Last week the German financial regulator, the Federal Financial Supervisory Authority BaFin, published a consumer warning in respect of initial coin offerings (ICOs). Like other regulators globally, the financial watchdog felt the urge to highlight the risks involved in investing in token offerings. Unfortunately, BaFin contributed little to the situation for German ICOs or the overall legal discussion on token offerings with this statement, but instead added to the confusion some may feel about the approach the authorities take. This post explains what the statement of BaFin in its monthly journal says and what else you should know.
When we analysed the ESMA statement on ICOs last week, we pointed out that the majority of European regulators had been fairly quiet on the subject. BaFin, the German financial watchdog, had only published a brief warning about the risks of ICOs. Like most regulators in Europe, the Bunderanstalt für Finanzdienstleistungsaufsicht had somewhat cautiously navigated around the subject, publishing some guidance on Blockchain and on Virtual Currencies without being very conclusive as to the underlying legal and regulatory issues. In April 2016, for instance, it provided an overview on Virtual Currencies, in which it advised on the authorisation requirements for platforms and exchanges. BaFin pointed out that different activities associated with the issuance and trading of cryptocurrencies already fall under existing laws and market participants therefore have to comply with it, but refrained from any further action. It also issued an introduction to Blockchain Technology and potential applications of blockchains and the related authorisation requirements in Germany. Considering the boom in token offerings, it is slightly surprising that BaFin hasn’t addressed the subject earlier.
ICO ¹ IPO?
Unfortunately, the regulator does not seem to have used the time to prepare a more practical approach other than warning consumers against the risks of investing in a token offering. BaFin stresses the unfortunate similarity by name only between ICOs and IPOs (Initial Public Offering), but it is questionable that at this stage and popularity of ICOs this really is the key issue. Instead, it adds to the confusion by highlighting the lack of applicable regulation in the legal basis section. This amplifies the impression that ICOs operate in an unregulated field, which they do not. Not even in Germany as the BaFin statement later shows when it explains the role of the regulator and the potential regulatory contact points. In that context it is also interesting to read that, according to BaFin, the costs associated with the issuance of tokens are extremely low in comparison to those of issuing shares. What BaFin doesn’t say here is that while the cost of launching an ICO might be miniscule from a technical perspective, launching a successful one that is based on the advice of lawyers and other professional service providers, that involves people to drum up and entertain the community, that cuts through the noise can easily cost between 100 and 500 grand. True, an IPO is still more expensive, but costs vary there as well depending on jurisdiction and exchange. For the sake of completeness, a listing on AIM, London’s market for smaller and growing companies, saw in 2016 an average IPO fundraising of £18.4m with the total costs paid by companies floating on AIM last year, was an average 7.7% of all funds raised. That would be approx. £1.4m on the average AIM IPO.
In any case, what the statement does is to explain the different risks for consumers BaFin could think of:
- Risk of loss: ICOs are a highly risky and speculative form of investment. A total loss of the sum invested is possible.
- Lack of regulation: many ICOs are conducted in an unregulated environment.
- Lack of protection: there are often no relevant consumer protection provisions, no investor protection instruments specific to the capital market and no protection of personal data.
- Insufficient information: rather than a regulated prospectus, investors often receive objectively insufficient, incomprehensible or misleading information in the form of white papers.
- Complexity: extensive, and in particular technical, knowledge is necessary to be able to assess an IPO project comprehensively.
- Projects in early phases: typically, projects to be financed using ICOs are still in their very early, in most cases experimental, stages. Therefore, their performance and business models have never been tested.
- Volatility: substantial price fluctuations are possible. There is often no secondary market. Tokens might also turn out to be completely illiquid.
- Risk of fraud: the structures of ICOs can entail a significant potential for abuse and fraud. The program code might also contain errors that can be exploited by third parties.
The (real) legal basis
To get back the point of the legal nature of ICOs, BaFin eventually makes it clear that in accordance with German Banking Act cryptocurrency tokens constitute financial instruments (units of account). The regulator emphasis therefore that “undertakings and persons that arrange the acquisition of tokens, sell or purchase tokens on a commercial basis, or operate secondary market platforms on which tokens are traded are generally required to obtain authorisation from BaFin in advance”. BaFin also states that “based on the specific formulation of the contract for each ICO, BaFin decides on a case-by-case basis whether the offeror is required to obtain authorisation pursuant to the German Banking Act (Kreditwesengesetz – KWG), Investment Code (Kapitalanlagegesetzbuch – KAGB), Payment Services Supervision Act (Zahlungsdiensteaufsichtsgesetz – ZAG) or Insurance Supervision Act (Versicherungsaufsichtsgesetz – VAG) and whether they must fulfil prospectus requirements”. Well, nothing else would you expect, so why didn’t the financial watchdog offer the people behind token offerings an olive branch to invite them to raise funds in a way compliant with German laws? Certainly, an innovation friendly location might have done that, but instead BaFin concludes its statement with a stern warning underlining the responsibility of law enforcement authorities for the prosecution of criminal offences.
Following a brief consumer warning a week earlier, BaFin has issued a more detailed one. The German regulator has missed a chance to clarify the regulatory situation regarding ICOs in Germany. It has also missed out on a chance to present it as a location that embraces innovation and is FinTech friendly in a time when German cities actively seek to promote the country for a life after Brexit.