Defining the intangible, balancing innovation with the application of 'good old' regulation, and managing crypto's emergence into the mainstream of financial services beyond its statistical systematic significance

During the course of 2017, Gibraltar has become a leading light in the cryptocurrency space which, during the same period, has experienced its own 'mini' industrial revolution. It is certainly not 'mini' by reference to the spectacular growth the space has seen or the amount of activity and buzz it has generated, but 'mini' only because of the diminutive, in relative terms, group of people who have been involved and the amount of time we're talking about. As at the submission of this article, the market cap of all alt coins/crypto currencies reported by stood at over $220bn shared amongst well over 1,200 coins/cryptocurrencies — by way of illustration of the explosion of this space, at the turn of the year global market cap stood at just $17bn — an astounding 1,300% growth in less than eleven months. Bitcoin dominance stands at approximately 57%.

The burgeoning nature of this industry means that investor protection, and the general lack thereof, is a hotly debated subject, part of which debate is the distinction between utility and security tokens. In simple terms, if a token looks like, acts like or smells like a security token, then it IS a security token. If it qualifies as such, the tokenisation of the security does not operate to take the product out of the scope of the key regulations governing such financial instruments. In the EU (which, of course, Gibraltar will be leaving, kicking and screaming, in 2019), relevant regulations are the Prospectus Directive, MiFid, AIFMD and the 4th AML Directive. In the American context, falling within scope of the SEC's reach is, of course, a principal concern of many token developers, particularly where the developers seek to market the token to US investors — in fact, US utility token creators favour referring to their fundraising initiatives as 'token generation events', avoiding the 'ICO' nomenclature for fear of being found guilty by association of promoting a security in breach of regulations.

The distinction between utility/security is the basis of many of the official statements we have seen from regulators around the world this year, the most recent of which came from ESMA in mid-November. The European regulator issued timely advice to both investors and firms operating in the space, timely because, for the first time, advertising spend on the online search terms 'Buy Bitcoin' exceeded the spend on 'Buy Gold' as crypto appeared to accelerate its drive towards the mainstream, spurred in no small measure by the eye-watering, headline-grabbing performance of, for example, Bitcoin Cash.

So what makes a token a utility token? Key considerations are, amongst others, the nature of the participation that the token bestows on the token holder, whether the token grants any kind of governance action on the company in the vein of participation rights and whether the token entitles the holder to a payment of profit or other revenues from the company, whether distributed autonomously by the promoter's blockchain or otherwise. The detail of the functionality of the token is a key consideration as it is only on the basis of a case by case assessment of this functionality that a determination can be made on the legal nature of a token. This is, and should be for all token developers, a key part of the token launch process.

In the context of better defining the distinction and as part of continuing efforts to cement Gibraltar's position as a centre of excellence for blockchain business, the Gibraltar Government, in association with the Gibraltar Financial Services Commission and the cryptocurrency working group (co-chaired by ISOLAS' Joey Garcia), is working towards developing the regulatory framework for initial token offerings ('ITOs'). In the race to become one of the first jurisdictions to create such an environment, Gibraltar has the advantage of having already taken an important first step in the process –the creation of a regulatory environment and wider eco-system for DLT providers.

The forthcoming ITO regulations will be built on the foundations of the principles-based regime announced earlier this year and contained in the Financial Services (Distributed Ledger Technology Providers) Regulations 2017 ('the DLT regulations'). The DLT regulations seek to regulate only entities "carrying on by way of business, in or from Gibraltar, the use of DLT for storing or transmitting value belonging to others." Regulating on the basis of nine principles, in respect of which guidance notes are currently being drafted and should be public well before the DLT Regulations come into force on 1 January 2018, it is anticipated that the ITO regulations which will follow during 2018 will offer some legislative guidance as to what does and what doesn't constitute a utility token.

Time will tell, in the context of the tokenisation of securities, whether the market will see the development of specific regulation for such tokenised 'financial' instruments and what, if any, advantages might be built in for their promoters. One thing is certain — there is a long way to go towards bridging the gaping trust chasm between the cryptocurrency space and mass market adoption. The development of certainty of definition is an important part of that process but so too is the deployment and successful management of a regulatory space where relative safety can be found by the many investors yet to be wooed by this new era in the story of financial investments.

This article first featured on the November/December 2017 edition of 'The Ghost in the Machine, ADM Investor Services International's industry and client newsletter — the full newsletter can be found by clicking the link below:

The Ghost in the Machine — November/December 2017

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