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Initial coin offerings

Asking the right regulatory questions

15 May 2018

Initial coin offerings or ICOs are growing rapidly. Essentially a method of crowdfunding facilitated through blockchain and cryptocurrency technologies, ICOs are reported to have raised almost $10 billion globally from the start of 2017 despite being denounced by some commentators as Ponzi schemes. Companies and financial institutions are keen to explore the possibilities of ICOs – whether as a fundraising method or to cash in by acting as advisers or arrangers – but what are the risks, how are ICOs regulated and how might this change?

The tokens under an ICO will typically entitle holders to a right derived from the underlying asset or business arrangement, for example:

  • The right to a profit or asset (such as the distribution of actual profits or through the repurchase and the virtual destruction (termed ‘burning’) of repurchased tokens which theoretically reduces supply, so increasing the token price).
  • A right of use (say of a system or particular service offered by the issuer).
  • Voting rights (for example, as a participant of a decentralised currency exchange operated by the issuer).
How does it work?

ICOs are typically announced through online channels such as cryptocurrency forums and websites. Most issuers will provide access online to a white paper describing the project and key terms of the ICO (its economic terms, subscription details, timeline, for example), and providing information on the status of the project as well as the key team members involved.

In the subscription process, the participant generally is required to transfer cryptocurrency to the issuer – typically to one or more designated addresses (an online reference for cryptocurrencies similar to an account number) or online wallets of the issuer. Subscriptions may be completed in minutes. A participant may also be rewarded with tokens by taking certain actions, such as marketing on cryptocurrency forums. Once the ICO is completed, the tokens will be distributed to the participants’ designated addresses or online wallets. Issuers may have tokens listed on cryptocurrency exchanges (eg, Poloniex or Bittrex) to trade against other cryptocurrencies to create liquidity and value.

What should you ask?

Here are some questions to consider before deciding whether to participate in an ICO; the regulatory implications are much broader than simply considering whether the tokens issued are regarded as ‘currency’ or ‘securities’. Because blockchain platforms such as Ethereum operate without borders, issuers/operators must carefully structure ICOs to be compliant with regulations across multiple jurisdictions. Similarly, participants and service providers must be mindful of the regulations applicable to their own jurisdictions, including those by virtue of extra-territorial effect.

  • Who is the issuer and in which jurisdiction(s) will it operate?
  • Who are the service providers, what are the services being provided, and where will they perform their service operations?
  • Who are the participants of the ICO and in which jurisdiction(s) are they based?
  • How and by what means could participants acquire the tokens? For example, by crowd sale with subscription through payment of other cryptocurrency, or by performance of certain actions?
  • What is the asset or business arrangement underlying the tokens? What rights does the participant acquire from holding the tokens, for example, a right to profit, right to use or voting rights?
  • What are the economics behind the tokens (for example, how can the participant expect to obtain a return, monetary or otherwise, if at all)?
  • What are the underlying operations of the issuer (for example, is it a business venture or new technology solution) and how is it structured/managed/operated (for example, fully decentralised with no formal legal structure or through a legal vehicle)?
Regulatory analysis

Taking into account the answers to the questions above and any other relevant circumstances, a regulatory analysis can then be undertaken for each of the relevant jurisdictions (ie, those of the issuer, the service providers and the participants). Some points to note:

  • Think broadly about what could impact your position. For example, issuers should always consider the regulations of each potential participant’s jurisdiction as they may affect how an issuer may market to or accept subscriptions from participants.
  • Each party involved is likely to have a different perspective. For example issuers may be interested to know which jurisdiction is the most regulatory ‘friendly’ for it to perform the underlying operations or to host the ICO; a service provider may be interested to know whether the services it is providing are regulated services, and the participants would want to confirm that it is legal for them to participate in the ICO.
  • What is the legal nature of the tokens being offered under the ICO in the relevant jurisdiction? For example, would it be categorised as any of the following in accordance with the laws of each relevant jurisdiction and what are the regulatory implications? In many jurisdictions this is likely to vary depending on the exact terms of the tokens being issued and the nature of the treatment of these legal concepts in that jurisdiction.
    • Currency
    • Commodity
    • Security
    • Property
    • Structured product or derivative contract
    • Foreign exchange contract
    • Loan
    • Deposit
    • Collective investment scheme/fund
    • Insurance product
    • Other regulated investment contract or product
  • Could any circumstances arise that would trigger regulatory licensing/registration/authorisation requirements and/or other regulatory compliance requirements with respect to the nature of the tokens being offered under the ICO and the proposed role of each of the issuer and each service provider and participant under the ICO? Have relevant requirements, such as the obligation to undertake anti-money laundering and know-your-client checks, been complied with? The following (non-exhaustive) list of activities may trigger such requirements, although again this will vary depending on the jurisdiction and specific circumstances:
    • Dealing/marketing/offering/advisory activities relating to securities or any other regulated contract or product
    • Money lending activities
    • Deposit taking activities
    • Operation of stored value facilities
    • Operation of securities, commodity or other regulated exchange
    • Management of a collective investment scheme/fund
    • Remittance and/or money changing activities
    • Insurance brokerage activities
    • Business operation/establishment
    • Handling of personal data/privacy
    • Tax presence
    • Intellectual property
    • Gambling

There is no one-size-fits-all solution for designing a regulatory analysis framework for ICOs and the regulatory analysis we have outlined is by no means exhaustive. The regulatory analysis will be affected by the laws and regulations of the relevant jurisdictions, the nature of the crypto-world and its ongoing evolution, the usage and meaning of the term ICO, and the fact that the structure and nature of ICOs may change or evolve very quickly.

To read the full briefing, click here.