These aren’t a perfect metaphor for initial coin offerings, but they have a few things in common. Photo by Elisabeth Dellinger.
Once upon a time, young companies raised cash by issuing something called a “token.” Prospective customers could buy these tokens, which they could then use to purchase goods and services from the company. Customers were free to buy and sell these tokens from and to each other, presumably at prices above or below face value as the market dictated. These companies were called video arcades. I’m not aware of anyone who ever made a fortune on them.
All analogies are terrible, and I am not about to argue arcade tokens are perfect cryptocurrency analogs. There are plenty of differences, not least the fact that arcade token supply is basically infinite. But functionally, there are plenty of similarities between them and most of today’s Initial Coin Offerings (ICO), where an unproven startup raises money by issuing a cryptocurrency—aka a token—which early backers can eventually use to buy goods and services from the company. Think Kickstarter, only you get snazzy e-money while you wait for the company to start producing anything. People are going nuts for these ICOs, eager to get in on the ground floor of the next bitcoin or ether. But at least those two have slightly broader uses. To me, these other rinky-dink ICOs seem mostly like an end-run around securities regulations, and the SEC increasingly seems to agree. Call me an old fuddy-duddy if you like, but I can’t help wondering whether ICO backers will eventually feel the same way about these tokens as I feel about the useless pile of Malibu Grand Prix tokens in the back of my dresser drawer.[i]
Let us now turn the microphone over to SEC Chairman Jay Clayton.
A key question for all ICO market participants: “Is the coin or token a security?” As securities law practitioners know well, the answer depends on the facts. For example, a token that represents a participation interest in a book-of-the-month club may not implicate our securities laws, and may well be an efficient way for the club’s operators to fund the future acquisition of books and facilitate the distribution of those books to token holders. In contrast, many token offerings appear to have gone beyond this construct and are more analogous to interests in a yet-to-be-built publishing house with the authors, books and distribution networks all to come. It is especially troubling when the promoters of these offerings emphasize the secondary market trading potential of these tokens. Prospective purchasers are being sold on the potential for tokens to increase in value – with the ability to lock in those increases by reselling the tokens on a secondary market – or to otherwise profit from the tokens based on the efforts of others. These are key hallmarks of a security and a securities offering.
This is an excerpt from his official Statement on Cryptocurrencies and Initial Coin Offerings, published Monday, which explores the legality of ICOs and some of the fishy ways companies market them. One striking example of fishiness earned some headlines the same day, courtesy of the SEC’s cease-and-desist order against an ICO by Munchee, Inc., which as near as I can tell has nothing to do with a late-night food delivery service aiming to capitalize on cannabis legalization. Rather, it had to do with online restaurant reviews and envisioned its token as a medium of exchange for services it planned to provide. It also envisioned its token as a magic return-generator. Hat tip to Bloomberg’s Matt Levine for highlighting the fun part:
On or about October 25, 2017, Munchee created a public posting on Facebook, linked to a third-party YouTube video, and wrote “199% GAINS on MUN token at ICO price! Sign up for PRE-SALE NOW!” The linked video featured a person who said “Today we are going to talk about Munchee. Munchee is a crazy ICO. If you don’t know what an ICO is, it is called an initial coin offering. Pretty much, if you get into it early enough, you’ll probably most likely get a return on it.” This person went on to use his “ICO investing sheet” to compare the MUN token offering to what he called the “Top 15 ICOs of all time” and “speculate[d]” that a $1,000 investment could create a $94,000 return.
Now, this is not a column about whether or not Munchee’s token was a security. Nor is it a statement about whether Munchee is a scam, making one wonder if you will pretty much probably most likely get a return of your money. It also isn’t a forecast of future ICO returns. Yes, they look bubbly, but as we often preach on MarketMinder, bubble chatter is self-deflating, and everyone trading these things (as well as bitcoin and ether) has heard all of said bubble chatter. One could rationally argue markets have priced it all and we could be far away from the crash—just as one could rationally argue the cryptocrash will start tomorrow since these bits of code have zero fundamental support. Bubbles are funny and unpredictable like that, and I’m no Jesse Livermore.
But the SEC’s findings can help you understand why investing in ICOs with visions of sky-high returns is speculation. In most cases, you are not buying an equity stake in the business (even if you were, the percentage of venture capital investments that eventually pay off is tiny). Instead, you are pre-paying for their product. Ask yourself: Would you invest in an ETF with nothing but arcade tokens? Starbucks gift cards? Free car wash vouchers? Handwritten IOUs? Coupons for free hugs? Of course not. One, these things have no prospects to appreciate in value. Two, they are worthless as soon as the issuing company goes out of business, nothing but relics of a bygone consumer era. Sort of like that old Loehmann’s brass-plate gift “certificate” that is also languishing in my dresser drawer or your old Gimbels or Bullock’s credit card.[ii]
Yes, it can be fun to throw some money at a fluke with huge potential returns. But this is speculating. It is not investing. When you invest in a stock, you buy a piece of it and its future profits. It is easy to describe what you own: a sliver of a company that is out there selling products and/or services and (hopefully) making money. That sliver has the potential to grow in value as the company grows, thrives and makes more money. It is a sliver of a business you can analyze and assess. It probably won’t bring quick riches, but you’re (theoretically) in it for the long haul, and it is reasonable to expect someone to buy it from you at a higher price down the line. With most ICOs, there is no good reason to expect this. “But people are paying a lot for them now!” is not a good reason. That is like saying, “because there is a mania now, there will be a mania in the future.” Sir Isaac Newton and others who lost a fortune in the South Sea Bubble called to say, “huh?”As always, do what you want. If you dig the not-so-cheap thrills of speculation, that is your prerogative. But know the difference between investing and speculating, and always understand what you’re buying. And remember that if you’re taking a flyer on a glorified gift card, there is no rational reason for someone ever to buy it from you at a higher price.
[i] Ok so they won’t sit around thinking “if only I had played more videogames or taken a few more swings in the batting cage.”
[ii] Full story: My mom received this as a “thank you” gift for volunteering at my elementary school’s walkathon in the mid-80s. She never used it and gave it to me seven years ago, by which time Loehmann’s had switched to gift cards like a normal store and didn’t have the infrastructure to process the brass plate thing. I spent an hour on the phone with corporate one day trying to get them to agree to send me a gift card in exchange for it but gave up when I became convinced they’d never send me anything. This was four years before they went out of business. So, I tried.
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