ICOs: a hype or here to stay?
12 June 2018
Valeria Hoffman of Dentons gives an overview of the phenomenon of coin and token offerings, as well as their legal background
Image: Shutterstock
Initial coin offerings (ICOs) or initial token offerings (ITOs) seem to be the rising star of the alternative finance industry over the past two years. Its supporters and opponents are divided into two hostile camps, where the respective rhetoric ranges from the accusation that most ICOs are scum and fraud to the glorification of ICOs, leaving blockchain as the beginning of a new era of technical progress and innovation. As is often the case with new developments that have great public resonance, both parties are equally right and wrong.
On the one hand, a lot of ICOs indeed make use of the current hype and broad public interest, as well as taking advantage of the fact that investors—especially retail investors—generally tend to be over optimistic and are prone to herd behaviour. Early bird offerings, ‘take it or leave it’ procedures and unlimited funding periods, where the issuer can just wait until the required amount of financing is raised, increase the psychological effects on the investors and promote a lack of information and transparency. Even when sufficient information about the ICO is available to them, investors tend to invest just because it is an ICO. The useless Ethereum Token ICO is a great example of this, having raised contributions amounting to $178,223 despite the responsible persons clearly stating that the token is absolutely useless and that the money will be used to buy televisions.
On the other hand, blockchain technology does indeed provide many benefits. Here it is important to understand that blockchain was not initially developed with the finance industry in mind, although bitcoin—the most famous example of a blockchain application—clearly has a financial connection. However, blockchain technology as such can be used for a plethora of purposes, such as logistics tracking, counterfeit protection and origin tracking with regard to various products. For companies seeking financing an ICO can be a measure of last resort or an easier and less expensive strategy to raise money. Blockchain technology enables the creation of new tokens via a so called ‘smart contract’ which is a computer programme, functioning on an ‘if-then’ basis. Usually, the issuer will use the Ethereum blockchain and issue a so called ERC20 token. However, there are also other distributed ledger technology providers, which allow the definition and launch of tokens such as the smart asset system of the NEM blockchain. When compared to a traditional debt or equity financing, token issuers face fewer administrative burdens and intermediary costs, as well as being able to approach investors directly—at least at first sight.
A closer look, however, indicates that the charming simplicity of ICOs and the assumed lack of regulatory and administrative hurdles is deceptive. Although the crypto token hype initially took the supervisory authorities around the world by surprise, they have sprung into action these past couple of months, making it abundantly clear that players in financial markets are subject to existing regulations whether they use blockchain for their activities or not.
Accordingly, it all comes down to the classification of the respective tokens and the assessment of the rights and benefits which are attached to such tokens. As for Germany, the German Financial Supervisory Authority differentiates between so called utility tokens, security tokens and currency tokens. Utility tokens grant the investor the right to participate in a certain network created by the issuer and to obtain products or services via this network. Security tokens are tokens bearing security like rights and are comparable to bonds or shares. One could also say that they are ‘tokenised’ debt or equity instruments, where the issuer could have opted for the traditional financing route via an IPO or private placement but decided to use blockchain technology instead. Finally, currency tokens like bitcoin are designed for payment and are widely accepted as a means of payment between various parties. Interestingly enough, security tokens are the easiest to handle. This is because once the token is classified as a security token, the regulatory demands and requirements are easily determinable. A token which is comparable to a bond will be treated as a bond and a tokenised share will be treated as a share. The issuer will certainly need to comply with the respective provisions of the applicable prospectus regime or the Market Abuse Regulation (EU) 596/2014 and the respective intermediaries will need to ensure compliance with the German Banking Act, for example when advising investors with regards to such tokens, but the regulatory framework is more or less clear and contains few uncertainties.
However, issuers frequently try to avoid the aforementioned regulatory regime, as well as the application of the security regime, by claiming that they only have a utility token or, alternatively, a hybrid token combining the elements of a utility and currency token. The regulatory treatment of such tokens is harder to determine as the supervisory authorities decide how to proceed on a case-by-case basis, usually after undertaking a detailed assessment of the token’s features.
The most important thing to note with regards to the German Financial Supervisory Authority’s stance, however, is the classification of virtual currencies (and comparable instruments) as ‘accounting units’ in terms of sec. 1 (11) Nr. 7 second alternative of the German Banking Act.
In 2016, the German Financial Supervisory Authority qualified bitcoins as accounting units pursuant to sec. 1 (11) Nr. 7 second alternative of the German Banking Act. According to this qualification, accounting units are comparable to foreign currencies without being legal instruments of payment. This also includes any substitute currency that is used as means of payment in multilateral payment networks under private contracts. This legal classification applies to all virtual currencies, according to the German Financial Supervisory Authority, and does not depend on the underlying software or encryption technology. Although the market is currently slowly learning to distinguish between ‘tokens’ and ‘coins’, one can assume that the German Financial Supervisory Authority did not intentionally restrict their assessment to ‘coins’ (for example, excluding tokens) in 2016. Broadly speaking, a crypto coin can be limited to a means of payment, while a token has wider functionality. In general, a utility token will also have a ‘payment’ aspect; usually being a hybrid token and therefore also a ‘means of payment’. Accordingly, compared to other European (and global) regulators, the German Financial Supervisory Authority is in a more or less comfortable situation with regards to virtual currencies—and any kind of (payment) tokens—nearly all of them can be classified as accounting units and therefore as financial instruments in terms of the German Banking Act.
The mere issuance of such ‘accounting units’ is not subject to a licence requirement under the German law, so far; however, further services related to crypto assets, such as investment advice, investment brokerage, financial portfolio management etc. will likely raise some issues with the supervisory authority.
Considering the EU Commission’s ongoing effort to simplify (traditional) public funding for small- and medium-sized enterprises (SMEs) on the one hand and to ensure a harmonised regime for European crowdfunding service providers on the other, one has to question the actual scope of and need for ICOs. The new Prospectus Regulation (EU) 2017/1129, which will be fully applicable from 2019 onwards, provides for several exemptions from the prospectus obligation for public offerings. In all probability, the most important exemption will already be applicable from 21 July 2018 onwards, namely prospectus free offerings up to €8 million. The German draft implementing the legislative proposal makes clear that Germany is going to make full use of this open clause and the €8 million threshold. Another attempt was made with the new proposal for a regulation on European crowdfunding services providers introducing a new European label for investment-based and lending-based crowdfunding platforms (European Crowdfunding Service Providers for Business) and aiming to enable crowdfunding platforms to easily provide their services across the EU.
Platforms will only have to comply with one set of rules, both when operating in their home market and in other EU countries (the so called passporting regime). These and other measures targeting SMEs are based on the EU Commission’s regulatory approach towards increased availability of market-based financing across the EU since launching the Capital Markets Union (CMU) in 2015. It will, therefore, definitely make sense for blockchain related issuers and projects to raise money via an ICO or ITO. Other issuers without any connection to blockchain should ask themselves whether they are indeed on the right track with an ICO or whether traditional debt or equity financing would be more suitable. After all, the next two years will show whether ICOs will be regarded as an industry-specific financing option or whether the market is heading towards the tokenisation of traditional finance instruments.
On the one hand, a lot of ICOs indeed make use of the current hype and broad public interest, as well as taking advantage of the fact that investors—especially retail investors—generally tend to be over optimistic and are prone to herd behaviour. Early bird offerings, ‘take it or leave it’ procedures and unlimited funding periods, where the issuer can just wait until the required amount of financing is raised, increase the psychological effects on the investors and promote a lack of information and transparency. Even when sufficient information about the ICO is available to them, investors tend to invest just because it is an ICO. The useless Ethereum Token ICO is a great example of this, having raised contributions amounting to $178,223 despite the responsible persons clearly stating that the token is absolutely useless and that the money will be used to buy televisions.
On the other hand, blockchain technology does indeed provide many benefits. Here it is important to understand that blockchain was not initially developed with the finance industry in mind, although bitcoin—the most famous example of a blockchain application—clearly has a financial connection. However, blockchain technology as such can be used for a plethora of purposes, such as logistics tracking, counterfeit protection and origin tracking with regard to various products. For companies seeking financing an ICO can be a measure of last resort or an easier and less expensive strategy to raise money. Blockchain technology enables the creation of new tokens via a so called ‘smart contract’ which is a computer programme, functioning on an ‘if-then’ basis. Usually, the issuer will use the Ethereum blockchain and issue a so called ERC20 token. However, there are also other distributed ledger technology providers, which allow the definition and launch of tokens such as the smart asset system of the NEM blockchain. When compared to a traditional debt or equity financing, token issuers face fewer administrative burdens and intermediary costs, as well as being able to approach investors directly—at least at first sight.
A closer look, however, indicates that the charming simplicity of ICOs and the assumed lack of regulatory and administrative hurdles is deceptive. Although the crypto token hype initially took the supervisory authorities around the world by surprise, they have sprung into action these past couple of months, making it abundantly clear that players in financial markets are subject to existing regulations whether they use blockchain for their activities or not.
Accordingly, it all comes down to the classification of the respective tokens and the assessment of the rights and benefits which are attached to such tokens. As for Germany, the German Financial Supervisory Authority differentiates between so called utility tokens, security tokens and currency tokens. Utility tokens grant the investor the right to participate in a certain network created by the issuer and to obtain products or services via this network. Security tokens are tokens bearing security like rights and are comparable to bonds or shares. One could also say that they are ‘tokenised’ debt or equity instruments, where the issuer could have opted for the traditional financing route via an IPO or private placement but decided to use blockchain technology instead. Finally, currency tokens like bitcoin are designed for payment and are widely accepted as a means of payment between various parties. Interestingly enough, security tokens are the easiest to handle. This is because once the token is classified as a security token, the regulatory demands and requirements are easily determinable. A token which is comparable to a bond will be treated as a bond and a tokenised share will be treated as a share. The issuer will certainly need to comply with the respective provisions of the applicable prospectus regime or the Market Abuse Regulation (EU) 596/2014 and the respective intermediaries will need to ensure compliance with the German Banking Act, for example when advising investors with regards to such tokens, but the regulatory framework is more or less clear and contains few uncertainties.
However, issuers frequently try to avoid the aforementioned regulatory regime, as well as the application of the security regime, by claiming that they only have a utility token or, alternatively, a hybrid token combining the elements of a utility and currency token. The regulatory treatment of such tokens is harder to determine as the supervisory authorities decide how to proceed on a case-by-case basis, usually after undertaking a detailed assessment of the token’s features.
The most important thing to note with regards to the German Financial Supervisory Authority’s stance, however, is the classification of virtual currencies (and comparable instruments) as ‘accounting units’ in terms of sec. 1 (11) Nr. 7 second alternative of the German Banking Act.
In 2016, the German Financial Supervisory Authority qualified bitcoins as accounting units pursuant to sec. 1 (11) Nr. 7 second alternative of the German Banking Act. According to this qualification, accounting units are comparable to foreign currencies without being legal instruments of payment. This also includes any substitute currency that is used as means of payment in multilateral payment networks under private contracts. This legal classification applies to all virtual currencies, according to the German Financial Supervisory Authority, and does not depend on the underlying software or encryption technology. Although the market is currently slowly learning to distinguish between ‘tokens’ and ‘coins’, one can assume that the German Financial Supervisory Authority did not intentionally restrict their assessment to ‘coins’ (for example, excluding tokens) in 2016. Broadly speaking, a crypto coin can be limited to a means of payment, while a token has wider functionality. In general, a utility token will also have a ‘payment’ aspect; usually being a hybrid token and therefore also a ‘means of payment’. Accordingly, compared to other European (and global) regulators, the German Financial Supervisory Authority is in a more or less comfortable situation with regards to virtual currencies—and any kind of (payment) tokens—nearly all of them can be classified as accounting units and therefore as financial instruments in terms of the German Banking Act.
The mere issuance of such ‘accounting units’ is not subject to a licence requirement under the German law, so far; however, further services related to crypto assets, such as investment advice, investment brokerage, financial portfolio management etc. will likely raise some issues with the supervisory authority.
Considering the EU Commission’s ongoing effort to simplify (traditional) public funding for small- and medium-sized enterprises (SMEs) on the one hand and to ensure a harmonised regime for European crowdfunding service providers on the other, one has to question the actual scope of and need for ICOs. The new Prospectus Regulation (EU) 2017/1129, which will be fully applicable from 2019 onwards, provides for several exemptions from the prospectus obligation for public offerings. In all probability, the most important exemption will already be applicable from 21 July 2018 onwards, namely prospectus free offerings up to €8 million. The German draft implementing the legislative proposal makes clear that Germany is going to make full use of this open clause and the €8 million threshold. Another attempt was made with the new proposal for a regulation on European crowdfunding services providers introducing a new European label for investment-based and lending-based crowdfunding platforms (European Crowdfunding Service Providers for Business) and aiming to enable crowdfunding platforms to easily provide their services across the EU.
Platforms will only have to comply with one set of rules, both when operating in their home market and in other EU countries (the so called passporting regime). These and other measures targeting SMEs are based on the EU Commission’s regulatory approach towards increased availability of market-based financing across the EU since launching the Capital Markets Union (CMU) in 2015. It will, therefore, definitely make sense for blockchain related issuers and projects to raise money via an ICO or ITO. Other issuers without any connection to blockchain should ask themselves whether they are indeed on the right track with an ICO or whether traditional debt or equity financing would be more suitable. After all, the next two years will show whether ICOs will be regarded as an industry-specific financing option or whether the market is heading towards the tokenisation of traditional finance instruments.
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