Howard Marks

@howardmarks

2019 Predictions for the SEC

2018 was a wild ride for the crypto marketplace and the companies that raised capital through Initial Coin Offerings. At the beginning of the year, prices soared, and capital flowed into the ecosystem in a tumultuous flood. It had the appearances of a bubble, but not many noticed or cared to do anything about it until it popped.

And pop it did. Over the course of the year, prices collapsed. As the market cap shrank, doubt was cast on the value of cryptocurrencies and the underlying technology they were built on. Yet many have drawn a comparison to the burst of the internet bubble. At the time everyone said it was over: two decades later, five of the top ten companies in market value are internet companies. Perhaps the technology itself shouldn’t be in doubt. Rather, the popping of the bubble was simply a means of course correction: money flowed in ahead of product and ahead of market adoption.

The speculation had to reverse at some point.

ICOs, the river of gold in Neal Stephenson’s Cryptonomicon

The ups and downs of crypto last year can largely be attributed to ICOs, the new form of capitalization that revolutionized how companies got funding. Why pitch VCs when you could raise billions directly from the crowd? For entrepreneurs interested in generating network effects, this fundraising method was even more appealing. The data backs up the appeal, though the specific amount raised by ICOs in 2018 remains unclear. Some accounts say $22B. Others that it is half that.

However, despite money still flowing into ICOs, warning signs are starting to appear that this method isn’t all it’s cracked up to be. Some jurisdictions such as China are utterly uninterested in participating in the crypto market. Regulators, notably the SEC in the US, are coming forward and warning that ICOs were being conducted illegally.

The SEC’s view was that these ICOs were issuing securities, not utility tokens or whatever the issuer had decided to call it. As a result, the companies needed to either register their offering or seek an exemption from registration. No one registered because that process costs millions. Instead, those with an eye towards securities law turned to the exemptions:

Regulation D 506(c), a public offering for accredited investors
Regulation A+, a public offering to raise up to $50M that requires qualification by the SEC but no security token offering has been qualified as of today
Regulation Crowdfunding, a public offering that doesn’t require qualification by the SEC but has a $1.07M limit
Regulation S, which allows US companies to raise capital from non-US persons, but it requires the company to comply with the regulations where the investor lives

The result has been a near halt in terms of US investor participation in ICOs because crypto exchanges would not accept tokens or cryptocurrencies publicly deemed securities. Because that would mean they would have to become a registered exchange or broker-dealer ATS in order to trade securities.

This has been a loss for entrepreneurs who need capital to build their businesses. Clearly, they can still go to the venture capital and angel investor communities and raise the capital the old fashion way. However, the retail investors are again shut out of any speculative and high-reward investment opportunities, and entrepreneurs that have long struggled to access VC investment (such as female founders who receive less than 4% of VC funding) continue to struggle.

2019 Predictions for the SEC

A psychic I am not

I am writing this prediction analysis only because someone has to do it. I do not have any inside information or a crystal ball. What I do have is some common sense. Whether my sense is indeed sound, the readers can decide for themselves.

In my opinion, the SEC’s behavior is predictable because they write with public bulletins what they expect from CEOs and companies raising capital in public bulletins. They use the laws to successfully complete enforcement actions. My predictions are not based on secrets. The first step is to know the law, and the second is to read the SEC’s bulletins.

1. Enforcement continues for ICOs

The SEC is going to continue to announce enforcement actions against companies and the executive officers that raised capital through ICOs. They will require a rescission offer to be made or they will prosecute. A rescission offer is when the company makes a proposal to its investors: accept a full refund of the capital you put in plus interest or agree to keep your holdings under this new agreement that complies with the necessary regulations.

What complicates the rescission offer is how to calculate the initial investment in dollars. When the investor purchased tokens during the ICO using Bitcoin or Ether, the prices were probably higher than they are today. In theory, the investor will receive more dollars than the current price of cryptocurrencies because the SEC is going to look at the conversion price in dollars at the time of investment.

How is the company going to be able to refund more dollars than they have if they did not convert the investment to fiat at the time of investment? Should the company not agree to a rescission or be unable to refund investors because they used the capital for operations, then the SEC is going to prosecute or send the case to the Justice Department. Then we will see more severe sentences, which include jail time.

Add to this dilemma, the plaintiff attorneys who will salivate with the prospect of civil lawsuits that will drain companies of the only cash they have left. Once all is said and done, lots of companies will file for bankruptcy or close. Many investors will be left with nothing.

2. Enforcement will continue for exchanges

It started with EtherDelta’s settlement with the SEC this fall after they charged the founder with operating an unregistered exchange, and it will continue in 2019. The SEC will prosecute more crypto “exchanges” and require that they either register as broker-dealers or close. The reason is simple: they are trading securities and acting as unregistered broker-dealers and brokers.

Will enforcement freeze liquidity in its tracks?

This could have the largest impact on the crypto marketplace to date because this involves the liquidity of these tokens that are owned by millions of Americans. Imagine if Kraken, Shapeshift, Poloniex, Bittrex, and others were shut down. What will happen to prices? Will investors lose their tokens when the exchanges are closed? After all, in many cases the exchanges themselves control the wallets where investors keep their tokens. If the exchanges are shut down, what happens to the tokens under their control?

The SEC has been clear about the illegal activity of these exchanges, and in 2019 it will only continue. EtherDelta’s settlement was light because of the high level of cooperation.

You may ask why I did not include Coinbase in the list above? They are working hard to not violate the regulations by trading only commodities. Bitcoin and Ether are considered commodities, and Coinbase has a framework to justify why Litecoin, Bitcoin Cash, and others fall in the same category. Recently, Coinbase launched 0x, which is decentralized and notably did not raise capital using an ICO. If a token is decentralized and never sold prior to launching the service, it is likely a commodity, not a security.

3. The first Regulation A+ STO will be qualified

The current status of the Reg A STO: mythical

The SEC is going to qualify the first cryptocurrency Regulation A+ offering in 2019. It is uncertain when or who it will be, but this will be the year it happens. The main issue the SEC wants to resolve is investor protection. Can investors who lose their private keys also lose their investment? If yes, which is the case for most cryptocurrencies, then it will be a no-go for the Commission.

Solutions do exist, and they can be found with new proposals such as ERC-1450 (I co-wrote this standard), Harbor’s R-Token, Polymath’s ERC-1400 and Securitize’s DS Token. As long as the issued securities are either recorded with the company or with a registered transfer agent, then investors are protected in case of loss of the private keys.

4. The SEC (slowly) ushers in new players

And welcoming to the stage…

The SEC will register new broker-dealers and Alternative Trading Systems to handle securities issued as tokens. This may take some time as the SEC sorts out investor protections, who takes the risk with cryptocurrency conversions, and other customary investor protections.

The SEC will also be reviewing the stable coins and assess if they are currencies or securities. It seems logical they will be considered currencies and could be supervised by the Treasury. Stablecoins as currencies could truly deliver the first internet currency, one used by millions for online commerce and media.

Finally, the SEC will approve cryptocurrency exchange trading platforms as long as they can either ensure the assets or prove the safety of their systems. This will be a challenging one for the SEC to approve because an ETF is a public entity, accessible to any kind of investor and traded on national markets. Investors can purchase shares in ETFs, they can short them and purchase calls and puts as well. Approval of one or more ETFs will shake the market and probably help increase the value of many of the top cryptocurrencies.

It is clear that 2019 will keep the SEC very busy. This assumes, of course, the government will re-open soon because the SEC has published a list of departments that will no longer operate during the shutdown. One of them is the Division of Corporate Finance, which handles the review of every Regulation A+ offering. Hopefully, the shut down will be short, and the SEC can go back to business as usual.

In times when the SEC is paired down, it will bring a renewed appreciation of the hard work and dedication from the people at the Commission. I am appreciative and thankful for their work, and I look forward to seeing whether some of my predictions will come true in the new year.

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