Initial coin offerings (ICOs), also known as initial public coin offerings (IPCOs), have become a controversial topic in the recent developments of cryptocurrency and blockchains. ICOs are an unregulated method of public offering and crowdfunding that allow startup companies to raise money by avoiding the cost of regulatory compliance (i.e. financial regulators) and intermediaries (i.e. investment banks). Unlike traditional initial public offerings (IPOs), which offer shares in the ownership of the issuer, ICOs offer coins of the issuer to investors in the form of tokens in exchange for legal tender or more common types of cryptocurrency (e.g., Bitcoin). Although the tokens offered in ICOs are similar to the shares sold to investors in IPOs, an investor’s returns on an ICO investment depends on the appreciation of the value of the tokens, which is further dependent on various factors such as the performance of the business and the market reactions to the projects. This dependence adds to the high-risk nature of the ICOs since investors might not be able to understand the business of the coin issuers in the absence of a compliant offering document registered with the financial regulators.
In recent months, there have been some developments regarding financial regulation of ICOs. This article will consolidate these developments and analyze the future prospects of ICOs.
The History of ICOs
ICOs were initially inspired by tokens for online gaming and social media. The first ICO dates back to July 2013. Mastercoin, now known as Omni Layer, conducted the first ICO in July 2013 and raised $500,000 worth of Bitcoins. In July 2014, Ethereum raised $18.4 million in Bitcoin in exchange for its token “Ether,” which was the first large scale ICO. The number of ICOs has increased rapidly and more than 400 ICOs have been conducted since 2013. In addition, more than $5.6 billion of capital was raised in 2017 through ICOs, compared with only $240 million in 2016.
Recent Developments of ICOs
ICOs are generally not accepted by major financial regulators. Indeed, the decentralized and autonomous nature of coins makes ICOs inherently inconsistent with the concept of financial regulation. To reconcile this inconsistency, different financial regulators have adopted different strategies. For example, in 2017, financial regulators in China and South Korea banned ICOs, which resulted in a substantial price drop of several digital currencies. Some countries, like Australia and New Zealand, have released guidance on regulating ICOs, while others, like Canada and France, are working on the regulations on ICOs.
In the United States, ICOs have triggered the question of whether coins or tokens are securities under the federal securities laws. Although the U.S. Securities and Exchange Commission (“the SEC”) has not established a separate legal framework for ICOs, recent actions by the SEC have demonstrated that it intends to regulate the ICO market. In July 2017, the SEC reiterated in the Report of Investigation (“The DAO Report”) that “whether a particular investment transaction involves the offer or sale of a security, regardless of the terminology or technology used, will depend on the facts and circumstances, including the economic realities of the transaction.” In September 2017, the SEC created a Cyber Unit within the Enforcement Division focused on targeting cyber-related misconduct, including violations involving distributed ledger technology and ICOs. On December 11, 2017, the SEC released a “Statement on Cryptocurrencies and Initial Coin Offerings.” Chairman Jay Clayton stated that “the structures of initial coin offerings that I have seen promoted involve the offer and sale of securities and directly implicate the securities registration requirements and other investor protection provisions of our federal securities laws.” During a United States Senate hearing on February 6, 2018, Chairman Clayton further claimed that “I believe every ICO I’ve seen is a security.” All these actions and statements reveal that possibility of ICO regulation in the United States is emerging.
In Hong Kong, the Securities and Futures Commission ("the SFC") issued a “Statement on Initial Coin Offerings” on September 5, 2017, which explained that “depending on the facts and circumstances of an ICO, digital tokens that are offered or sold may be ‘securities’ as defined in the Securities and Futures Ordinance, and subject to the securities laws of Hong Kong.” On February 9, 2018, the SFC released a warning against cryptocurrency risks in which SFC disclosed that it has taken regulatory action against a number of cryptocurrency exchanges and issuers of ICOs by writing warning letters to them. Most recently, the SFC has ordered Black Cell Technology Limited, a Hong Kong-based issuer, to halt its ICOs of digital tokens called KROPS to investors through its website. The intensified regulation and scrutiny by Hong Kong financial regulator show that ICOs have become a regulatory target in this international finance hub.
The Future of ICOs
It remains to be seen whether financial regulators around the world will develop a new regulatory regime for ICOs or continue regulating this new market by applying existing securities laws. Even for a country like China that has entirely banned ICOs, we have seen optimistic signs that it is preparing new regulation on ICOs in 2018 and may lift the ban on ICOs eventually to avoid missing out on the opportunity to develop a new industry. As such, it is expected that regulation of the ICO market will continue to develop in the foreseeable future.
Before the promulgation of any ICO regulation, it is still risky for investors to engage in the purchase and sale of digital tokens as many ICOs are fraudulent. In addition to the possibility of fraud, investors should be wary of the increased risk of extreme price volatility and internet hacking when investing in ICOs. Considering the risk and return of ICOs, issuers and industry practitioners who would like to conduct ICOs in the future might have to find a proper and balanced approach that complies with the applicable securities laws while obtaining the benefits of ICOs.
Ken Zijian Ye serves as a graduate editor of the NYU Journal of Law & Business. He is an LLM candidate at the NYU School of Law. During his studies, he worked at the New York State Supreme Court and the NYU Clinical Law Center. Prior to attending NYU, he worked at the Hong Kong office of Skadden, Arps, Slate, Meagher & Flom focusing on capital markets and mergers & acquisitions. Ken graduated from The University of Hong Kong Faculty of Law in 2013.