Regulation Authorities Pick Up Pace Issuing Guidelines On ICOs
Switzerland and Russia have indicated that they will be examining the regulation of ICOs. South Korea has banned local companies from raising capital through the new vehicle while China has draped a complete ban on ICOs. Canada, Hong Kong, Australia, Abu Dhabi and Lithuania have also entered the fray with guidelines.
Increased financial risk has raised a red flag for financial regulators as the ICO market continues to grow quite rapidly with over $2Bn raised in 2017 (See Graph). ICOs organized as a single entity make regulation much more feasible than regulating a decentralized cryptocurrency such as Bitcoin.
The key problem facing regulators however, and companies who plan to raise capital through ICOs, is the unclear categorization of new tokens and how regulators might classify the coin.
According to TokenMarket CTO Mikko Ohtamaa, most of the ICOs classify their tokens as utility tokens, app coin or donations with potential profits coming solely from speculative value. In doing so, they avoid being categorized as an issuer of equity security, which is heavily regulated in most jurisdictions.
Consequently, ICOs started to prohibit investors from the United States (and sometimes from Singapore) to participate in fear of being criminally liable. Some ICOs went as far as stating, in their terms of conditions, that the tokens have no intrinsic value. For example, Block.One, which raised approximately $185Mn, stated that their token is not “an investment, currency, security, commodity, a swap on a currency, security, or commodity or any kind of financial instrument.”
In July 2017, the U.S. Securities and Exchange Commission (SEC) stated that the sale of tokens through an ICO when made available to persons in the U.S. may be subject to the requirements of the federal securities law. SEC chairman Jay Clayton added in a statement that the SEC “seeks to foster innovative and beneficial ways to raise capital, while ensuring – first and foremost – that investors and our markets are protected.”
The Securities Act, also known as the Howey test, states that a security is “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” Therefore, the tokens that return revenue or profits to its investors are almost definitely classified as securities in the U.S. while the determination for other tokens would be made on case-by-case basis. Furthermore, the exchanges trading the ICO tokens that could be considered securities would need certain registrations. As a result, Hong Kong Exchange Bitfinex decided to end the trading of certain tokens for customers from the U.S. on its exchange. Shortly after the SEC released another report that warned about the potential fraudulent practices used during ICOs.
The Monetary Authority of Singapore (MAS) released a very similar warning that some tokens could qualify as securities and that ICOs should seek independent legal advice while also consulting MAS when appropriate. It specified that the tokens that represent ownership, debt or a security interest over an issuer's assets or property will be considered securities. Singapore also requires the platforms that facilitate trading of the tokens to be properly approved and recognized by the central bank. Canada and Hong Kong followed with very similar announcements saying that some tokens classify as securities and that they must comply with the current regulations in place. The latest regulatory guidelines, similar to other nations, has come from the Central Bank of Lithuania.
Australia’s corporate regulator has issued formal guidance in September stating that ICOs must comply with the regulatory framework in place. The legality of ICOs in Australia depends upon its circumstances such as how it is structured, operated and which rights are attached. The guidelines specify that some ICOs will fall under the general and consumer laws while other will be subject to the Corporations Act.
On September 4, China outright banned ICOs. The People's Bank of China (PBoC) stated that the tokens are "illegal and disruptive to economic and financial stability." PBoC also added that ICOs are a “kind of non-approved illegal open fund-raising behavior, suspected of illegal sale tokens, illegal securities issuance and illegal fund-raising, financial fraud, pyramid schemes and other criminal activities.” Moreover, PBoC demanded that all the proceeds from ICO activities must be refunded to investors and a refusal to do so will results in a severe punishment according to the law. Indeed, China-based ICOs such as LLToken, UIP, CCC, HMS, Atmatrix and NEO have released statements that they will refund investors.
On September 29, Financial Services Commission (FSC) of South Korea decided to take a similar approach and announced that they will ban all domestic companies from raising money through ICOs.
2017: ICOs Raise Over $2Bn Outpacing Angel & Feed VC Funding (Internet)
Source: Coindesk, CB Insights, Bloomberg, Diar
South Korea’s financial regulator threatened that violators involved in issuing of ICOs will face “stern penalties”. Contrary to the ban in China, it is still possible for domestic investors to participate in ICOs that are conducted outside of South Korea.
On the same day as South Korea’s ban, Switzerland’s financial regulator announced that it is examining a number of ICOs to determine whether some of them have violated regulatory provisions. ICO organizers have called for regulatory competition, in which the countries or regions can compete economically in order to attract ICOs to their jurisdiction. Switzerland, most notably the lakeside town of Zug, dubbed “Crypto Valley”, is known for having quite a favorable regulatory environment for cryptocurrencies and ICOs and therefore attracted many of the companies seeking an ICO. Cryptocurrency companies have historically not been required to have any specific license to operate. On top of that, Switzerland considers cryptocurrencies assets rather than securities under the current laws. ICOs are not regulated in Switzerland because they do not use the intermediary of a platform and instead use their own platform. However, Switzerland noted that depending on the structure of each ICO, some could be covered by the existing regulations of AML/CFT, banking law and securities trading. Regulations were expected even in Switzerland but ICOs are hopeful that the regulators will classify tokens as a completely new asset class rather than a security.
The Financial Services Regulatory Authority (FSRA) of Abu Dhabi, stated that the transparency of ICOs varies too greatly, causing some issuances to bear an extremely high risk of fraud. FSRA said that the ICOs will be treated within its regulatory framework but added that they are aware that ICOs do not fit neatly into existing regulatory classifications. They recommend that the companies that want to raise funds through an ICO should approach FSRA as early as possible to determine whether it falls under the body’s regulation. Moreover, FSRA stated that if the tokens exhibit the characteristics of a security, it would regulate them similarly to company issuing stocks. Any market intermediaries or secondary markets dealing with security-like ICOs will also have to register with the FSRA.
On October 11, Finance Minister Anton Siluanov said that Russia has officially decided to regulate “the process of issuing cryptocurrencies, the process of mining, the process of circulation”. Vladimir Putin stressed the need of regulation of cryptocurrencies through a regulatory environment, which would not create barriers for investors but rather protect the interests of citizens, business, and the state. Furthermore, the ministry expressed its support for the idea of purchase limits of cryptocurrencies but has not yet created a concrete control mechanisms or stated what these limits might be.
So far there are three different approaches from financial regulatory bodies around the world, however it remains very much a gray market. The first approach is a radical regulative oversight where a country decides to either fully ban or domestically ban the presence of ICOs as in the case of China and South Korea
The second, more conservative approach, is to issue a formal guidance that stresses that some ICOs and its tokens could qualify as securities and therefore must follow the local laws and regulations while seeking an independent legal advice and consulting the regulatory bodies. This has been the case with the United States, Singapore, Canada, Hong Kong, Australia, Abu Dhabi, Switzerland (to a certain extent), Russia and Lithuania.
The last approach is by far the most common, where no official statement regarding ICOs - either intentionally or unintentionally has been made. Some countries have released warnings but no official information regarding regulation.