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The people behind the hype-filled ICO craze are trying to regulate themselves

  • Digital coin developers need to tread carefully and make sure their fundraisers, or token sales, don't run afoul of the law.
  • Without clear guidance from the Securities and Exchange Commission, some groups are developing their own systems for digital coin developers and investors to stay safe.
  • A fintech lawyer and blockchain developers laid out in a paper Monday how certain initial coin offerings can avoid falling into the designation of "security," while a trading platform announced last week intends to offer other new digital coins a regulator-compliant system.
Chris Ratcliffe | Bloomberg | Getty Images

The digital coin industry is increasingly trying to find ways to curry favor with regulators on fundraisers known as initial coin offerings.

"We are starting to see the self-regulation of this market, I think the taming of the Wild West," said Marco Santori, head of fintech practice at Cooley and an advisor to the International Monetary Fund, told CNBC.

Along with Juan Benet and Jesse Clayburgh of blockchain developer Protocol Labs, Santori released a whitepaper on Monday that lays out how certain initial coin offerings can avoid falling the designation of "security."

Even in Switzerland, where financial authorities approved a private bank for bitcoin asset management, the Crypto Valley Association distributed Tuesday a paper by local lawyers to define three categories of tokens and four kinds of associated risks.

Four of the five largest token sales on record are from Swiss-based companies, according to the release.

Many blockchain-focused startups see initial coin offerings as an easier and cheaper way to raise money than going through traditional means such as finding venture capital. Global investors have poured the equivalent of $2.3 billion, into initial coin offerings, mostly in the last six months, according to CoinDesk.

The rush of money into what are often very early-stage, failure-prone projects has prompted regulatory concern.

The U.S. Securities and Exchange Commission indicated in late July that national securities laws may apply to sales of new digital coins and warned investors of the risks of participating in the token sales. Many of those token sales are officially off-limits to U.S. residents out of fear that U.S. regulators will come after the founders in case the project fails.

However, not all tokens are strictly coins like bitcoin that can be speculated upon. Instead, some tokens are meant to be used to access or interact with a new system, such as a decentralized cloud storage system.

The paper Santori co-authored attempts to emphasize the distinction between utility and security tokens.

The paper describes how a "simple agreement for future tokens," or "Saft," serves as an initial investment contract between a startup and accredited investors. That way, by the time the token launches publicly, the token is a usable part of a new system — clearly not an investment security.

The SEC declined to comment to CNBC.

All-time cumulative funding raised in initial coin offerings

Source: CoinDesk

Others are working on a legal way to support digital coins that are meant to become securities.

Last week, Overstock.com announced its majority-owned subsidiary tZero, along with financial services companies RenGen and Argon, are forming a joint venture to launch an SEC-compliant alternative trading system for trading digital coins issued in initial coin offerings. Overstock has a license for an alternative trading system through its acquisition of Pro Securities two years ago.

"The SEC needs to give more guidance ... because businesses crave more certainty and I think investors crave more certainty as well as protection," said Jonathan Johnson, a board member of Overstock.com and president of its blockchain-focused subsidiary Medici Ventures.

That said, both the alternative trading system and "Saft" whitepaper emphasize the role of accredited investors and appear to contradict the coin offerings' goal of giving all investors early access.

Typically, initial coin offerings give anyone with bitcoin, ethereum or whichever digital currency the fundraiser accepts the access to what may be the next bitcoin or internet system.

But the little-regulated token sale process as it stands provides little protection for investors in case of fraud or loss.

"On the one side you are eliminating the people who are going to be users of the token," said Erik Syvertsen, general counsel at AngelList, and a consultant on the "Saft" project. On the other hand, "people who have the income or net worth are better able to bear the risk."

The SEC on Friday alleged a businessman and his two companies were selling unregistered securities and charged them with defrauding investors in two initial coin offerings supposedly backed by real estate and diamonds.

The U.S. is not the only country scrutinizing the token sales. China banned the initial coin offerings last month, sending bitcoin's price tumbling. South Korea also announced a ban on the token sales last week. Bitcoin mostly shrugged off the news and recovered Tuesday to around $4,300, according to CoinDesk.

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