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Regulators need to be more creative if they are to understand coin offerings, report says.
The challenges presented by initial coin offerings (ICOs) will require regulators to learn about technologies such as blockchain, and to devise creative ways to regulate them, according to a report released recently by an international team of legal scholars from Germany, Australia and Hong Kong.
“From a compliance standpoint, the key point is the need to be aware of legal risks involved in ICOs, which are probably still underappreciated,” said Professor Douglas Arner of the University of Hong Kong (HKU)’s Faculty of Law, one of the authors of the report, “The ICO Gold Rush: It’s a Scam, It’s a Bubble, It’s a Super Challenge for Regulators”.
“There is a real risk that [an ICO] which is not designed innocently will go viral, with potentially significant impact on large numbers of unsophisticated investors, and on confidence in blockchain and related developments more generally. The biggest challenge for regulators is that [ICOs] are global: taking advantage of the best aspects of democratisation of finance but at the same time making them difficult for individual legal jurisdictions to address,” he said.
Significant challenges for regulators
“To me, there are two significant challenges for regulators. First, keeping up with the sheer pace of change,” said Billie-Jo Dixon, managing consultant with financial services regulatory consultancy Bovill in Singapore. “And secondly, dealing with regulatory arbitrage whereby some players may seek out jurisdictions where there seems to be less attention from the regulator,” or where the regulator had not yet taken a stance, she said.
“Initial coin offerings typically use blockchain technology to offer tokens that confer some rights in return, most often for cryptocurrency. They can be seen as effectively a conjunction of crowdfunding and blockchain,” the paper said. “At the moment, many ICOs are offered on the basis of utterly inadequate disclosure of information, and the decision to invest in them often cannot be the outcome of a rational calculus. Many of the hallmarks of a classic speculative bubble are present in many, but certainly not all, ICOs.”
The report points out, however, that ICOs also provide an innovative structure for raising funds to support new ideas and ventures, “with the potential for aspects of the underlying structures to have an important impact on fundraising systems and structures in future”.
Indeed, in the past 18 months around 1,000 worldwide ICOs have raised more than $3 billion. Although the paper says such figures are not indicative of a global trend, the growth rate for digital currencies is picking up; more has been raised in the past six months than in the previous three years, especially when one considers that bitcoin came online in the aftermath of the global financial crisis in 2009.
“ICOs initially began as a mechanism among the blockchain community to attract financial support for new ideas and initially involved small amounts of money and small numbers of investors. However, as amounts raised have increased, so has interest in using ICO structures to raise money for ever-broader purposes and among ever-broader groups of investors, with issuance in 2017 forming one of the largest portions of early stage fundraising globally. Recent high-profile examples have included celebrity promoters such as Paris Hilton, Wu Tang Clan … In addition, while early structures sought largely to avoid legal and regulatory considerations, in recent months, there has been an increasing involvement of major legal and advisory firms in the area,” the report said.
Investor protection
The paper accepts that governance problems experienced by some ICOs have led to concerns for financial regulators, with many feeling that investor protection should be their top priority.
“There has been a wide range of initial regulatory responses: from an outright ban of ICOs in the case of China and South Korea, to warning notices by European, U.S. and other regulators reinforced by statements that securities laws could well apply and registration be necessary, to more lenient approaches in other jurisdictions, with Singapore and Switzerland as leading examples,” the paper said.
“As the ICO market is currently too small to pose a systemic or stability risk, financial regulators in Asia will be most concerned with consumer and depositor protection issues. ICOs represent high-risk investment opportunities, are volatile and highly speculative in nature,” said Etelka Bogardi, a partner at law firm Norton Rose Fulbright in Hong Kong.
“In addition, ICOs tend to pose a higher fraud risk and there are heightened money laundering concerns which regulators are grappling with. To the extent [that] such ICOs cannot be shoe-horned into the existing regulatory framework, investors will not receive adequate protection against such risks,” she said.
It may, however, be precisely the lack of an existing regulatory framework that is driving greater interest in digital currencies.
“In my view the greatest regulatory challenge for regulators with regard to ICOs is understanding them and, more importantly, understanding the basis for why they have become so popular. ICOs are definitely very high-risk but many investors are so jaded with participating in the costly and burdensome regulated markets, that they are prepared to take the higher risk of being scammed or misled,” said Bill Majcher, head of EMIDR, a cyber security and risk management firm in Hong Kong.
“A better question to be asked is why, after all the financial scandals, are a growing body of investors flocking to ICO’s, which is really crowdfunding with a tech twist? Source of funds is always an issue with crowdfunding-type deals so this will be a concern for regulators, as ICOs and crowdfunding … are great mechanisms to ‘park’ money,” he said.
Learning curve
It is perhaps unsurprising, however, that financial regulators are experiencing something of a learning curve at the moment.
“Regulators are facing the same issues that they have with any fintech innovation: new product, new technology, new players and, overall, a new paradigm to regulate. The promise of ICOs is to become a kind of ‘crowdfunding 2.0’, or an intermediary layer between private and public markets. In order to enable this potential, they will have to figure out a new regulatory framework, with lower regulatory requirements while preventing money laundering and protecting investors,” said Aurélien Menant, co-founder and chief executive of Gatecoin, one of the first bitcoin exchanges in Hong Kong to be registered with the local Customs and Excise Department.
He said most regulators had still not properly defined or regulated the digital currencies that were usually the collateral of the ICO tokens.
The Hong Kong Monetary Authority has taken the view that, while digital coins are subject to anti-money laundering rules under the territory’s Anti- Money Laundering and Counter-Terrorist Financing Ordinance (AMLO), they are not regarded as currencies of any kind, but as digital commodities which market participants purchase and trade at their own peril.
Nov 24, 2017 Ajay Shamdasani, Regulatory Intelligence
Ajay Shamdasani is a senior regulatory correspondent with Thomson Reuters Regulatory Intelligence in Hong Kong. He covers regulatory developments in Hong Kong, India and South Korea. He also writes about money laundering, tax evasion, fraud, corruption, data privacy and cybercrime.
Source: Thomson Reuters Regulatory Intelligence
Copyright © Thomson Reuters 2017. All rights reserved.
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