CryptoPolitics: The Irony of the SEC Tough Stand About ICOs Part III: Historical References
This is the third part of an essay that explores some of the ironies about the position taken by the U.S Securities and Exchange Commission regarding initial coin offerings(ICOs). Specifically, we compare the constrained potential damage that can be caused by ICOs with the high risks imposed by the virtually unregulated world of financial derivatives.
The first part of this essay provided some pragmatic metrics about ICOs compared to the massive market of financial derivatives. In the second article, we covered some of the history behind financial derivatives tracing it back to Scottish mathematician John Law and his rivalry with Isaac Newton . Following those two posts, I would like to explore some new perspective to the potential risks of financial derivatives compared to ICOs.
Systemic Risk vs. Unjustified Paranoia
As mentioned in the previous articles, the biggest irony of the SEC position about ICOs has been to aggressively warn investors about the potential bad actors in the tiny ICO market while following a history of actively endorsing risky products( that share some commonalities with digital tokens) in the form of financial derivatives. Obviously, both things are not mutually exclusive. ICOs need and should welcome some regulation but they don’t present a systemic threat to investors and financial markets. Financial derivatives definitely do. How bad van it get when derivative products go wrong? Let’s review some of the most notable examples of crisis influenced by financial derivatives in the last few years:
1)The Collapse Long Term Capital Management: One of the most hyped quant funds of all time, Long Term Capital Management(LTCM) included luminaries such as Nobel laureates Myron Scholes and Robert Merton(Black-Scholes formula fame). The fund focused on trading sophisticated derivatives products and posted impressive gains in its early years. However, in 1998, LTCM collapsed, and almost brought down the entire US financial system, when Russia defaulted on its bonds. It turns out that such a “Black Swan” event was never considered in LTCM models.
2)Financial Crisis: At the center of the 2008–2009 financial crisis, we have derivative products such as collateral debt obligations(CDOs) and credit default swaps(CDSs). Those type of products helped to shift risk between investors and created a massive expansion of money and credit which eventually was the genesis of the crisis.
3) Flash Crash: In May 6 2010, the Dow Jones dropped 9% of its value over 1 hour wiping a TRILLION dollars off the U.S equity markets. Companies like Accenture traded at a few cents a share for a few minutes while others like Apple skyrocketed. Although the exact cause of the Flash Crash are still debatable, all hypothesis share a common denominator: derivatives.
4) High Frequency Trading: Not an event itself, high frequency trading(HFT) is considered by many a Damocles sword hanging over financial markets. HFT is the channel by which many risky derivative products make it into the market by relying more on speed than on statistics or data intelligence. HFT has been constantly responsible for some of the irregular behavior in financial markets in the last few years.
Back to ICOs
The examples presented in these three articles are trying to convey the point that financial markets are constantly exposed to risks exponentially more dangerous than those created by ICOs. From that perspective, the position of the SEC results incredibly ironic. Additionally, the idea of classifying all ICOs are securities is questionable at best. I believe some level of regulation would be welcomed by the ICO community but I see no need for the paranoia created by recent statements which portraits ICOs as a bigger risk than they really are. In the long term, let’s hope that rational minds prevails and that regulators learn to embrace the innovations behind ICOs that can help improve financial market.