There are numerous reasons why the market is punishing crypto, and more specifically utility tokens.
Below are some of the major factors which have led to the crash.
Flawed Business Concepts:
While there are some valid projects in the space such as Factom, and Stellar, most projects are either outright frauds, or at the very least, awful business concepts.
I’ve been contacted at least twenty times by different projects who plan on being ‘Uber on the blockchain’. In this case the business model features paying drivers in cryptocurrency so that they can cut out the middle-men.
I initially inform these Uber clones that General Motors, Tesla, Uber, and Lyft are all planning on releasing autonomous vehicles within 5 years. Afterwards, I proceed to ask how they plan on tackling this challenge. Generally, they have no answer. In other words, they plan on disrupting Uber by paying drivers in crypto, while Uber are busy disrupting themselves by removing drivers.
Another example are projects which advertise themselves as ‘AirBNB on the blockchain’. Ask how they plan on marketing and they have no idea. They somehow expect the average consumer to want to purchase bitcoin, transfer the bitcoin to an exchange, purchase the companies token, and then transfer that token to the ‘AirBNB clone platform’.
This is not user friendly to simply book a holiday. If you ask these companies how they will monetize, often it involves the value of their tokens increasing. A sloppy business with no actual business plan, one example of this are Bee Tokens.
Nowhere do these ICOs validate how they will market the product, or how they plan on earning money. The reason is that 90% of these companies have no intention of earning money from the business, they only look at raising money from the ICO.
The same could be applied to dozens of other verticals which ICOs claim to disrupt such as advertising, affiliate marketing, data storage, esports, healthcare, etc.
While there will be some bad businesses conducting STOs the numbers will be reduced. Institutional investors will be more demanding, and the added regulatory environment helps ensure that STOs are more transparent.
There are 2 types of businesses that raise money from ICOs. The fraudulent ones which have the goal of raising money and hyping the product, and regular start-ups.
Start-ups operate on a tight budget, they carefully measure the burn-rate, and attempt to stretch raised capital as much as possible. Funds are used on payroll, rent, and other operating expenses. They cannot afford to pay 40 BTC to list on HitBTC, or up to $3,000,000 to list on Binance.
Meanwhile fraud projects ‘invest’ raised funds into listing fees. The ICO reserves some of the raised capital for marketing, and the rest is kept as profit for important assets such as ‘lambos’.
Who does the market reward?
Often, the market rewards the fraudulent companies which can afford to pay exorbitant listing fees. The success of an ICO is dependent on marketing and hype instead of actual product adoption or market penetration.
Exchanges should be profiting from trading, not from listing fees. Credit should be given to Bittrex for being one of the few exchanges with no fees. Legitimate security exchanges will not charge anything more than basic listing fees, ensuring an even playing ground for legitimate businesses.
The theory is that forks are evolution, there’s a disagreement between management, and both parties go their own way to then ‘fork’ the code. The best fork then wins.
While there is some validity to this theory it causes numerous issues as outlined:
- Market Confusion – The average consumer considers purchasing bitcoin. Now they must somehow learn to differentiate between the various versions which include: Bitcoin Gold, Bitcoin Diamond, Bitcoin Dark, Bitcoin Cash ABC, Bitcoin Cash SV, Bitcoin Private, and Bitcoin.
- Dilution of Brand – If there were 15 versions of Apple products by 15 different companies named Apple, it would dilute the value of the brand. The same applies to Bitcoin or any other fork. The more forks, the more the value will decrease. The worst thing that happened to Bitcoin was Bitcoin Cash.
- Magic Money – The entire concept of Bitcoin is that there’s a maximum limit of 21 million coins. Every fork then teaches the market that this maximum limit is arbitrary, as you can keep on ‘forking’ or duplicating this 21 million into infinity. It destroys the limited supply concept.
Digital securities cannot be forked, this ensures the integrity of the brand and removes market confusion.
There are two problems with Bitcoin being as volatile as it is currently is.
- When the price begins to crash, merchants do not want to accept it. Some industries are super competitive with tight profit margins, they cannot afford the risk of accepting Bitcoin unless it’s converted immediately to fiat.
- When the price escalates as it did in December 2017/January 2018 the opposite problem occurs. Consumers do not wish to spend Bitcoin as they know they are losing money, instead this price escalating causes hoarding behavior.
Both above problems cause market friction and deter user adoption. Stable Coins which were the first true security tokens can solve this issue.
Hacking and User Error:
Using cryptocurrencies is difficult and unforgiving. It requires storing private keys, hoping that the keys are never compromised, and that the user will never make an error. It requires humans to be perfect and to behave like machines.
The average person does not want to be stressed out by losing private keys. This alienates anyone who is not tech savvy and who does not live and breathe crypto.
Cryptocurrencies are an area of vulnerability for merchants. They know that if the funds are hacked, they can never be recovered. This begs the question, why would they bother with the risk? It’s one thing to worry that a bad staff member might empty out a cash register for $500, it’s something else to worry about them stealing 1000 BTC.
This same problem is why institutions are not wanting to invest in crypto. When you are dealing with a billion dollars in volume, the last thing that you need to worry about is a potential $200 million heist.
I do not foresee any type of real market adoption for any token unless it has some type of KYC baked into it.
Security tokens solve this problem, they have KYC baked into the token which means if the token is stolen, that compromised token can then be destroyed, with a new token being reissued to the rightful owner. This simple feature solves the issue of hacking, lost private keys, etc.
Institutional money has seen the writing on the wall when it comes to utility tokens for many months now. They have reduced exposure to these assets to focus on tokenized securities. This has further driven down the price of most utility tokens.
While it is undeniable that there are many issues outside of the 5 that I have highlighted, I believe that these are some of the fundamental problems which have led to the market crash. Digital securities in the form of security tokens will be the next wave of crypto.
Solving the Liquidity Puzzle for Security Tokens – Thought Leaders
There is a wide consensus in the financial industry that blockchain technology is going to disrupt the securities market. However, despite the claims, there is no double-digit annual growth of securities on blockchain, which would be expected from a disruptive technology. The reason for that are regulatory roadblocks that don’t allow delivering the biggest promise of digital securities – liquidity for previously illiquid securities. In this article we break down this problem and present a solution.
What are security tokens/digital securities?
From a legal perspective, security tokens are common securities and are subject to the same regulations. The difference is that records about securities ownership are stored on blockchain instead of paper-based or other forms of records. That’s why they are often called digital securities.
Innovative technology significantly improves operations with securities, making them digital and automated. In particular, transfer of digital securities is much easier and may happen in minutes or seconds instead of weeks, spent on signing physical contracts, doing compliance checks and updating government registers.
Why liquidity is so important for security tokens
Liquidity of an asset defines how easy it can be sold. For example, publicly listed securities are highly liquid, while real estate and startup equity are highly illiquid. Although security tokens have multiple advantages, greater liquidity is a principal one. For this reason, they often represent ownership in traditionally illiquid assets.
Mass adoption of security tokens first and foremost requires interest from investors, which will create incentives for businesses to issue digital securities instead of traditional ones. For investors, lack of liquidity is the biggest problem of securities that are not listed on exchanges as it makes investments in them riskier and makes investors wait for decades until they pay off. Therefore, unlocking liquidity of security tokens is crucial for their mass adoption.
Why is liquidity in the conventional meaning of the word is out of reach for security tokens
In the narrow sense of the world, securities are considered liquid if they are traded on a stock exchange. For this reason, lack of regulated secondary markets is considered the main limitation. However, this ignores the fact that there are already operating exchanges for security tokens: tZERO, Open Finance, MERJ, GSX – but very few tokens are listed there. Furthermore, Open Finance is on the edge of delisting all security tokens because their trading does not generate enough fees to support operations.
Therefore, the problem is not in the lack of marketplaces. It is in fact that listing on an exchange is overly complicated. It requires registering the offering at competent authorities, having minimum trading volume, minimum market cap, being under increased reporting requirements, which often include annual audit. Basically, it requires becoming a public company. These requirements will arise not only in the case of listing on a classical exchange but any kind of regulated market. This means that listing on a regulated trading venue is not feasible for most security token issuers.
Such a flawed understanding of the problem stems from crypto origins of security tokens. They were seen as a regulated continuation of utility tokens and cryptocurrencies, for which listing on exchange is much easier, so it became a synonym for liquidity. This myth should be debunked in order for the market to move to more realistic sources of liquidity.
How is liquidity for security tokens possible?
To answer this question, we need to go back to an original definition of liquidity, which is the ability to quickly sell assets at any moment. It has two main components: complexity of conducting the transaction and how easy it is to find a counterparty.
The former problem is solved by blockchain technology. Its main benefit for private securities is that it vastly simplifies conducting the securities transaction, making it possible to do everything online in a few minutes. Conventionally, transfer of securities would require signing physical agreements, reporting changes to the government register, settling a transaction via a wire transfer, and doing manual compliance checks on individuals engaged into the transaction.
Complexity of the transfer also impacts the number of potential counterparties. When the transfer is complicated and expensive, it becomes not feasible to transact small amounts. This cuts off smaller traders and investors from the market, making it even harder to find a counterparty.
The problem of finding a counterparty is traditionally solved by an order matching mechanism of exchanges, which for security tokens is not feasible. Therefore, the key to unlocking liquidity is in creating an efficient way to find counterparties for transactions that would not be considered a regulated market.
This way is already known. It is a bulletin board for P2P transactions. As these transactions are private and do not involve an intermediary, they don’t require regulation. However, there are a number of nuances and requirements for such a venue not to be regulated, which will be covered in a separate article.
To the author’s knowledge, at the time of writing there is no venue that enables legally compliant and efficient P2P liquidity for security tokens.
What impact unlocking the liquidity of security tokens will have on capital markets?
Currently, venture investors may sell their shares only if businesses they invest into go public or are acquired. This has two implications, which both lead to money being used inefficiently and slow down the economic growth.
Firstly, it means that only businesses with the potential for IPO are worth investing. Businesses that can offer a solid yield but don’t offer “disruption” and outsized returns are deprived of funding. These are often businesses with a need for high capital investments – manufacturing, agriculture, physical infrastructure etc. The problem with a lack of capital investment is covered in a widely discussed article in Andreessen Horowitz blog “It’s time to build”.
Secondly, illiquidity makes VCs prioritize growth over profitability because when most investments don’t pay off even a 10x exit from successful ones may be not enough. It creates incentives to scale even when the business model is not tested enough, leading to extremely large companies, such as WeWork or Uber, struggling to deliver a profit.
The plague of private markets has impacts on public markets as well. It leads to the emergence of the IPO bubble, when more than 80% of newly public companies are not profitable. It is problematic because public securities are considered less risky, and thus fit into portfolios of retail funds and pension schemes, harming them by being overpriced.
Thus, solving the liquidity problem will have a drastic impact not only on the VC industry but on the entire economy.
HODL Your Hoopla Over SEC Changes For Exempt Offerings – Thought Leaders
Last week the The U.S. Securities and Exchange Commission released a proposal – that has yet to become regulation – to simplify how exempt offerings are done. Shortly thereafter, a flurry of articles and newsletters made their way through the digital asset industry – many of which suggested their platforms were already being modified to fit the new rules. While the SEC has proposed changes, time will tell whether the proposal is adopted – and if so, whether there will be changes to the final draft that will be published to the Federal Register.
The US exempt offering framework includes tools such as Reg D, Reg A, crowdfunding (a.k.a. Reg CF) – essentially everything that is not a public or retail offering. This framework has seen little in the way of changes or modernization since the Securities Exchange Act of 1934. There has been significant public criticism of the current rules for exempt offerings, largely because they reserve access for only the wealthiest Americans to invest in private funds, companies, and other offerings.
If passed, the proposed changes could allow for the average person to invest in earlier stage deals – such as Uber or WeWork – before they reach their lofty valuations and dumped into the public markets. Enabling SPV (special purpose vehicles) and harmonized reporting (ie combing Reg D and Reg CF into one, not two reports), and increasing the total amount that can be raised would help streamline compliance for issuing firms. Additionally, the changes could also enable crowdfunding to become a viable capital formation tool for investing in such asset classes as real estate.
Currently, US offering exemptions such as Regulation CF (crowdfunding) are quite restrictive, limiting the total amount you can raise to $1.07M USD per 12 month period and includes significant restrictions per investor. The US SEC appears to be following the lead of other jurisdictions such as Canada where regulators proposed similar changes, or Europe where regulations were updated last year, increasing the limits for the EGP (European Growth Prospectus) to €8M EUR, a little over $9M USD. According to the new proposal, companies would be able to raise up to $5M USD. While $5M is still a relatively small amount of capital, it does allow early stage companies to build their tribe with a broader investor base.
The SEC proposed similar changes to Reg A, increasing the upper limit to $75M USD. This could make Reg A viable for many later stage companies where larger Series B, C, or even D rounds demand more capital than what is currently available in Reg A.. This also opens up these investment opportunities to the retail investor, previously these deals were only available to the wealthiest corporate venture firms, private equity shops, and high net worth individuals.
Further changes include allowing accredited investors to participate in crowdfunding. Previously, if you used a crowdfunding exemption, you could not accept funds from accredited investors and would actually have to use another exemption, such as Reg D, simultaneously. This typically forces companies into more paperwork, legal fees, and an increased risk of getting something wrong – which could result in regulatory or civil actions. The proposed changes would enable companies to combine accredited and retail investors into one offering.
Aside from accredited investors, the changes also open the doors to institutional and corporate investors, including the SPV (Special Purpose Vehicle).
An SPV is a corporate entity created for a specific purpose – usually for reasons such as limiting liability, tax efficiency, investment, or capital formation. For example: In order to tokenize a piece of real estate, you might form an SPV, and transfer the deed to the real estate into this company. The purpose of that company/vehicle is to hold the deed of this real estate and maintain a accurate record of who the owners are, SPVs are commonly used for investment funds as well.
Combined, SPVs, corporate investors, accredited investors, and major institutional investors can move large amounts of capital. However, they weren’t able to invest in crowdfunding offerings in the US. This created an interesting paradox for companies raising capital, if you could get the big fish interested, you would avoid the crowd – but, if your offering didn’t look good enough for professional investors, your last resort may be crowdfunding. The crowdfunding industry as a whole has faced a lot of criticism from professional investors for low returns and low deal quality, this is likely to change when retail investors have access to the same deals as larger institutions.
Finally, the new crowdfunding regulations propose several major changes to how much each investor can put into any one offering. Currently, investors who do not meet the accreditation thresholds were limited on how much they could invest based on the lower of their income or net worth. The new regulations would change this to the greater of those two. These changes are expected to not only fuel innovation, they are likely to bring in a lot of smart money as well.
For example, an investor with a net worth of $750,000 and an income of $150,000 couldn’t qualify as an accredited investor. This person has a Phd in bioscience and finds a startup with a revolutionary innovation in the field of bioscience – they are not qualified as an accredited investor and barred from investing. Ironically, they can be an advisor to any institutional investor on why this particular startup is so hot – but under the current rules, they are not qualified to risk their own money.
While these changes are welcomed by most market participants, they are not a sure thing. This proposal for a new exempt offering framework is not yet regulation, it still has to make it’s way through the government and be entered into the Federal Register. Looking back at the proposals for crowdfunding in the US we can see how different a proposal can be from the regulation – and there are still a lot of lobbying dollars that want to see the status quo maintained. It is important to not make important business decisions based on this proposal – rather, look at these changes as a larger trend among securities regulators globally.
We’re seeing securities regulators trying to make easier for distributed capital formation. Crowdsales and crowdfunding are actually becoming something that the regulators across around the world are working together to harmonize their frameworks. By combining the crowdfunding regulations from jurisdictions around the world, early stage companies would be able to access global capital and build a global investor base, without being forced to break the rules like most of the ICO and STO issuers are doing today.
Perhaps the most exciting thing about the SEC’s proposed changes is how they demonstrate a very coordinated effort among securities commissions globally. As this new era of capital formation emerges, businesses will be able to combine and leverage the regulatory frameworks of multiple countries. That being said, for US based offerings, we still have to wait for the new regulations before knowing what they will look like, or their impact on the digital securities industry.
Why EU blacklisting the Cayman Islands matters for the STO industry – Thought Leaders
On February 18th the European Union added the Cayman Islands to its tax haven blacklist. While this has not made the news in the security token industry, it has had major implications. Due to the strict demands of AML & KYC in many jurisdictions, regulators are focusing more resources on beneficial ownership, tax transparency, and enforcement.
For companies raising capital, the blacklisting means you should not take money from a Cayman fund if you’re a European issuer. In the EU, a lot of the investment in security tokens, real estate, and private equity comes from or through Cayman fund structures. Cayman is also where a large portion of American VC funds are domiciled.
The current tax haven blacklist also includes American Samoa, Fiji, Guam, Oman, Palau, Panama, Samoa, Trinidad and Tobago, US Virgin Islands, Vanuatu, and Seychelles.
Any company taking funds from a Cayman domiciled fund, or working with a platform/issuer/bank in that market should be aware that being associated with a blacklisted country could create significant new risk exposure for your project, and possibly yourself. These changes are effective immediately. Until recently, most firms could fly under the radar but the EU is also rolling out a public registry of corporate ownership. This will not only make non-compliance much easier to spot but also increases the ability for regulators in the EU to investigate and enforce.
The regulation could impact people working at (including directors, officers, or significant shareholders) a company that received funding from a Cayman source after the blacklist date. Enforcement severity changes by country but can include criminal charges, company seizure, and known associates may end up on a variety of sanctions and watch lists. Not to mention the reputational damage.
This is a good example of why a good AML program does not only consist of face matching a document and pinging an API to name match a sanctions list – you are opening up your venture, and most likely yourself, to massive liability. Your legal and regulatory obligation is to take a risk based approach. What that looks like can change by country, transaction value, activity history, etc., so AML program needs to be dynamic, robust, and comprehensive enough to catch things like narrative sanctions.
For example: The most popular security token platforms today only use KYC for digital onboarding of natural persons – not corporate entities. However, when you look at the investors in their previous token issuances you can see that most of the funds are coming from corporate accounts, corporation owned wallets, but the on-chain transaction and KYC is done by an individual. These platforms are missing the technical capabilities to spot transactions coming through blacklisted jurisdictions such as Grand Cayman.
iComply recently helped a virtual asset exchange pass the audits needed to offer their users the ability to spend virtual assets, such as Bitcoin and Ethereum, with a Visa card. This process involved independent audits from Visa, their banks, and regulators – each wanted to see the client demonstrate how they would be able to identify these risks and fulfill the requirements of a whole web of regulations.
Now that they have passed the audit, they are first to market with a very compelling offer compared to their competition who still have months of development on their AML systems before their applications will go through. Using iComply to get ahead of the regulations has also put them ahead of their competition.
We can expect the same for the security token market. Token issuers need to pay close attention to their AML compliance – Telegram had to refund over $1B USD over AML, has spent millions in court with the SEC, and the OCC has not even started with them yet…after that, how many of their “not investors” will be ready to jump onto an investor class action lawsuit? We have already seen this with the recent OCC case against MYSB in New York, or with the SEC and AirFox in Boston.