There are still some areas of uncertainty when it comes to the regulation of cryptocurrencies
An initial coin offering (ICO) is a way of raising money from the public using cryptographic coins or tokens.
Tokens are issued and put up for sale in exchange for fiat or other cryptocurrencies.
Initially, many ICOs raised funds without any or complete regard to the relevant regulatory environment.
Some thought that this new way of funding fell completely outside the regulations.
It allowed organisations to raise funding without the due diligence, legal requirements or documentation that an initial public offering (IPO) would require.
The popularity of ICOs as a means of start-up fundraising then exploded.
Current figures show a total of nearly $19 billion has been raised across over 750 ICOs in 2018 alone, dwarfing the amounts raised for blockchain projects via traditional venture capital in the same period, which sits below $2 billion.
As a result of the amount of money being raised this method of fundraising soon became of concern to regulators around the world.
Warnings have been issued that existing regulations may apply, while largely leaving it to those involved in ICOs to determine the extent.
There is a huge range of opinions from regulators, from outright scepticism and bans in some countries, to more cautious investor warnings and guidance from others.
Types of token
There are three broad categories of token.
The first is a payment token, such as bitcoin or ethereum, which can be used as a store of value and a medium of exchange.
The second type of token is a security token.
These tokens represent an underlying financial asset, such as participation in a company, the right to receive a dividend or the right to receive interest payments.
The final type of token is known as utility or consumer token. It is principally designed not to be an investment, but instead used in order to consume or use a particular service.
An example might be that users are required to purchase tokens to use some form of cloud service to store photos or documents.
Why is there uncertainty in the regulation of ICOs?
The crux of the debate around the regulation of ICOs is the regulatory treatment of utility tokens issued as a result of the ICO.
As a matter of principle, capital markets regulation was designed to protect investors when making investments in regulated instruments or securities.
It has been suggested that utility tokens should be treated in a different way and that these tokens should not be afforded the usual investor protections as they are not designed to be an investment but purely allow access to a service or product.
As such, they should be treated like a voucher which entitles the user to access a service or product.
The concern from some regulators is that the label used by those issuing ICOs can be used as an attempt to circumvent investor protection rules.
This is particularly the case when it is clear that some tokens appear not to have been purchased to consume a product or service but rather as a speculative investment.
So instead of intending to use the product or service which is being offered the purchaser of the token intends to sell the token on the secondary market hoping for a profit.
This has been made more difficult for issuers by the different tests for what falls within the regulations in different countries and the divergence in approach of regulators.
Differing attitude of regulators
In the US, the Securities and Exchange Commission (SEC) has adopted a relatively aggressive approach expressing concern that many of the ICOs it has seen are either scams or attempts to raise money without complying with the appropriate investor protection laws.
In July 2017, it issued a landmark report stating that a blockchain-based project called the DAO (for 'decentralised autonomous organisation') had issued securities under US regulations.
An important aspect of this report was that it showed how the Howey test – the test for determining whether something sold in the US is a security – applies to tokens.
The Howey test states that where there is an investment in money and a common enterprise, with the expectation of profit primarily from the efforts of others, then there is a security.
The SEC opted to word the report in such a way to as to deem the DAO tokens as securities, but not necessarily all tokens.
If a token is purchased in the expectation of profits, it is likely to be classed as a security.
Jay Clayton, chairman of the SEC, commented on this issue, stating: "If I have a laundry token for washing my clothes, that’s not a security.
"But if I have a set of 10 laundry tokens and the laundromats are to be developed and those are offered to me as something I can use for the future and I’m buying them because I can sell them to next year’s incoming class, that’s a security."
He has separately suggested that he has never seen a utility token when reviewing ICOs.
The European Securities and Markets Authority (ESMA) alerted investors to the high risks of ICOs, stating that they are highly speculative investments.
However, ESMA has made it clear that ICOs may fall outside of the regulated space if they are structured in a certain way.
Regulators in Europe such as the Swiss regulator (FINMA) and the UK Financial Conduct Authority (FCA) have both acknowledged that there is a token which does not fall within the regulated space.
Regulation of different types of token
So when might an ICO fall outside of the scope of regulation?
Even if the token is issued to a token holder in a jurisdiction that accepts that there are tokens that will not fall within the regulatory regime, there are some key issues to consider.
The first common issue is where organisations wish to sell utility tokens to potential users of the system and also sell the same tokens to companies that have no wish to use the prospective service, eg an investment bank or a venture capital company.
A similar problem area arises where the purchaser of the token buys many more tokens than they could possibly want to use.
In these cases, it looks much more like the tokens are being used for investment purposes.
FINMA has made it clear in its guidance that if a token is used for investment purposes then it is not a utility token.
The second issue is where tokens are issued as utility tokens but there is no service to consume at the point of issue of the token.
Again, FINMA has made it clear that a token will not qualify as a utility token if there is no usable service at the point of issue of the token.
Other regulator concerns
Regulators have a number of other concerns relating to cryptocurrencies.
As users are able to purchase cryptocurrency and tokens under a pseudonym, there are concerns regarding how adequate know your customer checks and anti-money laundering safeguards will be implemented.
Financial promotion is also an area that must be addressed in order to protect investors.
Cryptocurrencies have been seen as attractive by both sophisticated and unsophisticated investors.
For unregulated currencies and tokens there are few standards setting out how these should be marketed.
Some ICOs and cryptocurrencies aimed at the public have been promoted by celebrities on social media, leading to increased scrutiny on marketing by regulators.
The impact of cryptocurrency on the financial system is also yet to be seen.
If cryptocurrencies continue to grow and account for a larger portion of global GDP (it is currently less than one percent), a sudden price crash could have significant impacts on the financial industry.
The problem of regulatory uncertainty
This has led to real difficulties with those organisations that wish to use tokens in a legitimate way and are committed to complying with the regulatory regime wherever the token is made available.
They have to deal with a situation in which countries differ widely in approach on the regulatory perimeter for token and which looks set to change potentially materially over the next few years.
The problems are particularly stark when one considers the reasons why organisations wish to adopt cryptocurrency as part of their infrastructure.
The traditional method of fundraising is for the founders to raise either debt or equity finance to fund their business.
This is clearly seen by both sides as risk capital on which the lender or investor should expect some form of return if the business is successful but will appreciate that this is risky particularly with an early stage business and they may well not see their money back.
Should the company prove to be successful then the holders of the equity can expect good returns and the money invested will rise in value as the company is more successful.
By contrast, those organisations wishing to sell tokens may be looking for investment, but may alternatively be looking to build a user base through a network effect.
If the organisation is looking for an investment, it is perfectly reasonable for regulators and policy makers to expect them to comply with the usual investor protection laws.
It would not seem equitable for an organisation using cryptocurrency to circumvent investor protection laws where the money raised from the tokens was really an investment.
However, it is often the case that organisations using a token model will want to build a network of users by offering them utility tokens to use in the ecosystem which is being built.
The tokens would be used to effectively pay for a service.
They want to encourage users to purchase the tokens in order to use a service provided by the ecosystem.
Should the organisation prove successful then the value of the token should accordingly increase as usually there is only a finite amount of the new currency sold. In this way, it is users of the ecosystem who benefit from its success and popularity and not the equity investors.
Future proofing ICO fundraising
In order to reduce the risk of failing to comply with uncertain future regulations while still raising the required funds, we have started to see fundraising undertaken in three tranches.
Traditional equity/debt securities
A small amount of initial fundraising would be carried out through traditional means, either by issuing equity or loan finance.
This money would be used to fund the planning and execution of the offering of tokens.
Security tokens offered to institutional investors through private placing
An initial offering of security tokens would then be undertaken.
This is also known as a security token offering (STO).
As an STO would be issuing securities, the offering would have to comply with the Prospectus Directive and financial promotion and marketing rules.
This offering would be targeted only at those investors who fall within the definition of qualified investors or sophisticated investors.
This would allow the offer to be exempt from constituting an offer of transferrable securities to the public which is a very common approach across most jurisdictions.
An STO would allow an organisation to build a platform through which they can later offer utility tokens to the public, while being confident that they are complying with existing regulations in relation to securities.
Utility tokens offered to the public
The final stage of fundraising would be a utility token offering.
This would involve issuing utility tokens to the public, similar to a traditional ICO.
The organisation making the offer would be required to have systems in place to ensure that these tokens could not be used as an investment.
Keeping this offering separate from the STO ensures that there is a strong distinction between the regulated offering of security tokens and the unregulated offering of utility tokens.
It should be made clear that the tokens can only be used for a specific utility within the specific system in which they are issued.
Limits should also be placed on the value of tokens that one user can buy.
This would avoid the issue of institutional investors purchasing a large amount of utilities that they do not intend to use.
This should reduce the likelihood of the utility tokens being used as an investment vehicle and therefore treated as investments by the regulators.
This article was first published in the December/January 2019 edition of IFLR.
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