Decoupling Tokens From Trading: Reaching Beyond Investment Regulation for Regulatory Policy in Initial Coin Offerings

Abstract

Initial coin offerings (ICOs), a means by which technology entrepreneurs raise finance from members of the public to fund the development of innovative technology projects, has become a growing market. About 50 ICOs have raised over USD$1 billion in the first two months of early 2018, with the top ten ICOs raising between the equivalent of USD$36 to USD$100 million. In the absence of well-accepted institutions of financial markets regulation, it is an astonishing phenomenon to witness the appeal and growth of the unregulated ICO markets.

The innovative structures of ‘tokens’ or ‘coins’ offered in ICOs do not fit neatly into existing fundraising regulatory regimes, and the international/borderless nature of ICO markets defy national enforcement. However, the US SEC issued a report in mid-2017 to classify certain tokens as securities and offers of such tokens would need to comply with securities regulation or exemptions to such regulation. Although the EU and UK have not issued precise clarifications on regulatory treatment, the European Securities and Markets Authority and the UK Financial Conduct Authority have warned that existing regulatory regimes may apply to ICOs depending on how they are structured and that investors should be aware that these are high-risk and unregulated investments.

There is understandably concern over regulatory arbitrage- whether ICOs are merely a means of using technological innovation to obfuscate the true nature of an investment offering, and therefore avoiding regulatory compliance. This regulatory avoidance potentially jeopardizes investors by not adhering to standards of investor protection enshrined in securities and financial regulation. On the other hand, ICOs may defy regulatory classification because they could be truly innovative in terms of redefining asset classes and the fund-raising process. This article argues that instead of attempting to fit ICOs within the current definitions of financial instruments that may most resemble the ICO, such as ‘securities’ or ‘collective investment scheme’, both of which attract the need for regulatory approval and compliance with regulatory requirements, policy-makers should consider more broadly how regulatory policy should be conceived (a) in relation to the development of asset classes in financial innovation and (b) how the balance of investor protection and fund-raising should be achieved.

Section A discusses the development and characteristics of ICO markets in terms of primary markets (where subscription is made directly for ICO tokens as offered by ICO issuers) and secondary markets (where tokens are traded and resold amongst market participants). Section B discusses the potential application of regulatory classification to ICOs, comparing the US SEC’s approach to the EU’s and UK’s potential approaches in securities and collective investment scheme regulation. We argue that there are genuinely distinguishing characteristics in ICOs and that an approach that forces ‘coherences’ is counterproductive. We suggest that the primary markets should be governed by proportionate buyer protection regulation that adheres to common standards in consumer protection but these are not necessarily at the same level as investor protection.

Section C argues that investor protection issues really only arise in relation to the secondary markets where tokens are traded like derivative financial contracts and a regulatory framework can be considered to achieve the protection of market participants. We sketch the contours of such a framework. We argue that our suggestions form a package of proportionate reforms for policy-makers, addressing key market protection needs while paving the way for asset innovations to take place and access to finance to be facilitated. Section D concludes.

Keywords: Initial Coin Offerings, Securities Regulation, Collective Investment Regulation, Financial Markets Regulation, Consumer Protection