By David Siegel of the Pillar Foundation.
This post is part of our series of CVA member feedback to the recent FINMA ICO Guidelines. It reflects the private opinion of the author, and does not constitute or represent the official opinion of the CVA. Adds the author: “This piece is not meant to be the opinion of the CVA or other members. It is also not meant as advice for anyone launching an ICO.”
To the Directors and Management of FINMA,
Your ICO guidelines of 2017 and your recent update on how you intend to apply the guidelines show that you are listening and learning and want to help people in our nascent industry comply with regulation while discovering new technologies and ways to finance innovation. You are to be applauded for your approachability and thoughtfulness. In this short response, I would like to place it in context and add some data.
Financial Firsts in Europe
In the 16th century, voyages from Europe to foreign lands in search of spices and treasures were financed as single projects. But in 1600, the British East India company was formed as a private corporation to launch and maintain a network of ships and trading infrastructure. It was financed by issuing private shares to its investors, who were the typical high-net-worth investors of the day. Two years later, the Dutch East India company was similarly created by a group of entrepreneurs hoping to create a “unicorn” company to rival the British. In 1606, they collaborated with the government to raise more funds by going to every city and town in Holland holding meetings and explaining to citizens that they were issuing something called an “actie,” which gave public investors the right to own shares in the company. The charter said that the company would not redeem those shares; rather, the holders could then sell those shares to others if they wanted liquidity. These were the first public shares, followed soon after by the first public stock market, in history.
Both companies lasted more than 200 years and made their shareholders more wealthy than anyone could have imagined – HODLing shares of the Dutch East India company yielded a steady 16 percent average annual dividend for most of the life of the enterprise. The well-funded Dutch company had better technology than any other company, or even government, in the world. It has been argued that the Dutch remained far ahead of their British competitors throughout the 17th century. Adjusting for inflation, the Dutch East India company became the world’s first trillion-dollar company, hundreds of years before Apple and Amazon were even close.
These companies were soon followed by many more. Some, like the Mississippi Company, were unsustainable and poorly governed. Others were simply scams. But in retrospect, letting members of the public buy, share, and trade the risk in a new enterprise – sans regulation! – was one of the most successful financial innovations of all time. Four hundred years of continuous delivery and continuous improvement on these basic concepts bring us to where we are today.
Protecting The Public
FINMA has issued a middle-of-the-road statement, outlining the three main types of tokens and acknowledging that there can be hybrid versions. FINMA is focusing on the tokens and their intended purpose. They are taking a SAFT approach, saying that if a system is not yet built and is raising funds to build it, then the token must be a security, as there is too much risk to simply call it a utility token. Only when the system is working and the token can be used could a token be considered a utility token.
Recently, the SEC issued a similar statement, and I responded with an essay pointing out the flaws in trying to regulate types of tokens. I also looked for evidence that regulations were performing their intended purpose – keeping retail investors safe – and concluded that the evidence largely doesn’t exist. Researchers may well refer to the last eighty years of financial regulation as “the failed war on financial crime.” I encourage all regulators to understand whether banks or blockchains are better at facilitating money laundering, and to realize that cash, not bitcoin is where the money-laundering action is, especially in a country where the thousand-franc note is so easy to get, carry, and exchange anonymously. If you wanted to design the perfect tool for money laundering, that Swiss note would probably be at the top of the list. I’m not sure that research supports the basic theory behind money laundering in the first place.
Now, let me make three simple arguments in favor of rethinking the current framework.
First, there is an implicit assumption that if a system is already built then it offers less risk to the token buyer. As a blanket statement, this is probably true, but the reality is far more complex. For starters, if a working system had been needed before the public was allowed to send money, most of the decentralized technology we have now would not exist. Many world-changing projects, like Ethereum and others, were funded by a large number of small investors who weren’t taking much risk and, overall, have pushed society forward with innovative technology that regulators agree is valuable. But let’s assume some intrepid entrepreneurs have built a system that works, and then they have an ICO to sell the utility tokens necessary to access it. Is the risk gone? Obviously, the risk has not disappeared, it simply has been reduced by some percentage.
What is that percentage? How many successful companies have pivoted completely away from their original plan – or even their original system? The answer is – almost all of them. Almost all new companies pivot after launching their original product or service, because the number one cause of start-up failure is that the market wasn’t there in the first place. Those who listen to customers and conserve cash (and get lucky) are able to pivot and survive. Given the sophistication of ICO marketing these days, I can imagine plenty of startups raising money by selling utility tokens to a system they’ve already built that customers still don’t really want. So if this is the norm, not the exception, aren’t we back at square one, trying to keep investors safe?
There are other things you can do to help protect investors. You could get better data from exchanges on wash sales, consolidation, front running, and more. You could require pre-sale investors to lock up for six months. You could require that token main-sale tokens of de-novo projects be locked up for a year. This not only gives the development team time to get their system ready, it prevents speculators from selling on the initial pop.
Second, there is an assumption that the risk is all in the building of the system, after which the tokens sold are simply “tickets” to use that system. I could not disagree more and have written about this at length. Why? Because selling a fixed number of tokens to the public and providing exchanges for trading practically guarantees volatility in the price of the token. I keep asking entrepreneurs – why should your customers have to deal with the volatility of the price of your service simply because the market forces on your token force it? In other words, whatever you’re selling may have its own volatility, but the pumping, dumping, and manipulation of your token, not to mention your monetary policy, has a larger effect on the price of what you’re selling than the actual benefit the user gets from using that token. Token volatility often has nothing to do with the underlying value it represents. Shouldn’t we be trying to reduce volatility for what effectively should be fixed-price services? Imagine paying twice as much to ride a bus this week as you did last week – how does derisking the construction of the bus affect the ultimate risk the tokenholder faces? Why should the value of a work of art go up simply because the tokens are in (artificially) short supply? To get a feel for this in reality, see the average price of an ether transaction over time.
Simply by allowing the public to buy a fixed number of tokens, FINMA is practically endorsing huge market risk, including the risk of market manipulation and failure. I would argue that this is the wrong way to think about risk.
Third, the tax incentives are backward. Current tax laws require people to report gains/losses on every token transaction, which penalizes “utility” and encourages speculation. How does a token become no longer a security when every time you go to use it you have to calculate your capital gain/loss?
Project vs Company Finance
One common misperception is that groups launching ICOs are startups. In many cases, this is not true! In the case of open-source systems, most ICOs are project finance, not equity. A nonprofit foundation has no equity. There’s no scenario in which a group starting an open-source project like Ethereum can later be acquired, providing an exit to investors. In most cases, the exit is simply the ongoing use of the system which, through network effects, increases the price of the token. The “exit” happens on day one. Furthermore, when a group publishes a white paper they propose to build a single system with a single goal. If they are forced to pivot, the right thing to do would be to give the remaining money back to tokenholders.
We are collectively making some progress in decentralized governance – one thing we’re going toward at Pillar is a tokenholder’s council that can properly veto any major spending and straegy decisions. Ultimately, tokenholders should probably have the right to force liquidation in certain circumstances. This shows how far we still have to go in governance of blockchain-based projects, and why Vitalik and others continue to work on next-generation governance issues. Equity investors, on the other hand, know full well they are going along for a roller-coaster ride. They are backing the team to try things and see where the market takes them.
Whether financing companies or projects, we can expect most to fail. That’s what happened with joint-stock companies, it happened during the 1990s, and it will happen again to groups selling ICOs. As I have argued, asset-price bubbles are poorly understood and mostly don’t exist. In fact, it’s the normal pattern of progress.
Keeping the Public Safe
I continue to point out that it’s impossible to make investors safe by focusing on the products, the intent, or the exchanges. The category definitions simply don’t hold.
I applaud Swiss regulators for listening and trying to work within the system they have already set up. But given that several Swiss banks have paid billions of Swiss francs in fines for cheating their customers over the past ten years, and that the Swiss central bank itself has been directly responsible for the demise of several financial firms, and the fact that this year will see a radical shift toward equity tokens, I think now would be a good time to rethink the regulatory platform for this century.
The Future of Tokens
I think regulators tend to regulate by looking in the rear-view mirror, but in this case we should be trying to think ahead. As explained in detail in The Token Handbook, I believe that tokens first should be seen as one of three types:
Security tokens should be for for-profit companies and funds. While I don’t agree with the current framework for regulating equity markets, I think it would be a good place to start. I think perhaps half of all ICOs should simply be equity offerings, which would solve a lot of problems. It would be great if every jurisdiction followed Wyoming’s lead, but that would require a complete overhaul of our securities laws. I don’t think the token magically becomes a utility once the system is working.
Tickets are unlimited number, fixed-price access tokens. Given that so many of our existing (non-blockchain) digital tokens are tickets, I’m surprised that regulators haven’t recognized this important product category. I believe roughly 40 percent of all token sales should be for tickets. This is what crowdfunding is for – I encourage you to read “The Kickstarter method” chapter of the Token Handbook to learn how this can be done.
Utility tokens are important for open-source projects only. They have way too much volatility, but I think these kinds of speculative sales to the public should continue without requiring a working system. I think we should let the public decide what to fund. We can and should work on new token standards and guidelines for these sales. It’s not clear that regulated products and markets provide more protection. Perhaps 10 percent of all tokens sold will be of this type. The best solution here is consumer education, not token regulation.
I don’t think the current thinking about token categories will protect investors any more than I think most financial crime laws protect the public today. This is a conversation to have at the legislative level, the regulatory level, and the self-regulatory level. I don’t speak for the CVA, but I am personally willing to help FINMA create a level playing field that does help Swiss citizens, investors, and innovators.
David Siegel is a serial entrepreneur from the United States. He is the founder of 20|30 and the Pillar project. 20|30 provides consulting services and is building the CryptX — a broadly diversified portfolio of cryptocurrencies in a single token. His full bio is at dsiegel.com. Connect to him on LinkedIn.