Barbados should carefully consider policies to promote the utilization of alternative capital formation arrangements.
The Barbados Stock Exchange has announced its interest in providing a platform for cryptoasset trading within Barbados. While this should be fundamentally embraced we have to step back a little to understand the realistic prospects of this move. In this article, I will give an overview of the key concepts and instruments involved in the cryptoasset trading debate and then briefly outline how they should be treated in Barbados. In future articles I should be able to give deep dives on each key concept stated below.
The Primacy of Capital Formation
Capital formation is essentially the transfer of otherwise unproductive money to businesses which are in a position to use that money to expand product lines, enter new markets, etc. This is the reason why an institution like the BSE exists. Many companies prefer not to get financing from banks (or shadow banks) because they want to limit their debt intake. And in most cases banks are not even willing (or able; because of regulatory constraints) to loan money to companies. For this reason equity financing has been a key capital formation strategy. When a company issues equity to the public this is a capital formation strategy. But early stage companies are not able to issue stock to the public (via IPOs). IPOs have an immense regulatory burden which early stage companies simply cannot withstand.
For this reason other capital formation strategies have become popularly used such as seeking investment from venture capital (VC) funds in exchange for equity in the early stage company. VC funds are capitalized by private investors who want to invest in early stage companies without deciding where to put the money themselves.. The management of the VC fund decide which companies the fund will invest in. Early stage companies are attracted to this model because the VC funds are higher risk takers and there is very little comparative regulatory rules on how they must invest their capital. So companies that have only been around for 2 years, with no profit, and no solidified business model can still seek funds from VC funds. Most of the large tech firms we know have been significantly funded in this way: Uber, Airbnb, LinkedIn, etc.
Crowdfunding is another capital formation strategy that has recently emerged. Persons (or already existing early stage companies) can list their project (expanding a product line, building a prototype, etc) on a qualifying crowdfunding platform (like Kickstater.com) and then other persons can decide to invest capital in that project. Persons will invest (if they believe the project is worth it) because they get a return in some way. This return could take the form of equity, payback of the investment with interest, or simply a commodity reward of some kind. Because crowdfunding is effectively targeted at the public some countries have imposed caps on how much money can be raised in total and caps on how much each contributor can invest. The JOBS Act in the USA imposes such constraints.
There are, however, some early stage companies who are not satisfied any of the four strategies mentioned so far: they cannot attain a bank loan; an IPO is not an option; VCs are not willing to take the risk, and they claim that crowdfunding is too limited. For this reason, in the last 4 years among a particular category of businesses, a new capital formation strategy has gained popularity: Initial Coin Offerings (ICOs).
What are ICOs?
Initial Coin Offering is a confusing term. It was semantically modelled (by software engineers; not financial professional) after the more well-known term “Initial Public Offering.” But the only thing in common with these two concepts is that they involve the transfer of money from a large number of people to a single corporate vehicle. This is why you often see other (more clarifying) terms in place of ICO, like TGE “Token Generation Event”. But the term ICO has gotten too popular to displace.
This is how they work. Early stage companies use a blockchain technology (Ethereum, NEO, VeChain, Stellar, etc) to create a large number of tokens. These tokens can be traded on secondary markets (called crypto exchanges) with prices completely dependent on the demand-supply dynamics of the markets. But before the company lists the tokens on the exchange they do a “pre-sale” of the tokens. That is, they collect money from persons (publically)and issue them directly with the particular token at a price predetermined by the token issuer. The reason people buy tokens in the pre-sale is that they believe the price will inevitably increase when the token goes on the secondary market. Therefore they would make a quick (and possibly large) profit.
This may sound like an IPO but there are important fundamental differences to understand. In an IPO the issue price is determined by a complex and robust underwriting process based on corporate fundamentals. In an ICO the issuers esstially make up what they think is an attractive price. In an IPO persons are buying equity in a company. In an ICO (in most cases) persons are not buying equity into a company. They are just buying a method to speculate on potential price increases. IPOs are heavily regulated and come with effective robust disclose requirements. ICOs are unregulated and are often fraudulent because there is no forced disclosure requirements. There difference in regulatory laddenness should always be explicit in these discussions.
Firms that perform ICOs use the funds to then build the services/products. This capital formation strategy led to some very large funding rounds. For example Block.one raised over $4 Billion USD in 2018 via an ICO without having a single live product. And to this day they have not reconciled such a large raise with a robust product offering. The problem with ICOs is that it is essentially a wild west of capital.
Howey Test or…?
Before there were securities laws, the US markets were akin to this wild west of capital. But it was never to the extreme of the ICO market. Another company, Bancor, raised $153 Million USD in less than 3 hours via an ICO. You can see the explosion of ICOs since 2014 in this infographic.
But to keep the capital markets in check in the USA, the securities laws were passed (I am purposely simplifying the raison d’etre here). This created the Securities and Exchange Commission and placed large disclosure burdens on the issuers of securities. When they defined what counts as a security they included a term called an “investment contract” to capture other possible securities that were not enumerated in the legislation. It was only until the landmark Howey v SEC decided in 1946 in USA that the term investment contract was defined.
The Howey Test (as it is now commonly known) states that an instrument is a security if it is offered where (a) there is an investment of money; (b) in a common enterprise; (c) by a party seeking to earn a profit; (d) significantly due to the efforts of another party. All four factors must be present concurrently for the financial instrument in question to be an investment contract and hence a security.
Almost all ICOs meet this definition. And this was so stated last year by the Director Hinman of the US SEC. His commission has already issued cease and desist orders to projects that have done or have attempted to do ICOs within the jurisdiction of the USA. Since the ICO falls under the investment contract category of a security, persons and firms that do not register with the SEC and comply with the necessary regulations are subject to administrative sanctions.
In Barbados, our securities legislation formulated under the Securities Act Cap 318A and its amendments, has incorporated the Howey Test for investment contracts. Therefore our jurisdiction will have to treat ICOs in a very similar way as the US does. But jurisdictions like the Cayman Islands do not have an equivalent of the Howey Test incorporated into their securities laws and therefore they have an advantage to attract persons interested in ICOs.
The management of the Barbados Stock Exchange have incorrectly tried to categorize tokens into separate arbitrary semantic categories to show why some of them should not be defined as securities. But this misses the point. The securities laws apply to the offeringof an instrument and not the instrument itself if we are talking about investment contracts. The BSE must take caution in not falling for marketing blitz.
Where to go from here?
Barbados is in need of more channels for capital formation. The local economy will not develop without it since business growth in turn grows the economy. But this should not been done in a way to disadvantage investors nor put the jurisdiction at international risk since we are already in a precarious situation. In following articles I will dive deeper into the concepts outlined above.