At a Glance…
In the latest of a series of articles commenting on global regulatory developments in cryptocurrency, this client alert explores recent regulatory engagement with the token market (with a particular focus on Europe) and looks ahead to proposals for 2018. Gibraltar’s ICO regulations, as well as the Swiss regulator’s publication of ICO guidelines have arguably set the tone for an interesting year in the developing regulatory landscape.
As noted in our previous alert1 on this topic, regulators in North America, Asia and Australia have all made token issuers aware that initial coin offerings (ICOs) are firmly on their radar. In September 2017, the UK’s Financial Conduct Authority (FCA) also offered its ‘two cents’ on ICOs2, warning market participants that certain coin offerings could fall within their jurisdiction.
Towards the end of 2017, the European Markets and Securities Authority (ESMA), as well as several national regulators in the EU and elsewhere, published opinions on ICOs, adding further to the growing library of regulator pronouncements on ICOs.
The trend appears to be continuing this year. In the shadow of the dramatic drop of the price of Bitcoin3, ESMA, in conjunction with the EBA and EIOPA4 (together the three ESAs), published a pan European warning on the risks of purchasing virtual currencies.5
Gibraltar’s financial services commission has also announced that it plans to publish draft regulations on ICOs in the coming weeks – claiming that these would be the first of its kind.
Recap – what are ICOs?
Widely referred to as token sales, ICOs involve companies issuing digital coins in exchange for cryptocurrencies such as Bitcoin or Ether. While in a public offer of securities, a company will typically be required to publish a prospectus prior to the float; token issuers will produce an online ‘whitepaper’ business plan to promote the ICO. Typically, this will be less detailed than a prospectus because it does not have to comply with securities law disclosure requirements (although any whitepaper should still be clear, fair and not misleading).
ICOs have become exponentially popular, with over US$3 billion in cryptocurrency being raised during the course of 2017. Some ICOs (for example, FileCoin, Tezos and Votes) have raised over US$200 million each6. The total market capitalisation of the 100 largest cryptocurrencies is estimated to exceed US$400 billion globally today.
What have the regulators said?
i. FINMA releases ICO guidelines
The Swiss Financial Market Supervisory Authority (FINMA) released new ICO guidelines7 in February 2018. These set out how FINMA will treat ICOs against the backdrop of its currency financial market legislation, and importantly what information it will consider when making such analysis. FINMA hopes that this will create more transparency in the market.
Switzerland does not have regulations, or case law, which deal specifically with ICOs. Instead, it has considered how ICOs may be subject to current market legislation. In these guidelines, FINMA emphasises that each case will be decided on its own merits and there will not be a ‘one-size fits all’ approach. Instead, FINMA will consider the economic function and purpose of the tokens, as well as whether they are tradeable or transferable.
In addition, FINMA has split tokens into three categories and looked at each category generally. These categories are:
Payment tokens: these tokens are intended for use as money or value transfer (e.g cryptocurrencies) and do not result in any claims on the issuers. FINMA has indicated that it will not treat these types of token as securities unless new case law or legislation provides otherwise. However, ICOs involving payment tokens will need to comply with anti-money laundering regulations.
Utility tokens: these tokens are intended to provide digital access to an application or service. If this is the token’s sole purpose, and they can be used in such a way at the point of issue, then these will not be treated as securities. However, if they are also used for an investment purpose they might be caught by currency financial markets legilsation.
Asset tokens: these tokens will represent assets, for example a debt or equity in an issuer. These are analogous to securities and consequently, FINMA will treat them as such. Issuers of asset tokens will therefore need to comply with applicable regulations such as prospectus requirements.
FINMA has noted that tokens may fall into more than one category, and ‘hybrid tokens’ are possible. Currently, FINMA does not believe that issuing tokens will fall within the classification of deposits, and require a banking licence. However, this may change if tokens have characteristics of debt capital. FINMA has also clarified that the Swiss Collective Investment Schemes Act will only apply if the funds that are raised by an ICO are managed by third parties.
ii. The pan European statement
On 12 February 2018, the three ESAs released a joint warning regarding the risks of buying and holding virtual currency. The three ESAs are permitted under their founding regulations to issue such warnings in the ‘event that a financial activity poses a serious threat to the objectives [of the authority]’.8
The warning sets out the reasons why investing in virtual currency is risky, citing extreme volatility, an absence of protection, lack of exit options and misleading information. It goes on to confirm that investors who choose to invest in virtual currencies, or even financial instruments which are exposed to virtual currencies, should be aware of such risks and should not expect these risks to be mitigated by buying the virtual currency from a regulated financial services firm.
This warning is the latest in a series of publications by the three ESAs, following two statements by ESMA on ICOs (as detailed below) and earlier warnings and opinions by EBA published over the past five years.9
iii. ESMA speaks out on both sides of the coin
In an effort to alert parties involved in ICOs to consider their regulatory rights and responsibilities carefully, ESMA published two statements, one detailing the risks of ICOs for investors and another on the rules applicable to firms involved in ICOs.
Statement one – investors
In line with the comments of national authorities before it, the statement (targeted at investors) notes that ICOs are ‘highly speculative investments’ and acknowledges that they may fall outside of the regulated space. ESMA also notes that information provided in ICO whitepapers may be ‘unaudited, incomplete, unbalanced or even misleading’. It is therefore imperative that potential investors review the statements made in whitepapers carefully, and make further enquiries where information appears unclear or exaggerated.
Statement two – token issuers
ESMA has explicitly asked firms involved in ICOs to give careful consideration as to whether their activities constitute regulated activities. Most noticeably, ESMA specifically lists four European Directives that firms involved in ICOs must be wary of. In an arguably more helpful note than the general cautionary statement we have come to expect from regulators, ESMA identified the Prospectus Directive, MiFID10 , AIFMD11 and the Fourth Money Laundering Directive as regulatory regimes that token issuers must be particularly wary of12 :
- The prospectus directive
ESMA notes that a coin and/or token which is deemed to fall within the definition of a transferable security could necessitate the publication of a prospectus that is subject to approval by the relevant national competent authority.
- MiFID/MiFID II13
Where a token qualifies as a financial instrument (now defined in Section C of Annex 1 of MiFID II14), the trading of that token will be caught as an investment service or activity. In an extreme scenario, an unlicensed firm dealing in these tokens would be carrying out a MiFID II activity without a licence.
Depending on the structure of an ICO, ESMA warns that ICOs could qualify as Alternative Investment Funds. An ICO may be caught by the AIFMD if it is used to raise capital from a number of investors with a view to investing it in accordance with a defined investment policy.15
MLD4 captures, among others, payment services institutions and e-money issuers. Should a token issuer fall within scope, it will be required to carry out due diligence on customers, as well as ongoing monitoring. Further, the European Commission has published proposals to bring virtual currency exchanges and virtual wallet providers within the scope of the European money laundering regime.16
In issuing one statement to warn investors and another to warn issuers, ESMA is clearly asking parties on both sides of the transaction to undertake a thorough regulatory analysis before becoming involved in any ICO.
iv. The French Autorité des marchés financiers (AMF) launched a consultation paper on ICOs.
The AMF launched a consultation paper on ICOs, which closed on 22 December 2017.17 In a similar vein to the FCA’s comments this summer, the AMF notes that any regulation that might apply to token offerings ‘can be determined only on a case-by-case basis’.
The AMF additionally expressed concern regarding the fact that many ICOs, which involve the solicitation of public savings in large amounts, ‘could well escape AMF regulation entirely’. In an attempt to bridge this gap, the AMF invited market participants to consider three possibilities for future regulation:
Maintain a regulatory status quo and establish best practices.
This approach would likely mean that most ICOs would remain unregulated in France. This is certainly the most laissez-faire approach, which many would argue is needed at this nascent stage. However, the AMF’s warning that this approach would result in ‘very large amounts of money’ being offered ‘without any safeguards’ suggests that the AMF’s appetite for this liberal approach is minimal.
Regulate ICOs using the existing legal framework for prospectuses.
The AMF suggests that ICOs should be captured by the existing rules relating to public offerings of financial securities (see the Prospectus Directive, above). In acknowledging that there is no one-size-fits-all model, the AMF suggests that the prospectus regulations are amended at the European level to ensure that rules governing review processes reflect the commercial reality of ICOs. As ICOs are inherently different to the sale of transferable securities, the amendments would have to be carefully considered.
Adopt an ad hoc regulation tailored to ICOs in one of two ways:
a) This option would satisfy those who believe that ICOs cannot be captured satisfactorily by existing regulations. Such regulation would offer guarantees and protections that are commensurate with the risks that many argue are inherent in ICOs today.
In August 2017, the Monetary Authority of Singapore (MAS) warned that digital tokens will be regulated if they constitute products regulated under the Securities and Futures Act (SFA). Following on from this, MAS has issued a guide to digital token offerings, explaining the application of Singapore securities laws to digital currency. The guide, which was published in November 2017, explains how digital currency may be categorised as a capital markets product under the SFA.18
Although outside of the European Union, the publication of a guide (as opposed to a direct risk warning) presents slight but nonetheless important divergence from the typically cautious regulatory attitude.
Around the same time, the BaFin warned that virtual currencies are a ‘highly speculative form of investment that is often not subject to existing capital market regulations’. BaFin in particular asks consumers to be extremely diligent before purchasing virtual currency and highlights the risk in offerors not being subject to any transparency requirements.
vii. The UK
The FCA has followed its earlier warnings on ICOs with a Feedback Statement on Distributed Ledger Technology (DLT), confirming that it will conduct a deeper examination of the ICO market to consider whether further regulatory action should be taken.19 In the statement, the FCA suggests that current FCA rules may be flexible enough to accommodate the use of DLT by regulated firms. It therefore proposed no specific changes.
The Gibraltar Financial Services Commission (GFSC) announced in February that it is developing a draft law to regulate ICOs (the ICO Bill). The lawmakers claim that this will be the first regulation in the world specifically developed for ICOs.20 One of the principal aspects of the GFSC ICO regulations will be the introduction of the concept of ‘authorised sponsors,’ who are supposed to be ‘responsible for assuring compliance with disclosure and financial crime rules’. Gibraltar’s parliament expects to consider the ICO Bill in the second quarter of 2018.
The laws will stand separately to Gibraltar’s DLT regulations (the DLT Regulations), which came into effect on 1 January 2018.21 While the DLT Regulations bring a licensing regime to intermediaries using DLT to store or transmit customer assets, they do not extend to the use of tokens as a means of raising finance. It is expected that the draft ICO Bill will cover this.
As the first of its kind, how these rules are structured, and how effective they are, may inform any future regulations by other jurisdictions.
What will happen next?
In 2018, we may well see regulatory and legislative engagement transition from high-level statements and knowledge gathering, to concrete proposals and most likely an increase in enforcement in this developing space (following a path similar to that of U.S. financial regulators who have recently announced several enforcement actions). We expect 2018 to be an informative year for the token markets.
Reed Smith has experienced professionals in this area across Europe, Asia and the United States. If you would like to discuss the content of your whitepaper and/or any regulatory engagement with respect to a token offering, please contact us.
Brett Hillis specialises in energy trading and derivatives, and related regulatory and transactional work. He primarily works for banks and energy companies active in the trading sector, advising them on OTC, OTC-cleared and exchange-traded commodity and other derivatives; power and gas trading; and financial services regulation.
Kari Larsen has extensive international experience in building businesses and managing global commercial, legal, and compliance risks. For almost 20 years, Kari has represented clients in US and EU regulatory, legislative, risk management, compliance, internal control and transactional matters related to exchange and over-the-counter commodities, options, and derivatives markets, with a particular focus on cryptocurrencies, digital assets, energy, agricultural and environmental commodities.
Alex Murawa advises energy and commodity companies, banks, hedge funds and exchanges on a variety of transactional, cross-border regulatory, compliance and risk management matters within the energy sector. Alex has experience in advising on the commercial impacts of cross-border regulation and has advised clients on UK / EU regulations and legislation relating to the energy and financial services sectors, including advising clients on the impact of EMIR, REMIT, MAR, MiFID II, CRD and other EU regulatory initiatives. Alex has also advised on regulatory issues surrounding fintech, including blockchain and cryptocurrencies.
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3 See, for example, https://www.ft.com/content/c3c25960-080f-11e8-9650-9c0ad2d7c5b5
4 European Banking Authority (EBA) and the European Insurance and Occupational Pensions Authority (EIOPA)
8 See Article 9(3) of Regulation (EU) No 1093/1094/1095/2010 of the European Parliament and of the Council of 24 November 2010 establishing a European Supervisory Authority (EBA), (EIOPA), (ESMA).
9 See, for example, http://www.eba.europa.eu/documents/10180/657547/EBA-Op-2014-08+Opinion+on+Virtual+Currencies.pdf
10 Markets in Financial Instruments Directive (2004/39/EC) – which has since been repealed by MiFID II
11 Alternative Investment Fund Managers Directive (2011/61/EU)
12 Although some EU Member States may have implemented broader regimes
13 Markets in Financial Instruments Directive (2014/65/EC)
14 Now Section C of Annex 1 of MiFID II
15 As defined under the ESMA guidelines on key concepts under the AIFMD https://www.esma.europa.eu/sites/default/files/library/2015/11/2013-611_guidelines_on_key_concepts_of_the_aifmd_-_en.pdf
18 Under section 2(1) of the SFA, ‘capital market products’ means any securities, futures contracts, contracts or arrangements for the purposes of foreign exchange trading, contracts or arrangements for the purposes of leveraged foreign exchange trading, and such other products as MAS may prescribe as capital markets products
19 See the FCA’s feedback statement on DLT at https://www.fca.org.uk/publication/feedback/fs17-04.pdf
21 To view a copy of the DLT Regulations, please follow this link: http://www.gfsc.gi/dlt