UK: Regulators' Warnings Zoom In On Initial Coin Offerings

Last Updated: 27 December 2017
Article by Michael Huertas and Manuel Lorenz

Initial Coin Offerings (ICOs) come in different sizes and forms. They also offer different risk exposures to different business models across different jurisdictions and their legal systems. Interest in ICOs, cryptocurrencies and digital assets, notably from retail clients and non-professional market participants, are increasingly causing EU and national as well as supervisory authorities including ESMA to issue warnings on their risks and those financial products that reference cryptocurrency and other digital assets.

What is an ICO?

In an ICO, an offeror (typically a real or purported FinTech startup company) offers to sell a blockchain based "coin" or "token" against payment of another cryptocurrency, such as bitcoin or ether to finance itself or to finance a particular project. The tokens are also blockchain based and, thus freely transferable via the blockchain. Whether the tokens represent some kind of claim against the "issuer" and if so, what, is described typically described in a short "white paper". The tokens may contain a smart contract, i.e. a self-executing set of instructions that will automatically transfer to its holder the promised benefit. The benefit can be a return on investment from the profits of the project or venture or company that is financed from the proceeds of the token sale. Sometimes, the tokens may represent the right to use the product that is being financed with the proceeds. And sometimes, the token represents nothing except the token itself, i.e. it is simply a new virtual currency that may be used as a means of payment (if someone accepts the token as payment) or a means of speculation (if a market develops for the tokens).

According to estimates, approximately 80% of all ICOs are fraudulent offerings. Most of the remaining ICOs are difficult to evaluate in light of the extremely thin documentation surrounding the offering and the lack for investors to verify the accuracy of the information provided. Moreover, coin investors have no guarantee whether the project that they helped finance will be successful and whether the tokens they acquire are free from technical defects that makes them prone to malfunctioning or cyber-theft.

The fragmented regulation of ICOs (or the absence thereof)

Aside from valuation concerns along with how certain market participants may be channeling the market comes the fear that that the ability to buy and sell cryptocurrency and other digital assets relies on a handful of points of "exchange" and/or intermediaries. The majority of these operate beyond the EU's supervisory perimeter. Where activity falls within the supervisory perimeter, then, in the continued absence of EU (or global) action, it remains fragmented. ICOs, cryptocurrency, digital assets and how market participants activities or investors engagement are supervised are not subject to uniform standards across EU Member States or the global level. There is also no common definition of what a coin or a token is and how it should be categorized or regulated.

In the absence of uniform regulatory standards, fragmentation can cause new channels of systemic as well as idiosyncratic risk propagation to emerge. The flurry of participants ranging from professional to retail clients and consumers has caused a number of supervisory authorities in those jurisdictions, including at the EU1 and global level, to issue formal warnings. This is a first step with more to possibly follow. Consensus amongst users and offerors to whom those formal warnings are addressed is that increased regulation and supervision may actually be a good thing. Having safer and more uniform standards in FinTech is seen by a number of stakeholders, including cryptocurrency and FinTech users and offerors as a key tool to separate fraudulent and unsound offerings from more serious and honest projects, while others simply laugh at such attempts to regulate a phenomenon that has been designed to evade regulation as much as possible.

So what has ESMA done?

ESMA has issued two short ICO Warning Statements released on 13 November 2017, the context they operate in along with key takeaways for investors and participants. One Statement is addressed to investors, while the other is addressed to firms involved in ICOs. Both ICO Warning Statements are compact in length. Although they are written for two different stakeholder groups in mind, they build upon one another and should thus both merit consideration. Both refer to ICO specific risks. These stem from the nature the way an ICO is structured and/or where the capital raising component may not comply with applicable EU legislative and regulatory standards. As interest in cryptocurrency and participation in ICOs grow, so too, at least in the eyes of the supervisors, should the understanding and disclosures of ICO specific risks.

Investors are given five warnings, namely (i) the risk of fraud in an unregulated space, (ii) the risk of total loss of the investment; (iii) the risk of illiquidity and volatility; (iv) the lack of adequate information and (v) the risk of technological flaws.

Firms are reminded of the potential application of a number of pieces of EU legislation namely the Prospectus Directive, MiFID, the AIFMD and the 4th Money Laundering Directive.

ESMA's Warnings to the firms are drafted to clearly remind recipients that even where an ICOs structure falls outside of the 'existing'2 regulatory perimeter, if the cryptocurrency qualifies as a regulated financial instrument, then regulated investment activities are likely to apply. One key trigger for regulation is whether or not the tokens or coins are financial instruments. In the EU, despite largely harmonised standards, the categorisation and treatment of cryptocurrency varies and across EU jurisdictions tokens, coins or other cryptocurrency are not always treated as financial instruments. It is conceivable that ESMA, as with other components of the ESFS, will need to consider how this might have to change sooner rather than later.

So how does this fit into the wider picture and what next?

Since the issue of the warnings, the UK's regulatory authorities, including the UK's Financial Conduct Authority, which is considered to be quite at the forefront of nurturing the regulation and supervision of FinTech has joined supervisors in the US and various EU Member States in calling for greater supervisory scrutiny. The German Regulator BaFin, who had already published its own warning, has published a German translation of the ESMA Warnings to reinforce its own position. Moreover, a number of traditional market makers have, especially following the run-up to the start of options and futures referencing cryptocurrency assets as underlying values have begun to trade on select U.S. domiciled markets, voiced their concerns.

In summary, there is likely to be much more to come, certainly as the EU regulatory and supervisory policymakers take note of developments and announce a comprehensive framework on regulating and supervising FinTech activity. Whether this will develop independent of a hiccup or a more serious event to prompt action remains to be seen.

So what does that mean for firms and for investors?

Firstly for firms, it means taking stock of what one is doing where and with whom and whether that might or could be conceivable as triggering a regulatory perimeter for itself or that of its counterparties. Whilst firms are assessing their supervisory stocktake, investors have been warned that their investments in cryptocurrency, digital assets and participation in ICOs (assuming it does not trigger regulatory/supervisory implications for them) relies heavily on a range of factors beyond their control, most of which have not been disclosed and thus remain opaque, subject to a host of operational risks, financial crime along with a range of liquidity risks.

To further complicate things, market conditions for a lot of the cryptocurrency inventory are narrow. Assets as well as relevant 'exchanges' are susceptible to a multitude to crypto and non-crypto specific risks and stresses. Due to these exchanges providing the connectivity between digital assets and the 'real-economy' and equally due to increasingly credit leverage being employed, any number of transaction chains could easily cause a cascade of calls from the digital environment back to 'main street'. This is especially the case as a number of less sophisticated investors may be borrowing, including against real estate and other tangible assets or key income streams that are financed by lenders and other market participants which may have limited appetite to finance a foray into these digital and ultimately intangible assets. It is therefore conceivable that supervisory action and application of uniform standards might look to bolster the resilience of cryptocurrency points of exchange as well as harmonised cyber-resilience standards to reduce market participants' and infrastructure providers' susceptibility to financial crime and digital crime.

A more detail assessment can be found in our client alert "European Securities and Markets Authority (ESMA) issues warnings on Initial Coin Offerings (ICOs): What does this mean for investors and firms involved in ICOs?", which concluded with the following statement, which still rings true irrespective of how this market and its participants develop both in terms of commercial activity and how that is supervised:

"...whilst the ICO Warning Statements may seem stringent for some stakeholders, the ESFS and the EU are advancing to make the EU's Single Market more digital. Embracing cryptocurrency is one of many means to do that."

Footnotes

1 See our recent coverage on the BCBS Consultative Document on FinTech and the EBA's FinTech Discussion Paper.

2 And the reference to existing is deliberate in the drafting of the ICO General Warning Statement.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration
Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:
  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.
  • Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.
    If you do not want us to provide your name and email address you may opt out by clicking here
    If you do not wish to receive any future announcements of products and services offered by Mondaq you may opt out by clicking here

    Terms & Conditions and Privacy Statement

    Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

    Use of www.mondaq.com

    You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

    Disclaimer

    Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

    The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

    Registration

    Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

    • To allow you to personalize the Mondaq websites you are visiting.
    • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
    • To produce demographic feedback for our information providers who provide information free for your use.

    Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

    Information Collection and Use

    We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

    We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

    Mondaq News Alerts

    In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

    Cookies

    A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

    Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

    Log Files

    We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

    Links

    This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

    Surveys & Contests

    From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

    Mail-A-Friend

    If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

    Emails

    From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

    *** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .

    Security

    This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

    Correcting/Updating Personal Information

    If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

    Notification of Changes

    If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

    How to contact Mondaq

    You can contact us with comments or queries at enquiries@mondaq.com.

    If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.

    By clicking Register you state you have read and agree to our Terms and Conditions