Initial Coin Offerings (ICOs) are currently a hot topic in the financial markets. By the end of 2018, issuers are expected to have raised about US$20 billion in ICOs. The annual energy consumption of mining new tokens for cryptocurrencies in 2018 will equal the energy consumption of Austria, a country with a population of 9 million. Even US political commentator and comedian John Oliver cautioned his viewers against the dangers of investing in crypto tokens, stating that ‘you are not investing, you are gambling.’
From a technical standpoint, ICOs use the now much described blockchain technology to offer so-called ‘tokens’, which come in various forms. ‘Currency tokens’ can be used for payment. ‘Investment tokens’ typically give the owner the right to participate in the issuer’s future returns, and sometimes provide voting or other participation rights. ‘Utility tokens’ offer a wide variety of benefits for the owner, such as access to particular services offered by the issuer.
However, the legal framework for ICOs is still not clear. Issuing crypto tokens in return for funds resembles the process of issuing shares in return for funds, as occurs in initial public offerings (IPOs). Since IPOs are regulated by securities laws, the obvious question is: How do ICOs fit into the existing framework of securities regulation? In our current paper ‘Regulation of Initial Coin Offerings – Reconciling US and EU Securities Regulation’, forthcoming in the Chicago Journal of International Law, we discuss whether tokens are ‘transferable securities’ as defined in Art. 4(1)(44) of the Directive on Markets in Financial Instruments (MiFiD 2) and as such are subject to the full scope of EU financial markets regulation, including prospectus requirements and prospectus liability for offers of tokens to the public. Failure to comply with these rules could have dire consequence (eg, high fines) for the issuer and for the persons organizing the token sale. Importantly, the EU framework would apply to all tokens (if classified ‘transferable securities’) that can be subscribed for from the EU, irrespective of where the issuer domiciles. This is obviously at odds with the notion of selling blockchain-based units over the internet, which is surprisingly often perceived in the internet community as non-regulated.
The question is warranted as the two most important regions for ICOs are the US and the European Union. In the US, the SEC has confirmed that investment and hybrid investment/utility tokens pass the Howey test, meaning those tokens are ‘investment contracts’ and therefore subject to US securities laws.
EU law takes a different approach. According to Art. 4(1)(44) of MiFiD 2, ‘transferable securities’ are those classes of securities which are ‘negotiable on the capital market’, with the exception of instruments of payment. It is obvious from the wording that the term is based on the transfer of units in the secondary market rather than on the investment character of the instrument. This is a major deviation from the US approach. However, a closer look at the EU definition shows that its application leads to results that are comparable to its US counterpart.
‘Negotiability’: Transferability, Negotiability and Standardization Requirements
In order to be ‘negotiable’ under Art. 4(1)(44) of MiFiD 2, a security needs to be ‘transferable’, ‘negotiable’ and ‘standardized’ . The transferability requirement is met provided that transfer remains possible, including when the issuer imposes some restrictions. This is obviously the case for most tokens as the blockchain-based two-tier system with private and public keys have been specifically designed for such transfers.
Tokens also need to be negotiable to be considered ‘transferable securities’. A unit is negotiable if its format allows its sale or purchase in a structured market setting (such as in the capital markets). Any ‘investment token’ listed on a crypto exchange is a negotiable security. The same applies to ‘non-traded tokens’ with characteristics similar to those that are already traded because it is sufficient that such units could be traded in the future.
Negotiability requires the respective units to be standardized. This flows from the concept of capital markets transactions, which require the respective units to be identifiable and enumerable. If all tokens in a particular ICO are of the same kind, or the ICO comprises different classes of tokens that are clearly identifiable, the standardization requirement is met. This is typically the case in ICOs.
Negotiable ‘on the Capital Markets’
MiFiD2 refers to negotiability on the ‘capital markets’, a term that is not defined under EU law. It is our view that the essential issue is what market participants consider to be a ‘capital market’. Generally, one main difference between capital markets and other parts of the financial markets (eg, money markets) is the ongoing relationship between the issuer and the investor based on the traded instruments. For example, stocks provide investors with membership rights. The investment is based on the expectation of profits. Similarly, a token granting a flow of monies is potentially negotiable in the capital markets. As a consequence, hybrid tokens with some sort of investment aspect would also meet this requirement.
Based on this reasoning, only if the token does not provide any membership rights, comparable rights or monetary streams, a token cannot be a ‘transferable security’. If a pure ‘utility’ token grants benefits, its focus is on consumption. Thus, some types of crypto tokens, such as pure utility tokens, would not be negotiable in the ‘capital markets’.
No Payment Instruments
Art. 4(1)(44) of MiFiD 2 excludes ‘payment instruments’ from the definition of ‘transferable securities’. This term needs to be interpreted according to the general understanding in the markets. ‘Currency tokens’ fall within this category because they are designed to function as a means of payment (see eg, Case C-264/14 Hedqvist  ECR 718). They exhibit strong similarities to e-money which is classified as a payment instrument. Further, it is our view that hybrid tokens should only qualify as ‘payment instruments’ if their sole, or main, purpose is payment. This is because any other interpretation would open regulatory gaps and allow for regulatory arbitrage. If adding some limited payment functionality would result in the inapplicability of Art. 4(1)(44) of MiFiD 2, issuers would have a simple way of escaping financial markets regulation even if the token conveyed significant investor rights.
Not So Different After All
In sum, most of the ‘investment tokens’ would be considered as ‘transferable securities’ pursuant to Art. 4(1)(44) of MiFiD 2. For the EU, this results in the applicability of regulatory cornerstones such as the Market Abuse Regulation and the Prospectus Regulation which also use this definition of ‘transferable securities’. From a comparative perspective this outcome is remarkably similar to the SEC’s approach. Thus, it is possible to reconcile the scope of application of US and EU securities laws. The only major difference is that non-transferable tokens would thus not constitute ‘transferable securities’ under EU law and therefore not qualify as securities.
Prof. Dr. Philipp Maume is an Assistant Professor for Corporate Governance & Capital Markets Law at TUM School of Management, Technical University of Munich, Germany.
Mathias Fromberger is a Research Assistant at TUM School of Management, Technical University of Munich, Germany.