Initial Coin Offerings (ICOs) have raised US$1.5 billion this year alone, compared to US$100 million in all of 2016. This FOMO-inspiring figure is thanks to the until recently near-complete absence of any securities regulations. In most cases, companies have raised funds entirely in Bitcoin and Ether, and did not put investors through any Know Your Customer/Anti-Money Laundering (KYC/AML) process.
But regulation is coming, and depending on the jurisdiction, companies who have held ICOs in the past could be held to existing securities laws, and this could put a chill on the red-hot ICO market. At the heart of if and how to regulate an ICO is one question; Is a token a security?
Securities are well-defined, and definitions are similar from one country to the next. The most oft-used definition for a security, the “Howey Test,” comes from a US Supreme court case. The test determines whether a transaction is considered a security, and there are four conditions that need to be met:
1. It is an investment of money.
2. There is an expectation of profits from the investment.
3. The investment of money is in a common enterprise.
4. Any profit comes from the efforts of a promoter or third party.
However, each jurisdiction has its own particular set of laws governing what exactly a security is and how they are regulated, and this determines how ICOs are seen.
This quickly evolving world of regulation can be divided into several categories; Jurisdictions where tokens are explicitly deemed not to be securities, think Singapore and Switzerland; Jurisdictions where securities regulations are non-existent, not enforced or can be influenced with money, think much of the developing world; Jurisdictions where authorities are watching and waiting to decide how to regulate, and possibly punish, companies holding ICOs, think USA, Russia, Australia, and Canada; And China, where regulators recently banned ICOs completely.
China has taken the position that all ICOs are illegal, and any funds raised this way must be returned to investors immediately. While this caused an immediate drop in markets, both in China and abroad, there is speculation from within China that signs this initial ban will set up subsequent regulation of the ICO market.
Hu Bing, from the Chinese Institute of Finance and Banking, attempted to clarify the government’s position, stating that the move to ban ICOs was meant to protect investors, and China will look to resume ICOs in the future once a regulatory framework has been established.
In the US, the Securities and Exchange Commission (SEC) was eerily silent for a long time, but recently made decisions signaling that they are carefully scrutinizing the cryptocurrency world.
In March, they put the brakes on a Bitcoin ETF backed by the Winklevoss twins. One concern highlighted in the Winklevoss decision was the lack of transparency and oversight in cryptocurrency exchanges, which could lead to price manipulation.
In July, the SEC issued a report concluding that tokens sold by The DAO were indeed securities, and warned the blockchain industry that they must obey securities laws when holding ICOs. While it’s still too early to see the effects of this report, the USA just became a much less attractive home to hold an ICO. Whether this will stifle innovation, or merely cut down on scams, remains to be seen.
Australia, on the other hand, has been proactive in welcoming blockchain innovation. The Australian Securities and Investment Commission (ASIC) has become a world leader in creating conditions conducive to the development and advancement of blockchain and fintech, going so far as to publish an information sheet designed to foster dialogue between regulators and the private sector.
ASIC chairman Greg Medcraft has an open-minded view to ICOs, stating "They’re a very interesting concept.”
“An ICO is not equity – you're offering basically something that is the product of the entity that is doing the launch. You're taking a bet on getting that product early. How different is that if I go to Kickstarter and I buy something – a watch – and then I get that watch and sell it in the future? It's no different, is it?”
- Greg Medcraft, Australian Securities and Investment Commission Chairman
In Canada, regulators are attempting to strike a balance, taking action to foster innovation while at the same time emphasizing the importance of protecting investors.
Last fall, the Ontario Securities Commission, which regulates Canada’s largest province and Toronto, the 11th largest financial market in the world, hosted a hackathon at which startups attempted to innovate regulatory solutions using blockchain.
A white paper was then published which detailed the many regulatory options made possible by blockchain. Still, the OSC preaches caution, having issued a warning that an ICO could trigger securities law requirements even if the tokens themselves don't signify an ownership stake in a particular business.
Last month, the Canadian Securities Administrators (CSA) issued a notice entitled “Cryptocurrency Offerings,” which outlines how to apply securities laws to cryptocurrency crowd sales.
The notice confirms that, in the case of a token fitting the definition of a security, a crowd sale must comply with all prospectus and registration requirements, as well as KYC/AML regulations pertaining to securities. Also, cryptocurrency exchanges will be considered to be marketplaces subject to the general regulations governing stock exchanges or alternative trading systems.
Time will tell how the increased friction in the purchase process will affect ICO earnings, but signs from the first post-regulation ICO are encouraging.
The first company to receive an exemption to hold an ICO in Canada is impak Finance, which was accepted into the sandbox of their home province of Québec’s regulator, L’Autorité des Marchés Financiers (AMF).
This exemption gives regulators the opportunity to observe the new crowd sale regulations in action, and to understand if the regulations put in place adequately protect investors.
impak Coin, which is designed to grow the impact economy by incentivizing spending and investment in socially impactful companies, was deemed to fit the definition of a security according to the AMF, as there is a reasonable expectation of profit.
Receiving this exemption was a huge vote of confidence for impak Finance from the AMF, and its case was certainly helped by the fact that the company is in the process of launching a debt fund that will lend to businesses creating a positive social impact, and a digital bank that invests 100% of its deposits in the impact economy.
But with this vote of confidence brought a significant added workload. From a technical perspective, working with the regulators to add the necessary KYC/AML protections, as well as stringent security standards, made the crowdsale’s website more complex.
The increase in friction to buy impak Coin raised questions of how many investors would be turned off by the process, and whether the increased complexity of the site would be able to withstand the crush of traffic on the first day of the ICO. Making these improvements to the original plan took added time, receiving the regulatory approvals at each step took even more time, and thus led to significant delays in the launch date.
From a communications perspective, how do you explain to investors that the launch date was to be moved back yet again, and keep their confidence?
The key to success was to be completely transparent every step of the way, sharing the experience with investors to help them understand the benefits of this added protection. Specifically, the KYC/AML requirements limit investment by a participant to $2,500 unless the participant can prove that they are an accredited investor or an eligible investor.
These requirements undoubtedly left some money on the table by deterring some investors wishing for complete anonymity, but for a token designed to incentivize spending over holding, anonymous investors with no intention to participate in the ecosystem offer no real value anyway.
The evolving global regulatory frameworks provide an opportunity for investors to see a company’s true intentions. If projects choose to launch in jurisdictions where regulations are in place to protect investors, it’s a good sign that the project has a real long-term plan. If companies choose to launch in regulatory-free zones, it’s a fair question to ask whether the ICO is designed to support a real project, or to raise the maximum amount of capital for its founders.
While the KYC/AML process will inevitably deter some investors wishing for complete anonymity, this anonymous speculation on cryptocurrency leads to artificial demand and distorts the price of a token.
So far, impak Coin’s experience has been encouraging. In the first two weeks, the ICO has raised C$1.32 million from over 1900 investors in 52 countries. For the time being, the wide range of options for regulatory jurisdictions leaves other blockchain projects with some choice of where to hold their ICO. It will be interesting to see how investors respond to companies’ choice to regulate, or not.