Regulation of ICOs: the end or beginning of a healthy market?

One of the hottest – and also one of the most controversial – things in  the crypto currency environment are so-called  Initial Coin Offerings or ICOs. ICOs, which employ the use of crypto currencies, have become a popular means of fundraising for start-ups in recent months. The increasing need of blockchain technology and the lack of regulation allows them to raise money quickly in return to so-called tokens (also described as digital certificates). This hype has driven a steep rise in this sector’s market value, reaching a high of $177 bn.

The latest cryptocurrency boom however is beginning to stall as a growing number of regulators worldwide turn their attention to the ICOs world and have decided to come into action. China recently decided even to ban these ICOs. And others such as the US SEC, Singapore, Hong Kong, Russia and others followed soon though in a more lighter variant.

Is this the end of fundraising via ICOs or should it be seen as the beginning of a healthy market?

ICO hype
ICOs have become highly popular. In the past months there has been a complete hype around ICOs. ICOs have allowed digital currency start-ups, to raise millions of dollars quickly, in many cases from ordinary investors. The ICO fever is especially triggered by the success of Ethereum, the platform that invented the digital currency Ether. Already in 2014 Ethereum arranged a very successful ICO.

More than $1,6 billion has been raised worldwide from these ICOs up till now. China for example has seen 65 ICOs and 2.62 billion yuan ($400 million) raised from more than 100.000 individuals so far in 2017.

But what are ICOs?
An initial coin offering or ICO is a relatively recent innovation for cryptocurrency developers, that has  become one of the important financing channels for blockchain start-ups.  It provides start-ups a completely new way to fund their projects using blockchain and crypto currencies such as Bitcoin, Ether (Ethereum), XRP (Ripple), Litecoin and others.  By using blockchain technology, this enables companies to raise funds without using venture capitalists, banks and other intermediaries associated with traditional fundraising.  

An ICO is a sort of initial public offering (IPO) that involves issuing a project-or-company-specific token on the blockchain at the launch of the project which investors, potential users and suppliers can purchase with cryptocurrencies. Owners of these tokens will be registered on a blockchain.

Compared with real public offerings, investors however do not get a share in the company, but via these tokens they could (often) buy services / products of that start-up. The tokens give the holder a right to participate in a given blockchain activity. For instance, a company might require people to have tokens to join an automated investment project or to get access to cloud computing services. But the tokens can also be bought and sold on secondary markets. The owners of digital tokens can exchange them for cash or bitcoin on special websites. These crypto currencies can be traded without interference of a bank or other intermediaries, completely out of sight of regulators.

Is ICO a risky business?
However, not everything about ICO is so bright. Cryptocurrencies exist in a legal grey area and thus bear a number of risks, especially for investors. While only wealthy accredited investors meeting strict requirements issued by national regulators can invest in private companies, anyone can invest in an ICO, even anonymously. Unless, that is, the authorities step in with ICO regulations.

Since the ICO concept was first mooted, there have been concerns over its legality. Experts are warning that “selling a cryptographic token which entitles the holder to a share or profits in a business could be a violation of financial regulations”.

“The rise of coin offerings has disrupted social and economic order and created relatively large hidden financial risks, and in some cases may amount to fraud.” “Misleading rates schemes at home and abroad may constitute fraud and amount to illegal fundraising.” China National Internet Finance Association

That is why regulators are increasingly warning investors who should be warry to suspected crimes.

-          According to the SEC investors have no idea what their money will be used for exactly. For investors there is no official guarantee or promise whatsoever what the company will do with their invested money. If it fails to deliver on its promise, there is no real penalty for doing so.

-          Since virtually none of these ICOs are registered with the SEC, none of them are officially recognized by the U.S. Non-registered projects are not covered by federal securities laws. That means investors in failed projects will not have their funds recovered.

-          For the SEC the most concerning aspect of ICOs is how they are organized. In most cases, investments on such a scale are only accessible by accredited investors. In the world of ICOs, however, the requirement of investors to be registered rarely exists.

And there are plenty of other things to be wary of when looking at cryptocurrency ICOs.

Regulators and ICOs
Regulators worldwide have turned their attention to these ICOs. A growing number are going to take action, now scrambling to come up with new rules on digital coin offerings.  They are responding to the rising media profile of both ICOs, as well as cryptocurrencies themselves, warning that, in many cases, the tokens for sale are “simply a new form of shares – and that selling them without a license violates securities laws”.

China recently announced to ban ICOs in their country immediately, declaring them illegal and a threat to financial stability. But also regulatory authorities in other countries worldwide are looking at ICOs to regulate or ban these in one way or another. The US Securities and Exchange Commission (SEC) strengthened its rules in July, while regulators in other countries such as Singapore, Hong Kong and Russia are warning that digital currencies are no safe investment.  The IMF issued a staff note in June that speculated about the legal impact of ICOs.

China
Chinese regulators including the People’s Bank of China (PBoC) and the Chinese Securities Regulatory Commission are looking if they should ban ICOs altogether, or just until the country has more stringent regulation in place.

A ruling from the Chinese central bank declared it illegal to raise money through launching new cryptocurrencies. Individuals and organisations that have completed ICO fund raising should make arrangements to return funds, according to a joint statement from the bank, China’s securities and banking regulators, and several other government departments.

US SEC
While not as wide-ranging as the Chinese statement,  the US Securities and Exchange Commission (SEC) leaned in the same direction. The SEC officially confirmed that is was looking into regulation of ICOs and issued its own ruling in July. This by saying that some of the tokens for sale are actually securities -  and are thus subject to the agency’s regulation. The SEC has also posted a bulletin warning investors to be careful in deciding whether to invest in these things. The US regulator is mainly concerned with the risks these ICOs pose.

The SEC’s statement was prompted by the conclusion of its investigation into the biggest ICO failure to date, a 2016 experiment called the DAO which ended up losing millions of dollars’ worth of cryptocurrencies due to a bug in its software. The SEC’s  Report of Investigation found that tokens offered by “The DAO” were securities and therefore subject to the federal securities laws.

The Report confirms that issuers of distributed ledger or blockchain technology-based securities must register offers and sales of such securities unless a valid exemption applies. Additionally, securities exchanges providing for trading in these securities must register unless they are exempt. “This to ensure that investors are sold investments that include all the proper disclosures and are subject to regulatory scrutiny for investors' protection."

In the coming weeks or months, the SEC will likely announce more detailed guidelines as well as enforcement proceedings against some of the most ‘fly-by-nigh” ICOs.

Russia
Following China’s ban on ICOs , also the Russian Central Bank, has issued a new statement on the risks of taking part in initial coin offerings (ICOs) and using cryptocurrencies.  The central bank went on to say that it will not “greenlight” any cryptocurrency trading on any official exchanges, nor would it approve the use of the tech for infrastructure purposes. Nevertheless, the Bank of Russia does not serve as a financial regulator in Russia; that role falls to the State Duma and the Ministry of Finance.

Hong Kong
Hong Kong's chief securities regulators issued a warning of their own on ICOs, remarking that some tokens may constitute securities, echoing statements issued by officials in Singapore, Canada and the US in recent weeks.

UK
In the UK cryptocurrencies and tokens are considered “private currency”, and as for ICOs specifically, issuers are operating on their own interpretation of the law. The paper the Bank of England launched on DLT and crypto tokens is not binding. But also the landscape for ICOs in the UK could very well change in the near future.

Singapore
Singapore also followed saying it too will regulate offerings that are deemed to be securities. The Monetary Authority of Singapore (MAS) published a note to inform that it will regulate some (but seemingly not all) ICOs. MAS will regulate an ICO offering if it looks like a product that falls into Singapore’s Securities and Futures Act, i.e. if it behaves like a stock or any other security. MAS will also regulate exchanges and other services that enable post-ICO coin trading, the note said.

The MAS disclosure has been welcomed by one industry body, ACCESS, which is comprised of representatives from Singapore’s cryptocurrency and blockchain industries.

“ACCESS welcomes today’s statement from MAS. They recognize the wide variety of digital tokens available and that not all fall under the remit of the SFA. We appreciate their clarification and reiteration of their position on virtual currencies,” an ACCESS spokesperson

How did the market react?
Since China’s measures to ban ICOs completely they brought about a collapse in ICOs market value. The total value of the hundreds of tracked crypto currencies has fallen by more than 18% since its end-August-high to $145 billion. The price for instance of Ethereum, whose token – known as Ether – are used to conduct many ICOs, fell about 10% in one day, after SEC’s announcement. The SEC’s stance also had a chilling effect on the creation of new ICOs in the US. A number of planned offerings have been put on hold as a result.

“It was a pre-emptive action based on the project’s conclusion that there is just too much uncertainty within our current model to forge ahead without some careful assessment and perhaps revision. ”  Harbour reaction on its planned ICO

Is there a life for ICOs?
It is not a surprise that regulation of ICOs would come in play at some point. These regulatory interventions may very well change the landscape for ICOs. But will this  also mean the end for ICOs?

I do not think so!

It is logical (and inevitable) that ICOs must be regulated in one way or another. Especially to protect investors on one hand and create a sound foundation for this sort of fundraising on the other. This will “sort out the bad apples from the good ones and will pave a better way for the whole crypto currency market going forward”. But banning them completely would be  a bad thing.

Those in the cryptocurrency sector believe a short period of overregulation will eventually be reversed when the merits of the technology become clearer, and regulators better understand the phenomenon.

“Regulators globally are struggling to understand what ICOs are, what the risks are, and how to ring-fence and regulate them.” “I think it will be slightly a temporary measure.” Zennon Kapron, director Shanghai-based financial technology consultancy Kapronasia.

“The initial coin offering is a new business model leveraging blockchain technology and it will remain,” “This is not the end of the ICO – absolutely not.” Oliver Bussman Switzerland-based Crypto Valley Association.

The challenge for regulators will be: “Not stifling these innovative models, while also protecting investors”.

While some ICOs are analogous to stocks and shares, many, such as those which offer re-sellable access to an application to the holders, are more novel, and may survive regulation unscathed. More regulatory certainty will also reduce the risk of drastic losses such as at the DAO example, once the initial ICO hype is over, and only the more serious and credible coin offerings remain as a result, something which ultimately will benefit the blockchain in general.