Regulatory Bulletin: ICOs

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How are Initial Coin Offerings (ICOs) regulated?

WHAT is it? 

ICO, or Initial Coin Offering is a fundraising mechanism, which allows people to sell crypto-tokens in exchange for bitcoin and ether (which are cryptocurrencies).

To understand how this works it is important to make sure you understand how cryptocurrencies came about in the first place, what they represent and why this could be of interest to your firm.

Let’s start with a description of a transactions made in a cryptocurrency, just to see why they are talked about so much and what makes them attractive:

  • Accounts from which transactions are realised are not connected to real identities, hence they are made anonymously
  • Transactions are known to the network of peers almost immediately, so it is fast and you can send money anywhere in the world
  • All transactions are protected by unique keys which makes them secure
  • There are no barriers to entry: all you have to do to start buying or selling cryptocurrency is download a software on your computer
  • There is a limited supply of cryptocurrency, it is known that we will run out of it in around 2140
  • And after the transaction is confirmed it cannot be reversed or cancelled.

HOW does it work?

The inventor of the first ever cryptocurrency Bitcoin -whose identity is still unknown to the world – has developed “A Peer-to-Peer Electronic Cash System” in late 2008. His attempt to create a digital cash system was the first successful one after many people’s failed attempts. To explain it simply: a digital cash system like any other payment system requires a network with accounts, balances and transactions between those accounts.

The main problem with any payment network is its ability to prevent ‘double-spending’. So, a peer-to-peer network would not have a centralised server to prevent double-spending and essentially confirm the legitimacy of transactions. This is the problem the inventor of bitcoin faced and he was the first one to solve it.

To give an example, if two people exchange value in the traditional payment system, there is a centralised authority to confirm each of the parties’ outstanding balanced. In a digital network, there is no such authority, which is why the system is referred to as ‘decentralised’.

This is where blockchain comes in. Every peer in this decentralised system has a record of their transactions (hence the balances of all accounts). An example of a transaction record would be ‘John gives Michael an X number of bitcoins’. This piece of information is normally referred to as a block. Thus, in the peer-to-peer digital cash system, there will be blocks of information about transactions, which appear as a chain, hence the name ‘blockchain’. For the purposes of security, John would sign the transaction with his own unique password key and once it has been signed it is sent off to appear in the network.

So far, there are two qualities of a digital cash system that makes it so attractive to people:

(1) there is no central clearing house, so peers can directly and securely exchange money;

(2) the transaction will be known to other peers in the network almost immediately but only after a specific amount of time it is confirmed. This second part of the process is very important, since before the transaction has been confirmed it can be cancelled.

So who confirms these transactions? These participants of the network are called miners. It is the miner’s job to confirm that transaction has taken place and it is legitimate. Since anybody can become a miner, and there is a system to stop miners from abusing their power, the inventor of this system has set a Proof-of-work rule. This rule basically dictates that for someone to be qualified as a miner they have to have the ability to solve a mathematical problem.

These mathematical problems use a cryptographic algorithm, which is quite difficult to understand; but more importantly, there is an incentive for miners in the form of bitcoins, so solving one of these problems means a minor can add a block of transaction which can be attached to the previous one to continue creating a chain. Additionally, solving one of these problems gives minor a right to create a valid bitcoin.

This is where cryptocurrency gets its name from, it is built on cryptographic algorithms. Miners do not perform these calculations themselves but utilise the much greater power of computers, effectively using powerful graphics cards intended for gaming to mine cryptocurrency. However, miners can only create a limited number of bitcoins in a given period of time (as stated above, there is a limited supply of cryptocurrency). This is because the difficulty of the problem to be solved increases the amount of computer power which miners invest.

Moving onto Initial Coin Offerings…

Bitcoin is the most famous cryptocurrency, however, there are a few other well-known ones:

  • Ethereum (or ether)
  • Ripple
  • Monero
  • Dash
  • NEM

In May this year, the price of Ether doubled and peaked at just over $400 (roughly £298) the month after. This is of course starting from its initial price of $0. Many investors believe that the value of these cryptocurrencies could be worth 10, 40 or even 100 times their current value in the next 5-10 years.

ICOs are essentially campaigns to raise funds for new cryptocurrency undertakings related to a specific project. Just like in the case with an IPO, the firm undertaking the project creates a business plan which includes information about what needs to be done for the project to kick off and the amount of digital cash needed. Investors who are interested in supporting these projects buy their cryptocurrency and pay in crypto-coins or tokens in the same way shares are bought during IPOs. In a case where amount of money raised does not represent a sufficient amount for the owners of the venture to undertake it, the money invested is returned to the investors and the ICO is deemed unsuccessful. However, if the ICO was successful, then the investors have their money at risk in the future.

One of the features of an ICO is the fact that the projects related to them can vey widely in design: the crypto-coin that you are buying could represent a prepayment for future service, a share in a firm a voucher and sometimes ICOs start so early on the in the project the design of it has not even been finished, so it is hard to understand risks involved.

In the next section, we will describe what risks there are and what you can do if you suspect an ICO is a scam.

HOW is it regulated?

The main difference between an IPO and an ICO is ICOs are totally unregulated in the UK. This is not, however, because the FCA is comfortable with their risks; indeed, the regulation-light Chinese government has banned ICOs altogether in China. The FCA on the other hand has issued a warning, branding ICOs as ‘very high risk, speculative investments’. Whilst they have not taken steps to regulate the sector, the risk remains that a large-scale conduct issue – or the bottom falling out of a major cryptocurrency market – will force them to step in and take draconian measures. Risks for investors include:

  • There is not enough knowledge about the industry as a whole and its potential for an investor to differentiate between promising ventures and high-risk scams.
  • There is no protection for investors in forms of compensation schemes, such as the Financial Services Compensation Scheme (FSCS). The FCA add that the firms undertaking these ICOs are located all over the globe, so it will be difficult to understand under what jurisdiction they operate in the first place.
  • There is very high risk of fraud and it is hard to predict if the issuers are actually planning to undertake the project they are marketing.
  • At the time of writing the price of Bitcoin and Ether went down by 6.1 and 7.2 % in one day accordingly. This is just one example of how volatile they are, so you can expect dramatic changes in the price.
  • As the FCA mention on their website, there is ‘no adequate documentation’ , such as a Prospectus Directive-compliant offer document, which you can refer to should the ICO be unsuccessful or fraudulent.
  • As mentioned above, the designs of these project vary, some of these projects could be incomplete or at early stages, they might have unsustainable business models, which again, puts investors’ capital at risk.

Looking from a perspective of a potential investor, it is evidently highly risky to invest in ICOs, since there is a lot of uncertainty about the legitimacy of projects and what potential ‘emergency breaks’ there are in the worst-case scenario. The FCA has a page and an online form to report ICOs which you think could be a scam. It is worth noting that many cryptocurrency providers are adopting self-regulation based on the FCA Handbook to project an image of legitimacy; however, the measures they are taking are not audited or monitored in any way.

If you are thinking of funding your project through an ICO, you are legally allowed to do so. The UK government has not banned ICOs, however as mentioned above the FCA has reportedly warned investors however it is unclear at this stage what the FCA’s next move will be in regards with this. The main requirement here is to ensure the project itself is within the legal framework. So, for example if you are thinking of funding a start-up business which will carry out regulated activity, you need to ensure the business is compliant with relevant regulation.

If you are looking to use cryptocurrency, blockchain or ICO as a part of your business, here is a list of things you can and cannot do:

  • You can raise money from bitcoin investors to fund a business, but you cannot use cryptocurrency for FCA regulatory capital purposes
  • If you are an investment manager or fund manager holding client money, you cannot hold client money in the form of cryptocurrency – the rules state clearly that you must place customer funds with an appropriately authorised custodian.
  • You cannot use cryptocurrency to capitalise a regulated business, it will need to be converted into sterling.
  • You can carry out Cryptocurrency-only investment management activity. In this case investment management is still considered as regulated activity and requires compliance with relevant regulation.
  • You cannot mix traditional regulated investment management with cryptocurrency investment management since the FCA will not tolerate some of the clients’ money being invested into high risk, unregulated products. The two services must be delivered through completely separate entities.
  • There is nothing to stop you using blockchain technology in a more general sense to underpin other aspects of your business such as invoicing and contracts.

WHAT can we do to help?

At FinTech Compliance we work with a number of clients at the cutting edge of blockchain and cryptocurrency technology. Through our extensive research and network of contacts we can offer detailed advice on how cryptocurrency touches upon aspects of regulation, and how you can make it work in your business.  If you have an idea, let us know, and we will help you assess the riskiness of your potential project and guide you through to ensure you are in compliance with relevant regulation.

Please do not hesitate to contact us to via telephone at +44 (0) 207 100 4058, or visit our Contact page on our website if you require more information on this topic, or you would like to engage our assistance in other areas.