Financial Innovation: Digital Assets and Initial Coin Offerings

Financial Innovation: Digital Assets and Initial Coin Offerings

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October 17, 2018
Financial Innovation: Digital Assets and Initial Coin Offerings
This In Focus provides an overview of policy issues
Figure 1. Top 5 ICOs (September 2018; in $Millions)
regarding “digital assets” in the capital markets. Digital
assets (often referred to as “crypto assets,” among other
terminology) are digital representations of value made
possible by cryptography and blockchain (see CRS Report
R45116, Blockchain: Background and Policy Issues). They
were originally designed to facilitate transfer of value
without a trusted third-party intermediary (such as a bank).

While debate remains as to the proper terms for and
Source: CRS based on data and ranking from CoinSchedule.
classification of these assets, a commonly cited industry
source on the topic, Cryptoassets: The Innovative Investor’s
Digital Assets as a New Asset Class
Guide to Bitcoin and Beyond, provides a categorization of
Digital assets have quickly emerged as a new asset class.
digital assets into three main types:
Within the past two years, this new asset class has
experienced rapid growth, high volatility, maturing
Cryptocurrencies serve as a medium of exchange, store of
practices, and regulatory scrutiny. A recent global survey
value, and unit measurement of account. Cryptocurrencies
by Dalia Research indicates that digital assets have gained
themselves often have little inherent value, but they are
mainstream awareness, with 74% of respondents being
used to price the value of other assets (for more details, see
aware of the term “cryptocurrency.” A July 2018 Financial
CRS In Focus IF10824, Introduction to Financial Services:
Stability Board (FSB) report identifies other asset classes,
“Cryptocurrencies”). Bitcoin, launched in 2009—widely
such as gold and equities, as comparators with crypto
considered the first digital asset—is a cryptocurrency.
assets. This status enhances digital assets’ long-term
prospects and attractiveness to investors for investment
Crypto commodities are raw material building blocks that
portfolio diversification needs.
serve as inputs into finished products. Examples of crypto
commodities are storage capacity and network bandwidth.
Securities Regulation
Crypto tokens provide means to access finished digital
The Securities and Exchange Commission (SEC) is the
goods and services in games, media, and more.
main regulator overseeing securities markets, including
digital asset-related investments, and investor protection.
Although more than 2,000 digital assets in the forms of
Many digital assets arguably qualify as securities if they
cryptocurrencies and crypto tokens exist today, a majority
promise a return based on the management practices of
of their valuation is contributed by Bitcoin, Ether, Ripple,
those offering them, among other conditions. Depending on
and other major cryptocurrencies.
their specific characteristics, digital assets could also be
subject to other forms of regulation. For example,
Initial Coin Offerings
cryptocurrency Bitcoin is a digital asset but not a security
An initial coin offering (ICO) is a method of raising capital
because it is not issued by a profit-seeking business (for
through the creation and sale of digital assets. A typical
more details, see CRS Report R45301, Securities
ICO transaction involves the issuer selling new digital
Regulation and Initial Coin Offerings: A Legal Primer).
“coins”—crypto tokens—to individual or institutional
Once a digital asset is deemed a security, existing securities
investors. Investors pay for these tokens in either
regulations apply without any differentiation between
cryptocurrencies or traditional currencies. ICOs are often
digital assets and traditional securities. There are already
compared with initial public offerings (IPOs) of the
ICOs filed through the SEC’s existing private and public
traditional financial world because both are methods for
securities offering processes. For a comprehensive
companies to acquire funding. The main difference is that
overview of securities offerings in general, see Table 1 of
ICO investors receive digital assets in the form of virtual
CRS Report R45221, Capital Markets, Securities Offerings,
tokens or the promise of future tokens. Unlike IPO
and Related Policy Issues.
investors, they do not receive an equity stake representing
company ownership. ICO funding activities reportedly
Policy Issues
started to escalate in 2017, and the largest ICO has raised
Congress and regulators face many policy challenges at this
$4.2 billion (Figure 1).
early stage of ICO and digital asset development in the
capital markets, a number of which are discussed below,
but an overriding concern is the ability to provide
regulatory clarity and investor protection without hindering
financial innovation and technological advancements.
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Financial Innovation: Digital Assets and Initial Coin Offerings
Regulatory Fragmentation. Digital asset issuers and
the SEC. In response to increased regulatory attention,
investors face a steep learning curve in comprehending the
some crypto exchanges have become federally regulated by
regulatory landscape and determining how or if securities
acquiring companies with existing federal licenses.
laws apply to them. As noted above, it may not always be
clear whether a digital asset is a security subject to SEC
Cybersecurity. Because digital asset transactions take
regulation. Multiple agencies apply different regulatory
place solely on the Internet, digital asset investors may risk
approaches to digital assets at the federal and state levels.
losing their investments as well as personal information
For example, for certain digital assets, the SEC treats them
through hacker attacks. A December 2017 Ernst & Young
as “securities,” the Commodity Futures Trading
study estimates that more than 10% of ICO proceeds are
Commission treats them as “commodities,” and the Internal
lost as a result of such attacks.
Revenue Service treats them as “property.” State regulators
oversee digital assets through state money transfer laws,
International Coordination. The creation and exchange of
and the Treasury Department’s Financial Crimes
digital assets take place online and are generally not
Enforcement Network monitors digital assets for anti-
restricted by national boundaries. As such, the industry is
money laundering purposes.
prone to international regulatory arbitrage, meaning crypto
activities may flow toward countries that offer the most
Enforcement Capacity. With the emergence of digital
favorable regulatory conditions. For example, Malta is an
assets as a new asset class, the SEC has deployed new
international crypto-exchange hub, largely attributable to its
enforcement capacities. In 2017, the SEC established a new
pro-crypto government guidelines. Crypto enterprises could
Cyber Unit and the SEC increased its monitoring of and
also make activities officially available only to countries
enforcement actions against entities engaged in digital asset
with less regulation. Block.one’s EOS, the world’s largest
transactions. In addition to issuers and investors, who are
ICO, for example, reportedly excluded U.S. and Chinese
the end contributors and recipients of funding, there are
ICO investors in order to circumvent applicable regulations.
market intermediaries—namely, broker-dealers and
In addition, the funds invested into digital asset transactions
investment managers—against whom the SEC has also
may travel overseas without the investors’ consent, and
taken enforcement actions. In addition to more traditional
U.S. regulators may not be able to pursue criminals or
SEC enforcement actions against entities for non-
recover funds in such situations.
compliance with securities regulations, the SEC has also
halted allegedly fraudulent ICOs.
Policy Proposals
Many policy proposals exist to address various issues
Investor Protection. ICO and digital asset investors—
discussed above, including proposals to (1) unify the
which may include less-sophisticated retail investors, who
regulatory space by designating a primary regulator for all
may not be positioned to comprehend or tolerate high
digital assets; (2) increase investor protection through more
risks—may be especially prone to new types of fraud and
customized ICO disclosure requirements, for example,
manipulation, leading to questions about investor
through the standardization of ICO whitepapers, which are
protection. First, there appears to be high levels of ICO
common forms of ICO operative documents describing the
scams and business failures. One 2018 study from Satis
tokens and business models; (3) promote trading and
Group found that 81% of ICOs are scams and another 11%
exchanges by considering safe harbors for crypto exchanges
fail for operational reasons, although other studies suggest a
and providing regulatory exemptions for money
lower but still significant rate of fraud and failure. Second,
transmitters; and (4) provide testing grounds for ICO
many ICO companies fail to comply with registration and
companies through federal-level “regulatory sandboxes,”
disclosure obligations associated with traditional securities,
which are already in place in more than 20 countries and
potentially affecting investors’ ability to understand their
multiple states. When viewed in the aggregate, these policy
exposure risks. Third, the high volatility of digital assets’
proposals tend to aim for either greater investor protection
valuations creates large gains and losses. Lastly, digital
or regulatory exemptions from investor protection and other
assets operate outside the traditional financial system and
provisions that could encourage innovation or address the
thus may not offer common types of transaction
unique attributes of the new asset class.
protections. For example, although banks have the option to
halt or reverse suspicious transactions and associate
Although a 2018 cryptocurrency survey conducted by Foley
transactions with user identity, a digital asset transaction is
& Lardner suggests that the crypto industry desires greater
generally irreversible through intermediaries.
regulatory certainty and formalized self-regulation, SEC
Chairman Clayton stated in August that the existing
Trading. Investors use trading platforms to buy or sell
securities regulation has served U.S. investors and
digital assets, including coins offered in ICOs. Many of
companies well through periods of significant innovation
these trading platforms are registered as money services
for over 80 years. The SEC has not promulgated rules or
businesses (MSB) instead of national securities exchanges.
exemptions specific to digital assets or ICOs. Rather, the
MSBs are part of a money transfer or payment operations
SEC’s efforts in this area continue to revolve around
infrastructure that was not designed for digital asset trading
fostering new technologies and new investment
purposes, which may create the potential for operational
opportunities while requiring information disclosures for
inefficiencies and investor protection concerns. The SEC
investor protection.
has stated that the online platforms for trading digital assets
could potentially be unlawful if they are trading securities
Eva Su, Analyst in Financial Economics
and operating as “exchanges” but have not registered with
IF11004
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Financial Innovation: Digital Assets and Initial Coin Offerings

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https://crsreports.congress.gov | IF11004 · VERSION 2 · NEW