Yesterday, Kik released their response to the SEC complaint, denying the allegations put forth, citing repeated instances where the SEC distorted (or exaggerated) the facts, asserting that Kik did not violate federal securities laws, and falling just short of moving to dismiss the suit.
Since the SEC made their Complaint public (June 4th 2019), a lot has been written about the case. Not surprisingly, the SEC had stacked the deck in their favor by piling on a variety of allegations to make it appear that their case is strong. This over-the-top approach is apparently typical. However, Kik’s comprehensive and lengthy response peels off the fallacies from reality.
From now on, anyone who wants to provide intelligent commentary about this case needs to read Kik’s response in its entirety before commenting. Unfortunately, up to now, much of the public commentary that came after the SEC released their complaint was off the mark because it was based on one side of the story.
Substantial parts of the SEC Complaint go in great lengths at attempting to portray Kik with their backs to the wall, alleging they raised the ICO funds as a desperation move. This couldn’t be further from the truth, and demonstrated the SEC knows nothing about the nature of startups. In addition to the specific responses that provide contrary evidence to what the SEC concocted, this Blockchain Association write-up did an excellent job summarizing why going that rabbit hole is irrelevant to the case, Cutting through the Noise: The nature of start-ups and the SEC-Kik complaint.
Regulators Don’t Decide How to Define Innovation
In the news cycle following the publicizing of their Complaint, an SEC official said “Companies do not face a binary choice between innovation and compliance with the federal securities laws.” Well, regulators do not decide how to define innovations. Entrepreneurs do. Regulators are supposed to let innovation thrive and not become a hindrance to it. Regulators are supposed to regulate after innovation has had a chance to take shape, and not suffocate it while it is still in the crib. Regulators are supposed to be aware of the impact of upcoming innovations, apply good judgement on its applicability, and guide the market accordingly, not trap it. As I wrote in my previous blog post, the SEC has some wiggle room for suggesting updates and reforms to existing regulations, but they chose not to do that pertaining to cryptocurrency innovation for far too long.
The SEC’s continued lack of regulatory clarity around token offerings is the real issue here. And they are guilty of confusing the market.
Less than a week ago, at a speech in Singapore, SEC Commissioner Hester M. Peirce said this:
“As I have expressed elsewhere, I would like to see more focused momentum at the U.S. SEC toward finalizing our regulatory regime for digital assets.
Another notable feature of U.S. law is that the definition of what constitutes a security is a bit nebulous. Unlike many other countries, we do not have an exclusive list of what counts as a “security.”
Truth is, the blockchain market wants to innovate, but they are continuously bogged by the daunting question “what will the SEC think?”. The SEC has instilled fear, uncertainty and doubt in the eyes of the market and entrepreneurs in the US. This has forced real innovators to grow their businesses elsewhere, in Asia or Europe, and they are doing it unburdened from the heavy hands of the SEC (e.g Binance is now the #1 crypto-exchange in the world, at the expense of Coinbase).
Fighting the Good Industry Fight
Let’s not lose sight of the bigger context: Kik is fighting the SEC not just to defend itself. This fight is also on behalf of the industry in the US and Canada. Kik is going to argue in Court that the aging Howey Test does not apply in its entirety to token-based offerings that have the characteristics of a community currency, as they explained in their Wells Response filed in November 2018.
Of notable mention is Defend Crypto, the new initiative that Kik seeded (with $2M) that is dedicated to helping other projects outside of Kik in their fight to defend crypto, and is now stewarded by the Blockchain Association.
Why Does This Matter for the Industry?
Why this matters for the blockchains is the key question we should keep reminding ourselves. It matters, because depending on the outcome of this lawsuit, every blockchain related company in the US and Canada would be affected. In the worst case scenario, all companies wanting to innovate with token-based models will have no choice but to go down the path of a lengthy, costly and painful Reg A+ process, or go offshore to Singapore, Switzerland, the Cayman’s Islands or other more clement jurisdictions.
In the best case scenario, token-based models will see a revival and blockchain tech innovation will continue to flourish.
While this suit has been going on, and despite its costs and distraction, it is amazing to see Kik and Kin continue to thrive and grow, while they executed perfectly according to what they promised (a feat that is not shared by 95% of ICOs). The Kin cryptocurrency is now touching millions of users across over 60 apps, and is used in a variety of valuable earn/spend use cases. Just have a look at the stats and progress that are being tracked by the Kin Foundation (disclosure: I’m a board member of the Kin Foundation).
There is some irony and nonsense, pertaining to the SEC and how they continue to view cryptocurrency.
Suppose you develop a blockchain-based App (or dApp), and use BTC or ETH as your in-app currency for something like buying/selling, earning/spending, etc. You are not subject to SEC regulation, because BTC and ETH were already deemed as non-securities, and you appear to be just like any other tech startup developing software. You are only using cryptocurrency as a choice for the monetary exchange of value, instead of the dollar, yen, euro or pound.
So far, so good.
What if, one day after you’ve proven your traction and model, you decide to switch to your own cryptocurrency, and you then allow users to swap their crypto balances and/or NFT holdings from their wallets to your new cryptocurrency? What happens then?
You still haven’t sold an ownership in your company, nor have you promised an expectation of profits. Would your token then be deemed a security, a “decentralized enough” utility, or an acceptable payment cryptocurrency? Would you be subject to SEC regulation and be required to submit follow-on filings, if any?
What if you retained a percentage of the tokens you originally issued to your users, and subsequently, these cryptocurrency tokens appreciate in value, because, due to your success, a secondary market has developed around your “hot” cryptocurrency? Would the SEC then consider your token as a security, although you’ve already widely proven its utility and your original intent had an expectation of usage before any expectations of benefits?
Is this all confusing? Yes, because the SEC prefers to fit everything inside their existing Securities compliance thinking. Yet, tokens exhibit salient novelty factors that didn’t exist before: 1/ they have multiple usage properties, 2/ their lifecycle is dynamic, and 3/ they can be traded in new secondary markets,- all of these are new elements that don’t fit the old mold.
Software Products Are Not Broadway Plays
For the sake of arguments, let’s follow SEC Chairman Clayton’s theatre play analogy [starts at 15:00]. In this November 2018 interview, Chairman Clayton says “if your play is done”, the tickets sold are not securities anymore, because “all you can exchange the tickets for is watching the play”, even if the tickets sold prior to the play’s opening were deemed securities. So, using that train of logic, if you’ve already developed the software, and you are now providing a means to exchange currency (crypto or not) for a variety of transactions within your marketplace or service, then that token shouldn’t be a security.
Unfortunately, the SEC has not being prescriptive enough in admitting that several tokens with proven functionality are not securities anymore. The theatre play analogy alone is not strong enough, as software products (unlike theatre plays) are never “fully developed” because software continuously evolve. New features and capabilities are introduced, enabling users to perform new actions they couldn’t perform before. So, how can a regulatory agency judge when a given software product is complete enough in order to grant it a sufficiently operational status?
Let’s consider this other comparison: the secondary market for events tickets. Here’s a heatmap of ticket prices for the first game of the 2019 NBA championship. A good number of tickets are available at exorbitant prices fetching 10-50 times the original ticket costs. These prices are inflated due to speculation and “hotness” factors surrounding the event, given that it is the NBA finals, and the fact that the Raptors kept winning beyond foreseen expectations. Original ticket owners will profit from their re-sales, even if they didn’t have an expectation of profits when they bought their tickets, and even if they had intended to watch all games, and not sell their seats later.
Here is the irony of this second analogy: if these ticket prices were quoted in cryptocurrency and/or issued by a project that distributed crypto-tokens, the SEC would likely be labelling them as securities.
Then, if you followed the SEC’s logic, they would regulate StubHub, VividSeats, Ticketmaster, Live Nation, Gametime, Viagogo, etc. And anyone buying these tickets would be subject to KYC/AML screenings. You might think that these amounts are small enough to fly under the scrutiny radars, and the analogy may be far fetched as it pertains to cryptocurrency and ICOs. That’s not entirely correct, because the average consumer contribution to an ICO has been in the $3,500 range, and several ICOs have average contributions as low as $1,000. Furthermore, several token services are offering micro-transaction levels of activity, in the value range of cents or fractions of dollars, yet the SEC wants to regulate these activities and exercise undue supervision on them.
If It Doesn’t Fit, Create a Glove that Fits, Don’t Force-Fit It
Contrary to what the SEC believes, every token issued is not a security. Each token has a different functionality lifecycle and exhibits a variety of properties.
If only the SEC would see the innovation potential behind tokens and cryptocurrency, they could adapt their existing regulation to allow token models to prosper, instead of forcing all companies to fit an old model that doesn’t apply anymore.
Instead, today’s reality is filled with confusion, irony, contradictions, uncertainty and fear.
As a result, companies are fleeing the US and Canada and planting their innovation seeds elsewhere. Therefore, the future tech giants of the cryptocurrency era will not based in North America. The few that remain in North America are jumping through costly hoops and battling an uncertain future that will be even more costly to the industry as a whole.
[In a recent Twitter survey I posted, 81% of respondents felt that the SEC has NOT been clear enough enough in defining what constitutes a “Utility Token” that would be exempt from the same compliance requirements that follow existing security laws.]
It is time for the tech industry and all of its advocacy associations and centers to rally together and find the common voice that unites it.
As an external observer, a prominent European securities lawyer told me recently they were astonished that no one in the US seems to be strongly challenging the SEC about their limited optics on the state of tokens.
If the SEC was seriously interested in the well-being of the crypto industry in the US, they would open-up a new registration process for ICOs and token offerings, and ask a few questions, such as the ones I enumerated almost two years ago, in my post Safe ICO Practices.
Subjecting the token novelty to an old regime is not the answer. Most companies cannot afford the costs and uncertainties of a Reg A+ process (estimated at $1.5M-2M), and it only solves the issuance stage, not the trading, nor the usage of tokens by real users.
So, as an industry, what do we do? Do we let the SEC continue to mislead us, confuse us, divide us, scare us, and string us along? Or do we rally with a common voice that enlightens the market more than obscucates it? Alas, this is the juncture we are in.
Defend Crypto is a new initiative that the Kin Foundation has started to galvanize the industry and fight the good fight with the SEC. You can help by donating to this defense fund. This matters a lot, because the stakes of winning these arguments are high. Winning will pave the way for other bona fire token projects that want to succeed and innovate in North America.
As the Defend Crypto website aptly notes, we need to let the SEC know that we won’t be pushed around anymore. It is time to Defend Crypto.
You can join me in supporting DefendCrypto by contributing to it, and by voicing your support for it.
Just because the SEC continues to pretend there is nothing new with tokens, and tags most of them as securities, doesn’t mean that tokens are doomed and have no future except for being labelled and treated like securities.
To the contrary, the token model is a fundamental innovation of blockchain technology, and it will eventually gain its footing and respect with the regulators who haven’t yet seized the scope of the paradigm shift that tokens encapsulate.
I’ve been thinking about and analyzing the tokens phenomenon long enough to have acquired a significant depth in perspective [here, here, here, here, here and on Tokenomics]. What I’m seeing now is a significant lack of knowledge and understanding on the part of the gatekeepers of change. We could blame them for not trying hard enough, but we can also blame ourselves for not trying to better explain these changes.
Simplicity increases the chances that the general public, regulators and incumbents of all nature comprehend the need for change.
What makes the token difficult to comprehend is that it is a multiple function abstract, and we are not used to seeing something that simultaneous a) has several functional properties, b) represents diversified units of value, and c) is embodied in a digital form that binds it all together. Tokens are a new beast, and if we keep wanting to fit them or classify them within the previous paradigms or lenses we have, we will fail to seize their beckoning.
Simply put, tokens could simultaneously have properties of a:
Currency
Equity
Financial Instrument
Reward
Right
Digital Asset
So far, we have used separate artifacts to symbolize each of these functions. Then, came the token that melded them together in a mush, causing our mental ability to also become mush.
For currency, we have had the dollar, yen, euro, pound, and scores of sovereign fiats.
For equity, we have share or stock units, and they are known as securities.
For financial instruments, we have derivatives, bonds, futures, options, swaps, etc. and they are typically administered by brokers, agents, custodians or exchanges.
For rewards, we have mileage points, airline miles, loyalty cards, and the likes.
For rights, we have government-issued identity cards, or share proxies that allow us to have a (voting) voice in the governance affairs of what matters to us.
Finally, we have a blockchain novelty: a singular representation of a digital asset as a uniquely transferable unit of value: the non-fungible token that could represent a caricature-like version of a cat (eg CryptoKitties), a cartoon monster, a tank toy, or a purple sword won at a game, but could also represent a concert ticket, a collectible, or maybe something else not invented yet.
I believe that this classification covers all of the use cases for cryptotokens. Currency is used for payments, either for goods and services or for blockchain-related computer resources (eg gas). Equity represents ownership in a physical asset (eg real estate) or a proxy to some commodity (eg gold). Financial instruments include all of the existing (and new) financial services products that will eventually move to a purely digital format. Rewards embody what is also referred to as a “work token”, because some human or computer work has to be generated to earn these tokens, either actively by doing something or passively by sharing something else of value (eg our data). A right could include a right to vote (eg governance related), or a right to access something (eg digital content or some actionable service). The digital asset represents what is also called in the blockchain circles as NFT (non-fungible tokens), and they represent natively created digital objects that live only in a purely digital form, and have no physical equivalent. Finally, there’s one more factor that can apply to any token: they can be locked or unlocked, which means that their usage is tied to a time element.
A cryptotoken can be all of the above functions at once, or it can be some of them. Or, it could start as one thing, and develop into different ones, hence lies the puzzle and head scratcher that regulators and others are grappling with: how can we regulate, let alone understand this novelty concept that has many concurrent lives, when we have been used to seeing them and treating them as distinct units?
Furthermore, each token can have many different permutations in how it can be created, earned, bought, sold, granted (or received), stored, or used. And the most important remaining feature is that these tokens can be exchanged, traded or transmitted in a purely peer-to-peer fashion, without the friction of central actors.
As a chameleon symbol, the token is a weapon that punches through societal, governmental, and business related constructs via a technology component that is powerful and potent. It collapses many constructs into one.
This brings us back to regulation. It is erroneous to start with a securities framework for regulating how we want to govern the advent of tokens. Not only is that starting point like fitting a square peg into a round hole, it’s like trying to apply something where it doesn’t belong. More importantly, it chokes the new business models that want to emerge out of these token use cases.
Therefore, we need to recognize that the token is a unique type of asset. For a lack of a better set of words, it is “a new asset class” that needs its own laws and regulation. Unlike the “security” moniker that regulators want to box it in, the token doesn’t always represent a personal financial interest nor an equity share of a financial stake into something else. It is a new type of proxy to our increasingly digital lives.
The token needs to be given respect and it needs to be accepted as such. If the current regulators want to govern it, they will need to open their minds much wider, and one way to help them is by trying to explain it in a more friendly manner with a simple language like I’ve attempted here.
I don’t believe we have explained tokens in a simple enough layman’s language, yet. That is largely why change makers quickly put their blinders on when they approach the topic, or they only see what they can comprehend.
I believe that regulatory headwinds are the most imminent hurdles facing token adoption, and we must work on those first, by making it easy for everyone to talk about tokens, and to be accepting of the many applications that want to include them.
It is commendable for the SEC Chairman to have come out with a response to Rep. Budd’s inquiry about clarifying their stance on Ethereum and token classifications.
It took a while (5 months) for the SEC to respond, probably because they didn’t want to give these positive signals too early, while they were pursuing other enforcement actions that were already underway.
Begging the SEC for further clarity has been the industry’s crying signal for a while. In January, I enumerated 28 questions that the SEC needed to answer. Coin Center is to be commended for helping Rep. Budd draft that letter.
In my opinion, Chairman’s Clayton’s response represents a turning point in how the SEC might view tokens in the future. It is a first step, but a good one. They had been entrenched so deep against tokens as a utility for so long, such that they could only dig themselves out of that narrow hole gradually, and that was a very good first step.
What are the implications that could be interpreted from this response letter?
The SEC has indirectly implied they didn’t move fast enough to fine token offerings that were previously a security during issuance. As time went by, tokens became in use, and networks became operational and decentralized as intended. The end-result has made their case for finding (and fining) potential violators weaker and weaker.
The SEC acknowledged that a token can change its characteristics over its lifetime, and that’s a very important factor in accepting the novelty aspect surrounding the utilitarian role of tokens.
They acknowledged that they are willing to react to, and become more straight forward (or change their opinion) if prompted by a political force (the letter from Rep. Budd). [But it is interesting that industry calls for the same seemed to have fallen on deaf ears.]
Did the SEC just blink? I think they did. And maybe with a wink too.
They have no choice but to become more friendly and accepting of the innovative token-based models that entrepreneurs are eager to test the grounds for.
I am hopeful that an SEC token clemency regime is just beginning.
In my CoinDesk year end opinion piece, entitled The Future of ICOs: In the Hands of Regulators or Innovators?, I predicted that 2019 will be a year where the SEC will face an industry that will be reluctant to cave in to its vague, inconsistent and antagonistic posturing vis a vis cryptocurrencies, tokens and ICOs in the US.
I encourage you to read that piece.
This morning, my inbox and news feed had a number of related news and developments that I’d like to highlight.
… the SEC sought to define most, if not all, ICOs as unlicensed securities in the US, despite no regulation or law ever having been passed to that effect (and muddled reasoning at best on how one defines a security vs. a commodity in this age of cryptographic tokens).
I like the description “muddled reasoning” because it aptly describes how the SEC has been communicating with the market, exercising its own version of cryptic messaging via occasional speeches, interviews and regulatory enforcement actions- which do not sum up to cohesive clarity.
Michael Terpin continues on the subject of security tokens:
… heightened regulatory scrutiny is making it an easier path to offer equity in one’s company, asset (real estate, art, etc.), fund or, in some cases, as a two-step process to funding an ICO in the US through deeming it a security (not appropriate in many cases, but it’s happening).
The keyword highlighted here is “not appropriate in many cases”, and I concur that this is indeed happening, as I said in my CoinDesk piece that an STO (securities token offerings) is not necessarily a good path, just because you are compliant.
More Questions than Answers
In a surprise development, the CFTC issued a public Request for Information, entitled Request for Input on Crypto-asset Mechanics and Markets, specifically focusing on ether and Ethereum. It is a list of 25 questions, ranging from the mundane (e.g., How many confirmations on the Ethereum blockchain are sufficient to wait to ensure that the transaction will not end up on an invalid block?) to the more complex (e.g. Does the Ethereum Network face scalability challenges?)
This is a very progressive move on the part of the CFTC, and it demonstrates their genuinely inquisitive seriousness pertaining to Ethereum, but I wonder if the broad public request won’t result in a cacophony of answers that will need to be carefully curated. I would have preferred if they limited these inquiries to expert opinions that could still be varied and diversified. I can imagine Ethereum antagonists going to some extent at attempting to present subjective views that may not be so accurate, and I hope that the CFTC is able to properly analyze and digest the flood of facts and opinions they will receive. Nonetheless, this is a big stamp of approval for Ethereum, as it puts it on par with Bitcoin from an importance point of view, in the eyes of the regulators at least.
Maybe related to the CFTC development, earlier this week, 2 US Congressmen introduced 2 bills, one promoting Consumer Protection, and the other aiming to “conduct a comparative study of the regulation of virtual currency in other countries and then make recommendations for regulatory changes to promote competitiveness in the U.S.. Both bills are directed to the CFTC. The scope of the comparative study could be quite a big project, and I’m not sure if they retained some external consultancy to help them analyze the data, but both this initiative and the CFTC’s own RFI point to how little the regulators think they know about cryptocurrency and the blockchain, as they raise more questions than provide answers. However, kudos to the CFTC who at least, is indirectly acknowledging that they know what they don’t know, as contrasted with the SEC who has taken more bombastic approaches to slicing and dicing the blockchain market as they see fit.
Incidentally, last year, I had created an initiative to survey the global state of regulatory practices, called Token Awareness. Here’s a page rounding up some activities around the world, but it needs some updating.
Token Users as the Trump Card
Moving on to another recent development,- Basis, a much publicized stablecoin startup has decided to shut down and return unspent money to their investors. Then CoinDesk offers a contrasted picture in the Blockstack ICO highlighting their conservative nature about how they are spending their cash, and how they have de-linked their token from speculative market hands. Blockstack was birthed as a startup where they were disciplined enough to appreciate the value of a venture round, investor scrutiny and sound, measured progress. [Sidenote: I will be speaking at the Blockstack Decentralize the World event in Hong Kong on January 10 2019). This all boils down to two trends:
1/ Some ICOs who are encountering headwinds or challenges to implementing their vision are being true to themselves and shutting down, and returning unspent moneys or tokens to investors. We have already seen Cofound.it do that a couple of months ago. There are scores of ICOs who have not made progress, but they aren’t being true to themselves nor to the market. They are hiding under a rock, hoping the market will recover and lift all the boats. In reality, that will not happen. Their reserves will dwindle, and they will be eventually forced to shut down.
2/ The underlying lesson of all this, is that without a lot of users, a token is worth nothing. I’ve been saying this a lot throughout my dozens of presentations this year, “The only token that matters is the one actually being used.” And I have written about that topic multiple times, here and here.
Wither the SEC?
A most interesting comment was buried in a MAMA (Multichain Asset Managers Association) email I received this morning, in a piece co-authored by Andreas Glarner & Alex Lindgren of the Swiss Law firm MME. The article offers an analysis of the November 8th 2018 US Securities and Exchange Commission settlement and charges against decentralized exchange EtherDelta. The authors start by observing that “Obviously, the view of SEC does not necessarily have an implication on how other jurisdictions and regulators approach the question.” They add that this is the “first opinion of a regulator on the topic and therefore will remain to have an importance on the future discussion of the matter“. That seems to concur with the SEC’s approach of trying to win a few enforcement actions so they can establish a trail of case law precedents which they hope will serve as a basis for future regulation interpretations and market signals. It is the opinion of many in the industry that this approach would be detrimental to the health of the North American blockchain market (because the OSC typically follows the lead of the SEC).
I will continue writing about the regulatory aspects of cryptocurrency and blockchain technologies because of the heightened importance of that topic, its critical nature and the conjectures that we have now reached.]]>
In my CoinDesk year end opinion piece, entitled The Future of ICOs: In the Hands of Regulators or Innovators?, I predicted that 2019 will be a year where the SEC will face an industry that will be reluctant to cave in to its vague, inconsistent and antagonistic posturing vis a vis cryptocurrencies, tokens and ICOs in the US.
I encourage you to read that piece.
This morning, my inbox and news feed had a number of related news and developments that I’d like to highlight.