ICOs - a crypto conundrum

Andrew Crooke

Regulators are grappling with initial coin offerings, the latest cryptocurrency trend. China and South Korea have banned them, but elsewhere the focus is on whether they can be treated like securities, and how best to protect investors.

Initial coin offerings (ICOs), the controversial new crowdfunding mechanism based on the use of crypto tokens, has seen a remarkable growth in the past 12 months, predominantly driven by demand in Asia. The value of ICOs has surged from less than $100m in 2016 to well over $3.5bn, although late-2017 saw a slowdown and signs of volatility in the market.

Financial regulators both in the region and worldwide are divided in their views on the phenomenon, and are struggling to agree on market standards, amid fears of a cryptocurrency bubble.

Crypto symbols

In September, the Chinese government quickly moved to ban ICOs, viewing them as an illegal means of financing. It also launched an investigation into 60 local platforms dedicated to managing them. South Korea followed suit, introducing an ICO ban later that month.

It’s a different story in many other developed economies with strong legal frameworks, including Australia, Canada, the European Union, Hong Kong, Singapore, the United Kingdom and the United States. Regulators in these jurisdictions are now looking to treat a coin that functions like a security in a similar way as it would be under their existing domestic securities laws.

Japan, an early adopter of ICOs, has more than ten regulated bitcoin exchanges, controlling a large chunk of the global market.

‘A key topic in various jurisdictions is to try to put ICOs under the umbrella of the local securities laws, but there is no best practice yet globally,’ says Alexei Bonamin, a partner at TozziniFreire Advogados and Membership Officer of the IBA’s Capital Markets Forum.

‘ICOs are looking to avoid being defined as a security, so trying to regulate them seems to conflict with the purpose of ICOs and cryptocurrencies,’ he adds. Such inconsistency is breeding uncertainty among market practitioners.

What’s worrying for those investors that don’t want to see ICOs hindered by excessive regulations are noises in markets like the US.

In December, scrutiny of cryptocurrencies by the Securities and Exchange Commission led to an emergency asset freeze to stop a fast-moving ICO fraud that raised up to $15m from thousands of investors by falsely promising a 13-fold profit in less than a month.

The Swiss Financial Market Supervisory Authority, while broadly welcoming ICOs, has also threatened enforcement action against ICOs that deliberately flout securities regulation and anti-money laundering rules.

A key driver behind the soaring popularity of ICOs is their ability to enable startups to raise funds by selling cryptocurrency ‘coins’ or ‘tokens’ via crowdfunding. Yet, these may or may not give holders certain rights – and, if not, will have purely speculative value.

‘A key reason why an ICO investor needs to take responsibility for, and be aware of, what they are buying is because issuers might choose to structure their offering so that the tokens might not be construed as securities,’ says Adrian Ang, a partner at Allen & Gledhill and Co-Head of the firm’s fintech practice.

Various jurisdictions are trying to put ICOs under the umbrella of local securities laws, but there is no best practice yet globally

Alexei Bonamin
Partner, TozziniFreire Advogados; Membership Officer, IBA Capital Markets Forum

This stems from an ICO being able to choose its structure. So, rather than investors getting the common protections and safeguards afforded by traditional securities, they might look at an ICO to gain access to data, for instance. Or investors might want to participate in crowdfunding a new product launch by pre-selling rights to receive the product.

‘Where ICOs are structured so that they are less likely to be considered as a security, investors do not benefit from the usual protections and there is a greater likelihood for fraud to be perpetrated,’ says Ang.

Indeed, until the ICO community develops its own traditions, culture and track record, critics will be able to continue to cite a vulnerability to fraud, deception and manipulation.

ICOs at a glance

An ICO is a largely unregulated way for startup companies to generate capital through crowdfunding by issuing crypto ‘coins’ or ‘tokens’, where investors can raise money in a cryptocurrency as an alternative to venture capital. It’s akin to an initial public offering, in which investors purchase shares of a company.

Most ICOs work by having investors send funds (usually bitcoin or ether) to a smart contract that stores the funds and distributes an equivalent value in the new token at a later point in time.

Rather than conferring ownership rights, the digital tokens might rise in value to benefit the investors.

Legally, ICOs currently exist in a grey area, with arguments being made both for and against them being new, unregulated financial assets.

There are far-reaching implications of ICOs not being structured as securities. Essentially, such ‘utility’ tokens have similar rights as a gift voucher from a department store, explains Ang. The holder is not entitled to interest payments, for example, or to vote in the shareholders’ meeting. This would lead to increasing caution among potential investors.

Another important consideration for some regulators is that tokens from ICOs should not be exchanged for bitcoins and other cryptocurrencies from other jurisdictions. ‘Doing this would trigger foreign exchange controls,’ explains Bonamin.

Yet, market sentiment suggests the focus among regulators generally in the short- to medium-term is unlikely to be solely on ICOs. Efforts to ensure greater control over the intermediaries and third-party exchanges that are used to list cryptocurrencies may well be more of a priority.

The Monetary Authority of Singapore, for example, is looking to formalise into legislation the requirement for ‘know your customer’ due diligence on these types of exchanges, says Ang. Meanwhile, South Korea has announced plans for a new law banning the trading of cryptocurrencies through its exchanges.

This is partly related to money laundering concerns among regulators surrounding ICOs, says Bonamin. ‘Even in those jurisdictions where the regulators do not think ICOs should be regulated, they are still concerned that ICOs might be used for illicit purposes.’

Andrew Crooke is a freelance journalist based in Hong Kong. He can be contacted at andrew.crooke@gmail.com