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28 October, 2017
Banning initial coin offerings (ICOs) is not the way forward for regulators, despite the legal and regulatory risks that could arise if they are not subject to proportionate regulation.
In the interests of innovation and competition in the investments market, regulators should instead look to safeguard prospective investors in ICOs as far as possible, and underpin regulation with a communications campaign to ensure risks are clearly highlighted.
The pressure on regulators to address ICOs in detail stems from the fact that the market for ICOs is growing quickly, spurring potential new risks for inexperienced investors as well as media interest and scrutiny.
Cryptocurrencies in the news
It has been a busy weekend for cryptocurrency news and comment. There have been a slew of stories in the Financial Times, including some tongue-in-cheek pieces about Harry Redknapp's foray into cryptocurrencies, the potential for Russia to crack down on cryptocurrencies and a story suggesting that Wall Street plans to "crush" bitcoin. If nothing else, all of this proves that cryptocurrencies and ICOs are the story of the moment.
ICOs are an increasingly popular way for businesses to raise money. Typically, businesses will develop a digital token, such as their own proprietary virtual currency, and look to sell those tokens to investors in a bid to raise capital in return for existing cryptocurrency, such as Bitcoin, Ether or Ripple rather than fiat currency such as dollars, euros or pounds. The trade of these tokens is recorded using blockchain.
Investors can in most cases sell on those tokens for profit on certain peer-to-peer exchange platforms should the value of the tokens increase. They are sometimes further incentivised into buying the tokens by being given the opportunity to share in profits generated from the business ventures that benefit from their investment. According to press reports, the amounts raised in ICOs are somewhere between $1-2 billion this year, already – so it is a big deal.
We have previously written about the fact that regulators are running to catch up with ICOs, and it seems that this is true not just of the regulators.
One FT piece quoted Jamie Dimon of JP Morgan Chase and Larry Fink of Blackrock, both of whom spoke negatively about bitcoin and suggested that it was a tool for criminals and money launderers rather than for legitimate investment purposes.
China and South Korea have banned ICOs, and Russia is making noises about additional regulation. However, Vladimir Putin is not suggesting a ban, at least at this stage. Instead he is proposing a stronger regulatory framework to prevent cryptocurrencies being used for illegal purposes.
The cryptocurrency industry has fought back against the views of Dimon and Fink by saying that challenges around criminality and money laundering also apply to traditional, fiat, currency. In addition, supporters of ICOs suggest that traditional venture capitalists have a vested interest in dampening down ICOs, because ICOs threaten their business model.
In the UK, the Financial Conduct Authority (FCA) is looking at ICOs and in the meantime has joined other regulators in warning the public to look carefully at ICO opportunities in the same way as they should approach any investment, and to be aware that ICOs are not subject to the same regulatory standards as traditional share issues.
Proportionate regulation is needed, not an outright ban
ICOs spur a number of legal issues that need to be considered.
Questions that arise include:
Are the proceeds of the ICO being used for legitimate purposes? This involves due diligence into the ICO promoters.
What health warnings does the ICO proposal carry – it's important that those who are seeing it understand the risks involved and that these are clearly spelled out.
What regulatory framework applies? Currently ICOs are not regulated in the same way as the issue of securities through prospectus rules for example, but that may change. The SEC in the US is currently considering whether ICOs should be considered as "securities" and regulated accordingly.
ICOs cannot be targeted at a country where they are illegal – currently only China and South Korea.
There are concerns that ICOs are a bubble and that in many cases the primary rationale for investors is price speculation rather than the underlying investment. Having seen Harry Redknapp's promotion of an ICO, some might argue that footballers or football managers are not the best advocates for complex financial products given their track record. However, writing off these new forms of investment is not the answer either, and it doesn't promote innovation or market disruption.
There is no doubt that this is a fast-moving area which is causing real disruption of traditional investment products.
There is also no doubt that, like all investment offerings, the market will contain legitimate offerings and some which are not. The key is to ensure that the lack of regulatory structure is not exploited by 'bad actors', but not by banning cryptocurrencies and ICOs – instead a proportionate regulatory response is required, along with sensible due diligence into opportunities and appropriately clear 'health warnings'.
For further information, please contact:
Yvonne Dunn, Partner, Pinsent Masons
yvonne.dunn@pinsentmasons.com
