In the wake of chronic price volatility and a series of enforcement actions against the chaotic and unregulated market for Initial Coin Offerings (ICOs), alternative financial instruments have recently been developed to help investors share in the precipitous growth of cryptocurrency and blockchain technology. At first, the ICO – an instrument that Investopedia.com defines as “the cryptocurrency space's rough equivalent to an IPO in the mainstream investment world” – constituted the primary vehicle for investment in cryptocurrency.1 Under the terms of an average ICO, investors purchase an emergent cryptocurrency either with traditional currency or another, established cryptocurrency in the hopes that the emergent cryptocurrency will enter widespread usage and increase in value.2
Despite their seeming promise, many ICOs have faced regulatory headwinds and practical challenges from the start. In fact, several high-profile ICOs have been shut down because their issuers failed to comply with SEC securities regulations. In SEC v. Howey (1946), the Supreme Court set forth a canonical test for classifying financial products as securities, asserting that financial products should be regulated as securities when they constitute an “investment of money” as part of a “common enterprise” which entails “an expectation of profits [generated by a] promoter or third party.”3 Armed with this binding precedent, the SEC has classified cryptocurrencies as securities and has not shied away from clamping down on unregistered offerings. As recently as June 4th, 2019, the commission filed suit against the instant-messaging service Kik on the grounds that the company had “sold [cryptocurrency] tokens to U.S. investors without registering their offer and sale as required by[…]U.S. securities laws.”4 At issue in the Kik case was not just the company’s failure to register the offering with the SEC, but also the disconnect between cryptocurrency’s avowed purpose as a mode of exchange and its practical role as a store of value.5 That is to say, it becomes harder and harder to claim that cryptocurrencies are not securities when investors primarily acquire them in order to capitalize on price fluctuations.
Even though many ICOs have been registered after the fact to comport with securities regulations,6 they still constitute less than stable investment opportunities. According to a study conducted by Ernst and Young, “a lack of fundamental valuation and the due diligence process by potential investors is leading to extreme volatility of the initial coin offering (ICO) market,” trends which would presumably render them unacceptably risky choices for most investors.7
Faced with high levels of risk and the possibility of SEC enforcement, some investors are turning to Security Token Offerings (STOs) in order to acquire securitized cryptocurrency on capital markets. STOs typically offer securitized cryptocurrency “backed by real assets or things that have established value,” a characteristic that tends to immunize them against the price volatility of ICOs.8 STOs also have several key legal advantages over ICOs. Because the cryptocurrency offered is pegged to an identifiable group of revenue-generating assets, the issuers of the STO do not have to make the facile claim that their financial product is a mode of exchange and not merely a store of value. That is to say, as long as they are registered with the SEC and otherwise comply with securities regulations, STOs can be placed in essentially the same legal category as regular securities,5 a status which does not exempt them from federal oversight but can clear the way for the buying, selling, and trading of cryptocurrency on the open market. In this sense, STOs constitute safer, far less legally dubious vehicles for investors eager to take advantage of the cryptocurrency boom.