By Noah Qiao
Kirkland partner Noah Qiao analyzes a token registration disclosure framework in light of the recent FTX collapse. Based on the primary drivers of token value, the SEC could standardize token offering disclosures, he suggests.
Cryptocurrency exchange FTX collapsed in a spectacular fashion, and was followed by unprecedented bankruptcy filings with an estimated one million creditors.
The media widely reported the alleged causes of FTX’s demise: There was an $8 billion dollar void on balance sheet. There was an incestuous business relationship with an affiliate trading firm, Alameda Research. There was misappropriation of customer funds and borrowing funds against FTX’s own FTT token. And there was a “bank run” triggered by a competitor’s public threat of a massive dump of FTT.
The fact that Alameda Research allegedly used FTT as collateral to borrow funds suggests lenders believed FTT had value, which begs the question: What is the value of an FTT?
To understand the value of any digital token, one should understand the primary drivers of token value: reserve, future cash flow, liquidity profile, and token adoption growth rate.
Securities and Exchange Commission Chair Gary Gensler asserts that most tokens are securities and subject to existing securities registration requirements. But certain disclosure requirements, such as issuers’ audited financials, in many cases are not relevant to token investors.
Unlike equity prices that are anchored by the issuer’s earnings and financials, many tokens’ values are created in the secondary market through use and adoption.
Thus, for these digital assets, disclosures should be guided by drivers of token value instead.
Token reserve, if earmarked for redemption, provides a price floor for a token. If a token was backed by the same or greater amount of liquid assets—e.g., cash or treasury securities—then it could be worth the amount of assets backing it or face value, whichever is lower.
For tokens that generate cash flows from staking or utility—that is, loyalty rewards—their value can be estimated using the time immemorial discounted cash flow method. Some cash flows are predictable and dividend-like, which can be approximated using the Gordon growth model.
Liquidity profile and adoption growth rate both tie to the token’s secondary market value. Many tokens differ from traditional securities in a crucial aspect in that they generally do not give holders a legal claim on the issuer’s assets. Some tokens are not redeemable once minted—buyers can only earn a return if someone else is willing to pay more.
Hence, token promoters in their marketing will often tout the tokens’ potential secondary market liquidity and their plan for increasing token demand. The greater the adoption and growth rates, the more token buyers in the secondary market, which leads to greater liquidity and a potentially higher price.
Importantly, liquidity and adoption rate only matter if they stem from a viable token use case. Liquidity and growth fueled solely by secondary market speculation will eventually collapse.
Based on the primary drivers of token value, the SEC could standardize token offering disclosures. An issuer should discuss tokenomics—supply and demand characteristics of crypto—use cases, the level of developer activities, token transaction volume, and consensus mechanism, among other things.
Also, a registration statement should include information regarding the token’s reserve—e.g., cash, marketable securities, or other tokens—if any, and whether it is earmarked for redemption.
If the reserve is backed in part by other liquid tokens, the registrant should provide detailed valuation analysis on what those reserve tokens are worth and a market stress analysis—that is, if reserve tokens were down 10%, 50% or 90%.
Details around staking and other benefits—discounts or airdrops—should also be disclosed to enable investors to calculate cash flows. If liquid staking is allowed, that should be disclosed, as it will amplify leverage and the effects of a market downturn on token price.
Periodic public reporting for a token issuer, such as 10-Q and 10-K reports, should not require reporting of revenues and expenses applicable to a traditional public company. Instead, it should provide updates on reserve, network activity, transaction volume, developer activity, and adoption rates.
If a token is in early stages of a project cycle, and does not have an established use case, it should not be offered publicly to retail investors. Many of these tokens will not result in a viable use case and will rely heavily on secondary market speculation and present significant risks to retail investors.
These early-stage tokens can be offered to sophisticated investors in the private markets much like how start-ups raise capital in private markets today.
Most of the above can be shoehorned into the current requirements, but the lack of standardized token-specific disclosures in token offerings hinders investor protection.
There are additional considerations to be ironed out, but this framework provides a baseline on which to potentially build. Registration of FTT would likely not have prevented the FTX collapse given the significant alleged fraud and lack of corporate governance.
But it is a step closer to providing more relevant disclosure and a necessary step toward rebuilding crypto and regaining confidence from investors, much like the enactment of Sarbanes-Oxley post-Enron and Dodd-Frank post-Lehman Brothers.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
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Noah Qiao is a partner in the Investment Funds Regulatory Group at Kirkland & Ellis and a key member of the firm’s crypto advisory practice. He is also an adjunct professor at Cornell Law School, where he teaches a class on crypto regulations.
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By Noah Qiao