While regulators were still discussing the most effective way to regulate crowdfunding within the EU, a new wave of alternative financing overwhelmingly took them by surprise: ICOs are the new hype, and it seems like there is no other way to finance a project or a startup than to issue a new token via blockchain technology.
One reason for the supervisory authority's apparent paralysis is the complexity of the underlying technology, blockchain, which is difficult for someone without an IT background to understand. Initially, blockchains are not attached to any capital markets issues and are – simply speaking – tamper-proof distributed data structures in which transactions are recorded in chronological order and mapped in an understandable and unalterable form. Irrespective of any financial issues, blockchains are very helpful for the economy and can be used as technical support for several purposes (such as logistic track records, tamper-proof medication, product information for consumers etc.).
However, blockchains can also be used to create new virtual currencies, known as cryptocurrencies. The best known of these, bitcoin, has made an impact in financial markets all over the world.
The European Banking Authority defines "virtual currency" as a digital representation of value that is not issued by a central bank or other public authority, nor necessarily attached to a fiat currency, but that is used by natural or legal persons as a means of exchange and that can be transferred, stored or traded electronically.1 From a technical point of view, there can be decentralized virtual currencies, like bitcoins or ethereum, which are created through a predetermined mathematical procedure within a computer network by any blockchain user. This procedure is known as "mining." Any interested user can download programs to participate in the network and let their computer solve mathematical questions generated within the respective blockchain, thereby mining tokens.
In this case, there is no individual issuer to whom the virtual currency can be attributed. The network functions as a peer-to-peer network in which all users have equal rights. On the other hand, issuers can use existing blockchains (such as NEM or ethereum) in order to create their own virtual currencies by using a so-called "smart contract" – a computer program functioning on an "if-then" basis. The newly created virtual currency can then be sold to investors ("initial coin offering" as inspired by the classical term "IPO").
Accordingly, the term ICO usually stands for the issuance (or creation and distribution) of a token by a central issuer. The resulting regulatory questions are manifold and not easy to solve. Although the respective European supervisory authorities have willingly entered into a dialogue with the market participants, they were hesitant to render general official statements regarding the classification or overall legal treatment of virtual currencies and ICOs.
Recently some supervisory authorities finally broke their silence and issued general guidelines regarding the classification and regulatory treatment of crypto tokens. BaFin, the German financial supervisory authority, published a "reference statement" on February 20, 2018.2 Although BaFin outlines that any assessment is subject to individual structure of the respective token and will be undertaken on a case-by-case basis, the statement provides helpful guidance for issuers and the interested market participants. Unsurprisingly, BaFin repeats its position that tokens can be classified as:
- Financial instruments, either in terms of the German Banking Act (KWG) or (more significantly) as financial instruments in terms of the Market in Financial Instruments Directive 2014/65/EC (MiFID II), the Market Abuse Regulation (MAR) and the German Securities Trading Act (WpHG);
- Securities in terms of the German Securities Trading Act (WpPG); or
- Investment products in terms of the German Investment Act (VermAnlG).
Further, a token can be classified as a share of an investment asset in terms of the German Investment Act (KAGB).
BaFin clearly states that when considering whether a token is a security in terms of sec. 2 (1) of the WpHG or Art. 4 (1) Nr. 44 MiFID II, the following token criteria will be taken into account:
- Tradability on a financial or capital market, whereas cryptocurrency and trading platforms may be considered as financial or capital markets in terms of the security definition;
- The rights attached to the token, in particular shareholder or other equity rights or debt claims;
- Whether it meets the requirements of a payment instrument pursuant to sec. 2 (1) of the WpHG or Art. 4 (1) Nr. 44 of MiFID II.
Attention must be paid when involving a third party, like an Internet platform, as a mechanism to exchange virtual currencies into legal tender. Not only can such activity be considered as operation of an MTF pursuant to sec. 1 (1a) Nr. 2b) of the KWG, but also as provision of payment services, which would be subject to a license pursuant to sec. 10 (1) of the German Payment Services Act (ZAG).
FINMA, the Swiss financial market supervisory authority, also issued long-awaited guidelines in relation to ICOs (the so-called Wegleitung)3 on February 16, 2018. The Swiss statement confirms the existing differentiation among three types of tokens:
- Currency tokens, such as bitcoin, which are designed as a store of value and a payment instrument;
- Security or investment tokens, which grant their holders security-like rights;
- Utility tokens, which grant their owners certain access rights to functions and services within a network.
FINMA states that investment tokens representing asset values can particularly constitute a debt claim against the issuer or an equity right. According to FINMA, investment tokens promise a share of future corporate income or future cash flows. Dependent on its economic function, the token can particularly represent a share, a bond or a non-derivative financial instrument. The category of investment tokens may also include tokens that make physical valuables tradable on the blockchain. Such investment tokens will usually be classified as securities (Effekten) pursuant to Swiss law (i.e. securities, book-entry securities, derivatives that are unified and suitable for mass trading) and accordingly be subject to the respective applicable laws and regulations.
FINMA also stated that it will not consider simple utility or payment token as securities, unless there is a deviating approach from the legislator. Regarding utility tokens, however, this only applies as long as the token solely confers a right to access a digital usage or service and no investment function exists. Practically, this means that tradability of a utility token on a secondary market will most likely trigger the classification as an investment token.
In addition, AMF, the French financial supervisory authority, issued a statement with regard to cryptocurrency derivatives on February 22, 2018.4 The AMF concluded that a cash-settled cryptocurrency contract may qualify as a derivative, irrespective of the legal qualification of a cryptocurrency. Therefore, according to AMF, online platforms which offer cryptocurrency derivatives fall within the scope of MiFID II and must therefore comply with the authorisation, conduct of business rules, and the EMIR trade reporting obligation to a trade repository. Moreover, this means that cryptocurrency derivatives must not be advertised via electronic means.
Issuers must also be careful when issuing payment tokens, as the tradable rights to transfer the tokens prior to its actual existence, may be qualified as securities. Further, payment and utility tokens are usually subject to the Swiss Anti Money Laundering Act (AML Act), as the respective ICO constitutes an issuance of payment means which are subject to the AML Act. Utility tokens, however, can be left out if the token is primarily intended to enable access to the use of a blockchain for purposes outside of the financial industry.
The supervisory authorities' move to finally lift the regulatory veil is more than welcome, as it seems that the virtual currency industry is flooded with doubtful, risky offerings. Most supervisory authorities all over the world have warned against ICOs. The European Supervisory Authorities (ESAs) for securities (ESMA), banking (EBA) and insurance and pensions (EIOPA) have just recently issued a pan-EU warning to consumers regarding the risks of buying virtual currencies. The ESAs warn consumers that virtual currencies are highly risky, unregulated products and are unsuitable as investment, savings or retirement planning products.5
Such warnings seem to be confirmed by recent market research stating that more than 10 percent of ICO proceeds are lost as a result of hacker attacks.6 In addition, we believe that more than 50 percent of current ICOs are either of dubious nature or simply criminal. BaFin already banned unlicensed commercial activities in connection with virtual currencies like "OneCoin"7 and Crypto.exchange GmbH8.
Yet so far it seems these warnings fall on deaf ears, as financing built on blockchain technology raised more than US$886 million through 35 ICOs in January 2018 alone.9 In 2017, 279 ICOs raised more than US$4.8 billion,10 compared to about US$96 million through 46 ICOs in 2016.11 Currently, approximately 1,527 different cryptocurrencies are circulating in the market.12 What started as a pure tech movement for "fans and freaks" seems to be now developing into a genuine professional investors market, attracting institutional investors and other serious global players. Even established companies such as Kodak have announced ICO/ITO projects.13
The ongoing dialogue between regulatory authorities and market participants, as well as the slowly evolving clarity on regulatory requirements, will hopefully help clarify this emerging market. This will be necessary in order to distinguish serious players and projects from frauds and honeytraps and to build trust.
1. EBA Opinion on 'virtual currencies', www.eba.europa.eu, July 4, 2014
2. Initial Coin Offerings: Hinweisschreiben zur Einordnung als Finanzinstrumente, www.bafin.de, February 20, 2018
3. FINMA publishes ICO guidelines, www.finma.ch, February 16, 2018
4. The AMF considers that the offer of cryptocurrency derivatives requires authorisation and that it is prohibited to advertise such offer via electronic means, www.amf-france.org, February 22, 2018
5. ESMA, EBA and EIOPA warn consumers on the risks of Virtual Currencies, www.eba.europa.eu, February 12, 2018
6. EY research: initial coin offerings (ICOs), www.ey.com, December 2017
7. Onecoin Ltd (Dubai), OneLife Network Ltd (Belize) und One Network Services Ltd (Sofia/Bulgaria): BaFin issues cease and desist orders holding the companies to stop own funds trading in "OneCoins" in Germany, www.bafin.de, April 27, 2017
8. Crypto.exchange GmbH: BaFin orders cessation of unauthorized principal broking services, www.bafin.de, February 5, 2018
9. Cryptocurrency ICO Stats 2018, www.coinschedule.com
10. Cryptocurrency ICO Stats 2017, www.coinschedule.com
11. Cryptocurrency ICO Stats 2016, www.coinschedule.com
12. Cryptocurrency Market Capitalizations, https://coinmarketcap.com
13. KODAKOne platform & KODAKCoin cryptocurrency, www.kodak.com
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