016 in Jordan, increasing the reach of food aid while reducing the potential for fraud and data mismanagement.  In the capitalist corner, banks and financial institutions are eyeing up blockchain solutions to streamline their processes and reduce their costs, notably through the R3 Corda project whose membership includes banks, insurance companies, financial institutions, regulators, trade associations and technology companies. One of a growing number of high-profile implementations, the Australian Securities Exchange, is moving to a blockchain-based equities clearing system. In Wyoming, dubbed ‘Blockchain Valley’ by Newsweek, the legislature has passed five bills into law for the advancement of cryptocurrency and blockchain technology.

A good example of a private transaction that might be managed through a blockchain application is buying a house. Before a sale is complete there are searches and surveys to be done, legal agreements to be settled, money to be put in place and registries to be interrogated and updated. These transactions are repeated whenever a property changes hands, they involve multiple agencies (registries, banks, surveyors and advertisers) and we rely on trusted individuals to coordinate the paperwork. Would it be less frustrating as a buyer or seller to have a transparent view of the progress of the transaction? Could these familiar steps be managed by rules encoded in software? How would you pay for such services?

This is the background to an explosion of business proposals from payment processing to content sharing, through betting and gaming, to any situation where an agent could be replaced by a piece of software. Innovation is rapid and the blockchain technology itself is moving just as fast. New blockchains and cryptocurrencies are springing up in all directions following hard on the heels of the versatile Ethereum blockchain, which launched in 2015. It’s an exciting time.

Initial Coin Offerings and Tokenization

One of the many useful features of blockchain applications is the ability to settle transactions within the ecosystem using either a mainstream cryptocurrency or a local token. It’s cheaper than paying bank charges and gets over the headache and volatility of cross-border currency conversions. It reduces risk to the user by minimizing the personal and banking data that is exposed to the network. Tokens have the added advantage of building loyalty to the brand, in the same way that air miles keep regular travelers attached to their carrier of choice. These are generally referred to as ‘utility tokens’ and form an inherent part of transaction management in the application. In the example of a property transaction, buyers would acquire tokens to pay for the surveys and searches on their house.

For anyone who intends using one of these new applications, it could be an advantage to have some relevant tokens already in the bag. Software developers have not been slow to recognize this. If users are ready to pay before the system is launched, this is a potential source of finance for the development process, bypassing traditional funding routes and avoiding cumbersome paperwork.

The value of most cryptocurrencies has, over time, been rising against our fiat currencies (the dollar, pound sterling etc). This means that there could be an economic advantage in stocking up on tokens before a system goes live. Locking some cash away in a token could pay handsomely when a new system is launched successfully. So when does a token cease to be a useful form of local payment and become an investment vehicle?

This is the question that is challenging regulators the world over, and there is an urgency to their work. If you buy tokens for use in an application that exists only in potentia, can you be confident that the work will be done? Are you investing with your eyes open? Where can you turn if the ICO turns out to have no substance to it?

Unfortunately, there is a lot of snake oil about. Estimates vary, but speakers on the topic at the recent South by Southwest (SXSW) conference suggested that over 80 percent of ICOs to date have been fraudulent and noted that only a tiny percentage of genuine projects have succeeded in bringing applications to market in a timely fashion. Ethereum founder Vitalik Buterin went on record in January 2018 to warn potential investors to take care. The State of the Token Market report also makes for a worrying read. Of 913 ICOs identified in 2017, 347 did not report their end result, or simply disappeared. In San Francisco, a parody ICO called ‘Ponzicoin’ attracted substantial real investment before the shocked creator closed it down.

Securities regulation: Protection or overkill?

The Securities and Exchange Commission (SEC) has been forthright about ICOs and cryptocurrency, aiming to protect the investor. SEC Chairman Jay Clayton’s statement in December 2017 set out some clear boundaries: Is the product legal? Is the offering legal? Are the markets fair? What are the risks? There is great concern that the unethical are preying on the unwary, and the SEC is taking practical steps to protect its investors. Following investigations into several failed ICOs last year, suspension of trading in three companies linked to cryptocurrency in February, and targeted subpoenas on certain ICOs in March, the U.S. can probably expect some onerous regulation to arrive sooner rather than later. But is this a good thing?

There are legitimate concerns that over-zealous regulation, while tackling the unethical, will stifle the innovative and drive many towards the more lenient regulatory regime in Europe, or to unregulated nations. Blockchain is, by its very nature, no respecter of national borders. An application can be run from any or several places across the globe. The State of the Token Market report highlights the fact that token sales and their founding teams are geographically decentralized.

So what of the rest of the world? The range of measures already proposed covers the whole spectrum of possible policy. China banned ICOs altogether last year, alongside a clampdown on cryptocurrency mining. Switzerland, which welcomes and supports ICO fundraising, makes a distinction between securities and utility tokens, requiring the latter to be functioning on a live application before any money is raised through that route. In France, proposals have been put forward for deliberately light touch, optional regulation where adherence will signal reduced risk to investors and innovation is less likely to be stifled than if governed by strict stock exchange standards (read the original article in French here). The tiny Mediterranean island nation of Malta has declared itself the Blockchain Island, while neighboring Gibraltar has introduced a Distributed Ledger Technology (DLT) regulatory framework.

The recent announcement that the powerful Binance exchange is moving to Malta gives a clear warning of the dangers of over-regulation. The move to Europe has resulted directly from crackdowns in Japan and China, say commentators at Bloomberg.

How can policymakers promote ethical practice?

Our policymakers have two clear choices: Either they can clamp down hard on the unethical and fraudulent, and in so doing, discourage genuine innovation, or they can themselves innovate. Financial regulation has been the first port of call for most states, a reaction based on existing practices. But blockchain technologies and cryptocurrency are different and require more finesse and forward thinking. Robust legislation already exists to prosecute fraudulent business practice. Genuine applications of the technology are multiplying by the day.

Policy should be more granular to handle emerging technology. Why not require the auditing of ICOs before they go live? Companies like U.S. based Hosho Group are championing the audit process, a strategy which protects innovators and investors alike. What should investors demonstrate before they are allowed to place their money? However sophisticated the investor, if they do not have the technical know-how to evaluate an offering, they are in danger. Requiring a level of technical knowledge, or appointing a regulated specialist intermediary, should be the first test. Don’t run after the glint of gold: Learn to look carefully at the people who are selling the shovels.

Our challenges in this brave new world of blockchain, cryptocurrency and innovation are to embrace change and to educate ourselves. The challenge to policymakers is to lead the way in ethical practice and in doing so encourage the best to rise to the top.

Kate Baucherel
BA(Hons) FCMA is a digital strategist specialising in emerging tech, particularly blockchain and distributed ledger technology. She is COO of City Web Consultants, working on the application of blockchain, AR/VR and machine learning, for blue chip clients in the UK and overseas. Kate’s first job was with an IBM business partner in Denver, back when the AS/400 was a really cool piece of hardware, and the World Wide Web didn’t exist. She has held senior technical and financial roles in businesses across multiple sectors and is a published author of non-fiction and sci-fi. Find out more at katebaucherel.com