ICOs, the initial coin offering token sales that have fueled the launches of many new startups in the past few years, are an exciting, if controversial, new asset class. ICOs make use of the Ethereum blockchain and its smart contract technology to raise ether in exchange for specific "tokens" in a new company. 

As with any investment, you should know what the SEC rules are when embarking on an ICO. You may or may not know that the SEC has delineated guidelines for ICOs. Per an SEC report of July 25, 2017, they consider their purview to include all investment vehicles regardless of packaging:

"U.S. federal securities law may apply to various activities, including distributed ledger technology, depending on the particular facts and circumstances, without regard to the form of the organization or technology used to effectuate a particular offer or sale."

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Tokens are securities

The report was written specifically in response to the Decentralized Autonomous Organization's (DAO) ICO from 2016, concluding that DAO tokens are, in fact, securities. Given this classification, the SEC found that the ill-fated DAO violated section 5 of the Securities Act when it failed to register with the Commission. At this stage, the SEC has declined to pursue any action against the DAO or the startup behind the project, Slock.it, although it does not offer any explanation for why it has avoided enforcement in the recent report. Learn from the DAO case and stay on the SEC's good side to maximize the success of any ICO you are involved with.

[ Even if you're not launching your own ICO and are just interested in investing in one, it's important to understand exactly what an ICO is and the investment channels available. Taught by experienced cryptocurrency analyst Lex Sokolin, Investopedia Academy's Cryptocurrency for Beginners course equips you with the knowledge you need to successfully enter the cryptocurrency ecosphere. Check it out today! ]

What is a security? 

The SEC refers to the Exchange Act of 1933 in its explanation of what constitutes a security. In the case of an ICO, a token sale is a security if: 

  • it includes “an investment contract,”
  • it involves a "reasonable expectation of profits,"
  • the profits would be "derived from the managerial efforts of others," i.e. it requires a staff and does not increase in value on its own

So what do you do?

Register, register, register. Even if the investment does not involve regular money, this still might not preclude that investment from being classified as a security.  The bottom line, in the words of the SEC: "Issuers must register offers and sales of securities unless a valid exemption applies."

Investing in cryptocurrencies and Initial Coin Offerings ("ICOs") is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein. As of the date this article was written, the author owns no cryptocurrency.