In the recent days regulators across the world have come out with positions on ICOs after allowing a free for all for some time. Some people say there was (and still is) a frenzy going on and the regulators had to intervene. However the truth is far more nuanced and needs a deeper explanation.

In the recent few days a number of regulators across the world have come out with positions on ICOs after allowing a free for all for some time. Some people say there was (and still is) a frenzy going on and the regulators had to intervene. However the truth is far more nuanced and needs a deeper explanation.

A financial security (a share or a unit) is a very curious thing. It represents an ownership in something else. For instance a share gives you part ownership of a business, or a unit of a property backed asset may represent partial ownership of that asset. By itself a security cannot be “touched” or “felt”. It is not a physical construct. Which means a security is exposed to a lot of potential for manipulation.

Suppose you buy shares in barrels of wines. What prevents unscrupulous share issuers to siphon off the wine, replace it with something else and take the wine? Or sell the same shares to other people? Or even worse take your money, say that they are doing barrels of wine and go on a one way trip to fiji instead?

One of my favourite books is “Extraordinary popular delusions and madness of crowds.” It talks about a number of similar share market based scams from the 17th and 18th centuries. Human nature does not change, but if we are going to have a financial system that works people need to be able to trust that they are not being cheated.

To achieve that the regulators came up with a two pronged approach. One was disclosure and the second was audits. Companies raising money publicly were required to issue offer documents that followed certain standards and clearly laid down what the business is trying to do and what the risks are along with all the factual information. And regular audits means a 3rd party check to ensure that the money is being used for what it was claimed it will be.

This requirement of disclosure and audits is a technology agnostic principle that should stand the test of time.

The problem is during the ICO craze a number of players, some of them intentionally and other unwittingly, decided that regular rules need not apply and created offerings that were clearly securities which should have obeyed the regulatory requirements. It was this wholesale sidestepping is what caused the intervention by the regulators.

It is interesting to note that Western regulators (USA, Australia, Singapore) have taken a much more nuanced position than those from China, Korea, Russia where they have resorted to an outright ban.

Western regulators have correctly staked the position that while some ICOs are clearly security offerings, not all ICOs need be. There are clearly some ICOs that are actually not securities. How do we identify which is what? We will leave it for another article but lets consider a simple example before we close.

Suppose you want to launch a laundromat and you dont want to sell ownership of the business or take out a loan. What you do instead is mint plastic or metal tokens that can be used in the laundromat. You sell a bunch of these in advance and use the proceeds to fund your business launch. That is an ICO.

You are clearly offering a coin that can be used to pay for a service in your future network.

But if you offered tokens that represented ownership in the laundromat and offered share of future profits or income, then that is clearly a security.