The Chinese ban on cryptocurrency exchanges has caused a landslide in the community and for the question of regulation of ICOs. Already the SEC’s decision to practically consider tokens as financial securities in certain circumstance had kicked off a number of regulatory activities that has swept around the globe. PlanetCompliance provides an overview of the current situation and an outlook of things to come for ICO regulation.
The sudden explosion in ICOs and the incredible amounts that have been raised as part of it were certain to cause a reaction from regulators. So it isn’t really surprising that in a short period of time a number of financial authorities have published warnings, guidance or taken other regulatory measures in response. We try to summarise the current situation, describe the measures taken and also attempt to forecast where we will go from here. For the sake of order and completeness, let’s go from West to East:
At the end of July the U.S. Securities and Exchange Commission (SEC) published two documents on Initial Coin Offerings what can now be seen as the opening bell for the regulatory clampdown on ICOs.
The first document concluded in the form of an Investigative Report that DAO Tokens, a Digital Asset, were, in fact, securities, while the second, an Investor Bulleting on Initial Coin Offerings explained Blockchain, Digital Tokens and some key points to consider when determining whether to participate in an ICO.
Based on the SEC’s investigation, the regulator determined that DAO Tokens were securities under the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”). The SEC clarified that to establish whether an ICO involves the offer and sale of securities, depends on the facts and circumstances of the offering. Prior to the report, the use of smart contracts was often cited to establish that tokens should not be considered securities. However, the SEC report made it clear that the automation of certain functions through blockchain technology, “smart contracts,” or computer code, does not remove conduct from the purview of the U.S. federal securities laws. As a consequence of the DAO report, the SEC has jurisdiction over all ICOs that were open to US investors, which should be most, if not all as it is difficult to rule out entirely that someone from the US participated in an offering. A question that remains is who has the burden of proof if it cannot be determined because of the anonymous nature of the process. However, the report stresses in any case the obligation to comply with the registration provisions of the federal securities laws with respect to products and platforms involving emerging technologies and new investor interfaces. That means that the offer and sale of virtual coins or tokens must itself be registered with the SEC, or be performed pursuant to an exemption from registration. For people raising funds through an ICO it ascertains the need to comply with these requirements and related obligations. It also means that any potential wrongdoing can be investigated by US authorities. Considering that US securities laws are rather severe and offences can have draconic consequences with many years of prison time looming in case of significant violation, this should not be taken lightly.
In the great white north on the other hand, the Canadian Securities Administrators (CSA) published a staff notice on Cryptocurrency Offerings that confirms the potential applicability of Canadian securities laws to cryptocurrencies and related trading and marketplace operations. It is also intended to provide market participants with guidance on analyzing these requirements. While the paper primarily focuses on ICOs and cryptocurrency investment funds, and their intersection with cryptocurrency exchanges, the CSA pointed out that “this guidance should also be considered in the context of other cryptocurrency or distributed ledger technology-based offerings that may trigger securities law requirements.”
The CSA made it very clear, too, that despite businesses often presenting their coins or tokens as software products, and as such not subject to securities laws, the opposite in most situation is the case: “While every case has to be reviewed individually according to the regulator, in many cases, when the totality of the offering or arrangement is considered, the coins or tokens should properly be considered securities.” At the same time, the CSA points to cooperation instead of confrontation and advises all market participants to contact the dedicated staff at the securities regulatory authority in the respective Canadian jurisdiction.
The British Financial Conduct Authority (FCA) issued a consumer warning about the risks of Initial Coin Offerings on 12 September. The FCA generally is very accommodating towards Fintech and innovation. It also actively seeks the dialogue with industry participants and has issued several publications on related subjects like the FCA’s Discussion Paper DP17/3 on distributed ledger technology earlier this year. The consumer warning however highlights the large risks associated with ICOs like the extreme price volatility many tokens experience or the potential to use this form of fundraising for fraudulent purposes. While the FCA considers that many ICOs will fall outside the regulated space, some – depending on how they are structured – may involve regulated investments and firms involved in an ICO may be conducting regulated activities. Some tokens may also constitute transferable securities and therefore may fall within the prospectus regime. The FCA for that reason also issues a warning to business involved in ICOs and cryptocurrencies as they should carefully consider if their activities could mean they are arranging, dealing or advising on regulated financial investments. Digital currency exchanges, too, need to consider if they have to be authorised by the FCA.
Other European jurisdictions
Interestingly, it looks like other European jurisdictions have so far refrained from issuing similar consumer warnings on the back of the recent ICO excitement. However, various national authorities have already published documents on the nature of cryptocurrencies and associated risks or guidance in respect of applicable existing regulations. For instance, the German financial watchdog BaFin in its article on Virtual Currencies from April 2016 advised on the authorisation requirements for platforms and exchanges. While the article does not refer to the latest number of digital coins and tokens, the regulator made it clear that different activities associated with the issuance and trading of cryptocurrencies already falls under existing laws and market participants therefore have to comply with it.
Switzerland aims to develop the world’s best ecosystem for blockchain and other cryptographic technologies and business according to the independent, but government-supported Crypto Valley Association. For that reason, the CVA has begun to work on a Code of Conduct that clarifies the legal status of token launches, tokens and the investments made therein.
Following a statement made in January 2014 on the use of cryptocurrencies, the Central Bank of the Russian Federation on 4 September issued a new warning on the related risks. Given these high risks the authority considers it premature to admit cryptocurrencies, which is in line with statements made by the Russian Finance Minister, who had expressed his concerns on a number of occasions and the government’s plan to issue dedicated regulation by the end of the year.
Dubai as the dominating financial centre of the Middle East and Africa, it’s financial regulator, the Dubai Financial Services Authority (DFSA) in line with the course taken by other authorities around the globe issued a statement that warned investors with regard to cryptocurrencies. The DFSA made it clear that it does not currently regulate these types of product offerings or license firms in the Dubai International Financial Centre (DIFC) to undertake such activities. Investors, for that reason were urged to exercise caution and undertake due diligence to understand the risks involved.
For a while it looked like Singapore would become the dominating hub for cryptocurrencies and ICOs. However, on 10 August the authorities felt compelled to issue warning to consumers to mindful of the potential risks associated with digital token and virtual currency-related investment schemes. The statement from the Commercial Affairs Department (CAD) and the Monetary Authority of Singapore (MAS) said that the authorities had “observed the emergence of initial coin (or token) offerings (ICOs), and other investment schemes involving digital tokens, in Singapore” and advised “members of the public are advised to exercise due diligence to understand the risks associated with ICOs and investment schemes involving digital tokens”. The risks the regulators had identified were relating to:
- to foreign and online operators
- to sellers without a proven track record
- to insufficient secondary market liquidity
- to highly speculative investments
- to investments promising high returns
- money laundering and terrorist financing
The guidance came on the back of a MAS statement from 1 August, in which the regulator clarified that virtual currencies and tokens should be considered financial instruments subject to local laws. The regulator stressed that the offer or issue of digital tokens in Singapore will be regulated by MAS if the digital tokens constitute products regulated under the Securities and Futures Act.
As a result, issuers of tokens are required to lodge and register a prospectus with MAS prior to the offer of such tokens, unless exempted. Issuers or intermediaries of such tokens also need to be licensed and adhere to AML & CFT requirement in accordance with the laws of Singapore.
In addition, platforms facilitating secondary trading of such tokens would also have to be approved or recognised by MAS as an approved exchange or recognised market operator respectively under the SFA.
China / Hong Kong
The event that brought the recent Bitcoin rally to a halt though was the announcement of the Chinese regulators to crack down on ICOs and cryptocoin exchanges. On 4 September a number of government authorities including the People’s Bank of China, the Central Office of the Ministry of Industry and Information Technology, the Ministry of Industry and Commerce, the Banking Regulatory Commission, and the China Insurance Regulatory Commission issued a statement, in which they banned any future Initial Coin Offerings and order trading platforms and cryptocurrency exchanges to cease their activity. The authorities branded all forms of ICOs essentially an unauthorized illegal financing behavior and warned the public to be highly alert to the risk of currency issuance financing and trading risks. Any organisations that had already concluded or begun an ICO were instructed to make preparations to return the funds and ensure the protection of the rights and interests of investors. It also advised all financial institutions and non-bank payment institutions not to directly or indirectly engage in any form in related activities, e.g. to provide financing, to provide account opening, registration, trading, liquidation, settlement and other products or services in relation to virtual currencies.
It is certainly interesting that only a day later the Hong Kong Securities and Futures Commission (SFC) published a statement, categorizing tokens as financial instruments. The regulator 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 (SFO), and subject to the securities laws of Hong Kong.” While the SFC highlighted that a virtual commodity itself is not a ‘security’, that certain ICOs it had looked into contained terms and features making their tokens de facto securities. This means that parties involved in such activities are conducting regulated activities under the laws of HK, which in turn requires a license or registration with the SFC.
When Japan in spring made headlines when it recognized Bitcoin as a legal method of payment as of 1 April 2017, it also forced exchanges and platforms to register with the Japanese Financial Services Agency by the end of September. Since cryptocurrencies like Bitcoin are considered a form of prepaid instrument, these participants will need to comply with the AML and KYC rules of Japan’s financial laws.
With the supervision of cryptocurrency exchanges to begin from next month on, it will be interesting to see how the Japanese regulator in practice goes about this business. It will also potentially present a model for other jurisdictions to follow, but apart from certain aspects such as minimal capital requirements or the segregation of funds, key questions like accounting rules or ICO regulations remain unanswered.
Which takes us to take a look into the crystal ball…
Things to come?
Now that we have summarised the status quo, what is happening next? Naturally, that is difficult to foretell, but based on experience and the indications given by the regulators, we will try to give a little outlook on what to expect in the different jurisdictions:
The SEC has not publicly confirmed whether it is investigating any other ICOs at the moment, but neither had it done so in the case of the DAO. Furthermore, the fact that the SEC has also published an Investor Bulletin that highlights the risks in ICOs and warns against fraud and theft means that the regulator is determined to examine ICOs and go after possible offenders. The question whether there is a new set of rules on the horizon is different one though: with a notorious fragmentation of federal and state laws plus competing financial authorities a comprehensive regulatory framework is not realistic in the short term.
As for the UK, the FCA has stated that whether an ICO falls within the FCA’s regulatory boundaries or not can only be decided case by case. This in turn indicates that the regulator is actually looking into ICOs and will consider regulator measures were applicable. In general, the FCA is known to invest time and resources to understand and evaluate new technologies and their regulatory impact. It’s therefore likely that the regulator is taking a similar approach on ICOs and cryptocurrencies. If areas are not already covered by existing regulation and the FCA determines that additional rules are needed, the financial watchdog is sure to act though.
Other regulators like the German BaFin will also not stand idly by. For instance, the German watchdog organises an event in early November that focuses on white-collar crime in finance and on the use of ICOs and cryptocurrencies in that context. And with the new found wisdom, the authorities will probably take a good look at what is going on in the ICO space.
As mentioned above the Canadian regulators are trying to encourage businesses with proposed cryptocurrency offerings to contact their local securities regulatory authority to discuss possible approaches to complying with securities laws. The CSA has setup a regulatory sandbox to help fintech businesses seeking to offer innovative products, services and applications in Canada. At the same time the regulator recognizes that new FinTech businesses may not fit neatly into the existing securities law framework and that through collaboration and better understanding of each other better results can be achieved than through the hasty introduction of new rules.
And China? At the time of writing this, rumours circulated that the Chinese authorities were working on a further extension of the ban in respect of all cryptocurrency related activities, including the exchange of Bitcoin and other crypto coins between individuals or access to foreign platforms and services. In fact, the idea of a decentralised economy runs against the fundamental concepts of the Chinese constitution and the leadership of the Communist Party of China, so it is not likely to cease control easily. Clamping down entirely on innovation is not in the interest of China though and combined with the difficulties of controlling a decentralised phenomenon, it will probably seek the right regulatory measures instead than outright ban ICOs and cryptocurrencies permanently.
Exciting times ahead…