Julio Faura is the head of blockchain research and development at Santander. The views expressed are his own.
Much is being written these days about the need to regulate initial coin offerings (ICOs) and – to the extent possible – access to cryptocurrencies.
With close to $350 billion in (theoretical) market value, cryptocurrencies have started to hit the mainstream, and it is becoming urgent to find a suitable, enforceable regulatory framework that protects investors and helps companies leverage the advantages of ICOs as an efficient way to access funding.
Here are some thoughts that may be helpful to structure and fire up the debate.
Speculation on utility is a bad idea
In my opinion, it would be a good idea to clearly separate functionality from funding. Mixing them together ends up producing transaction costs that are artificially high, since access to functionality is subject to speculation.
A good example of this is the very case of the ethereum network, which has become very difficult to use for real things due to the high price of ether in U.S. dollars, and because the network is swamped with speculative applications and trading.
I always understood the role of ether as a mechanism to pay for the use of a network that implements a shared supercomputer, which is a truly amazing construct that can change the world for good. But its dual role as an access token and a currency to store value is making the construct expensive and difficult to use in practice.
The implication of the above is that utility tokens are not a good idea. Firstly, because they are subject to uncurbed speculation on basic goods and services that will be out of reach for the least favored segments of the population.
The problem is particularly acute in this digital realm, where the network effect is significant and most businesses show a “winner-take-all” behavior. Therefore, the lack of mechanisms to curb speculation on uncensorable, decentralized networks leads to higher service costs and significant concentration of wealth.
The other reason utility tokens are a bad idea is because, if we are honest, in most cases they are in fact securities, and treating them as if they were not would essentially be a lie to ourselves.
A comparison often made in response to this point is the down payment for a house that is yet to be built, or the payment for a Tesla car that is yet to be manufactured and even designed. But in both cases users 1) are buying these basic goods for their personal use, and 2) have a fairly good idea of what they are buying.
Utility tokens, on the other hand, are arguably sold as a way to raise funding, they are bought as an (speculative) investment, and only rarely do the buyers have a good idea of what is going to be built.
ICOs can be an alternative to VC
That said, ICOs are proving to be a great instrument to help companies and entrepreneurs to raise funding.
In my opinion, we should collectively work on a framework to build a clearly defined scheme for ICOs, recognizing from the very beginning that they are securities.
Indeed, they are an alternative to traditional venture capital since 1) they provide a much more liquid capital instrument (VC will typically lock you down for 5–7 years until an exit is possible), and 2) they grant access to a much larger, diverse and atomized investor base with fewer intermediaries and in a more democratic way.
As a matter of fact, they greatly resemble initial public offerings (IPOs), which in essence can be seen as nothing less than crowdfunding schemes for large companies.
ICOs could mimic the same process, but on a much more efficient, digitally native platform, suitable for smaller projects and an atomized investor base.
If the above is true, the ICO process should be designed in collaboration with regulators to comply with securities law, which exist for a reason: to protect investors.
Key elements of this process would be as follows:
- Securities would be issued on the shared ledger as tokens living on a smart contract, rather than in tokenized form. In other words, these smart contracts would implement securities as natively digital objects, instead of being digital representations of the (actual) securities living in traditional systems (or on paper).
- Required information about the project needs to be filed and audited, so it is clearly understandable by potential investors.
- Pursuant to know-your-customer rules, holders of tokens must be identified prior to the sale by the company, and also upon transfer to other holders.
- Tokens should grant access to dividends and should provide voting rights. Non-KYC’ed holders should not be given dividends and their votes should not be considered
Role of cryptocurrencies
The use of cryptocurrencies in the ICO process as described above provides for further points of optimization compared to traditional IPOs and subsequent corporate governance.
First is the ability to use cryptocurrencies as a source of capital, provided that the world accepts them as a legitimate instrument for storing value and facilitates ways to exchange them for fiat currency.
But second, because their digital nature can be used to execute corporate actions in a more efficient and transparent way in comparison with the traditional system.
In fact, smart contracts are a perfect mechanism determine the behavior of securities contracts, as all conditions, covenants and actions can easily be automated with no room for interpretation. For example:
- Dividends originated in fiat currency can be converted into cryptocurrency and paid to the token contract, which can then distribute the money proportionally to KYC’ed token holders (crypto businesses that produce profits directly in cryptocurrency have an additional benefit here, as dividends would be paid straight to the KYC’ed token holders).
- Options and voting rights can be exercised by signing on the same smart contracts after identification of signing parties through attestations on a self-sovereign digital identity construct.
- Lock up periods can very easily be enforced.
- Any other actions such as options issuance and exercising, new share issuance or buybacks can be easily executed, and covenants can be transparently modeled using smart contract code
In fact, the separation of the business and the security token even makes it possible to use cryptocurrencies to fund traditional businesses models not related to crypto at all.
But also, an alternative way to fuel ICOs would be through the use of tokenized fiat currencies, either through tokenization processes over smart contracts, or by creating ether on a private version of ethereum redeemable in fiat.
These constructs would not be reliant on classical cryptocurrencies, yet would enable most of the benefits of current ICOs in terms of liquidity of shares, democratization of investment opportunities, and automation of corporate actions.
All of which should represent a significant improvement from traditional venture capital and IPOs.
The question is, what will happen first, regulatory acceptance of cryptocurrencies as a source of capital for companies, or creation of legal, fiat-backed ones?
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