CFTC Warns Investors: Use Caution When Buying Digital Tokens

Thinking about buying what’s known as a “utility token” or a “consumption coin”? Think twice, says the Commodity Futures Trading Commission (CFTC). In a customer advisory issued last week, the derivatives regulator urged potential investors to do their due diligence before making a purchase.

As we’ve discussed on the Blockchain + the Law blog, digital tokens are a blockchain-based representation of nearly any asset or utility, and function as a receipt or “IOU” for the underlying asset or function.  When a digital token is purchased, it can give the holder (i) ownership rights in tangible assets like art or real estate, (ii) ownership rights in intangible assets like airline points, traditional currencies or shares of a company, (iii) access to a platform, like a streaming music service or digital marketplace, (iv) the right to certain services like secure payment processing or ride sharing, or (v) the right to own or access any of the above, when available in the future. The uses for digital tokens are wide and varied, and subject only to the creativity of the coders and issuers behind them.  Digital tokens can be issued in an initial coin offering (ICO) or purchased directly from an individual or entity.

In some cases, a digital token may benefit from a “network effect,” meaning that demand for a product or service could actually cause the token to appreciate in value. If a buyer purchases a digital token with a goal of selling it for a higher price at a later date – classic speculation – this comes with a number of risks, many of which are inherent to new and novel markets.

In its advisory, the CFTC cautioned potential buyers of the myriad uncertainties surrounding digital tokens. First, there is no standardized process for valuing digital tokens, meaning that an overvalued token sold today may not have the purchasing power you expected down the road. Second, depending on which studies you rely on, fraud and failure in the world of ICOs are either prevalent or ubiquitous – either way, buyer beware:  guaranteed returns are not what they seem, and the issuer’s business plan might be a complete flop. Third, the regulatory classification of digital tokens continues to be uncertain, and buyers and sellers will need to analyze the unique facts and circumstances of each token in order to determine what the regulatory implications are. My colleagues have examined the evolving guidance on whether or not a digital token is a security, and also what your liability might be if you get it wrong.

So how do you protect yourself from all these risks? The CFTC has some tips:

  • Research the key players associated with the token sale, including the issuer, its affiliates, and any board members or management. A dearth of information is a red flag.
  • Determine whether the token is a security, and whether the ICO is in compliance with securities regulations (ask the issuer, or seek out your own legal counsel).
  • Be wary of guaranteed returns – no investment is foolproof, and in many cases investors should be prepared to not get their money back.
  • Determine what your rights are – how your money will be used, what token ownership grants you, and how losses are allocated in case of fraud or a failed business plan. The white paper associated with a token sale should be unambiguous about these rights.

And, as with any investment: understand what you are buying! What is the link between the value of the digital token and the underlying product or service? Who and what are the potential competitors and technological changes that could disrupt the issuer’s business? How much liquidity exists in the markets for this token? Are you at risk of being hacked? Will there be a fork in this blockchain application, diluting your token’s value or decreasing demand for it?

The CFTC makes a number of sound suggestions for digital token buyers in its advisory.  They may seem obvious to savvy investors, but given the number of fraudulent token sales we’ve seen in recent months, it bears repeating that this is exactly the sort of advice that potential investors should be considering.

Have more questions about digital tokens, their regulatory implications, and how they might disrupt traditional marketplaces?  Michael Best’s blockchain team is here to help!

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