As of July 7th, 2017, Initial Coin Offerings (ICOs) have raised over USD 380 million this year in exchange for the issuance of cryptocurrency. In the last 12 months or so, this process has emerged as a significant alternative to traditional fundraising activities by business entities such as private placements and public offerings of shares. The legal status of ICOs is unclear with securities regulators enquiring as to the nature of this process and the instruments they issue. This post seeks to raise a number of issues concerning the regulatory treatment of ICOs.
In traditional fundraising, entrepreneurs exchange ownership and control rights in their ventures for funds. An ICO, on the other hand, allows ventures or platforms to raise capital in exchange for digital ‘tokens’ or ‘coins’. In effect, ICOs merge the processes involved in blockchain protocols with the reach of crowdfunding. These coins do not have any basis in traditional real world value (such as being backed by gold reserves), are not issued by regulatory authorities and apart from limited avenues for specific digital currencies such as Bitcoin, have little use in the non-digital world. Having said that, such tokens seem to offer a large variety of rights, from the right to use or make payments on the digital platform offering these tokens, to more securities-like rights on governance and revenue sharing. Tokens are increasingly becoming complex instruments being embedded with a combination of rights such as payment, access, profit sharing, contribution, block creation and interestingly, governance and voting. Token holders therefore, may be offered the rights to influence the direction of the platform or protocol. These coins may further be traded between participants, converted into legal tender through licensed exchanges such as Coinbase, or used to purchase goods or services on the platforms they are issued in. Issuance, ownership and transfer of these tokens are secured by a blockchain protocol.
In the past month, a number of issuer companies have floated tokens with a concoction of rights. Tezos, for example allows its token holders to vote on changes to the Tezos blockchain protocol. Genevieve, a venture capital fund which presently seeks to raise funds through an ICO, offers its participants the ability to vote on which ventures the fund ought to invest into. This gives the fund investors hitherto rare powers to determine the direction that the fund will take. Further, the Dimcoin Foundation has offered through its ICO, the DIMCOIN, a cryptocurrency that allows access to the DIM Ecosystem as well as fiat-backed cryptocurrencies known as Dim Currencies. A novel feature of the Dimcoin ICO is that it seeks to set up a stock exchange platform known as Hybrid Stock Exchange (HYBSE), which will facilitate trading of shares, which will be ‘cryptonised’. These ‘cryptonised’ shares will be traded for DIM Currencies, which are bought with legal tender. However, the DIMCOIN prospectus also points out that these coins are not securities and that the ICO does not involve an issuance of currency or securities, whether equity or otherwise.
The definitions of ‘securities’ across jurisdictions are myriad. However, most of them seem to involve elements of shared ownership or control and an expectation of profit. In the United States, for instance, the definition of a ‘security’ includes ‘a certificate of interest or participation in any profit-sharing agreement’ or a ‘right to subscribe to or purchase the same’. In a similar vein, the UK Financial Conduct Authority defines a ‘security’ to include instruments with the following characteristics: ownership, control and a periodic monetary return. One may possibly argue therefore, that a ‘token’ or a ‘coin’ with profit sharing or governance rights is a ‘security’.
While securities regulators around the world are coming to terms with this new form of business entity and fundraising, entrepreneurs using ICOs are acutely aware that there lies a possibility that such tokens or coins would come under the ambit of securities law.
A further complication arises with the nature of the entity offering such tokens. Using the blockchain protocol, it is possible to create a contemporary business vehicle known as a Distributed (or Decentralised) Autonomous Organisation (‘DAO’). A DAO is an intangible entity that functions as a business organisation. Moreover, a DAO is borne out of a ‘smart contract’, i.e., self-executing agreements that can be programmed based on certain parameters to conclude legal relationships, independent of third party actions. In other words, a DAO seems to meet the requirements of a corporation, albeit without the formal, centralised incorporation process.
As with most ICOs, an issuer entity may opt for a DAO route and issue coins. Given the current regulatory ambiguity, platform developers may argue that their DAOs cannot be treated as corporations and that tokens do not fall within the legal definition of ‘securities’. It is interesting to note that the DIMCOIN Foundation, in its prospectus categorically absolves itself of any liability in the event that ‘DIM Tokens are classified or treated by any government, quasi-government, authority or public body as a kind of currency, securities, commercial paper, negotiable instrument, investment or otherwise that may be banned, regulated or subject to certain legal restrictions’.
Central banks and market regulators around the world have apprised investors about the ill-effects of cryptocurrencies. Both regulators and participants are acutely aware of the dangers associated with investing in a market or a process that is unregulated and prone to business failures and frauds.
The Bank of England has stated that digital currencies do not pose material risks to the monetary or financial stability in the United Kingdom due to the low volume of digital currencies in circulation. However, H.M. Treasury has recognised the need to apply anti-money laundering regulations to the use and exchange of digital currencies. In a parallel development, the Reserve Bank of India has prohibited the use of digital currency as it impinges upon anti-money laundering laws and does not qualify as legal tender. Similarly, the US Securities and Exchange Commission has also cautioned against the use of Bitcoins and other virtual currencies due to the numerous risks associated with them.
It seems that it will only be a matter of time before a regulatory treatment of ICOs begins to emerge. However, as we have seen with the regulatory treatment of crowdfunding, regulators may choose to stifle or promote the growth of a new fundraising process. Considering the wide ambit of the definition of a ‘security’ in various jurisdictions, market regulators may choose to treat tokens or coins as securities and apply stringent initial public offering regulations to fundraising via digital currencies. Moreover, with monetary authorities cautioning the use of such digital tokens, it is unlikely that they will be perceived as legal tender in the short run.
Given the surprising levels of interest shown by market participants in ICOs, it is hoped that regulators will choose to promote ICOs with appropriate checks and balances, thus furthering their own goals of financial inclusivity.