Cryptocurrencies, ICOs and Financial Regulation

ICOs (Inititial Coin Offerings) are becoming more and more popular as means of funding new cryptocurrency projects. Start-ups mostly in the field of blockchain technology use them instead of traditional or heavier regulated ways of fundraising because even though they are often compared to other forms like IPOs or Crowdfunding, they differ significantly and so are the regulatory implications.

What are ICOs

An Initial Coin Offering (ICO) is a process, during which a company raises funds by issuing new cryptocurrency coins. Cryptocurrencies are digital or virtual currencies like Bitcoin or Ether. The startup creates a new currency to finance a project. For that purpose it issues a form of business plan in the form of a whitepaper that sets out the objective of the project, how much financing is needed and how it will be used, and the details of the ICO process. These details include the duration of the ICO (usually a couple of weeks) and which forms of payment are accepted, in most cases only Bitcoin or other cryptocurrencies like Ether. In exchange the investors receive the newly created coins, which are referred to as tokens. In turn these tokens can, depending on the project, be traded on dedicated exchanges, give token holders rights as in, for instance, decentralized autonomous organizations (DAO – see related post) and so on depending on the structure and the objective of the issuing entity.

Similarities to other forms of financing

ICOs are sometimes also called Initial Public Coin Offering (IPCO), which highlights the similarity with more traditional forms of financing, in particular with Initial Public Offerings (IPOs), the issuing of shares in a company. In an IPO, stock in a formerly private company gets sold to the public, often through institutional investors though. The whole process is highly regulated with variations across different jurisdictions. The similarity stems from the selling a stake in a company and the motivation of investors of making a profit. The latter point, however, might be less prevalent depending on the kind of ICO. Take the ICO of Humaniq, for example, which aims to support financial inclusion and thus clearly adding an element that is closer to those found in Crowdfunding, which is another popular way to raise funds from a group of people that believe in the (though not necessarily financial) success of an undertaking. Depending on the jurisdiction and the form of Crowdfunding, it is also a regulated activity, but only recently and in many countries less strict then issuing shares on a stock exchange via an IPO. Neither of the two entirely fits the shoe though, which leads to the next part:

Regulatory treatment of ICOs

Which is the tricky part, the question of if and how ICOs are regulated. As ever so often, the lawyer’s answer is: It depends.

The progress of blockchain technology has caught regulators around the globe a little bit of guard, so they had to catch up first. That means the authorities are still somewhat in the process of trying to understand the technology and the legal ramifications better and only Switzerland and Singapore have issued dedicated Token regulation. Other jurisdictions are still in the process of how they want to deal with cryptocurrencies. For example,

But even though other countries haven’t issued any specific rules, it doesn’t mean that we’re navigating in unchartered space. Existing rules will apply even though they do not explicably mention ICOs.

Germany is a nice example of the learning curve regulators are currently climbing (with progress varying depending on jurisdiction): in December 2013 the European Banking Authority (EBA) issued a public warning by to consumers on a series of risks deriving from buying, holding or trading virtual currencies such as Bitcoins. Following this, the German financial regulator BaFin aimed to clarify the regulatory application of virtual currencies in general and Bitcoin in particular in early 2014. BaFin qualified Bitcoin with legally binding effect as financial instruments in the form of units of account pursuant to section 1 (11) sentence 1 of the German Banking Act. The authority has since issued guidance on blockchain technology in financial services and publicly stated that while existing regulation is likely to apply, the regulatory focus will be AML, Data Protection, legal aspects such as enforcement and recission of contract, and Outsourcing with practical cases eventually determining which regulations are applicable. Concrete steps to simply provide guidance or even create a more adept framework for the application are still not in sight though.

It’s a similar story in the US with it’s wide offering of regulatory authorities:

In September 2015, the Commodity Futures Trading Commission (CFTC) issued an enforcement order against Coinflip for operating a Bitcoin options trading platform in violation of the Commodity Exchange Act (CEA) and CFTC rules. As a result, the CFTC defined that Bitcoin and other cryptocurrencies are commodities covered by the CEA.

The Federal Reserve published a long awaited whitepaper on “Distributed ledger technology in payments, clearing, and settlement” avoided making a clear statement and instead highlighted that “careful legal analysis must be done to understand” the subject and what gaps need to be filled by contractual agreements or new laws and regulations.

The SEC has been active on several blockchain regulation related aspects. It has been in the press recently because of its decision to block the listing and trading of shares in the Winklevoss Bitcoin Trust. In December 2015 on the other hand it approved Overstock’s plans to issue digital stock via the blockchain. However, despite employing a dedicated Blockchain Task Force it has so far avoided to tie itself down defining the nature of virtual currencies in the context of ICOs.

The state level can be equally confusing: For instance, the State of New York State aimed to provide some guidance by introducing its BitLicence regulation, which came into effect on August 8, 2015. However, the regulation provided little clarity to the overall discussion on the regulatory nature of virtual currencies, but instead stifled blockchain innovation in the state.

In late 2015, the Conference of State Bank Supervisors (CSBS) its Model Regulatory Framework
for State Regulation of Certain Virtual Currency Activities. Under this framework, virtual currency is considered in part as ‘a digital representation of value used as a medium of exchange, a unit of account, or a store of value, but does not have legal tender status as recognized by the United States Government.’

Getting back to the initial problem of regulatory categorisation of issuing cryptocurrencies in an ICO, what does that leave us with: At least in the US the tendency seems to be (with the caveat that the level of support of this conclusion depends on which lawyer you talk to), however, that it should be considered as issuing financial securities with all the pleasant consequences this has for working with US investors even when you’re issuing in another jurisdiction (for more on those read our post on the subject here).

The bottom line is then with the exception of just a few jurisdiction, it is still unclear how to treat cryptocurrencies in the context of ICOs. What is clear though is that believing to be working in some sort of grey area, is probably not the wisest approach.