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ICOs and crypto funds in the context of recent regulatory decisions

John Rochester, Mourant Ozannes, Partner, Guernsey, 31 October 2017

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In the sixth of a series of regulatory columns by experts in Guernsey’s legal sector, we consider the popularity of initial coin offerings (ICOs) and their future in the face of increasing global regulatory attention.

Most people should by now have at least heard of blockchain – a distributed ledger or decentralised database of digital transactions grouped together in a cryptographically protected 'block' with other transactions that have occurred within a similar timeframe and have been circulated around the entire network. One thing virtually all tech investors acknowledge is that blockchain, the underlying technology behind cryptocurrencies, is here to stay. The digital ledger is already being used for payments, mortgages and incorporation documents. The most famous blockchain is probably Bitcoin – the first and greatest of the cryptocurrencies.

At the time of writing, Bitcoin's total value, or market capitalisation, is close to US$100 billion - bigger than that of Morgan Stanley, the American investment bank. At the start of this year it was just $15 billion. Ethereum, the second biggest cryptocurrency, is now worth almost $30 billion. Those who have gone deeper down the blockchain rabbit hole may also have heard mention of ICOs - or initial coin offerings (also known as ITOs, or initial token offerings). An ICO is an alternative means of raising funds – think of it as crypto-crowdfunding (typically accessible only by investors using cryptocurrencies). A start-up strikes upon a novel and unique product or service, but needs significant capital to develop that service or product. Rather than turning to the traditional debt or equity markets, or to venture capital, these new start-ups have developed the ICO. Investors (typically via a ‘white paper’ on the company's website) will be invited to invest, in exchange for tokens (as opposed to shares, as in a traditional IPO).

These tokens do not constitute a traditional equity or ownership interest in the underlying company, but rather can be considered (bluntly) as akin to an IOU – the investor can, once the underlying company is up and running and its product or service operational, exchange the tokens for that service or product. If the service or product proves popular enough, there may even be a secondary market for the trading of tokens.

Although an ICO is in many ways similar to the traditional IPO, the fundamental difference is of course that the investor receives a token, rather than a share. As a result, the vast majority of ICOs have been completed without regard to securities legislation or regulation, seemingly on the basis that a ‘token’ is not a ‘security’. Indeed, the Financial Times has referred to ICOs as ‘unregulated issuances of crypto coins’. ICOs have therefore become a quick, cheap and easy alternative to more traditional ways of raising funds.

The popularity of ICOs has exploded in 2017, with some staggering fundraising results. It is estimated that around 20 ICOs are introduced every month and, in the first half of the year alone, some $1.3 billion was raised through ICOs (up from a mere $26 million in 2014).

The Basic Attention Token, from the owners of the Brave Browser, raised $36m in just 30 seconds. Another project, Bancor Foundation, raised $153m in just three hours.

Crypto funds are also opening by the week as investors look seek returns on the fluctuations (sometimes wild) in the prices of cryptocurrencies such as Bitcoin, Ethereum and others that are emerging, while also obtaining stakes in new ICO projects as noted above. The new crypto hedge funds can take a variety of approaches, betting on new coins issued to raise ICOs, price direction or differentials between rates on the many cryptocurrency exchanges. For now, investors in crypto funds are high-net-worth individuals, companies managing money for wealthy families, private wealth managers and some venture capital investors.

These funds have offered institutional investors, who might be unfamiliar with the market, a potential route into the world of digital currencies. However, because most of the funds are relatively small and have microscopic track records, and because cryptocurrency price swings have been so pronounced, the world’s pension funds, insurance companies and large mutual funds are still looking at the crypto asset class with some caution...for the time being.

The turning of the tide?

As with all bubbles, however, recent events have led to suggestions that the ICO bubble may be about to burst. The US Securities and Exchange Commission (in a so-called investor bulletin published on 25 July) has stated that tokens issued through an ICO may be considered to be securities and therefore subject to federal securities laws. The bulletin contained a stark warning to fund-raisers to take care in the design of their ICOs to ensure compliance, if that is necessary. Hong Kong and Singapore have made similar noises. China has gone one step further, banning and 'deeming illegal' the practice of raising funds through ICOs, stating that any funds raised in an ICO based in China ought to be returned to investors.

At the time of writing, the SEC has recently rejected proposals to change existing rules to allow the listing of Bitcoin exchange-traded funds or ETFs. Such a rule change would have cleared the way for the first exchange-traded fund to track the digital currency bitcoin. The SEC said the proposed Bitcoin ETF was not consistent with rules that required a security to be "designed to prevent fraudulent and manipulative acts and practices and to protect investors and the public interest." In order for such a product to have met this standard, the SEC wrote that "the exchange must have surveillance-sharing agreements with significant markets for trading the underlying commodity or derivatives on that commodity [and] those markets must be regulated." The SEC said that ‘significant markets’ for bitcoin remained unregulated.

By contrast, the Canadian (Quebec) financial regulator has adopted perhaps a more pragmatic approach. Although it determined that a token sale by Impak Finance, a platform for investing in socially responsible enterprises, is indeed a security, it accepted the company into its regulatory sandbox (a consortium of provincial securities regulators, formed to jumpstart fintech projects that do not easily fit within the existing legal framework). As a consequence, Impak Coin will become the first regulated ICO based in Canada. The Canadian regulator seems willing to apply 'light touch' regulation to the offering, allowing Impak to avoid complying fully with rules to which it would normally subject issuers so as to protect investors from sharp practice.

The Isle of Man has also taken an accommodating approach to compliant ICO organisers. This Crown Dependency has recently created a set of rules to allow token sales to be compliant with AML and KYC regulations.
 
Next steps

It is clear that regulators the world over are now catching up with ICOs and crypto funds. They are taking a keener interest than ever before in this new technology and examining its structures to decide how to treat it (and indeed regulate it) in their jurisdictions.

Given the popularity of ICOs and their potential to make real changes to fundraising (even in non-tech industries), it seems unlikely that the coin, or token, offering will disappear in the face of this re-energised regulation. The ICO bubble will not burst, but will rather evolve and take on new forms. We expect that 'ICO 2.0' will be a compliant, regulator-friendly model, which should then provide a truly viable alternative to the traditional debt and equity markets.

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