While the meteoric rise of the value of bitcoins has captured public attention, the rise and fall of initial coin offerings (ICOs) and simple agreements for future tokens (SAFTs) in 2017/18, the subsequent advent of security token offerings (STOs) in 2019, and the explosive growth in Ethereum-based decentralized finance (DeFi) protocols since 2020 have largely gone unnoticed, even among finance professionals. This is surprising given the importance of the lessons these developments can offer for the future of finance.
An ICO is a new approach to raising funds commonly used in cryptocurrency projects to develop platforms. Investors engage in ICOs in the hopes that the coin (also called token) and its platform or ecosystem will succeed, that the value of the coins issued will increase, and that their return on investment will be high. Some observers view ICOs as a new, non-dilutive form of venture financing that allows founders to maintain control while raising funding and attracting future customers. Others compare ICOs to IPOs, but without a specific regulatory framework. ICOs are generally used by early-stage issuers with limited rights and varied levels of transparency, mostly targeted at token holders.
The rise of ICOs
In an ICO, a whitepaper outlining all ICO details including token supply schedule, problem statement, technical solution, team, etc., is drawn up, widely publicized, and actively marketed to investors and influencers. The token sale begins with a pre-sale phase and concludes with token issuance. These tokens can then be traded on one or more crypto exchanges that list them.
In 2015, the Ethereum network launched one of the first successful ICOs, raising 18 million US dollars. The decentralized autonomous organization (DAO), a third-party venture capital fund project, raised over 150 million US dollars on the Ethereum network in the summer of 2016 but was compromised when a hacker transferred one third of its funds to a subsidiary account. In response, the Ethereum community hard-forked the Ethereum blockchain, returning nearly all funds to the original contract.
Despite this unsettling event, the ICO wave continued. Since funds collected in ICOs are typically bitcoins or ether, it is no surprise that the first big ICO wave coincided with the 2017/18 Bitcoin bubble, when many early bitcoin investors were looking for ways to monetize and recycle their gains. For example, in September 2017, with the aim of building the first “decentralized data storage network that turns the world´s unused storage into an algorithmic market”, Protocol Labs raised over 200 million US dollars from investors for Filecoin, which incentivized the creation of a decentralized, censor-resistant virtual data storage system. Computer users wishing to store data on the decentralized system buy native tokens called FIL, while users providing data storage to the network earn FIL, and all storage deals are recorded on a blockchain.
ICOs peaked in 2018, when over 22 billion dollars were raised. In the spring of 2018, the messaging network Telegram launched two offerings, raising 1.7 billion dollars from institutional investors to develop their Telegram Open Network (TON). Soon thereafter, in June 2018, EOS, a public blockchain operating system designed to support commercial decentralization in competition with Ethereum, raised 4.2 billion US dollars.
ICOs on a collision course with the SEC
Particularly in the US, these remarkable ICO successes attracted the attention of the Securities and Exchange Commission (SEC), whose mission is to protect investors by ensuring that financial products and their offerings are legal, that trading markets are fair, and that risks are transparent. In 2016 and 2017, the SEC was scrutinizing the ICO space and especially unregistered token offerings heavily: “Companies and individuals are increasingly considering initial coin offerings (ICOs) as a way to raise capital or participate in investment opportunities. While these digital assets and the technology behind them may present a new and efficient means for carrying out financial transactions, they also bring increased risk of fraud and manipulation because the markets for these assets are less regulated than traditional capital markets.” Indeed, in 2018, the Vietnamese cryptocurrency company Modern Tech launched two fraudulent ICOs, PINCOIN and iFan, conning over 600 million US dollars from approximately 32,000 investors worldwide.
In their 2017 report on the failed DAO project, the SEC reiterated the fundamental principles of the US federal securities laws and asserted their applicability to “a new paradigm” of “capital raising entities that use […] blockchain technology to facilitate capital raising and/or investment of the related offer and sale of securities”. At the core of SEC security law investigations is the “Howey Test”, which refers to a US Supreme Court decision determining whether transactions qualify as investment contracts and must be registered as securities. The ruling finds that instruments are considered a security and fall under the purview of the SEC if they are:
- an investment of money,
- in a common enterprise,
- with an expectation of profit,
- and with the profit to be generated by a third party.
The SEC has brought cases against even highly successful ICOs. For example, in 2019 the SEC ordered Block.one to pay a 24 million dollar civil penalty for failure to register the EOS ICO as a securities offering. Similarly, in 2020, Telegram settled with the SEC, agreeing to pay an 18.5 million dollar civil penalty and return over 1.2 billion dollars to investors for failure to register its Gram tokens as a security.
Unlike SEC-regulated security tokens, non-regulated utility tokens grant access to a service or function as a medium of exchange in an ecosystem. While most ICO sponsors argue in court that their coins are utility tokens, very few are successful and most settle with the SEC. For example, in December 2020, the SEC filed a complaint against the RippleNet global payment platform and its native token Ripple (XRP), a top 10 cryptocurrency by market cap. RippleNet has sold over 14.6 billion units of XRP worth 1.4 billion US dollars since 2013. In their complaint against Ripple Labs, Inc. and the current and former CEOs Bradley Garlinghouse and Christian A. Larsen, the SEC accused RippleNet of failing to register XRP as a security offering. Ripple Labs argued that it had “never offered or sold XRP as an investment” and that “XRP holders do not acquire any claim to the assets of Ripple, hold any ownership interest in Ripple, or have any entitlement to share in Ripple´s future profits”, underscoring the utility of XRP as a settlement token. When the complaint was announced, XRP’s value fell by over 50 percent, but quickly recovered and is now among the top 10 cryptocurrencies with a current market cap of 27 billion US dollars. Several exchanges have delisted XRP to avoid lengthy and costly US security law requirements.
SAFTs as a workaround?
In order to lawfully avoid SEC registration and filing requirements, several projects have attempted to offer simple agreements for future tokens (SAFTs). SAFTs target accredited investors who finance the build phase of a crypto-currency project in exchange for the promise of tokens to be issued when the project goes live in the operational phase. Filecoin and Telegram, the two largest token offerings to date, were structured as SAFTs. The facts and evidence provided by Filecoin have (thus far) convinced the SEC of the fundamental utility of Filecoin in storing data on a decentralized network.
However, not all attempts have been successful. As mentioned briefly above, despite Telegram’s successful TON platform, the SEC forced it to stop offering SAFTs for Gram tokens in October 2019, arguing successfully in court that the tokens they would distribute at the end of the build phase are unregistered securities and that their sale is illegal in the US. The SEC argued: “We have repeatedly stated that issuers cannot avoid the federal securities laws just by labeling their product a cryptocurrency or a digital token”, insisting that ICOs must comply with legal disclosure obligations designed to protect primarily private investors. Once regarded as best practice compliance in the crypto space, the SEC´s enforcement action Telegram in particular has rendered SAFTs practically useless in the US.
SEC’s regulatory stance
The crypto community has criticized the SEC for their seemingly arbitrary approach of clarifying regulation via ex post enforcement. SEC Commissioner Hester Pierce appears to agree, underscoring the SEC’s commitment to “help[ing] people figure out when the securities laws might apply, so that we´re not faced with a situation…when we´re providing clarity through enforcement, which is never a good way”. Pierce proposes a safe-harbor policy to foster the development of a truly decentralized system without breaching securities law. Only the future will tell whether the SEC will adopt a more crypto-friendly approach under recently appointed SEC Chairman Gary Gensler, former chairman of the Commodity Futures Trading Commission, Goldman Sachs banker, and professor at MIT. Since the US securities market is the largest in the world, the SEC´s stance towards cryptocurrencies will set the tone for the regulation of cryptocurrencies around the globe.
Security tokens – Putting traditional securities on the blockchain
While ICO and SAFT sponsors underscore the utility aspects of their tokens on a specific platform or in an ecosystem, the subsequent listing of these fungible tokens attracts speculative investors who purchase tokens in order to sell them later at a higher price. When the courts agreed with the SEC that pre-functional utility tokens sold to investors expecting to turn a profit were, in fact, securities, traditional issuers began to turn away from ICOs and SAFTs, launching regulatorily compliant security token offerings (STOs) on regulated exchanges instead. tZero was the first compliant US-based digital securities exchange to initiate secondary market trading for their own security token. While the market for security tokens is still small, start-ups have begun tokenizing real assets (e.g., Exporo´s real estate token offerings) and larger companies have begun testing the market for tokenized bond offerings (e.g., Vonovia´s recent 20 million euro senior bond offering). To encourage more blue-chip issuers to follow suit, greater legal certainty around token property rights and token service offerings for safe-keeping or custody, and greater interoperability of the blockchain infrastructure facilitating the free transfer of security tokens across the internet are needed.
How could trading security tokens and traditional securities on the blockchain shape the future of finance? Many observers believe that a transparent, globally connected market enabling the instant transfer and settlement of even very small liquid investment contracts between investors and issuers could make security tokens an interoperable asset and an easily accessible, cost-efficient technology for investment markets. In addition to facilitating instantaneous 24/7 trading of fractional lot sizes, the technology simplifies dividend bundling and unbundling, voting, and other governance rights. Finally, smart contract designs ease the automation of compliance and the expansion of the design space for security contracts. Ultimately, security tokenization could disrupt the public securities markets, potentially leading to the securitization and democratization of enormous private asset markets.
The DeFi experiment – letting the genie out of the bottle
While traditional issuers have turned to security tokens, the progressive crypto community is shifting its focus to developing “decentralized finance” (DeFi). This is a movement to create and run decentralized financial service offerings and applications on open-source software platforms, developed and deployed on top of public blockchain systems - primarily Ethereum - utilizing permissionless blockchain protocols. Currently, the three largest functions of DeFi are creating monetary banking services (e.g., issuing stablecoins), providing peer-to-peer or pooled lending and borrowing platforms, and enabling decentralized exchanges, tokenization platforms, derivatives, and prediction markets. DeFi can be viewed as an experimental microcosm of a decentralized financial system running without intermediaries.
The DeFi space is currently small and has not yet attracted mainstream users or institutions. Many DeFi projects operate in regulatory grey areas and Ethereum currently faces severe capacity constraints. According to defipulse.com, approximately 45 billion US dollars is “locked” in DeFi applications on the Ethereum blockchain. At the end of 2020, Dune Analytics counted just over one million unique Ethereum addresses interacting with the major DeFi protocols. The largest DeFi protocol is Maker DAO, a non-traditional decentralized lending platform. Individuals all over the world hold the Maker DAO´s governance token, MKR, which confers the right to vote on changes to the network. The Maker protocol enables users to borrow against collateral. Unlike traditional collateralized loans, Maker allows users to borrow against various crypto assets, including bitcoins, Cardano, or Polkadot, that are deposited into Ethereum-based smart contracts. In exchange for their deposited collateral, borrowers receive newly minted Dai, a stablecoin with a soft peg to the US dollar, with the same value as their collateral. The borrowed Dai can be paid back at any time in exchange for the collateral and the returned Dai are destroyed. If the value of the crypto-collateral falls, the Maker protocol automatically liquidates that share of the assets to ensure the loan is secured. MKR tokens provide backstop liquidity in case the system accumulates bad debt. If the collateral is insufficient to cover the amount of Dai in circulation, new MKR governance tokens are created and sold automatically in an auction to raise the amount of missing collateral.
The Maker protocol is a crucial base-layer infrastructure designed to unlock the potential of DeFi. Other DeFi apps that currently operate in the Maker ecosystem and utilize Dai include the Outlet high-yielding alternative saving accounts, and Uniswap, a protocol that facilitates fast and efficient crypto trades on the Ethereum blockchain. In the gaming industry, Dai is gaining popularity as a means to build in-game economies, and Maker DAO has launched a Dai gaming initiative to incentivize the development of gaming apps with Dai rewards. It is also building a bridge to the art industry by encouraging artists to use Dai to trade digital art. Maker DAO´s long-term objective is to transfer all governance away from the foundation and to its users, relying on a system that polls MKR holders on all governance matters, such as accepted collateral, borrowing rates, and Maker representative appointments.
A critical question for the DeFi space is whether it can stay clear of surprise regulation. Unlike ICOs and SAFTs, which were issued by organizations and individuals, the space is more difficult to regulate because it is decentralized. Potentially, the SEC and other regulators could target individuals such as Rune Christiansen, the Danish CEO and developer who built the Maker protocol on the Ethereum blockchain, or other members of the Board of Directors of the Maker Foundation. However, experts consider it unlikely that courts would agree that DeFi tokens are securities. Given the global battle against money laundering and financing of terrorism, the “on-and-off ramps” that convert DeFi tokens via other crypto into fiat currencies are more likely targets. For DeFi to become mainstream, supervision will need to take place on-chain as well, monitoring activities in real-time as they are recorded on the blockchain. DeFi is likely to be adopted faster in developing economies lacking nearly all financial services, where citizens are tired of waiting for an intermediary-based financial system to develop and eager to jump directly into the decentralized future of finance. In any case, for DeFi to be more widely adopted, it needs to stay clear of scams and fraud cases. DeFi project Meerkat has certainly raised eyebrows with a claimed 31million US dollar hack just a day after launch and reports saying that there are signs the hack was in fact an exit scam.
Tips for practitioners
- Understand the history of ICOs and SAFTs and appreciate the potential of compliant security tokens, blockchain technology, and smart contracts to disrupt the securities industry.
- Observe decentralized finance (DeFi) as a live experiment in building a protocol-based financial system without intermediaries and appreciate its potential to achieve a more direct, transparent, efficient, resilient, and inclusive financial system.
- Consider designing, programming, and launching decentralized protocols and new financial instruments on public platforms to automate core intermediary functions such as receiving deposits, lending, and securities trading.
- SEC (2017b): Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Release No. 81207 / July 25, 2017, found at: https://www.sec.gov/litigation/investreport/34-81207.pdf.
- SEC (2019): SEC Orders Blockchain Company to Pay USD 24 Million Penalty for Unregistered ICO, Press Release 2019-202, found at: https://www.sec.gov/news/press-release/2019-202.
- SEC against Ripple Labs et al. (2020), found at: https://www.sec.gov/litigation/complaints/2020/comp-pr2020-338.pdf.
- Keller, Lachlan (2021): As the SEC goes after Ripple and Bitcoiin2Gen, is DeFi next in its line of fire?, February 1, 2021 (updated February 21, 2021), found at: https://forkast.news/defi-future-crypto-sec-decentralized-finance/.
- Exporo website at https://exporo.de/blog/blockchain-exporo-treibt-den-wandel-der-immobilien-anlageoptionen-an/
- Vonovia website at https://presse.vonovia.de/en/aktuelles/210113-vonovia-emittiert-erstmals-vollstaendig-digitale-schuldverschreibung
- McKeon, Stephen (2020): The Security Token Thesis, in: hackermoon, May 23, 2018, found at: https://hackernoon.com/the-security-token-thesis-4c5904761063.
- Crawley, Jamie (2021): DeFi Project Meerkat Raises Eyebrows With Claimed USD 31 M Hack a Day After Launch, on: coindesk, March 4, 2021, found at: https://www.coindesk.com/defi-project-meerkat-raises-eyebrows-with-claimed-31m-hack-a-day-after-launch.
Professor Dr. Axel Wieandt
Axel Wieandt - former DAX 30 bank CEO/CFO, Global Head of Corporate Development, FIG banker and McKinsey consultant - is a senior financial services professional with a focus on banking, fintech and finance. Axel is currently advising US and European private equity/venture capital funds and real estate companies on their investments and value creation plans. He is also serving on the ad-/supervisory boards of German fintech and real estate investment companies. Axel is an early fintech investor himself and has teaching assignments with top-ranked international business schools, e.g. WHU – Otto Beisheim School of Management. Over the years he has published over 70 research papers, op-eds, and interviews; he is a frequent conference speaker/panelist. Axel is the author of "Unfinished Business: Putting European Banks (and Europe) Back on Track" (2017).