The entire cryptocurrency marketplace is making heads turn, but what is really fuelling the explosion in token valuations? In the past, investors who ventured into technology investments with private companies had to wait patiently while the company was in development, and eventually, many years later, the company offered a liquidity opportunity through its sale to another company or by offering shares to the general public in an IPO. On average, it took seven years before these liquidity opportunities came to fruition. This is often way too long for ordinary investors who cannot wait that many years to earn a return on their money. Making the wait harder is the fact that most investments actually fail and return nothing to the investors. So what is different today with blockchain technology companies? The birth of Bitcoin in 2009 was not a big event at all. It was an underground technology that was exciting to a few hundred geeks who wanted to offer an alternative to government-based currencies such as the US dollar backed by the full faith of the US government. This faith, in their view, was overrated because of how the Federal Reserve Board is able to control interest rates and the flow of money. The first believers did not purchase Bitcoin: they mined it by installing a program on their computer and letting the application do its job. The result was hundreds of Bitcoin appearing out of nowhere. Today, these miners are full fledged enterprises with thousands of servers running in far distant locations such as Mongolia. The price of Bitcoin and its volatility brought in the general public who have helped create liquidity of this unusual asset called cryptocurrency. Some refer to it as a stored value, others as a currency. In reality, Bitcoin is not backed by any government, but by the full faith in its encryption technology. Yes, you read that right: the full faith of the technology instead of a government. In practice, it would take hundreds of years to crack the passwords protecting Bitcoin accounts, also called wallets. That fact is itself the reason why Bitcoin is so successful. People trust the technology. In order for Bitcoin to thrive and grow in value, it needed a marketplace where it could trade. Very quickly exchanges started popping up in every country. These services, mostly unregulated because no one knew what a Bitcoin should be, offered investors the ability to trade US dollars for Bitcoin and vice-versa. The entire technology behind Bitcoin is open source, which means anyone can copy the code and create their own version of Bitcoin. Of course, others tried to emulate Bitcoin’s success, and now thousands of copycats exist, some of them variations of Bitcoin’s technology, including Litecoin, Bitcoin Cash, Bitcoin Gold, Zcash and Ripple. This explosion in cryptocurrencies was led by the exchanges, who are able to trade a US Dollar into Bitcoin, a Bitcoin into Litecoin, and so on. These private marketplaces, or exchanges, are booming and trading billions of dollars in tokens every day. However,here is one BIG problem, which is waiting for a solution. These exchanges are unregulated, and if they count U.S. customers, they are probably violating securities laws. Why? Some cryptocurrencies are considered securities because they are sold to investors as an investment, and the companies behind them are using the money to build themselves into the next generation businesses. Investors are paying in Bitcoin or Ether for these new tokens and turning around and selling them for more money on the exchanges. The investors paying more for the token in the secondary marketplace are speculators looking for arbitrage and gains on their investment strategies. Because there is no regulation, no one really knows if the exchanges are rigged with front selling schemes and other fraudulent behavior from the owners of the exchanges or the investors. The SEC is expected to start requiring these exchanges to either register with the SEC or shut down. Jay Clayton, the Chairman of the SEC, has repeatedly warned the blockchain marketplace of his concerns that the companies issuing tokens through ICOs (Initial Coin Offerings), the lawyers helping them, and the promoters taking commissions are facilitating illegal trading and violating the securities laws. The real question is not if the SEC is going to shut down these U.S. exchanges and mandate foreign ones to filter out U.S. citizens but when. It turns out this year started with a big bang in SEC bulletins and enforcement actions. Next week, the SEC and the CFTC will appear before Congress to testify about cryptocurrencies and marketplace practices. This is not good news for the rule dodgers. Yet there is light at the end of this unregulated tunnel. Companies such as tZERO and my company StartEngine are building regulated solutions to trade securities tokens. It is unclear how the market will react to these regulated marketplaces, but my hunch is that business will just adapt to the new realities. Regulation is not all that bad. It means protecting the investor from obvious scams, such as pump and dump or front running in which people who work for an exchange see the orders coming in and buy in front of the investors only to sell right after for a profit. There are dozens of other scams going on, and all of them need to be contained by enforcing proven regulations. The winners of regulation will be the investors and the marketplaces that flourish because they care to do the right thing. In a nation of laws, the unlawful eventually get the ax. The future of trading securities tokens will be marketplaces operated by broker dealers who are registered with the SEC and members of FINRA. They will operate ATS (Alternative Trading Systems) and build technology to protect investors. These businesses will have additional costs just to make sure they comply with US regulations. This means hiring a Chief Compliance Officer and registering personnel who have contact with the investors and operate the marketplaces. Add to these costs insurance and audits, and you can get the picture. It’s expensive. This means trading commissions are going to go up. Rome was not built in one day, and neither will regulated marketplaces. The entrepreneurs issuing securities tokens will have to be patient because in the end regulation will benefit everyone. StartEngine does not endorse or highlight any individual companies on our website. Readers should not consider statements made in this post as formal recommendations and should consult their financial advisor before making any investment decisions.
