So you want to invest in crypto? These are the questions to ask, says the SEC

Image: Reuters/Dado Ruvic
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Every investor knows the mantra: Buy low, sell high. But as bitcoin surges to new milestones—and one particularly bullish trader predicts it could go to $100,000 in the not-too-distant future—fear of missing out is grabbing investors. After all, bitcoin was trading at around $800 this time last year, and now it’s at over 20 times that.

Over the weekend, the Financial Times reported that (paywall) Coinbase, a bitcoin trading service, became the most popular free app on the Apple store. While some warn we’re in the midst of a big crypto bubble, others say the underlying blockchain technology has such enormous potential for changing finance that euphoria is warranted. So in addition to acquiring bitcoin, investors are hoping to discover the next bitcoin, or get in on an initial coin offering (ICO), an increasingly popular funding mechanism, to buy into the next big thing.

Not so fast, says the US Securities and Exchange Commission.

While the SEC has signaled it may begin regulating ICOs more actively, it also noted on Dec. 11 that no ICO has registered with it so far. The SEC’s most prominent investigation into an ICO so far only began after a hacker made off with millions. At present, those using ICOs to raise funds haven’t made disclosures in the manner prescribed by the SEC for a better-known fundraising mechanism, the initial public offering (IPO). In an IPO, companies must file registration statements, including a prospectus, and these disclosures are subject to review for compliance.

Of course, ICOs have to share some information—they wouldn’t be able to get investors to put their money in otherwise—but this isn’t standardized. Investors who want to put money into crypto offerings need to seek out all relevant information to make a sound decision on their own. The SEC this week put out a handy list of questions to help determine what they’re putting their money into and how it may be used:

Sample Questions for Investors Considering a Cryptocurrency or ICO Investment Opportunity

Who exactly am I contracting with?

Who is issuing and sponsoring the product, what are their backgrounds, and have they provided a full and complete description of the product? Do they have a clear written business plan that I understand?

Who is promoting or marketing the product, what are their backgrounds, and are they licensed to sell the product?  Have they been paid to promote the product?

Where is the enterprise located?

Where is my money going and what will be it be used for?  Is my money going to be used to “cash out” others?

What specific rights come with my investment?

Are there financial statements?  If so, are they audited, and by whom?

Is there trading data?  If so, is there some way to verify it?

How, when, and at what cost can I sell my investment?  For example, do I have a right to give the token or coin back to the company or to receive a refund?  Can I resell the coin or token, and if so, are there any limitations on my ability to resell?

If a digital wallet is involved, what happens if I lose the key?  Will I still have access to my investment?

If a blockchain is used, is the blockchain open and public? Has the code been published, and has there been an independent cybersecurity audit?

Has the offering been structured to comply with the securities laws and, if not, what implications will that have for the stability of the enterprise and the value of my investment?

What legal protections may or may not be available in the event of fraud, a hack, malware, or a downturn in business prospects?  Who will be responsible for refunding my investment if something goes wrong?

If I do have legal rights, can I effectively enforce them and will there be adequate funds to compensate me if my rights are violated?

The “cash out” question is among the most important, since the answer (or evasiveness) could tip you off to a potential Ponzi scheme. But the SEC says this list shouldn’t be considered exhaustive.

If the answers lead you to conclude that the potential investment is in fact a security, that should raise more questions: Why are the fundraisers going this route, when really they should be following the rules laid out for securities? Or, if they’re sure they’re exempt—as some small crowdfunding efforts are—can they explain why?

All of this might result in a more basic question: What, exactly, is a security?

For a short definition, it’s an intangible financial asset you can trade, like stock in a public company. (Those offering tokens often say they’re not a security because they stand for the right to use something at a later date, a bit like a subway token, or a gift card. This is true for some tokens, and not for others.)

For a long definition, turn to the Securities Act of 1933 (pdf, p.1), passed just four years after the crash of all crashes in 1929, to which the SEC owes its very existence. Nearly a century has gone by since, but it’s still a big part of the way the agency tells its origin story:

Tempted by promises of “rags to riches” transformations and easy credit, most investors gave little thought to the systemic risk that arose from widespread abuse of margin financing and unreliable information about the securities in which they were investing. During the 1920s, approximately 20 million large and small shareholders took advantage of post-war prosperity and set out to make their fortunes in the stock market. It is estimated that of the $50 billion in new securities offered during this period, half became worthless.

It may well be that traumatic origin that Jay Clayton, SEC chairman, was referencing in his statement on cryptocurrency this week: “There are tales of fortunes made and dreamed to be made. We are hearing the familiar refrain, ‘this time is different.’”