Forecasting regulation (part 2)

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Happy New Year!

In our last blog on this topic we spoke about the need for stringent cyber security related controls in lieu of regulation. In this segment, we want to talk more about another area which is very much on the regulatory radar already: ICOs (Initial Coin Offerings).

Why is it important?

ICOs are typically used to generate capital for the delivery of a product the purpose and function of which is set out in a white paper. To put this another way, the “coins” are tickets for the use of a future product. Investors in them work on the basis that at some point in the future, their value will increase. It’s worth noting that these so-called coins are not always the basis of a currency (i.e. what’s referred to as a crypto-currency).

One problem associated with this model is that it became a means for theft where the capital raised would be expropriated with little or no recourse for investors.

It’s also worth mentioning STOs (Security Token Offerings) which are seen as an alternative to traditional venture capital fund raising and are considered to have a lot more controls and protections in place than ICOs.

Nonetheless, whichever acronym is being used to describe the process, it would appear as though the type of fund raising powered by distributed ledger technology (DLT) appears to be here to stay. As these mechanisms are increasingly used, they bring with them the increased attention of governments and regulators concerned with consumer protection. This of course means regulation.

The interesting challenge appears to be whether or not the coin offered within the ICO can be considered a security and thus, regulated as such. Once the companies behind the coin are fully formed, the coin itself takes on the nature of a security. Given this nature, legal and financial experts are already debating which area of legislation this falls under e.g. “securities and commodities law, capital gains taxes, international transactions, AML and trading and investment practices”.

What’s driving the need?

Fraud is a general concern for governments across the board. More specifically theft (see Mt.Gox), money laundering and terrorist financing.

It’s somewhat safe to say that in the early days, the regulators were caught off guard as they clamoured to truly understand the technology during the mania phase of Bitcoin. They scrambled to understand the risk and provide appropriate guidance to the public.

Today regulators are actively engaging the crypto exchanges with requests for information and are even placing wallets on to sanctions lists. This is a significant difference to where things were. However, there is still a lot of variance in how this is being managed:

• The FCC and the SEC in the US already deem ICO coins as a security even though their ability to maintain this definition on a case by case basis is being challenged.

• In China however, ICOs have been banned outright.

• Vietnam has vowed to tighten regulations on cryptocurrencies as authorities investigate an alleged multi-million-dollar fraud in the country. 

• The government of Gibraltar has become the first authority to publish proposals that will formally regulate ICOs.

• The UAE is a lot more positive and aim to have regulations on the ground in the first half of this year and are actively positioning themselves as a regional/global hub for regulated ICOs.

Some governments have made real commitments towards regulating ICOs in a way that acknowledges their growing importance. Then of course a whole host of cryptocurrency exchanges are being established and are looking to provide a more safer investing environment for consumers.

It’s worth mentioning the rise of crypto based ETFs (Exchange Traded Funds) which are essentially baskets of currencies grouped together in a single investment vehicle. ETFs will always need to go through regulatory approval before being offered to the market and as such fund managers would certainly need to demonstrate compliance in the same way they would for any other ETF.

What happens next?

In lieu of regulation, industry participants should self-regulate by implementing a framework of good practice not only to ensure confidence in the product being offered but more importantly, to ensure that their clients are safeguarded and warned of the potential pitfalls. A conservative approach would be simply to apply as many of the common-sense controls in place for securities as possible/plausible. For example:

• Start-ups making an ICO should ensure that their white-papers include a comprehensive (yet easily understandable) set of health warnings outlining the risks associated an investment and the potential downside e.g. complete loss of the investment. In addition, the manner in which the funds invested will be spent should be clearly articulated. A timeline outlining the key product milestones up until the point at which a token can be exchanged for a product or sold in the open market should also be specified.

• Companies looking to raise funds via STOs (as well as addressing the controls raised above) should clarify the redemption plan for the token in question e.g. voting rights, cash flow or dividends.

• Crypto exchanges should confirm the "rules of entry" for any company wanting to launch on ICO/STO or trade a token on their platform. These rules should ensure the types of safeguards mentioned above are adhered to by participants.

How can we help?

Contact us to discuss how the CaaS service framework can be used to ensure your company has suitable controls established to ensure your customers are protected on an ongoing basis. We will devise a framework that you can use to measure, monitor and improve your offerings and products that puts you in good stead for eventual regulation.

Thank you for reading and as ever, comments, likes and shares are highly appreciated.