Is regulation the way to better ICOs? Or market forces?

There’s been some important work done recently suggesting how ICOs could be improved. Most notably from Ethereum creator Vitalik Buterin, “who is so influential even rumours of his mortality can swing that cryptocurrency’s price, has come up with a way to revolutionize his industry’s hottest trend: the phenomena known as ICOs” (Forbes, 27 Sept).

The duo recommends solving this in two key ways. First, ICOs—which the authors call “token crowdsales”—would have no upfront cap on the amount of money raised, as is common among current offerings. That stipulation aims to avoid the stampede mentality that has overpowered rational buying behavior in certain capped ICOs, such as one in June that raised its maximum $35 million in just 30 seconds, with only 130 people able to buy tokens. “Capped sales can reach tens of millions of dollars and sell out in a matter of minutes, leaving buyers unable to participate, disappointed, and frustrated,” the authors write.

Secondly, the authors’ proposal would allow ICO investors to do something which has so far not been possible in token sales: cancel their purchase. The ability to withdraw offers in an ICO should help ensure that the law of supply and demand plays a healthy role in the process. That’s where the “interactive” component comes in, the authors write: “Potential buyers may enter and exit the crowdsale based on behaviors of other buyers, and in doing so tend the valuation towards a market equilibrium.”

To make this happen, Buterin and Teutsch’s new system introduces the concept of a “limit order,” something that has long existed in stock trading, to the ICO market. Instead of asking investors to buy tokens at an arbitrarily set price, the new method would allow buyers to enter bids for how many tokens they would be willing to purchase at different valuations. The buyers could also set a maximum price, or limit, at which they are comfortable participating. In effect, the system is not wholly unlike the one used at auction site eBay (EBAY, +0.25%).

Practically speaking, Buterin and Teutsch aren’t suggesting creating a new blockchain altogether; ICOs structured the way he proposes would still originate from Ethereum. But ideally, these simple tweaks, which the authors break down in greater detail in their paper, would make token prices more reasonable and fair, deter deep-pocketed investors (or “whales”) from gobbling up huge swaths of the market, and also prevent a lot of buyer’s remorse.

Underlining the need for change on 12 November the Dutch financial regulator the AFM pointed out the following risks of investing in ICOs:

  • In the current climate, ICOs are an ideal vehicle for fraudsters. The anonymous and cross-border nature of blockchain technology enables advanced forms of a traditional pyramid scheme that are difficult to recognise.
  • The returns are overstated, while the projects that ICOs represent are still at a very early stage of development and the underlying blockchain technology itself is still in its infancy.
  • Most private investors underestimate the specialist knowledge and expertise needed to be able to make a well-considered decision regarding this kind of investment. Without this expertise and in-depth knowledge of blockchain technology, it is almost impossible to distinguish viable revenue models from projects with little or no added value.
  • In addition, issuers of ICOs are often not transparent in their provision of information, meaning that it is very difficult to form an assessment of the value and to distinguish bona fide ICOs from fraudulent projects.
  • The current hype means that many people are investing in speculative opportunities. This is contributing to very high volatility in the prices of the tokens offered via ICOs. The tradability of many tokens is moreover limited, meaning that it is relatively simple to manipulate prices.
  • Due to their anonymous nature, there is little or no possibility of tracing ICOs back to natural persons. This makes ICOs an ideal vehicle for laundering criminal money.

This echoes the advice of the UK’s FCA which produced a similar list of investment risks on 12 September for ICOs, and concluded that each (ICO) “promoter needs to consider whether their activities amount to regulated activities under the relevant law”.

So does this statement on 13 November, from the European Securities and Markets Authority (ESMA) add or substract from that constructive debate? Does it add clarity or more red tape to the dynamic ICO sector? Does it mean regulation is going to beat market forces to reforming how ICOs work?

For sake of ease I have extracted the text of the ESMA statement below (online PDF), for firms involved in ICOs. And highlighted main points in bold again.

The European Securities and Markets Authority (ESMA) is issuing this Statement to draw the attention of firms involved in ICOs to the fact that they must give careful consideration as to whether their activities constitute regulated activities. This Statement is published alongside a Statement alerting investors to the high risks of investing in ICOs.

ESMA has observed a rapid growth of ICOs, which raise capital for enterprises, and is concerned that firms involved in ICOs may conduct their activities without complying with relevant applicable EU legislation.

ESMA reminds firms involved in ICOs of their obligations under EU regulation
Firms involved in ICOs must give careful consideration as to whether their activities constitute regulated activities. If their activities constitute a regulated activity, firms have to comply with the relevant legislation and any failure to comply with the applicable rules would constitute a breach.

Depending on how they are structured, ICOs may fall outside of the scope of the existing rules and hence outside of the regulated space. However, where the coins or tokens qualify as financial instruments it is likely that the firms involved in ICOs conduct regulated investment activities, such as placing, dealing in or advising on financial instruments or managing or marketing collective investment schemes. Moreover, they may be involved in offering transferable securities to the public. The key EU rules listed below are then likely to apply.

Please note that what follows is a high-level summary of the key applicable EU legislation. It is not intended to be an exhaustive account of the applicable rules nor of the requirements laid down in these legislations. In addition, national rules may apply.

It is the duty of the firms themselves to consider the regulatory framework, seeking the necessary permissions and meeting the applicable requirements.

Prospectus Directive
The Prospectus Directive (PD) aims to ensure that adequate information is provided to investors by companies when raising capital in the EU. It requires publication of a prospectus before the offer of transferable securities to the public or the admission to trading of such securities on a regulated market situated or operating within a Member State, unless certain exclusions or exemptions apply. In particular, the PD specifies that the prospectus shall contain the necessary information which is material to an investor for making an informed assessment of the facts and that the information shall be presented in an easily analysable and comprehensible form. The PD does not directly specify who should draw up the prospectus but requires that the party responsible for the information (being at least the issuer, the offeror, the party seeking admission to trading or the guarantor) is specified in the prospectus. Depending on how the ICO is structured, the coins or tokens could, potentially, fall within the definition of a transferable security, and could therefore necessitate the publication of a prospectus which will be subject to approval by a Competent Authority.

The Markets in Financial Instruments Directive
The Markets in Financial Instruments Directive (MiFID) aims to create a single market for investment services and activities and to ensure a high degree of harmonised protection for investors in financial instruments. A firm that provides investment services/activities in relation to financial instruments as defined by MiFID needs to comply with MiFID requirements. In the case of ICOs, where the coin or token qualifies as a financial instrument, the process by which a coin or token is created, distributed or traded is likely to involve some MiFID activities/services, such as placing, dealing in or advising on financial instruments. The organisational requirements, the conduct of business rules and the transparency requirements laid down in MiFID would then apply, depending in some cases on the services provided.

Alternative Investment Fund Managers Directive
The Alternative Investment Fund Managers Directive (AIFMD) lays down the rules for the authorisation, ongoing operation and transparency of the managers of alternative investment funds (AIFMs) which manage and/or market alternative investment funds (AIFs) in the Union.

Depending on how it is structured, an ICO scheme could qualify as an AIF, to the extent that it is used to raise capital from a number of investors, with a view to investing it in accordance with a defined investment policy. Firms involved in ICOs may therefore need to comply with AIFMD rules. In particular, AIFMD provides for capital, operational and organisational rules and transparency requirements.

Fourth Anti-Money Laundering Directive
The Fourth Anti-Money Laundering Directive prohibits money laundering and terrorist financing. It applies to firms including credit institutions and financial institutions, the latter including MiFID investment firms, collective investment undertakings marketing their units or shares and firms providing certain services offered by credit institutions without being one.

The Directive requires firms to carry out due diligence on customers and to have in place appropriate record-keeping and other internal procedures. Firms have an obligation to report any suspicious activity and to co-operate with any investigations by relevant public authorities.

So what’s the answer? To put it in the words of the German Federal Financial 
Supervisory Authority, there are no shortcuts to ICO respectability when it comes to investment credibility. Or to put it another way: “It should be noted that having a foundation registered in Switzerland is of no significance whatsoever as regards the regulation of ICOs.”

Ouriel Ohayon’s ICOs for Dummies restates the problem this way: “I feel this is a jungle and that ICOs need to be standardized and more fair in their approach. Right now it’s close to impossible to get into an ICO. There is just too much interest and there is zero regulation about it (actually kind logical for decentralized organizations). But it is extreme.”

Something that caught my eye therefore is the new report from Pinsent Masons which “provides a global assessment of the latest activity around Bitcoin”, incorporating a useful guide to countries and territories that:

  • have acted or are acting to regulate bitcoin
  • have banned bitcoin
  • have stopped short of regulating bitcoin, but have imposed taxes
  • are undecided in respect of digital currencies
  • do not regulate bitcoin

Each section also dives into international developments concerning blockchain and ICOs, which have taken the world by storm over the last 12 months.

Charlie Clarence-Smith, who produced the report, said: “Like other innovative ideas, even if they lose relevance, cryptocurrencies and ICOs have made an indisputable statement: there are achievable substitutes to institutionally backed digital transactions and alternative ways to raise funds. Their broader acceptance and legitimacy, however, will depend on what form of relationship they forge with such institutions and more importantly financial regulators, going forward.”

Read further commentary on To learn more, download the full report (PDF).

For more on this subject read the FT article ICO regulation inconsistent as cryptocurrency bubble fears grow (23 Nov 2017)


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