- Marco Dell'Erba
Regulating Initial Coin Offerings: The Approach of International Market Authorities
In the last few years, blockchain emerged as a disruptive technology. Blockchain is a distributed database, capable of holding a secure and immutable record of past transactions, quickly adaptable to a broad range of activities and objectives. Initial Coin Offerings (ICOs) are a major innovation implemented through blockchain, consisting in the sale of a stake in a project with the aim to raise funds at an early stage of development. The most successful digital currencies (including NXT, Mastercoin, Bitshares, Ethereum) and their marketplaces were created via ICOs. While ICOs have existed for four years under different structures, they have only experienced exponential growth in the last two years. In the second quarter of 2017, ICOs outperforming venture capital in the financing of cryptocurrency and blockchain startups for the first time.
After a first phase characterized by a “do not harm approach” put in place by market authorities in regulating blockchain, the growth of ICOs required market authorities to reassess their approach. To provide legal certainty in the context of ICOs, market authorities issued preliminary responses (to be further developed) on ICOs qualification for a sustainable development within the market.
Although ICOs share similarities with both IPOs and crowdfunding campaigns on platforms such as Kickstarter and Indiegogo, they differ from both of these. Differently from IPOs, where companies sell stocks via regulated exchange platforms, ICOs sell digital coupons, known as “software presale tokens,” to early investors via non-regulated exchange platforms. The issuance of tokens occurs through an indelible distributed legder, in the form of an organization’s cryptocurrency, a clone of bitcoin, created on a protocol (such as Counterparty, Ethereum, Openledger). These tokens create the capital inflow required for the project, as they can be purchased with fiat currency or another digital currency at a predetermined exchange rate. Differently from common stock available in an IPO, tokens do not generally confer ownership rights. Instead of the ownership right itself, a token offers a discount on cryptocurrency before they hit the exchanges once the ICO is launched, and it may also offer a right to vote on future decisions.
Due to their hybrid characteristics, regulators are highly concerned about the potential legal qualification of the tokens and virtual coins issued through ICOs as “securities.” In the majority of jurisdictions, such qualification would trigger the applicability of the securities law to ICOs and the supervision of national market authorities. In the last few months, the securities market authorities of the most prominent financial centers took a preliminary position on this matter.
One of the first movers in regulating blockchain and ICOs has been the Monetary Authority of Singapore (MAS). Regarding ICOs, the MAS took the position that digital tokens offered in Singapore shall be regulated by the MAS “if the digital tokens constitute products regulated under the Securities and Futures Act”. Although Singapore decided not to regulate virtual currencies, MAS considered that tokens perform specific functions that go beyond their status as a virtual currency, representing “ownership or a security interest over an issuer’s assets or property” and “may therefore be considered an offer of shares or units in a collective investment scheme under the SFA” as well as “a debt owed by an issuer and be considered a debenture under the SFA”. Qualifying digital tokens as securities under the SFA would consequently require issuers to provide a prospectus to MAS and become licensed pursuant to the SFA and Financial Advisers Act. Additionally, such a qualification would potentially require platforms serving as secondary markets for tokens to have the status of approved or recognized market operator.
The United Kingdom’s Financial Conduct Authority (FCA), concerned about the risks that ICOs may pose to investors, clearly stated that “[Investors] are extremely unlikely to have access to UK regulatory protections like the Financial Services Compensation Scheme or the Financial Ombudsman Service.” However, FCA specified the adoption of a case by case approach in establishing its regulatory scope. Although many ICOs may fall outside the regulated space, specific characteristics related to the investments’ structure may trigger the applicability of specific legal regimes provided for regulated investments and regulated activities performed by regulated entities. In the view of the FCA, ICOs may share some similarities with IPOs, private placement of securities, crowdfunding or even collective investment schemes, and may be categorized as transferable securities with the consequent applicability of the prospectus regime.
Consistent with the FCA, both the U.S. Securities and Exchange Commission (SEC) and the Canadian Security Administrators (CSA) suggested the adoption of a case by case approach. The SEC applies the well-known Howey test to determine whether the virtual coins or tokens offered through ICOs shall be qualified as securities. Using this test, the SEC recently concluded that the tokens issued by the virtual organization, the DAO, shall be qualified as “securities." The CSA applied a four-prong test, similar to the Howey test. Both the regulators came to the same conclusion that depending on the facts and circumstances of each individual ICO, the virtual coins or tokens that are offered or sold through an ICO may be securities. The consequence of their qualification as securities is the application of the securities laws to the offer and sale of these virtual coins or tokens in an ICO.
The Australian Security & Investments Commission (ASIC) has considered that an ICO may trigger the Australian regulation provided for managed investment scheme (MIS). Furthermore, the coins can be qualified both as shares, derivatives, non-cash payment facility. In addition, whether the ICO (or underlying coin) is qualified as a financial product, the platform operator enabling investors to trade in ICOs may be required to be licensed by the ASIC to operate in Australia.
Instead of identifying a potential regulatory framework, the Chinese Central Bank and the South-Korean Financial Services Commission opted for a ban of ICOs. Due to the significant rise of ICOs within their markets, both regulators were concerned about the risk of fraud that ICOs may present for investors.
Market authorities seem to converge towards a more restrictive approach in defining and, in the case of China and South-Korea, regulating ICOs to significantly reduce the deregulated framework, that ICO developers could exploit during these years. The qualification of tokens and digital cryptocurrencies distributed in the context of ICOs as “securities” and the consequent application of the local securities law coupled with the supervision of market authorities may potentially frustrate the development of ICOs. On the other hand, the need for a more secured framework implementing legal certainty and investor protection should prevail, and may contribute to the establishment of this new market trend, by limiting potential frauds while increasing the overall volume of the activity, due to a strengthened market confidence.
Marco Dell’Erba serves as the graduate editor of the NYU Journal of Law & Business. He is an LLM candidate in Corporation law (Hauser Global Scholar). Marco is a lawyer and a researcher. He holds a PhD in private law and financial regulation from the University of Paris I Panthéon-Sorbonne and a PhD in corporate and securities law from the University of Rome Tor Vergata. Marco practiced law in the departments of Banking & Finance and Litigation & Dispute Resolutions at Clifford Chance LLP (Rome) and as an independent consultant (Paris). He is Research Fellow at the Groningen Center for European Financial Services (University of Groningen, Netherlands), and Research Associate at the Financial Regulation Laboratory of Excellence (Paris, France, created among four leading French institutions, including Paris I Panthéon-Sorbonne, ENA, ESCP, CNAM).