Following the release of the Report of Investigation by the Securities and Exchange Commission in July, which concluded that certain digital tokens issued as part of initial coin offerings may be securities subject to regulatory requirements, the SEC has apparently begun contacting promoters of ICOs to alert them that their specific ICO may raise registration issues. One organization contacted a few weeks ago was Protostarr, in connection with an ICO of its digital tokens begun on August 13 to fund its Ethereum-based application.

(Click here for background on the SEC’s Report of Investigation in the article “SEC Declines to Prosecute Issuer of Digital Tokens That Violated US Securities Laws” in the July 30, 2017 edition of Bridging the Week.)

In response to the SEC’s inquiry, Protostarr voluntarily ended its ICO. According to a press release issued by the organization, “Unfortunately, as a startup, we do not have the necessary resources to both develop our [application] and challenge the SEC’s investigation regarding our ICO and its interpretation under US securities law.”

In addition to terminating its ICO, Protostarr indicated it would refund all ether—the digital currency of the Ethereum network—paid by individuals to its initial crowdsale payment address in a process that began on September 2.

Similarly, BTC China, one of the world's largest Bitcoin exchanges by volume and based in Shanghai, announced that it would end trading as of September 30 in response to the recent edict by seven regulators in China aimed at halting new ICOs. (Click here for background in the article, "China Bans ICOs While HK SFC Joins Regulator Procession Warning Digital Tokens in ICOs May Be Securities" in the September 10, 2017 edition of Bridging the Week.)

Separately, last week the UK Financial Conduct Authority joined a host of other international regulators in issuing guidance on ICOs that warned that some ICOs may involve regulated investments and firms conducting regulated activities, and that persons involved with an ICO should therefore consider their potential regulatory obligations.

My View: Last week, the leader of a major financial services firm labeled Bitcoin a fraud (click here for a sample public article describing this). With all respect, this characterization is wrong.

As background, Bitcoin—a type of digital token commonly referred to as a "cryptocurrency"—is first and foremost the reward to system administrators—more commonly known as “miners”—for validating and maintaining the decentralized, open, distributed and inviolable ledger—known as the blockchain—that electronically records transactions involving Bitcoin between parties. This reward is a powerful incentive that encourages miners to invest in the necessary computer hardware and to pay the attendant costs of running computer systems that perform the critical function of maintaining the blockchain and ensuring its integrity. Bitcoin has intrinsic value much like gold and artistic works; similar to other valuable assets, there will only be a finite number of Bitcoin (approximately 21 million). In the secondary market, Bitcoin is a medium of exchange that that can be used like a fiat currency for purchases and has a relationship value with other cryptocurrencies and fiat currencies (into which Bitcoin can be converted). As a result of the secondary market and the intrinsic value of Bitcoin, miners can sell to others the Bitcoin they received as rewards for maintaining the blockchain to generate liquid funds to pay for the necessary hardware and attendant costs and potentially make a profit.

Bitcoin and the blockchain is a technology that allows disparate persons located almost anywhere on Earth to securely conduct financial transactions with each other without any intermediating agents very quickly and without material transaction fees. Notwithstanding the potential threat to such enterprises, many credible investment banks, banking organizations and other large companies are substantial investors in blockchain application initiatives because of the way the technology can potentially quicken transaction processing, eliminate certain current intermediation steps, and generate non-alterable records Such firms are determined to learn how to leverage this new technology for themselves and their clients and not be sidelined by it.

In fairness, Bitcoin—just like the US dollar—has been used for money laundering and for other illegal purposes. By design, transactions in Bitcoin are ordinarily conducted on a totally anonymous basis. However, the identities of participants can be known. This is why the Financial Crimes Enforcement Network of the US Department of Treasury and state regulators have been endeavoring more and more to tighten controls around certain intermediators of Bitcoin and other cryptocurrencies to ensure that robust anti-money laundering protocols are applied. However, Excel spreadsheets—far less sophisticated private ledgers compared to the blockchain distributed ledger—are not fraudulent solely because some crooks use them now and again to account for their profits, and no one is asking that the US dollar be banned because it is used widely for illicit purposes.

Additionally, Bitcoin is just one of many digital tokens and not all digital tokens have the same pedigree or purpose. Ethereum and its associated cryptocurrency, ether, for example, offer a more advanced form of the blockchain, and are particularly conducive for the development and use of so-called smart contracts—agreements between parties that will automatically self-execute pursuant to their terms without ongoing manual intervention. Other digital tokens are more like securities (cryptosecurities) and evidence a payment in kind for the funding of projects with an expectation of appreciated value after the development of a project by other persons. Some other digital tokens are more like private contracts (utility tokens) in that they are rewards for paying to play in a game or for participating in the development of a project—not as an investor but as an active consultant or in a similar capacity. Frankly, to me, there is often a blur among these categories and there is likely a profound quality difference among different types of digital tokens (not to mention their promoters).

Accordingly, going forward—as with any nascent industry—there will be bumps in the road. For sure, for example, the prices of Bitcoin and other cryptocurrencies are likely to go down as well as up and may, at times, evidence great volatility. However, over time, as the understanding of digital currencies and other digital tokens heightens, thoughtful regulation (and likely some government enforcement actions and private litigation too) will address many peripheral concerns, and the acceptance of digital tokens (along with their associated technology) will become more widespread.

Thus, there are many ways to describe Bitcoin. A fraud is not one. The blockchain is real and Bitcoin is integrally linked to this increasingly important new technology. We are at the beginning of a new technological revolution—not remotely near its end!