A Blueprint for Reforming the Crypto Token Market

Michael J. Casey is the chairman of CoinDesk's advisory board and a senior advisor for blockchain research at MIT's Digital Currency Initiative.

The following article originally appeared in CoinDesk Weekly, a custom-curated newsletter delivered every Sunday exclusively to our subscribers.

The token industry needs to grow up.

I'm not talking about financial growth, at least not for now. With $20 billion raised in "initial coin offerings" and an overall token market valuation of $300 billion, early participants in crypto finance have done a spectacular job of "growing" their monetary value as measured by the very fiat currencies many claim are being disrupted.

But if digital tokens are to matter and if they are to enable networks of distributed trust, the industry needs to advance to adulthood.

Only with a self-regulating system, in which broadly accepted norms of behavior, modes of communication and business practices are encouraged, can the industry shake off a Wild West image of Lambo-loving scammers and move from the fringe into the mainstream.

This, by the way, is also the only way to experience true and meaningful financial growth by which opportunities are distributed beyond a small set of early adopters to a wider array of participants in the $100 trillion world economy.

As such, it is encouraging to see proactive efforts to promote best practices. The latest such effort comes from the Token Alliance, an industry initiative of the Digital Chamber of Commerce that comprises 350 global industry participants, including blockchain and token experts, technologists, economists, former regulators, and practitioners from over 20 law firms.

On Monday, the Alliance will release its first white paper, one that aims to bring two important constituencies – industry leaders and regulators – into alignment around the appropriate business and legal treatment of digital token issuances.

In particular, it seeks clarity for tokens that are not intended to be investment contracts – typically those that have a "utility" value in driving a decentralized network of users – and for that reason, deserve to be excluded from existing securities laws.

According to a foreword from Token Alliance co-chairs Jim Newsome, a former chairman of the Commodity Futures Trading Commission, and Paul Atkins, a former commissioner of the Securities and Exchange Commission, the principles outlined in the report "are designed to help market participants understand the parameters around their activity and to act in a fair and responsible manner toward potential purchasers."

At the same time, Newsom and Atkins add that these guidelines can help policymakers understand the technology better so as to avoid drafting draconian rules potentially creating "an environment of regulatory arbitrage, or even worse, unintentionally decrease the attractiveness of a jurisdiction regarding innovation and jobs creation."

The key point here is that this is two-way street.

On the one hand, policymakers clearly need educating – as highlighted by California Democrat Rep. Brad Sherman's ludicrous suggestion to ban bitcoin during Congressional hearings a week and a half ago.

But on the other, regulators are going to be much more willing to give the industry the regulatory space it needs to flourish if there isn't widespread public anger over unsavory and exploitative behavior in the crypto community.

After all, as smugly satisfying as it was to read all the "Old Man Yells at Cloud" memes that mocked Sherman, his and other lawmakers' misplaced proposals were prompted by some pretty shoddy industry behavior, especially in the initial coin offerings (ICOs) market.

Assessments of ICOs have concluded that as many as two-thirds of those in 2017 were scams. Notably, the lament heard most widely and vociferously about this problem is from within the crypto community itself, with serious developers complaining constantly about "shitcoins" and "vaporware" projects raising eight-, nine-, even ten-figure amounts without building a single thing.

Some in the community would much prefer that the whole "ICO" thing would go away. (In all fairness, "ICO" really is a terrible term, one that immediately labels tokens as purely a money-raising enterprise, substitutable for an IPO.) They want the world to recognize the relative purity of bitcoin and perhaps a smattering of other fully mined altcoins. (Ether is usually excluded from this list.) They view bitcoin and its ilk as the only true censorship-resistant systems, neither reliant on third parties to operate nor at risk of being shut down by regulators.

But token issuance can't be wished away. It's here to stay.

Irrespective of the debated legal distinctions between "securities" and "utility tokens," sales of these digital assets have already proven to be an effective way to bootstrap the development of decentralized networks and the decentralized applications (dapps) that thrive within them. It's not clear whether pure cryptocurrencies such as bitcoin bogged with scaling challenges will ever have the capability to support the smart contract functionality that dapps require.

Once you accept the premise that ICOs are here to stay, it should also be apparent that in order to flourish they must operate within a constructive legal framework.

This is not to say that token projects shouldn't be disruptive, but it is an acknowledgment of the need for pragmatism. It should be possible for crypto developers and entrepreneurs to hold true to their decentralizing and anti-corporate principles yet also foster a less cynical, more realistic relationship with government.

The best route to a constructive legal framework is to foster a reliable, structured system of self-regulation, which can be designed to soften the compliance blow for startups. Most of the responsibility for boosting public confidence in the technology should rest with industry participants rather than law enforcement, but fall within a predictable legal framework.

We must develop standards of accountability, attestation, reputation and certification (decentralized or otherwise) that weed out bad actors from the market and do so in a way that gives regulators confidence that the social objectives that define their mission are being upheld.

This is the basic principle behind self-regulatory organizations (SROs) at regulated exchanges and traditional certifying bodies in finance such as the Financial Industry Regulatory Authority (FINRA). This is not to say the crypto industry should follow these heavy-handed approaches, which are rightly criticized for overly protecting incumbents. Rather, it is to say that with the help of the kind of transparency and accountability offered by blockchain technology and crypto innovations such as multi-sig custody, an opportunity exists to build institutions that foster both public confidence and startup-led innovation.

For this self-regulatory approach to succeed, the authors of the Token Alliance paper argue, it is vital for governments to provide a supportive legal framework. Here, in their bid to educate regulators, they favorably describe the approach applied in the U.K. territory of Gibraltar, which requires "adequate, accurate, and balanced disclosure of information to enable anyone considering purchasing digital tokens to make an informed decision."

The section on Gibraltar's forward-looking framework for token regulation stands in stark contrast to preceding sections, which cover evolving legal approaches in Australia, Canada, the U.K. and the U.S. Put these together, and a picture emerges of continued uncertainty and contradictory perspectives.

On the industry education side, the Token Alliance paper takes a decent stab at laying down principles for how development teams that take on the role of "token sponsor" should bring their tokens into the world if they are to avoid having to comply with securities law.

Some of these proposed principles will be unwelcome to teams who've viewed ICOs as get-rich-quick opportunities. The authors argue, for example, that sponsors' white papers "should avoid discussion of any allocation of tokens for investors, developers, founders, or employees," since these facts would be more relevant to an investor than a token user – highlighting the token's vulnerability to being regulated as a security.

This, however, is the price of growing up, and it's a price worth paying.

Blueprint image via Shutterstock