Nadia Manzari, pictured, of Schiltz & Schiltz says Luxembourg's new ICO law adds some legal certainty for investors
Photo: Mike Zenari
Economic history is dotted with examples of excessive hype about new business trends followed by more modest but real benefits. From the railroad to the internet, boom and bust is often followed by maturity. Could the fate of initial coin offerings (ICOs) be a recent example of this process?
Although the 2017 bitcoin speculative boom and 2018 bust is a fading memory, the technologies and ideas developed around this phenomenon continue to attract interest. Distributed ledgers are online databases run and supervised in full transparency by their users on public and private blockchains. Smart contracts are computer protocols that allow agreed transactions to take place automatically. These plus algorithms, cryptography and more have been tested in real life conditions, demonstrating their potential for a range of business uses.
ICO shooting star
An offshoot of the cryptocurrency craze has been initial coin offerings. These were heralded as a new way for entrepreneurs to raise capital; like crowdfunding but using distributed ledger technology. A business idea is encapsulated in a “white paper” and this is advertised, often via social media and ICO websites. Interested supporters will then invest, either using traditional currencies or one of the more widely recognised cryptocurrencies.
For their investment, backers would receive three broad types of coins, or more properly “tokens”. Payment tokens are in the form of a new cryptocurrency. Just like other currencies, they are intended as a store of value for making purchases, but with investors perhaps hoping their value will rise. Utility tokens provide access to an application, service or a physical product at reduced prices. Asset tokens are like traditional debt or equity, that offer the promise of future interest payments or dividends.
Not so fast
For IT specialists with a bright idea, it appeared as simple as that. However, it isn’t, as often they neglected the law. Although creating a new financial product using new technology lowers barriers to entry, this doesn’t mean that players can simply ignore financial sector regulations.
There are examples of ICOs which have raised funds for innovative businesses. For example, the firm Tatatu raised a reported $575m last June for their video streaming service. They achieved this by selling TTU crypto tokens, with the grand duke’s second son Félix reported to be an investor. Dubbed the “Blockchain Netflix”, the firm pays TTU to content providers.
Whether this project has legs remains to be seen, but the recent history of ICOs isn’t encouraging. For each successful ICO there are more stories of broken promises, lost money, intervention by supervisors and court cases. Many operations have been little more than unscrupulous scams, which are now exciting global regulators and courts. Press reports suggest that 80% of ICOs were fraudulent, with around half carried out by companies without a registered company address. Indeed an academic study by the University of Luxembourg in late 2017 was entitled “The ICO Gold Rush: It’s a Scam, It’s a Bubble, It’s a Super Challenge for Regulators”.
Warnings from regulators
Regulators started catching up with this innovation about a year and a half ago. Initially they were loath to act, as it was judged that the ICO market posed little systemic risk. However, when it became clear that retail investors were getting burned, they decided to act.
An American financial regulator, the Securities and Exchange Commission, classified tokens from ICOs as securities in December 2017. As an investment contract underpinned this, there was a security with an implication of profits to be derived from the endeavour. In Luxembourg, consumers and providers were warned by the CSSF in March 2018 that any provision of financial services must conform to the law, even if there is no specific legal framework for virtual currencies, with no backing from the central bank.
There was a specific warning about the lack of legal guarantees and supervision around “highly speculative” ICOs and tokens “which feature a number of risks, including total loss of the investment.” Fraud, theft, hacking, hidden fees, and the potential inability to trade these currencies are some of the risks. Further, the regulator added that information on virtual currencies is “often incomplete, difficult to understand or does not reflect all the risks linked to virtual currencies.” Many other regulators have issued similar warnings, including the EU’s European Securities and Markets Authority.
Bernard Simon, pictured, is CIO of the Luxembourg Stock Exchange. Photo: Mike Zenari
STOs from the ashes?
Perhaps the biggest legacy of the ICO boom and bust has been new possibilities backed with robust technology, better equipped regulators, and a more wary market. Some analysts have hopes for security token offerings (STO), which grant investors clearly legally defined rights, even though they are delivered and exchanged digitally. These structures are created and disseminated using distributed ledger or blockchain technology.
Whereas many ICOs would more often offer little more than a slice of pie in the sky, STOs confer shareholding rights or might act like a bond with promises of interest payment. Potentially they could be packaged in such a way as to resemble an investment fund. “Despite the wild west nature of this business, there is clear value here with the prospect of efficient exchanges, whether they be public or private blockchain,” said Bernard Simon, CIO of the Luxembourg Stock Exchange. “These tools could revolutionise the market.”
How to regulate?
Rules are not totally clear as the first STO took place about two years ago. Often the tokens they produce resemble traditional securities and products such as investment funds, bonds, equities, derivatives, payments, money transfers, and so on. But not always. So regulations need to be complied with based on analysis of their economic and investment function, and investor expectations. Rules on transferability and negotiability need to be checked and enforced. They pointed out that prospectuses are needed when securities are issued, and that anti-money laundering and terrorist financing procedures must be followed.
These can be ascertained by looking at the economic rationale behind the issuance of the token, the rights of the owner, and the buyer’s and seller’s objective. This is a judgement call, and is pointed to by European regulations but these aren’t hard and fast definitions. “The basic legal and regulatory framework for tokens is in place. So even though the technology is new, where the token qualifies as a security, it must be regulated like a security,” agreed Nadia Manzari, partner at the law firm of Schiltz & Schiltz.
Keen to comply
STOs embrace the need for regulation as a guarantee of their serious, professional intent, and that securities and products are liquid, transferable and transparent. Yet, thanks to their digital nature, this could open the way to efficiencies. This approach is unlike that used for ICOs, where many developers thought they had found a way of bypassing regulations and traditional regulated intermediaries.
One of the main challenges is ensuring that promises are met, and this is where there is a role for an intermediary to curate this process. They can ensure that promises are honoured with the legal framework enforced, particularly on know your customer rules, anti-money laundering and counter-terrorist financing measures. This intermediary could be a stock exchange, a clearing house, brokers, banks and more, or a combination of these.
Building a new framework
A handful of European countries are seeking to smooth out some of the regulatory wrinkles in the hope of fostering development. Luxembourg was the first country in Europe to licence virtual currency exchange platforms as payment institutions, so has a track record. Then, on 14 February 2019, the Chamber of Deputies approved a law permitting the use of distributed ledger technology for the circulation of securities. “These are still the early stages and people are piloting ideas. The new law in Luxembourg is adding an additional layer of legal certainty. This is good for the industry but also for consumers,” said Manzari.
ICO, that sounds familiar
By their name, digital ICOs (initial coin offerings) sound like they may be a sort of virtual IPO (initial public offering). IPOs are a well-known, well-tested way to raise funds in exchange for company shares. ICOs, on the other hand, issue new virtual tokens to raise funds, but most often there is no guarantee that these “currencies” will have any future value as the project matures.
Often there are not even promises that these digital ventures will yield dividends or interest, just the prospect of the new token’s intrinsic value, plus a vague hope that they may appreciate in value. Sometimes there is not even a mechanism of how to exit the investments, with no token exchange planned.
That said, the phenomenon remains a small niche, and generally attracted investors speculating that they were getting onto the new big thing early. The hype around cryptocurrencies a couple of years back was potentially intoxicating, and some people allowed themselves to be swept along, sometimes blindly. That said, the technology underpinning these developments remains interesting and could yield interesting business and social benefits. And bitcoin is still trading at ten times its dollar value of three years ago.