It is no longer safe to be in the ICO arena without the blessing of the SEC

The most recent actions by the Securities Exchange Commission (SEC) demonstrate that it is time for projects and companies to rethink those carefully worded conclusions that considered their ICO and digital asset trading activities to be outside of SEC regulation or enforcement actions. And even for entities that are just transacting with companies at risk, it is time to raise the bar on the due diligence scrutiny.

1_lid5NoZ7sPS8OMfoMNy6_QTwo weeks ago (on 11/16/2018), the SEC released a Statement on Digital Asset Securities Issuance and Trading that briefly outlines the most recent enforcement activity in the space, as well as sets the tone for further actions to come. The statement focuses on the Commission’s Division of Corporation Finance actions involving AirFox, Paragon, Crypto Asset Management, TokenLot, and the well-publicized settlement of charges by the SEC against Zachary Coburn, founder of EtherDelta.

All of these actions focus primarily on the premise that the SEC considers (almost) all cryptocurrencies or tokens to be securities under the Federal Laws. This interpretation was first made public when the SEC issued the DAO Report (July 2017) and was later confirmed by the Munchee Order (Dec 2017).

Then in Feb 2018, Jay Clayton (SEC Chairman) declared at a United States Senate hearing: “I believe every ICO I’ve seen is a security”. A few months later, Willian Hinman (Director of SEC’s Division of Corporation Finance) also confirms the same interpretation in connection with ICOs and related activities.

The last public announcement from the SEC was made again by Jay Clayton just yesterday, during the Consensus: Invest conference in Manhattan, New York. Among other things, he stated: “If you finance a venture with a token offering, you should start with the assumption that it is a security.”.

There are still a number of open investigations and charges will continue to be issued. The SEC has been overemphasizing the concept of the functional approach (that takes into account the relevant facts and circumstances) when assessing whether (i) a digital asset is a security; (ii) a system constitutes an exchange; or (iii) an entity meets the definition of a broker or dealer, in all three cases regardless of how an entity may characterize either itself or the particular activities or technology used to provide the services.

With this functional approach, the SEC’s intended message is really: ‘if it quacks like a duck, come talk to us, or we will come talk to you soon enough’. Or, in the actual words of the SEC: “These two matters demonstrate that there is a path to compliance with the federal securities laws going forward, even where issuers have conducted an illegal unregistered offering of digital asset securities.”

Therefore, at this point, considering how things have evolved, if you are (already or about to get) involved in an ICO or related activity, or even in a transaction with a company involved in that space, you should really make sure that you or your counterpart are on the safe side of this discussion.

The good news: the regulated avenue is probably sufficiently wide for most projects, especially if one decides to use all possible lanes. With the simultaneous use of different exempted issuances (commonly referred to as Regulation D, Regulation A+, Regulation S, just to name a few), it is possible to safely raise considerable amounts of capital from a reasonably vast number of individuals. Yes, restrictions apply. But in the current days, it is becoming more and more clear that it is better to ask for permission than for forgiveness.

Finally, from what I have seen with a variety of projects, it seems that legal fees and regulatory burden are going to be significantly reduced if companies decide to walk hand in hand with the SEC.

Keep an open eye…

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Want a crash course on cryptocurrencies? Build a mining rig.

At this point in history, a lot of people already know the basics of cryptocurrencies: bitcoin, Ethereum, existence of other coins, the importance of the blockchain, but generally it does not go much further than that.

Again, what is mining?

Many also heard about the concept of “mining”. Mining is the term used for the process of auditing the transactions that were reported on a cryptocurrency network. If the majority of “auditors” agree that since the last audit (each audit happens rather frequently – from seconds to every 10 minutes), a certain person A transferred X amount of a cryptocurrency to person B, then that transaction gets registered in the blockchain and becomes a reality forever.

But how does one become a “miner” or an auditor? All it takes is to download the necessary software into a computer that will do the job and the system (or “mining rig”, as it is called) will do it by itself. So, no, you do not get to sit through thousands of accounting entries to check if they are good or bad. The software does that without much of your interference or knowledge of what is going on.

The software is the same used by thousands of other miners and the idea is that a largely scattered group of auditors will end up creating a trusted network of verification that will make it difficult or too costly for an individual to try to defraud the blockchain.

Some people are familiar with the SETI program that went on for years. This was a NASA sponsored program that at a certain point suggested that everyone that had a computer with internet connection could donate their computer’s idle time / performance to the purpose of analyzing data – from a distance – towards the goal of finding extraterrestrial activity. Many people made their resources available just for the fun of it, or because they found it a noble cause.

This was somewhat the way cryptocurrency mining started. At the time, a few people around the world started dedicating their processing idle time to crypto mining activities – bitcoin, ether, etc., especially since there is a reward attached to it – in the beginning, the reward’s value was not significant, but over time, with the appreciation of the value of tokens like bitcoin or ether, it became a profitable activity. Miners get a reward when they successfully mine a block.

In any case, because the likelihood if getting the reward is directly related to each computer’s performance, mining became a serious business in the last few years, and is currently highly competitive. As competitiveness rises, margins are reduced and all attention goes to cost – cost of electricity devoted to mining (a big component), cost of equipment, maintenance, etc.

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Mining Farm (a bunch of mining rigs) in China

 

And… why is it worth getting into it?

Well, for me, just for the educational aspect. As a hobby, it might be interesting. From a business point of view, nowadays, it is probably not worth it.

In addition to the risks that are faced by every business, the crypto mining business is also specifically affected by:

(i) the number of participants in the industry – there is no barrier to enter and every entrant shares in the limited amount of reward, leading to a tragedy of the commons problem;

(ii) new technologies coming into play – because mining depends on very specific equipment, every threat of a new equipment getting into the market shakes the world of miners, who are usually heavily invested in their current equipment and depending on current outcomes to achieve their expected returns;

(iii) fluctuations in cryptocurrencies, directly impacting the rewards because equipment, energy and still everything else is priced in fiat currency (US dollar, Euro, etc), while the rewards from mining activities are provided in units of the cryptocurrency itself. Therefore, a sudden drop in the cryptocurrency prices (as we are experiencing in these last weeks) makes a huge dent on the business plan of a cryptocurrency mining business;

(iv) regulation; in a still very much unregulated area like the world of cryptocurrency, impending regulation keeps miners awake at night.

In any case, without minding if the venture will be profitable or not, after arming myself with the courage to buy 15 different items from Amazon, I was set for an adventure into a completely new realm of unknown features.

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the start of it… I did not know what I was getting into.

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As much as I have a passion for technology, I have no IT or tech professional background. The process of building a mining rig actually involves building a computer, that is, buying a motherboard, a CPU, connections, fans, graphic cards (or GPUs), power supply, RAM memory card, etc. There are tons of videos on youtube related to how to build it. I spent quite some time in this learning process.

Just like with a cake recipe, one may have to adapt with what is available – in the absence of white sugar, can I use brown sugar? Or honey? Can I use wheat flour instead or regular flour? How will these small things affect the final outcome? Adapting with computer parts may be more troubling and risky.

I had to adapt a little bit, as the items in the shopping list I got from the youtube lessons were not always available. It worked for the most part, but I had to later replace one item or two, and return another that ended up being unnecessary.

This first mining rig took me a couple of days to build. I am sure that a second (if I ever get to it) would be much easier since I am now more comfortable with the sequence of events, connections, etc., but building it is just the first step.

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When it is finally ready to be powered, I found out that the software part was even more complicated than the hardware. Even the “easy” solutions are in fact not so easy if you are not an IT expert.

What I found to be doable was to use simplemining.net. I am not sure it is the easiest but since it is widely adopted, there are plenty of videos and reports on how to use the site and how to deal with the different options.

And specifically, the wide variety of options are horrible to deal with. If you do not know what they mean, how can you choose? Should I overclock the memory, or the core, or… what does that mean anyway?

So, I had a lot of trial and error until I got it right. And by the end of the second day, I finally saw a message on the screen indicating that the rig was, after all, mining!

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My goal is only educational. I set this rig in order to actually experience this learning curve to become more comfortable with the concepts I still did not understand. I’m getting there. It will still be a while until I fully comprehend the whole process.

If you would like a little more information on the subject, check Mining the Future of Money: Building a GPU Mining Rig by Oscar Lafarga published at CoinCentral.com,

 

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It is tax season! Remember to list your crypto activities…

DISCLAIMER: This blog post is not to be considered tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors for the purposes of any actions related to transactions and reporting.

With a lot a new investment entering the cryptocurrency world in the last 2 years, a lot of taxpayers are having to deal for the first time this year with the subject.

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Some crypto investors might even forget about it. They should not.

The Internal Revenue Service has issued guidance in 2014 on the tax treatment of transactions using virtual currencies, such as Bitcoins or other similar currencies.

That should be anyone’s starting point. In essence, the notice provides that “virtual currency” (that was the nomenclature chosen by the IRS) is treated as property for U.S. federal tax purposes.  General tax principles that apply to property transactions apply to transactions using virtual currency. It is generally the same concept for stocks.

 

First issue – bitcoin was “used”

Differently from stocks, we sometimes use cryptocurrencies as, well… a currency. Even if it is just for fun, many people (myself included) have bought a coffee or made an internet purchase using bitcoin or some other cryptocurrency, just for the sake of it.

And then many people may fail to report such a transaction on the perception that it was not a buy or a sell. But it is probably considered a sell, since the conversion of X bitcoin into coffee has an implicit conversion of bitcoin to USD, and then from USD to coffee.

That is one situation where some people might fail to accurately report their activities.

 

Second issue – beware of the reports you get

Another difficulty I noticed with tax reporting is related to Coinbase tax reports. Coinbase is still the major cryptocurrency exchange in the United States, with more than 12 million users. I am unaware of the procedures used by other exchanges but they might present the same situation. It is important to note that Coinbase is not a tax advisor and it is currently not required to provide 1099 forms. But it does provide a “cost bases for taxes”, in beta version, as a way to help out users keep track of their activities.

The problem is that even if a user trades only on Coinbase, such user might (hopefully) be holding the virtual currency in a digital or hardware wallet, and not on Coinbase’s wallet. As a consequence, every time such a user buys coins with Coinbase and sends these coins to the user’s own wallet, such a transaction (sending to wallet) is viewed by Coinbase as a sale – and it could as well be a sale; Coinbase cannot ascertain that.

Accordingly, Coinbase users have to be aware of that and not take that report from Coinbase as their basis for taxes without a deeper look. In some cases, it makes a lot of difference. Other exchanges might have the same issue, since for the exchange, when the user sends coins to an address, the exchange does not know if it is an address owned by the user (not a taxable event) or by a third party (a taxable event).

 

Third issue – replaced one coin with some other

Yet another interesting aspect that has been the object of heated discussions between tax attorneys, accountants and users, is the “Like-Kind Exchange” Under IRC Code Section 1031.

Essentially, IRC Section 1031 provides an exception and allows a tax payer to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. So, if an investor exchanged Bitcoin for Ethereum, for example, the possible gain from the time the investor acquired the Bitcoin to the time it replaced the Bitcoin for Ethereum could be in theory postponed.

If the IRS will interpret it as applying to exchanges of one cryptocurrency for another it is yet to be seen, but in any case, it will only apply (if at all) to transactions made until December, 31st, 2017.

Congress has approved an amendment to IRC Section 1031 (a)(1) that deleted “property” and replaced it with “real property”. Accordingly, that window of opportunity has closed for transactions after January 1st, 2018.

Fourth issue – the John Doe summons

Adding to all that, we witnessed throughout 2017 a battle between the IRS and Coinbase. The IRS won.

In a nutshell, back in November 2016, the U.S. government filed a civil petition in federal court seeking disclosure of all Coinbase U.S. customers’ records over a three-year period (2013-2015). A legal battle ensued and lasted 12 months – I will delve into the details in a future post. Then, in November 2017, the Federal Court of the Northern District of California granted in part the request by the IRS, ordering Coinbase to produce information for accounts with at least the equivalent of $20,000 in any one transaction type (buy, sell, send, or receive) in any one year during the 2013 to 2015 period.

Accordingly, your information might already be in the hands of the IRS…

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Fifth issue – OK, now, how much do I owe?

Now supposing you have crossed all your Ts and dotted all your Is in relation to buys, sells, uses of cryptocurrencies in 2017 – there is still the question of what accounting method is the most appropriate: First-in First-out? Last-in First Out? Average Cost? Highest-cost First-out? And so on. I will not even venture a suggestion in relation to those options. I will just say that depending on each one’s situation, tax reporting on cryptocurrencies might become an adventure.

But hopefully you are a true hodler (more about “hodling” here) and have never sold or disposed of any of your crypto assets. If that is the case, no reporting required.

Anyway, good luck to us all.

 

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Have we earned it?

 

“Have we earned it?” – probably the most important question posed in 2017 in the cryptocurrency community was this one by Vitalik Buterin, the founder of Ethereum.

In December 2017, the much celebrated 23-year-old Russian-Canadian posted the following on Twitter:

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There were many other tweets and explanations given later but, with that opening thought, he was able to encapsulate in a very concise and elegant manner a general feeling that currently permeates the cryptocurrency ecosystem: people are focusing much more on the wealth generated by the extreme valuation of coins than on delivering on the promises of real change and disruption that we have been hearing and/or propagating in recent years.

In Vitalik’s words: “how many unbanked people have we banked? How much value is stored in smart contracts that actually do anything interesting? How many Venezuelans have actually been protected by us from hyperinflation?”

Throughout 2017, many cryptocurrencies had stratospheric valuations, making a lot of early investors sudden millionaires. And, to be fair, this kind of story makes the media headlines a lot more often than, for example, the current efforts of replacing a century old finance industry with blockchain technology. The media frenzy over crypto valuation, predictions about the future and overnight millionaires have occupied much of the space last year.

The vast majority of people (many of whom investing in crypto) still have not fully understood the importance of the blockchain concept and its true potential. Moreover, many do not even care –  as long as whatever coin they bought yesterday continue to increase in price, that is all that matter.

Jeremy Gardner, another major player in the crypto community, made a similar point in his great keynote last week (Jan 19), at The North American Bitcoin Conference, in Miami.

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Gardner criticized the current focus on wealth that is so pervasive nowadays in the crypto community reminding the audience of the days when our parents dropped the protest sign on Wall Street to embrace instead corporate suits and pension plans, and urging the crowd to avoid going down that same path.

The ongoing blockchain revolution has deep social change roots and many in the community are in fact committed to doing something for the common good, irrespective of making money along the way. But their efforts have been shadowed by a growing number of investors/curious whose only focus is on making money fast without any regard to what is the effort about.

In other words, there is still a long way to go before cryptocurrencies will play a major role in society. There are a number of ensuing initiatives that will soon surely flourish but a lot more needs to be done.

One obstacle might be that a lot of the talented people capable of overcoming the challenges in the crypto world is presently devoted to ICOs (Initial Coin Offerings).

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While ICOs are a legitimate way of raising funds for startups, some argue the model is being abused and used for projects that are either nonsense or would not need to be involved in the crypto space. It is an interesting thought but I will leave that for a future post.

 

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The blockchain revolution is inescapable

You may want nothing to do with it right now but know that it will soon affect your life.

You don’t need to take my word for it. Just step back and look at the past. We have seen this before. Several times. Every major cultural or industry disruption starts the same way: with pirates defying social norm – and many times the law – for a reason, for an ideal (For a truly interesting reading on the topic: The Pirate’s Dilemma, a book by Matt Mason).

We have seen Napster bring P2P file sharing to the masses. It was eventually forced to shut down as a result of numerous lawsuits but it changed the music industry forever. We have seen this with Uber, who fought (and still is fighting) its way country by country, state by state, city by city, and ultimately was able to change a century old transportation industry. The same with Airbnb, who still faces numerous restrictions, criticism and roadblocks, but has nonetheless changed the hospitality business forever. Or Netflix, who reinvented itself and in the process, revolutionized TV and the movies industry.  Or we can go as far as back to the beginning of the last century and use the example of a pirate named William that defied social norm and intellectual property laws by fleeing to the west coast of the United States to continue using filmmaking equipment without respecting patent rights owned by Thomas Edison. In the (still) wild west of the early 1900’s, William thrived and among others, helped develop the movie industry as we know it today. William’s last name was Fox.

These pirates force the rest of society to look at the world through their lenses or to experiment with something in a novel fashion. An initial negative reaction is slowly replaced by resigned acceptance, and soon followed by a race to embrace the new movement before the masses.

We are at this second stage with the blockchain already.

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Several countries and many of the major financial institutions have already either fully embraced the concept of the blockchain or have at least a small team assessing its potential and keeping an eye on the market.

The easiest parallel to draw here is with the internet. In the early days of widespread use of the internet, it was still a ‘cool thing’ you could do stuff with, like search for information or reconnect with a high school lost friend. But that was it. In the early 90’s, the internet was something promising but no one was really sure in what way. We are living that moment with blockchain.

Needless to say that bitcoin is the most prominent celebrity of this revolution. The bitcoin blockchain was the responsible for getting the blockchain concept from the realm of ultra-geek ideas and making it mainstream. However, no one knows for how long it will survive. Some believe bitcoin might be the first one through the door – and the first one through the door always gets shot.

Bitcoin’s demise may look unlikely at this point but let us not forget, in the early days of the internet, how amazingly important were Altavista (the search engine), Myspace (social network), Netscape (browser), Yahoo (internet services provider) and later Napster (P2P file sharing). All of them were pioneers and responsible for bringing internet’s usage to the masses, but for one reason or another, are not around anymore. On the other hand, IBM, Apple, Microsoft, Amazon are still around and have resisted well throughout several winters.

In the end, it is irrelevant if bitcoin will ultimately continue to thrive. The most important contribution brought by bitcoin – the concept of the blockchain – is already understood and has a life of its own now.

The blockchain concept is still unknown for many – and will probably continue to be. In reality, one does not need to understand the intricacies of blockchain, mining, double spending, byzantine general’s problem, proof of work or proof of stake. As an example, the majority of people does not know what hypertext transfer protocol means even if it the foundation of data communication over the internet – the HTTP letters of almost every internet page in a browser.

There is sometimes too much effort being put on trying to explain the blockchain and trying to understand it. More important than that seems to be a discussion on what are the possible applications. Human beings tend to be more comfortable accepting something with examples rather than with its functionality.

The possible uses for blockchain are numerous, several of which are currently already operating while others are being tested. The main characteristics sought after in blockchains are the trustworthiness of the information resting on it, as well as its (almost) immutability.

Those aspects lead to several ideas related to the removal of the middleman – and when one thinks hard about it, there is a middleman everywhere. Easy examples are real estate registrar’s office, financial institutions being used for payment or transfer of value, identity confirming authority / business, energy utility company between power producers and consumers. The blockchain is even being used to improve farming, as described in this Article by Bennett Garner originally published at coincentral.com.

Another extremely interesting use for blockchains is the feature known as smart contract, which is essentially a more automated and less human dependent way of establishing action/reaction in a business setting, or in other words, an if/then relationship will not depend on a trusted third party to execute the second part of the sequence. For instance, a payment that is dependent on an upcoming event will happen automatically upon the occurrence of that event, instead of depending on a party first acknowledging the event and then taking steps to process payment.

And there is the dream of providing banking for the unbanked. There is still today a relevant portion of population without access to banking services, for a number of reasons. The promise of the blockchain as a means to correct this has been widely publicized but still has to prove itself viable. Blockchains and blockchain services providers also have costs associated with them and, in order to survive, will need to adhere by the same standards of KYC and AML that banks use. That combination of costs and KYC/AML by itself will undoubtedly be a hurdle to this imagined easy access of anyone to banking services associated with a blockchain.

This is at least part of a heated debate between some original pioneers, aka crypto evangelists, and on the other side, the traditional business establishment. The pioneers are mostly libertarians, who view the beauty of the blockchain in its complete isolation from the regulated industry or governments, and who despise any effort of widening adoption through regulation or adherence to existing systems. The other side, the current establishment, is eager to feast on the advantages of the blockchain but is still wary of its unregulated nature and somehow beat up reputation.

Odds seem to be on the ‘the suits’ side. At this point, there is already too much investment, interest and effort focused on working with the blockchain concept and making it successful. There is no turning back. At the same time, governments everywhere are either proactively pursuing regulation or being forced to do something about it.

Today, bad reputation still haunts any crypto related startup. The famous Wired article of 2011 about bitcoin brought the cryptocurrency to light and also forever associated its use with the silk road, the then underworld website for sale of anything illegal, from drugs to non-authorized guns. Since then, the silk road has been long dismantled, many people today understand that there are many more uses for cryptocurrencies than just illegal activity and furthermore, even criminals are more and more realizing that it is a bad idea to use cryptocurrencies for their illegal activities since the aspect of anonymity of the digital tokens is hugely overrated and they are finding – the hard way – that bitcoin-like ransom payments are very much traceable and thus a very bad idea.

Cryptocurrency businesses today are facing a path similar to that of the marijuana business. They are both legal (under certain circumstances, with certain limitations and, for marijuana, only in certain states) but face an overall lack of trust and are seen as a gray area business. Many banks are still refusing to do business with either marijuana or cryptocurrency related companies, or will sometimes close down accounts without much of an explanation.

But the current obstacles are necessary. It is at a minimum expected that a concept as disruptive as the blockchain will have to go through this rite of passage. Especially since one of the most affected industries is the most powerful of them – the banking sector. They will ultimately adhere, adjust and accommodate, but it will be on their own terms and on their own timing. And it is known that the financial sector infrastructure is one of the least updated around. The outer shell sometimes looks brand new but the spine is still pretty much 50 years old.

No one can truthfully predict – although many try –  where will this blockchain revolution lead us or even what will the price for Bitcoin be in 6 months. It is nonetheless interesting to have the opportunity to witness the unfolding of the many derivatives of this brilliant concept.

Keep an open eye.

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