Out-Law Analysis 6 min. read

Regulators playing catch-up on initial coin offerings

ANALYSIS: Businesses seeking to offer and sell digital assets to investors as a means of raising capital face tighter regulation in light of recent announcements made by regulators based around the world.

However, the approach regulators have outlined is not uniform, meaning fundraisers and investors alike face different rules and expectations over how they will proceed with 'initial coin offerings' (ICOs) in different parts of the world.

Regulators in major financial markets have all addressed the topic, some in more detail than others.

Their interest in clarifying regulatory matters reflects the sudden popularity of ICOs among businesses and is perhaps the latest example of how advancing technology is challenging existing regulatory frameworks.

What are ICOs?

ICOs are an increasingly popular way for businesses to raise money.

Typically, businesses will develop a digital token, such as their own proprietary virtual currency, and look to sell those tokens to investors in a bid to raise capital in return for existing cryptocurrency, such as Bitcoin, Ether or Ripple rather than fiat currency such as dollars, euros or pounds. The trade of these tokens is recorded using blockchain 

Investors can in most cases sell on those tokens for profit on certain peer-to-peer exchange platforms should the value of the tokens increase. They are sometimes further incentivised into buying the tokens by being given the opportunity to share in profits generated from the business ventures that benefit from their investment.

According to a report by the New York Times, more than $1 billion has been raised through ICOs since the beginning of 2017. PitchBook, referencing CoinDesk research, place the figure at $1.4 billion to-date.

The UK's Financial Conduct Authority (FCA) has said that it sees "various parallels" between ICOs and "initial public offerings, private placement of securities, or crowd sales". Initial public offerings (IPOs) are where businesses float on the stock market for the first time and make shares in their company available for purchase.

The approach to regulating ICOs in the UK

So far, the FCA's response to the rising popularity of ICOs has been muted. The regulator did, however, address the topic in a discussion paper on distributed ledger technology (DLT) (33-page / 779KB PDF) it published in April this year.

The FCA specifically asked firms to detail the legal and regulatory challenges they find "in fitting initial coin offerings into our regulatory framework".

The regulator did not provide much in the way of its own views about how existing regulation is engaged by ICOs, but did state that ICOs could "fall into the regulatory perimeter" depending on "how they are structured".

The FCA said it would review the feedback it gets to its discussion paper – the deadline for submissions was 17 July – and that it could potentially open up a further consultation if it wants to "take a closer look" at its regulatory requirements. The FCA is likely to address the topic of ICOs again before the end of 2017, according to a report by the Financial Times.

Regulators in the US and Singapore have offered much more detailed views on how existing regulations apply to ICOs.

The view of the US Securities and Exchange Commission  

In July, the Securities and Exchange Commission (SEC) clarified that it considers businesses that offer and sell virtual currencies as a means of raising capital to be subject to securities regulation in the US.

The SEC said: "Whether or not a particular transaction involves the offer and sale of a security – regardless of the terminology used – will depend on the facts and circumstances, including the economic realities of the transaction. Those who offer and sell securities in the United States must comply with the federal securities laws, including the requirement to register with the Commission or to qualify for an exemption from the registration requirements of the federal securities laws."

"The registration requirements are designed to provide investors with procedural protections and material information necessary to make informed investment decisions. These requirements apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralised autonomous organisation, regardless whether those securities are purchased using US dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology," it said.

"In addition, any entity or person engaging in the activities of an exchange, such as bringing together the orders for securities of multiple buyers and sellers using established non-discretionary methods under which such orders interact with each other and buyers and sellers entering such orders agree upon the terms of the trade, must register as a national securities exchange or operate pursuant to an exemption from such registration," the regulator said.

The SEC report (18-page / 172KB PDF) was prompted by an investigation it carried out into a German business, Slock.it, which had developed digital tokens to sell to investors. According to the report, however, some of Slock.it's assets were stolen by hackers. The theft occurred before the money accumulated from the sale of the digital tokens could be used to fund business projects that were intended to benefit from the investment. Slock.it had pledged to share earnings from those projects with investors in its tokens, the report said.

The SEC decided against taking enforcement action in the case.

A similar viewpoint expressed in Singapore

Just days after the SEC report was published, the Monetary Authority of Singapore (MAS) moved to clarify the regulatory position on ICOs in the city state. In its statement, MAS said that it had decided to regulate virtual currencies after it had "observed that the function of digital tokens has evolved beyond just being a virtual currency" and that the tokens may now "represent ownership or a security interest over an issuer’s assets or property".

"Such tokens may therefore be considered an offer of shares or units in a collective investment scheme under [Singapore law]," MAS said. "Digital tokens may also represent a debt owed by an issuer and be considered a debenture under the [legislation]."

As a result, offering digital tokens as security during a trade in assets, or issuing them as shares, will be a regulated activity in Singapore, subject to some exemptions applying.

The issuers of digital tokens that fall within the definition of securities in the Securities and Futures Act (SFA) in Singapore will be required to lodge and register a prospectus with MAS prior to offering them, unless they are exempt.

MAS has also said that platforms that enable secondary trading of digital tokens would have to be licenced, unless exempt. They firms will also be subject to the anti-money laundering and counter-terrorist financing regulations, it said.

Hong Kong follows Singapore closely

In the few weeks since MAS issued its statement, the regulatory approach to ICOs has been clarified in two other parts of Asia.

On 5 September, Hong Kong's Securities and Futures Commission (SFC) said that in some cases digital tokens could be classed as securities. In those cases, the sale or offer of those tokens would subject to Hong Kong's securities laws.

The SFC said that it had seen examples of some ICOs with "terms and features" that might mean the tokens on offer are securities.

Like MAS, the SFC said digital tokens could be regarded as shares or debentures.

It also said that if "token proceeds are managed collectively by the ICO scheme operator to invest in projects with an aim to enable token holders to participate in a share of the returns provided by the project, the digital tokens may be regarded as an interest in a 'collective investment scheme'".

Shares, debentures and interests in collective investment schemes are all regarded as securities under Hong Kong law, it said. Where this is the case, the "dealing in or advising on the digital tokens, or managing or marketing a fund investing in such digital tokens" will be regarded as a regulated activity, unless an exemption applies, the SFC said.

Firms must either obtain a licence from, or be registered with, the SFC to engage in a regulated activity that targets the Hong Kong public.

ICOs banned in China

While some regulators around the world have therefore clarified that ICOs are subject to regulation in some circumstances, China has taken a much tougher stance.

According to a Bloomberg reportthe People's Bank of China (PBC) has banned ICOs in the country, labelling the fundraising exercises as illegal.

The PBC said businesses that have already engaged in ICOs to raise funds must return the money to investors, and it further banned online platforms from facilitating the exchange of digital currencies into fiat currencies and prohibited banks in the country from providing services to those behind ICOs, the Bloomberg report said.

Luke Scanlon is an expert in financial services and technology at Pinsent Masons, the law firm behind Out-Law.com.

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