After our recent client alert summarizing recent U.S. regulatory developments in the crypto-world, the House of Representatives of the State of Wyoming passed HB 70, referred to as the “Utility Token Bill” and HB 19, known as the “Bitcoin Bill.” While these bills are intended to create a separate regulatory apparatus for cryptocurrencies and initial coin offerings (“ICOs”), the Wyoming bills, if passed by the Wyoming State Senate, would have limited efficacy since they would only apply to virtual currencies developed and sold exclusively within the State of Wyoming.
European market authorities have also been seeking to find a way to regulate ICOs. On February 16, 2018, the Swiss Financial Market Supervisory Authority (“FINMA”) published ICO guidelines, and the French Financial Market Authority (“AMF”) published soon afterwards, on February 22, 2018, its analysis of the legal qualification of cryptocurrency derivatives, as well as ICO guidance resulting from a public consultation of the relevant actors on the French market.
However, while both regulators are motivated to bring more clarity and certainty to the legal environment surrounding ICOs, they do not pursue it in the same way. In its guidelines, FINMA’s logic stems from securities law and seems to hinge on whether the issued tokens will be used to finance the development of a non-existing service or activity, or to the contrary, whether it will be used to pay for or access an existing service platform or application. The AMF’s reasoning, on the other hand, seems to dispense with existing regulations and creates a new legal framework unique to ICOs independently of the nature of the token (payment, utility, etc.), except in cases where the issued tokens share the same characteristics as a security, and thus are subject to EU prospectus regulation.
I. FINMA’s Guidelines for Inquiries Regarding the Regulatory Framework for ICOs
FINMA stated in its press release that the ICO guidelines it published set out how it intends to apply financial market legislation and principles when handling inquiries and responding to ICO sponsors. It is therefore clear that the Swiss regulator’s guidelines shed some light on its principles-based approach but hardly constitute a definitive legal framework for ICOs.
In assessing ICOs, FINMA will examine whether the ICO complied with applicable anti-money laundering regulations and investor protection and disclosure requirements, and will also focus on the economic function and purpose of the blockchain-based units known as tokens issued by the ICO sponsor. FINMA highlighted the underlying purpose of the token, their tradability and transferability as key factors of its assessment and classified tokens in three categories:
- Payment tokens, according to FINMA, are identical to currencies and have no further functions or links to other development projects.
- Utility tokens provide digital access to an application or service.
- Asset tokens represent assets such as participations in real (physical) underlying assets, companies, or earnings streams, or an entitlement to dividends or interest payments. In terms of their economic function, the tokens are analogous to equities, bonds or derivatives.
In respect of the above-mentioned criteria, FINMA will handle ICO inquiries as follows:
- Payment ICOs: In ICOs where the token is intended to function as a means of payment, FINMA will not treat such tokens as securities.
- Utility ICOs: The tokens would not qualify as securities if (i) their sole purpose is to confer digital access rights to an application or service, and (ii) the utility token can already be used in this way in the token’s existing ecosystem. However, a utility token that functions as an investment (in economic terms) will be considered by FINMA to be a security.
- Asset ICOs: FINMA regards asset tokens as securities and will apply securities law as well as civil law requirements under the Swiss Code of Obligations (prospectus requirements for instance) to those tokens.
As a result, FINMA’s guidelines demonstrate the importance of engaging legal counsel when structuring ICOs since the design and function of the ICO will determine the body of rules and regulations that the regulator will apply to the ICO. As will be discussed below, the French regulator’s principles-based approach seems similar to that of its Swiss counterpart; however, the AMF’s recent guidance is not identical to FINMA’s and the AMF’s guidance may suggest a willingness to adopt a new legal framework for ICOs.
II. The AMF’s Guidance on Cryptocurrency Derivatives and ICOs
a. The Legal Qualification of Cryptocurrency Derivatives
According to the AMF, EU law – and consequently French law – does not give a definition of derivatives, but instead lists different types of financial contracts or instruments that are deemed to be derivatives, in order for the existing legislation to be flexible enough to adapt to the ever-increasing creativity of the participants in the financial markets.
The AMF intervened after several online trading platforms started offering investors the possibility of betting on a cryptocurrency’s rise or fall without actually buying the underling cryptocurrency, through binary options, contracts-for-differences or Forex contracts with an end-of-day maturity (rolling spot forex). The French regulator’s analysis consisted of an examination of (i) the legal qualification of a “derivative” in the context of cryptocurrencies and (ii) whether a cryptocurrency is eligible to be an underlying asset for derivatives under applicable laws and regulations.
The AMF consequently concluded that a cash-settled cryptocurrency contract may qualify as a derivative, irrespective of the legal qualification of the cryptocurrency itself. Practically, this means that platforms which offer cryptocurrency derivatives must (i) not electronically advertise these products, (ii) obtain the necessary administrative authorizations, and (iii) comply with existing business conduct rules including the trade reporting obligation under EMIR.
b. The Summary of Responses Following the Public Consultation on ICOs
The AMF is in the process of implementing its ‘Universal Node to ICOs Research & Network’ (“UNICORN”), which is being effectuated through dialogue with ICO issuers and entrepreneurs. In that regard, it issued a discussion paper on October 26, 2017 and received 82 responses from participants in the French market.
When asked about their preferred approach to ICO regulation, the majority of respondents opted for the adoption of new legislation that would specifically regulate ICOs instead of adopting a best practice guide without changing existing legislation or extending the existing regulation on public offerings to ICOs. In addition, respondents were unanimous in their support of requiring a document – a ‘whitepaper’ – that would inform potential investors notably of (i) the ICO project, its stages and its development, (ii) the issuing entity, its managers and founders and their qualifications, (iii) the rights conferred by the tokens, and (iv) the accounting treatment of funds raised during the ICO. The vast majority of respondents also favor putting the funds raised by the ICO in escrow and complying with anti-money laundering and terrorist financing regulation.
With respect to the legal qualification of tokens, the AMF seemed to support the view that they neither qualify as debt securities nor warrant the application of the “miscellaneous assets” regime, but that they might be considered equity securities if they provide the rights typically afforded to shareholders, which would require a facts-and-circumstances analysis by the AMF. Consequently, it was suggested that ICO issuers targeting French investors secure the AMF’s approval of the ICO prior to its launch in order to provide a guarantee to investors that the ICO is not too risky from a regulatory perspective.
In conclusion, the AMF is far from finished regulating ICOs and continues to work on an ad hoc ICO legal framework in coordination with the other relevant public regulators and authorities.