The recent release by the Swiss financial markets regulator, FINMA, of guidance regarding its approach to the regulatory framework for Initial Coin Offerings (ICOs) is a welcome attempt to provide a more granular analysis of the ICO market and the likely applicability of securities regulation to this market. The guidance represents the first attempt by any regulator to properly consider, in a holistic manner, the different aspects of the ICO market and how existing regulation might apply to different genres of digital assets offered in an ICO.
ICOs have, to put it mildly, exploded in both number and volume over the last 12 months. By the end of 2016, the total of all funds ever raised globally through ICOs had reached US$300 million – it only took a further 12 months for this number to reach US$5.68 billion, with over 500 ICOs in 2017 alone. ICOs are an increasingly disruptive force in the fintech venture capital industry, with many firms choosing to part or fully fund projects through ICOs rather than seek more conventional equity funding from VC investors.
This exponential growth has left financial services regulators struggling to catch up. The reaction of regulators in different markets to the regulation of cryptocurrencies in general and ICOs in particularly has been relatively inconsistent. Reactions have ranged from cautiously welcoming (in the case of the Hong Kong and Singapore regulators), to neutral but concerned (in the case of the European Securities and Markets Authority) to downright hostile (in the case of China, which has banned ICOs outright).
Many regulators have expressed concerns around the potential losses to investors who may fall victim to fraudulent ICOs or, at the very least, may not fully understand the high risks of ICO investing. Concerns relating to the potential use of cryptocurrencies for money laundering also remain.
What is clear is that many regulators are clearly struggling to place the square peg of this rapidly evolving technology into the round hole of their existing regulatory frameworks.
Applying Existing Securities Regulation to ICOs
Many jurisdictions have opted to apply existing securities regulation to ICOs. The most high profile example of this was the release in July 2017 by the United States Securities and Exchange Commission (SEC) of the report of its investigation into the DAO. The DAO was the realisation in 2016 of a concept of the same name and initials, a “decentralised, autonomous organisation” which would operate as a stateless venture capital fund with no conventional management structure, that would make its investment decisions using the wisdom of crowds. At $150 million, it set the record for the largest crowd-funding campaign in history. The SEC confirmed its view that DAO Tokens issued by the DAO were securities for the purposes of the Securities Act of 1933 and the Securities Exchange Act 1934 through, among other things, the application of the so-called “Howey Test“ to DAO Tokens.
Although the SEC opted not to take enforcement action against the DAO and its founders, potential promoters of ICOs were put on notice that there would be increased scrutiny of ICOs to ensure no violations of US securities laws were taking place.
When one reads the full SEC report on the DAO, it is, in truth, not hard to see how the SEC reached its conclusion. The nature of the DAO Tokens, and the terms attached to them, left little doubt that they did constitute an “investment contract” as defined in the Howey case, and should therefore be regarded securities for the purposes of US securities law.
So the DAO was an easy one. But what about the hundreds of other ICOs which have launched since July 2017, and those which are yet to be launched? The digital assets offered in many ICOs have terms and use cases that are more nuanced than those of the DAO Token and would, they suggest, not be classified as securities under the Howey Test. Indeed, it was specifically acknowledged in the SEC report on the DAO that some tokens would not be classified as securities, although no further guidance was offered on this point.
What is missing in the SEC report, and what has been missing from pronouncements by regulators everywhere, is any attempt to offer any kind of framework to analyse ICOs by genre. Instead, regulators have tended to opt for bland statements to the effect that whether an ICO will be regarded as a securities offering will be taken on a case by case basis, and promoters should take legal advice. This lack of clarity is, it is suggested, unsatisfactory and unhelpful to the evolution of this market.
New FINMA Guidance on ICOs
On 16 February 2018, the Swiss regulator, FINMA, released its guidelines for enquiries regarding the regulatory framework for ICOs.
Switzerland is emerging as one of the leading global ICO hubs, and home to 5 out of the top 15 ICOs by size to the end of 2017. FINMA confirmed in its guidance that it is receiving an increasing volume of enquiries regarding the applicability of securities law to ICOs, and has released the guidance in response.
The guidance makes it clear (as the SEC has also done) that, for the purposes of Swiss securities law, some ICOs will be offering securities and some will not. However, FINMA goes further than any regulator has done to date by attempting to classify assets offered in ICOs into three genres:
- Payment Tokens – tokens which are intended to be used, now or in the future, as a means of payment or as a means of money or value transfer. Cryptocurrencies such as bitcoin, litecoin or ripple clearly sit within this category.
- Utility Tokens – tokens which are intended to provide access digitally to an application or service by means of a blockchain-based infrastructure.
- Asset Tokens – tokens representing assets such as a debt or equity claim on the issuer, including a share in future earnings or capital flows. These tokens are analogous to equities, bonds or derivatives. The DAO Token would appear to sit within this category. It is also arguable that USDT tokens (issued by Tether) would also be classified as an asset token.
Importantly, the guidance makes it clear that many ICOs will comprise “hybrid tokens” which may have the features of more than one genre. This is clearly correct: for example, a great many ICOs are launched for the purpose of building a blockchain network to deal with a specific niche or solve a specific need. Tokens from these ICOs act as both payment tokens (to transact on the network) and utility tokens (to use the network). Likewise, the classification of “asset tokens” as securities would appear to mirror the SEC interpretation of tokens which are “investment contracts” with an economic equivalence to conventional securities.
FINMA makes it clear that tokens that are payment tokens or utility tokens and do not have any aspect which would classify them as asset tokens are not securities. Only where a token has some characteristic which would bring it within the classification of an asset token does it become a security. In addition, a so-called “pre-sale” phase of an ICO, where investors pay for the right to acquire a token at a later date, would be classified as a securities offering.
The guidance also makes it clear that the Swiss Anti-Money Laundering Act only applies to the issue of tokens which have the characteristics of payment tokens. The Act would not apply to tokens which are purely utility tokens.
The FINMA guidance is both welcome and encouraging for a number of reasons.
FINMA has clearly given the matter some serious thought – the fact that it has gone beyond the generic pronouncements of other regulators to actually construct a considered yet flexible framework bodes well for considered and intelligent future regulation in the jurisdiction. The framework does also appear to accurately reflect the current state of the ICO market and the nature of tokens offered. Finally, it gives credibility to the ICO market, and is likely to mean Switzerland may become increasingly popular for ICOs in the future.
It remains to be seen whether regulators in other jurisdictions will follow suit.