International Regulation of ICOs

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The Regulation of cryptocurrencies and in particular ICOs [Initial Coin Offering] where cryptotokens are issued to investors has become a matter of international concern. In recent weeks, due to a large number of successful funding rounds for a variety of companies and buy-in from some of the largest tech companies & financial institutions in the world, public and private sector interest in the blockchain industry has increased dramatically.

Many commentators feel that regulation is needed to reassure and protect investors and the public so that a ‘dotcom bubble’ is not created which would have an adverse effect on the uptake of blockchain and other DLT technologies. Journalists are already warning that ICOs can damage your health [ See FT 25th May 2017]

The problem facing advisers and entrepreneurs is that different jurisdictions have taken widely differing approaches to the issues surrounding compliance and regulation. In Europe, the approach seems to be to apply AML regulation to tokens in the 4th AML directive which follows the approach of the US Financial Action Task Force, an international body. Problems may arise as certain types of token ( for example those which only act as ‘fuel’ for a blockchain system) are not suited to this form of regulation, so any attempt to introduce this type of regulation may stifle innovation. Interestingly, it appears that the new Payments Service Directive 2015/2366 does not regulate cryptocurrencies and will probably not apply to tokens.

Coinbase has reported that the U.S. Securities and Exchange Commission [SEC] has suspended the trading of shares in an OTC-traded technology company based in Florida over questions about the accuracy of a planned initial coin offering [ICO].

This is the second ICO that has attracted the attention of the SEC. On 7th June this year, the regulator made public its attempts to suspend the trading of securities offering exposure to the company, called Sunshine Capital, citing “public interest” and the “protection of investors”. Of particular concern to the SEC was the value and liquidity of its ‘dibcoin’ cryptocurrency, launched last October, and the accuracy of statements describing the token and its related opportunities.

Issued on 9th August, the order was made against a firm called CIAO Group (now rebranded as NuMelo Technology), which trades on markets operated by OTC Markets Group. NuMelo first announced plans for an ICO on 6th July, at the time indicating a desire to bring a “digital financial products marketplace” based on blockchain tech to the African market.

The SEC felt that the firm ‘blurs the lines between its ideas, evoking the power of blockchain, promising a “$530 billion target market collaboration” and making bold claims about the ability of the technology to revitalise economic access in developing markets.

The action follows the publishing of the SEC report ‘DAO Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: dated 25 july 2017’ which investigated to discover whether the DAO, an unincorporated organization; UG (“”), a German corporation;’s co-founders; and intermediaries may have violated the federal securities laws. The Commission determined not to pursue an enforcement action in this matter but concluded that ‘based on the investigation, and under the facts presented, the Commission determined that DAO Tokens are securities under the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”).

This is a widely reported decision which has led other jurisdictions to plan a similar approach to the regulation of cryptocurrencies. States such as Texas, New York, California and Illinois have made important moves to (de-)regulate cryptocurrency activities. In August 2015, New York State changed its Financial Services Regulation to include regulation on cryptocurrencies and its operations. Among the activities subject to licensing requirement are: receiving cryptocurrency for transmission or transmission thereof; storing, holding or maintaining custody on behalf of others; buying, selling or performing exchange services as a customer business, controlling, administering or issuing cryptocurrency. As a consequence, no person is allowed to engage into cryptocurrency business activities without a license, and such licensing requirements cannot be overcome by using an agent.

Following closely on the US action, Singapore has recently announced that the MAS [Monetary Authority of Singapore] will regulate an ICO offering if it looks like a product that falls into Singapore’s Securities and Futures Act if it behaves like a stock or any other security.

Because of a lack of clarity around the position in the UK and USA, many entrepeneurs are basing their ICOs in Switzerland, where a 30 kilometer stretch of land from Zug to Zurich, known as Crypto Valley has encouraged investment by progressive laws, competitive hiring and low taxes.

On one view, regulation is not necessary as investors in token sales have to pay in Ether, itself a cryptocurrency and are therefore properly described as sophisticated investors. Those who invented this form of instrument believe that they should be self regulated by smart contracts i.e code can be written to ensure that the recipient organisations perform fairly. The DAO itself provided for a group of founders known as the ‘Curators’ who are responsible governance issues. The SEC however found that this was unsatisfactory:

‘Thus, the Curators exercised significant control over the order and frequency of proposals, and could impose their own subjective criteria for whether the proposal should be whitelisted for a vote by DAO Token holders. DAO Token holders’ votes were limited to proposals whitelisted by the Curators, and, although any DAO Token holder could put forth a proposal, each proposal would follow the same protocol, which included vetting and control by the current Curators.

While DAO Token holders could put forth proposals to replace a Curator,such proposals were subject to control by the current Curators, including whitelisting and approval of the new address to which the tokens would be directed for such a proposal. In essence, Curators had the power to determine whether a proposal to remove a Curator was put to a vote.’

It is therefore felt that pending clarification by the EU regulators the safest approach is for a prospective ICO to take full legal and financial advice ( other issues that need to be considered are VAT and data protection) and also introduce a robust process of governance and compliance, to ensure for example that a full technical specification has been written in the ‘white paper’ and that full protection is in place to ensure that funds are used in accordance with the representations made to the coinholders.