You can’t really blame them – these problems do ravage the market. A lot of projects have started fundraising with nothing but the idea and a beautifully written whitepaper. Some have engaged in pump-and-dump schemes, where they artificially increase the value of their own tokens only to cash out once it’s high enough. Many more have simply failed and left investors helpless, as they couldn’t recoup their losses. There has even been claims that ICOs could become a way for terrorist organization to raise funds. It is thus understandable that regulators are stepping in – after all, their upmost interest is protecting the common investor from scams and losses that he cannot sustain. Regulatory framework The goal of investor protection has spurred a myriad of different regulatory regimes, that all claim to have a distinct – sometimes contradictory – solution to the problem. China chose to outright ban ICO-related activity, citing “scammers defrauding investors” as the primary motivation. US is fairly open, but the SEC has issued an alert on the rise of “pump-and-dump” schemes and the regulatory regime in the future could be moving slightly towards the bars-and-cages instead of skies-and-crazes model. EU, as a whole, is not unified in its stance on the new fundraising system. A few inviting beacons of freedom – such as Switzerland or Lithuania – shine through, but there are also shadowy parts of Sweden or Slovakia, that almost don’t see any crypto-related activity. There are disagreements over which countries are the most ICO-friendly. The list includes Estonia, Lithuania, Gibraltar, Singapore, Luxembourg, Cayman Islands and Malta. But Switzerland, with its official encouragement of the new technology tops the list. Those who are interested in the nits and bolts of each country’s regulatory stance, should see information here and here. How does one actually regulate? Cracking down on fraudulent activities At the moment, securities and commodities regulators in Europe are putting most of their man-power into eliminating fraud. They’re looking at what the new ICOs are promising investors, they’re looking at the firms’ statements and they’re judging just how exaggerated or how fishy the projects look. Statements like “205% GUARANTEED annual returns for our early contributors” or “the more friends you recruit, the more funds you will generate for yourself” will definitely raise red flags. Given the sheer number of unrealistic promises and misrepresented products, these efforts are welcomed both by investors and other legitimate ICO firms, whose reputations are harmed by such cases of shameless fraud. Adding definitions Currently, a great majority of different field-related definitions and token names have come not from the top, but from the bottom – from the emerging crypto industry, not their regulators. As these tokens have not been previously defined by law, regulators are stepping in.
Some agencies have defined “virtual currencies” as “monetary equivalents” for the purposes of anti-money laundering and money transfers. Other actors have them defined as market tradeable “digital goods” so they fall under “commodities” regulation. “Property” stamp has also been used for taxation purposes. Nevertheless, when weighing tokens primarily as fund-raising material, they’re most commonly considered as “securities” or “investment contracts”. These efforts, by all means, are welcomed as they pull ICOs away after the regulatory grey zone they’re currently operating in. Classifying token assets Similarly to adding definitions, regulators are also classifying company-issued tokens. In most jurisdictions, all tokens are separated into utility tokens (the token equivalent of digital exchange-coupon) and security tokens (equivalent to actual asset-backed investments). If you’re not familiar with the two, please familiarise here and here. [INSERT LINK TO PARTS I AND II OF SECURITY TOKENS] When weighing tokens primarily as fund-raising material, they’re most commonly considered as “securities” or “investment contracts”. The regulations for the two are like night and day. Security tokens are subject to rigorous security regulations, while the utility ones are simply left off-the-hook, because they’re not considered investments. The observed problem is that a number of projects have masqueraded obvious investment contracts as innocent utility tokens, thus opening a potential loophole of unregulated investing. Things are made worse, because most tokens are of dual-nature: not only do they have some consumptive utility built into them, but also can be traded, so they become a mix – or rather a mish-mash – of both security and utility tokens.
Regulators are responsible for deciding which is which on a case-by-case basis and then approving the validity of ICO. Otherwise, as utility tokens essentially remain unidentified in the regulatory framework, possibility of running into legal problems down the road is fairly high. The global test to determine if a token is a security versus a utility is the US-made Howey Test – it is closely observed and followed by the European Union. In testing, they look at how the token is actually being used by investors and whether they anticipate future monetary gains – that’s usually the strongest indicator that the token should fall under jurisdiction of securities legislation. Providing consultation Some authorities, such as that of Switzerland, provide consultation for the ICO startups and guide them through the regulatory process. This means a firm can present the token offering on paper and receive advice and opinions from the authorities, and not worry about falling under an investigation later, which is a major plus. In addition, a stamp of approval provides reassurances to the investors, as it signifies the legality of ICO. This trust is then monetized by the firms conducting token sales. In other words, everyone benefits from cooperation with regulators. Protecting investors’ interests Finally, regulators go an extra mile just to protect investors. They have good reasons to do so – regulator’s quality is often gauged by how well it protects the investors and how easily the authorities can be reached in the event of a dispute. Some countries go to extreme lengths to protect their investors. There’s a history of the US Security Exchange Commission (SEC) extending its jurisdictional reach across borders. Even if the ICO is conducted in an abroad location with a strong regulatory framework, such as Lithuania, the global regulatory heavyweights – the SEC and the Commodity Futures Trade Commission (CFTC) – may still claim jurisdiction. They may claim a breach in US securities law if a fraudulent ICO sells to some US investors, or if the company conducts any business from within the US. They might even interfere solely because the CEO of the ICO firm is a US citizen. European law enforcers are a bit more lax, but they also demand adherence to anti-money laundering/know your customer (AML/KYC) practices, and require additional regulatory steps, such as registrations and disclosure statements. The takeaway Taking in the Zeitgeist of the regulatory environment for ICOs is a wise idea for anyone wondering into the space. While regulatory regimes seek to better protect investors, it is the responsibility of the investor himself to do his own digging. Extensive research will go a long way if you decide to invest. Regulations are here to sort out any grievances and conflicts between a company and investors if something should go wrong. It is your obligation to not do something wrong in the first place. To be on top of your game – continue to surf the learning curve here and here (INSERT LINK TO PARTS I AND II OF SECURITY TOKENS).