Crypto markets took a dive earlier this week as Chinese regulators announced an immediate ban on ICOs, or Initial Coin Offerings, for Chinese startups, claiming this new fundraising mechanism has “seriously disrupted the economic and financial order.” The ruling stopped short of preventing Chinese citizens from trading new ICOs not based in China.

Afterward, the price of Bitcoin plunged nearly 20 percent from its high of $4,968 to a low of $4,028, before rebounding to a recent price of $4,654. Other crypto names faced steep declines, with China-focused NEO dropping 40 percent.

This isn’t China’s first attempt to clamp down on crypto-fever. In 2013, as yuan-denominated trades led the Bitcoin markets, Chinese officials prohibited banks and payment companies from dealing with the virtual currency, while allowing Chinese citizens to continue buying and selling it. This order led to a sharp 50 percent price drop in Bitcoin, although the leading cryptocurrency has rallied 400 percent since then.

The Hottest Market in the World

ICOs​ can be described as a hybrid of venture capital and initial public stock offerings, an unregulated mechanism to crowdfund digital “tokens” using the blockchain. Investors exchange cash or cryptocurrency for the new coins, which then can be used within these new networks for purposes such as trading storage space, renting computational power or anonymously searching the internet.

This year has seen a digital gold rush for ICOs, as crypto offerings have raised $1.8 billion, surpassing the amount of venture capital raised by traditional internet companies. According to Coinschedule.com, about half this total has come from the top 10 ICOs, with the top three—Tezos, EOS, and Bancor—raising $570 million alone.

Moreover, 50 percent of new investment is seeding “infrastructure” companies that are building the backbone to ensure the security and safety of future digital asset exchange. “Trading and investing” ICOs occupy the second space with an 11.8 percent market share, and “payments” are close behind with 9.9 percent.

Source: Coinschedule.com

The ICO craze has sparked demand for Bitcoin and Ethereum, the second-largest cryptocurrency with programmable features, which have risen eightfold and 30-fold respectively in the past year.

To attract investors via social media, some ICOs have hired celebrities such as Paris Hilton and Floyd Mayweather to hype new offerings. However, the unintended consequence may be that astute investors run in the other direction. When the focus shifts from product to endorser, one must wonder whether U.S. regulators will follow China’s lead and begin to crack down on the hottest investment trend of 2017.

In July, the Securities and Exchange Commission concluded that ICOs will be regulated as securities, warning that “issuers of distributed ledger or blockchain-based securities must register offers and sales of such securities unless a valid exemption applies.” The report served to remind “investors of red flags of investment fraud, and that new technology may be used to perpetrate investment schemes that may not comply with federal securities law.” In other words, buyer beware: Cryptocurrencies are subject to the same Ponzi schemes and boiler rooms as any other asset class.

To create a framework to evaluate whether cryptocurrencies are securities, the SEC applied the “Howey Test,” a Supreme Court ruling from a case against two Florida-based companies to determine whether or not a land real estate deal constituted an “investment contract” under the Securities Act of 1933. Under the Howey Test, a transaction is an investment contract if:

  1. Someone invests money.
  2. The investor expects profits.
  3. This type of investment is a common enterprise.
  4. Profits derive from the efforts of a promoter or third party.

The fourth point is key for cryptocurrencies as investors are turning over their dollars to ICOs and thereby ceding control to the startup to produce profits. It’s also notable that the SEC has taken a much lighter approach than China, choosing to allow ICOs to continue under the applicable securities laws.

The Bottom Line

The fact that the SEC is worried about investment fraud is a good thing for the developing cryptosphere. No amusement park attendee wants to get on “Rolling Thunder” knowing that it wasn’t properly inspected and subject to stringent safety laws. If anything, regulatory clarity will weed out the hucksters and fraudsters looking to make a quick buck and entice investors worried that their crypto investment is all hype and no substance.

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