RAISING CAPITAL ON THE BLOCKCHAIN – THE DISRUPTIVE CAPABILITIES OF INITIAL COIN OFFERINGS
L.L.M. International Business Law Master Thesis 2017-18
Author: Stefan Enchev – U1263131
Supervisor: Patricia Gil-Lemstra
Tilburg Law School
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Table of Contents
1. Introduction………………………………………………………………………………………………………………. p.3
2. Blockchain and Initial Coin Offerings…………………………………………………………………………. p.7
2.1 What is blockchain?...... p.7 2.1.1 Benefits of blockchain…………………………………………………………. p.10 2.1.2 Application in practice and use cases………………………………….. p.11 2.1.3 Blockchain risks and shortcomings……………………………………... p.13
2.2 Initial Coin Offerings………………………………………………………………………… p.16 2.2.1 The benefits of ICOs……………………………………………………………. p.21 2.2.2 ICO risks and concerns………….………………………………………..….. p.26 2.2.3 Existing regulation applicable to ICOs…………………………………. p.29 2.2.4 The world’s legislative responses……………………………………….. p.30
2.2.4.1 United States…………………………………………………….…… p.29 2.2.4.2 Switzerland………………………….………………………………... p.31 2.2.4.3 Singapore…………………………………………………………….… p.33 2.2.4.4 Malta……………………….……………………………………………. p.34
3. The current state of the ICO market: a case study……………………………………………………. p.35
4. Promoting the development of blockchain-based fundraising and ICOs…………………… p.38
4.1 Designing a regulatory framework ………………………..……………………….. p.38 4.1.1 A complete ban………………………………………………………………….. p.38 4.1.2 Regulatory sandbox regime………………………………………………… p.40 4.1.3 Case by case exemptions……………………………………………………. p.42 4.1.4 DAICO implementation………………………………………………………. p.43
4.2 Inclusion of all relevant stakeholders………………………………………………. p.44 4.2.1 Governments……………………………………………………………………... p.44 4.2.2 Issuers………………………………………………………………………………… p.47 4.2.3 Investors…………………………………………………………………………….. p.50
5. Conclusion……………………………………………………………………………………………………………….. p.53 6. Bibliography…………………………………………………………………………………………………………….. p.55
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1. Introduction
The newest developments in technology are reshaping almost every aspect of our lives. We live in an era where driverless cars are already hitting the roads and causing accidents which give raise to liability-related issues.1 Artificial Intelligence (AI) is looming over many industries, inciting fear among working people that they will be replaced by a mere sequence of software. AI, Machine Learning and Internet of Things technologies are steadily en route to cause another industrial revolution as concerns about data privacy and Terminator-like scenarios occupy the minds of many sceptics.2 Disruption is happening everywhere, at an unprecedented pace and inability to adapt will inevitably result in peril for many. One of the most trending technological advancements is undoubtedly the increasingly popular blockchain technology. Blockchain is the underlying technology behind Bitcoin, but there is significantly more to it than global money. It has a variety of uses that can benefit lawyers as well as cause endless conundrums on how to solve the problems associated therewith. Blockchain enables the creation of Smart Contracts which can be safely stored and universally trusted by parties, so creating a long called innovation among lawyer circles.3 The technology can further be utilized for example for secure transactions and record keeping, both being an essential part of the everyday work of the modern lawyer. Arguably the most popular by far, one of blockchain tech’s applications relates to its use within Financial Technology (FinTech). Blockchain enables entrepreneurs to raise capital in an innovative way resembling other traditional types of fundraising such as Venture Capital (VC) and Crowdfunding. Characterized by allowing participation of virtually any investor from any point of the world, Initial Coin Offerings or ICOs are one of the hottest contemporary topics as 2017 saw overall capital raised by ICOs almost reach $6 billion USD globally.4 Bigger corporates have their eyes on the technology as well. Kodak stock for example rose as much as 250% after the company’s announcement of a Kodak Token launch.5 Other companies such as Overstock and Sears have also expressed interest in launching a native network token for their services. Overstock, which is a publicly traded eCommerce
1 Sam Levin and Julia Wong, 'Self-Driving Uber Kills Arizona Woman In First Fatal Crash Involving Pedestrian'
retailer already listed on the New York Stock Exchange (NYSE), is expected to raise an amount in the area of approximately 250 million USD. Its CEO Patrick Byrne is quite bullish on ICOs and has already secured 50 million USD in funding during Overstock’s native token (tZERO) pre-sale.67 Sears, on the other hand, has been on a steady decline of share price due to the common struggles of retailers around the world against eCommerce websites. Their board has also expressed interest in salvaging their company through a token sale.8 Though while they carry a number of benefits for entrepreneurs as an alternative source of finance compared to IPOs and Venture Capital funding, Ponzi schemes, fraud and hack cases have planted a rather negative image of ICOs among many investors, economists, business people as well as regulators.9 BitConnect, against whom there was evidence for running such a scheme, announced it was shutting down last January which resulted in a 99% loss of value of the platform’s BCC token.10 Other occasions of similar practice are still on going, showing contemporary safeguards’ inability to clearly showcase the benefits of this particular blockchain application. When it comes to regulation, the world’s legislative response on ICOs and cryptocurrencies varies significantly from jurisdiction to jurisdiction. Potential financial scams have lead Chinese and South Korean authorities to issue full bans on token offerings11 while in Europe stringent Anti-Money Laundering and Know Your Customer rules under the Markets in Financial Instruments Directive (MiFID II) aim to provide investors and companies alike with sufficient protection.12 There are also jurisdictions that are considered ICO-friendly such as Switzerland or Malta, where the relevant regulatory body has opted for a balanced approach reflecting the high level of demand for cryptocurrencies.13
6 Joe Liebkind, ‘5 Major Companies Mulling an ICO’ https://www.investopedia.com/news/5-major-companies- mulling-ico/ accessed 19 August 2018. 7 A native token refers to a particular blockchain’s project’s own token. For example the native token of the Bitcoin network is (BTC), whereas for Ethereum it is the (ETH) token. 8 Thornton McEnery, ‘Sears Unsubtly Threatening an ICO’ https://dealbreaker.com/2018/01/sears-unsubtly- threatening-an-ico/ accessed 19 August 2018. 9 Usman W. Chohan, ‘Initial Coin Offerings (ICOs): Risks, Regulation, and Accountability’ https://poseidon01.ssrn.com/delivery.php?ID=2400690021210770010910031221200780750170730540320330920 74008002074009121004026066069126000025041062008124018125073117093120118007080012013002117092 12301603109906511204804607108601807902200101709612512206811910612606707710310812212500212511 0004100104064&EXT=pdf accessed 19 August 2018. 10 Fitz Tepper, ‘Bitconnect, which has been accused of running a Ponzi scheme, shuts down’ accessed 19 August 2018.https://techcrunch.com/2018/01/16/bitconnect-which-has-been-accused-of-running-a-ponzi-scheme-shuts- down/ 11 Jon Russell, ‘First China, now South Korea has banned ICOs’ https://techcrunch.com/2017/09/28/south-korea- has-banned-icos/ accessed 19 August 2018. 12 European Securities and Markets Authority, ‘MIFID II’ https://www.esma.europa.eu/policy-rules/mifid-ii-and- mifir accessed 19 August 2018. 13 Molly Jane Zuckerman, ‘Swiss Financial Authority Releases ICO-Specific Regulatory Guidelines’ https://cointelegraph.com/news/swiss-financial-authority-releases-ico-specific-regulatory-guidelines accessed 19 August 2018. 4
No matter the approach however, the call for the introduction of regulatory as well as self-policing methods on side of the issuer is evident as a whole new market has been created where main issues such as information asymmetries and lack of transparency pose the risk of significant losses of value among many parties. Additionally, many investors are entering the space due to the surrounding hype and fears of missing out on profits. Given the popularity of ICOs, it is imperative to not only protect investors, but also create a cooperative and transparent environment best suited for the technology’s incubation. The main goal of the following paper is to accentuate on the benefits of blockchain technology, more specifically in the area of ICO fundraising, and develop a risk-minimizing approach to incubate the development of this innovation. The paper will thus provide a thorough analysis of both the benefits and disadvantages associated with ICOs and blockchain technology in order to identify how this new fundraising method, despite some inherent shortcomings, is able to aid entrepreneurs. Subsequent to the analysis, the paper will provide recommendations to all relevant stakeholders in an ICO process (issuers, government authorities such as regulators, and investors) with the aim of improving the space and minimizing the negative effects of the imminent crash (industry bubble burst)1415 of many projects. Similarly to the .com bubble of past years, both private and institutional investors are pouring vast amounts of capital in the sphere and a number of issuers, as will be exemplified, are actively trying to make money solely based on the hype surrounding blockchain.1617 Many projects are additionally solving the same issues (think Bitcoin, Litecoin and many others trying to create global money)18 and in the end, it will only be a pair of these emerging as global leaders in the space, leaving the rest of the competition bankrupt or purely useless. When all relevant stakeholders are involved, the negative consequences of future bubble-like scenarios are to be vastly negated, thus minimizing massive losses of capital, effort and time. Additionally, proper government action coupled with smart investing and responsibility from the side of project leaders will cater for the increased maturity and efficiency of the blockchain ecosystem, hence paving the way towards a more investor-friendly with an enhanced trust
14 Per Investopedia, an economic bubble typically refers to an occurrence in an economic cycle ‘characterized by the rapid escalation of asset prices followed by a contraction, created by a surge in asset prices unwarranted by the fundamentals of the asset and driven by exuberant market behavior. When no more investors are willing to buy at the elevated price, a massive sell-off occurs, causing the bubble to deflate.’ In the cryptocurrency space this has happened on several occasions, most notably after the January grand market crash. Given recent tendencies and the overpricing of the most projects, the apparent bubble is expected to continue to burst until prices adequately reflect the value propositions of projects and the market reaches a maturity stage. 15 Investopedia, ‘Bubble’ https://www.investopedia.com/terms/b/bubble.asp accessed 19 August 2018. 16 The Dotcom Bubble is a historic bubble at the end of the last century (1995-2000). During the Internet-based bull market at the time investors were pouring in significant amounts of capital in the Internet industry (fad and fear-of- missing-out investing) and the prices of related assets grew in a way unrelated to their actual value. 17 See supra note 15. 18 Ripple, the second largest cryptocurrency is trying to achieve the same. Bitcoin Cash is fourth in market capitalization and is essentially an alternative to Bitcoin. DASH, 15th in market cap is another global money project. Solely in the top 20 currencies >5 of them are solving the same issue. 5
factor and specific protections. It will further be argued that Initial Coin Offerings could prove to be a preferable source of finance for companies and that their regulation must by no means hinder innovation in the sector by imposing in toto prohibitions. A more balanced approach will be advocated for, one not only limited to government action, but also one that includes innovation and transparency by design for example through the use of Regulatory Technology (RegTech) for blockchain startups or other technical solutions such as the DAICO, an alternative to traditional ICOs proposed by Vitalik Buterin, the founder of the second most popular cryptocurrency Ethereum. Regardless of the taken stance, it will be stressed out that existing regulatory frameworks are ill equipped to answer the market’s needs. Thus, governments must direct their efforts towards developing specific legislation rather than trying to adapt outdated legal methods to our digitalized world. Such an approach is already being tried into action by jurisdictions destined to propel innovation such as Malta, Switzerland and Singapore. The work’s main hypotheses that ICOs demand particular attention due to their disruptive capabilities will further be supported through a practical case study about the current state and general trends of the ICO market. I am currently employed by the innovative law firm ‘Watson Law’, based in Den Bosch, the Netherlands. Among others, Watson Law’s main lines of business include corporate litigation and ICO consultancy. My involvement in their day-to-day operations is thus an enabler for me to provide an adequate description of the practical implications of ICOs and how they are being handled by a top-class team of lawyers who are focusing on blockchain’s implementation in Dutch law. The data from the study has further helped me identify the needs of ICO teams as well as some areas in which they excel. The paper is divided in four main parts. First, an explanation of blockchain and its functionality will be presented in order to set the scene and provide some answers to questions such as how ICOs came to be, how they work and how they can be used to businesses’ and investors’ advantage. This part will furthermore include an analysis of the contemporary shortcomings surrounding the ICO ecosystem. In a second step, current regulatory responses to ICOs and cryptocurrencies will be analyzed to identify both positive and negative sides of given trends. The third main part will be devoted to a discussion of the future of token sales around introducing an approach specifically tailored to ensure a balance between the interests of the many stakeholders in the coin ecosystem such as investors, businesses and governments. Lastly, the conclusive part will summarize the paper’s main findings and recommendations.
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2. Blockchain and Initial Coin Offerings
2.1 What is blockchain?
Every initial coin offering has as its main purpose to distribute a fixed number of coins to interested parties. These coins are a form of a token issued by the offeror in a digital environment, a digital voucher of a sort which bears a certain value. Often compared to securities as they usually grant the owner certain types of rights, the issuance of tokens is only made possible in a digital environment, on the so called blockchain. To properly understand what ICOs are and how they work, it is therefore imperative to first become acquainted with the technology that makes the distribution of coins possible.
Distributed Ledger Technology and Blockchain
Contemporary means of storing data, be it financial or any other type, often make use of a centralized record book (a ledger) where data is stored and a trusted administrator is tasked with maintaining the data in proper order to ensure its validity and authenticity.19
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19 D Zetzsche et. al., ‘The Distributed Liability of Distributed Ledgers: Legal Risks of Blockchain’ (2017) 14 EBI Working Paper Series https://poseidon01.ssrn.com/delivery.php?ID=0431051271210241220920650060890921210090360000820610911 06021000025110008023081070011120058100122042024053115064115004079110076020090034037034100066 12010709507706504204600000007612610309512409309400308700308400211312710102811300312512111909 3120102006&EXT=pdf 7
In such a system, the trusted administrator acts as a sole intermediary for the execution of every transaction. To illustrate, consider the purchase of corporate stock during an initial public offering. As ownership of the issued shares has to be properly recorded, a central authority, in this case a securities exchange is expected to store the data in a central database. Here, the trusted administrator is the exchange and authenticity of stock ownership can only be proven by accessing the central server responsible for keeping records. In a distributed ledger environment, the information containing the details of ownership is disseminated to a variety of record holders. As a result, there is no single central server responsible for maintaining the whole data. Rather, any device running DLT software is able to collectively maintain the data with all the other inter-connected devices, forming a vast, distributed network of access points.21 The formed database can be shared across the network to all the participants, regardless of their geography and each participant has their own individual copy of the shared database, identical to every other copy.22 The security and accuracy of the information is maintained cryptographically and network users are assigned individual keys, reflecting their access and control rights within the network.23 In the example of stock purchase, an investor’s private key (similar to a password) is able to ‘unlock’ their transaction and show the type of assets they own, how much they have and what they can do with it. Blockchain is a type of a decentralized or distributed public ledger based on the science of cryptography which aims to keep information safe and secure. 24 Vitalik Buterin, founder of one of the most promising and developed blockchain projects to date – Ethereum, describes it in the following way:
‘a magic computer that anyone can upload programs to and leave the programs to self-execute, where the current and all previous states of every program are always publicly visible, and which carries a very strong cryptoeconomically secured guarantee that programs running on the chain will continue to execute in exactly the way that the blockchain protocol specifies’25 Although it is commonly believed that Bitcoin is the first initial use of blockchain, a
20 Medium.com accessed 19 August 2018. 21 David Mills et. al., ‘Distributed ledger technology in payments, clearing and settlement’https://poseidon01.ssrn.com/delivery.php?ID=545088089111020065023124123126094120007012007 06806500309403601002411401603002302005409503009205104403507611402600412311412501308003601907 5127108003081009116091082066069095123114076116127013064070080119113030001099074&EXT=pdf accessed 19 August 2018. 22 Government Office for Science, ‘Distributed Ledger Technology: beyond blockchain’ https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/492972/gs-16-1-distributed- ledger-technology.pdf accessed 19 August 2018. 23 Ibid. 24 Ibid. 25 M Pilkington, ‘Blockchain Technology: Principles and Applications’ https://poseidon01.ssrn.com/delivery.php?ID=5730030971241090250980230311010741020040310540520300661 03127101126127084090027070007006034063101028059032066030100000125068101046016071077042068007 08408707412308006208008211109302900009507308300108412607011208709402911701700602802512307710 1020097086&EXT=pdf accessed 19 August 2018. 8
detailed description of the structure and functionality of the technology dates back to 1991 already, in a work by Stuart Haber and W. Scott Stornetta.26 That being said, the first conceptualization of block chain came amidst a time of great distrust towards financial institutions. Shortly after the Global Economic Crisis of 2009, Satoshi Nakamoto (arguably an individual or a group of coders) created the digital currency Bitcoin, where blockchain ensured the solving of the double-spending problem and the elimination of a central trusted intermediary controlling the in-and-out flow of data.27 In essence, blockchain consists of different data sets which are composed of a chain of data packages (blocks). 28 Each individual block of the chain is comprised of sets of transactions which once imported on the blockchain, cannot be changed or otherwise manipulated to reflect a value different than the one initially specified, unless the whole network collectively decides to do so.29 The blocks are also organized in a chronological order, which further enhances the security of the network and makes access to a particular transaction easier.30 Every single block with valid transactions contains a cryptographic hash (a stamp of a sort) that links the block with the previous one from the chain to ensure the authenticity of the contained information. Once a type of data has been imported to the block, it is assigned its very own hash that is subsequently transferred from block to block and kept intact throughout the whole chain, thereby greatly reducing the risk of third party manipulation.31
26 A Narayanan et. al., ‘Bitcoin and cryptocurrency technologies: a comprehensive introduction.’ (Princeton: Princeton University Press 2016). 27 Satoshi Nakamoto, ‘Bitcoin: A Peer-to-Peer Electronic Cash System’ https://bitcoin.org/bitcoin.pdf accessed 19 August 2018. 28 Michael Nofer et. al., ‘Blockchain’ http://aisel.aisnet.org/cgi/viewcontent.cgi?article=1421&context=bise accessed 19 August 2018. 29 Stephen Armstrong, ‘Move over Bitcoin, the blockchain is only just getting started’ https://www.wired.co.uk/article/unlock-the-blockchain accessed 19 August 2018. 30 Investopedia, ‘Blockchain’ https://www.investopedia.com/terms/b/blockchain.asp accessed 19 August 2018. 31 N Bhaskar et. al., ‘Bitcoin Mining Technology’. In Cheun, David Lee Kuo. Handbook of Digital Currency: Bitcoin, Innovation, Financial Instruments, and Big Data (Academic Press 2016). 9
32
To verify each transaction, the blockchain network is premised on the peer-to-peer consensus of the individual participants rather than the verification of a central authority. This consensus is what is commonly referred to as mining in the crypto world.33 Open access is a central feature of blockchains and virtually anyone can become a miner, as long as they have access to the specialized software on which the network is running.34 However, the process consumes a great amount of energy therefore making it arduous for anyone without a powerful computer to be able to partake. Miners are responsible for maintaining the blockchain and for completing the separate blocks of information. Once a block has been completed, the miner who solved the digital algorithm thus completing the last block is rewarded with a fraction of the currency underlying the network.35 As a result, there is an incentive system in place which rewards active participation and development of the blockchain, thereby ensuring its continuity.
2.1.1 Benefits of blockchain
Transparency and enhanced trust
As blockchain is a type of a distributed ledger, every participant in the network has their own copy of the ledger which is identical to every other copy owned by others. The system furthermore functions on the basis of peer-to-peer consensus which means that data can only be altered with the approval of all participants.36 To change one transaction record in the blockchain, the technical characteristics of the technology require the subsequent alteration of all the data that has been imported after the changed transaction. This is, least to say, a very challenging endeavor requiring more than just resources, effectively making the information stored on the blockchain immutable and trustworthy.37
32 Bitcoin Exchange Guide accessed 19 August 2018. 33 See supra note 21. 34 Christian Scheinert, European Parliament, ‘Virtual Currencies – Challenges following their introduction’ http://www.europarl.europa.eu/thinktank/en/document.html?reference=EPRS_BRI(2016)579110 accessed 19 August 2018. 35 Investopedia, ‘Bitcoin Mining’, https://www.investopedia.com/terms/b/bitcoin-mining.asp accessed 19 August 2018. 36 Arthur Iinuma, ‘What is Blockchain and What Can Businesses Benefit from It?’ https://www.forbes.com/sites/forbesagencycouncil/2018/04/05/what-is-blockchain-and-what-can-businesses- benefit-from-it/#61d361f9675f accessed 19 August 2018. 37 Matthew Hooper, ‘Top five blockchain benefits transforming your industry’ https://www.ibm.com/blogs/blockchain/2018/02/top-five-blockchain-benefits-transforming-your-industry/ accessed 19 August 2018. 10
Security
Transactions made on the blockchain bear the main characteristic of requiring a collective network approval before going through. After approval, every transaction is encrypted and given its own cryptographic hash, as discussed above. The hash function serves as a stamp and cannot be changed once approved. Together with the fact that data is stored on multiple computers at the same time rather than on one central server, it is a lot more difficult for hackers to tamper the data or even gain access to it in the first place.38
Efficiency and cost savings
Once matured and properly maintained, blockchains process transactions faster and more efficient than contemporary methods of handling data. Information can be disseminated in a matter of seconds, ownership can be transferred almost instantly and everyone has access to the same information. The middle man is eliminated, thereby eliminating transaction costs and the significant loss of time of paper-heavy processes is a thing of the past. The human error aspect is also greatly reduced as the system is automated.39
2.1.2 Application in practice and use cases
Financial services
A major spotlight falls on utilizing potential and actual uses of blockchain within financial services. The introduction of Bitcoin by Satashi Nakamoto in 2009 acted as a response to a growing public distrust towards the world’s financial system, in particular regard to the work of banks and other popular actors in the asset management sphere.40 Global money, quick and commission free transaction form a very small minority of the innovative solutions currently being brought up by various startups utilizing blockchain. Its ability to virtually eliminate the middle-man in a transaction is in itself an answer to significant contemporary mass inconveniences when transferring not only currency but also with various titles of ownership including stocks, digital property and others. Lastly, many new startups who reach the point where they need external investment face fundraising problems. Debt investment based tools are increasingly losing popularity due to discontent with interest rates or disproportionate covenants among others. As a result, raising
38 Ibid. 39 See supra note 34. 40 See supra note 26. 11
capital on the blockchain was made possible through ICOs whose adoption continues to grow.41
Smart contracts
Blockchain enables the creation of smart contracts. What makes a contract ‘smart’ is its ability to self-execute based on conditions predetermined by the parties in question.42 To illustrate, consider a between friends. Joe and Jack are fiercely competitive between each other and chose to take their competition to the forum of world football earlier in July (yes, they decided to bet on the World Cup winner). Joe has been to France a couple of times and the country has a special place in his heart – needless to say he is certain they will win over Croatia. Jack, on the other hand, loves to support newcomers and ‘the little guy’- logically he chooses the EU’s newest member as winner. They bet $1000 each. Though Joe and Jack do not seem to be that close as Jack is nowhere to be found once the clock reaches the 90th minute and France take home the spoils of war. In a smart contract scenario such a mishap is mitigated – once a clear winner has been established, the contract will allocate a $1000 from Joe’s account to that of Jack, as previously agreed by them. As one may imagine, the application of smart contracts is virtually limitless and significantly negates the possibility of fraud and deception. On a larger scale, they can be employed to improve the efficiency of automated clearing houses, similarly to the situation of Jack and Joe’s bet.43 In the context of initial coin offerings, smart contracts can be used to lock a certain amount of funds for later use. Suppose a company rolls out 10,000 of its native tokens, out of 20,000 in total. Once the goal has been reached, the system is able to lock the remainder 10,000 for later use on a pre-specified date, as agreed on within the contract.
Supply chain management
The characteristics of blockchain enable its application in the area of supply chain management (SCM). It has been previously mentioned that once imported into a blockchain, a set of data is immutable – it cannot be amended to look different than the original. For SCM, this development is revolutionary as it can be potentially applied to products from their initial point of origin. A piece of hardware, for example, can be given its very own stamp (hash) which can be tracked by authorities to ensure compliance or by companies themselves to send out a positive signal to its customers. Everledger, a blockchain-based application is already working on a real-life solution to associated issues.44 With their proprietary technology, the company aims
41 David Floyd, ‘$6.3 Billion: 2018 ICO Funding Has Passed 2017’s Total’ https://www.coindesk.com/6-3-billion- 2018-ico-funding-already-outpaced-2017/ accessed 19 August 2018. 42 Cointelegraph, ‘What Are Smart Contracts? Guide For Beginners’ https://cointelegraph.com/ethereum-for- beginners/what-are-smart-contracts-guide-for-beginners#what-are-smart-contracts-for accessed 19 August 2018. 43 See supra note 21. 44 Everledger.io, ‘What We Do’ https://www.everledger.io/ accessed 19 August 2018. 12
to record the origin of diamonds, thereby reducing risks of misappropriation and fraud while at the same shedding light on how the diamond has been mined, which in itself can provide for improved working conditions.
Voting
Blockchain can be used to introduce a transparency promoting election system fit for 21st century democracy. Again due to immutability of the ledger, the votes of citizens are recorded once and cannot be averted by a political party. Some earlier elections in Russia showed a 140% voter turnout.45 Both biologically and mathematically, this is not possible which raised some eyebrows among the general public regarding the authenticity of the elections. In countries who are willing to display their democratic status, blockchain can provide more seamless, more transparent and more effective elective processes.
2.1.3 Risks and shortcomings
Technical complexity and cyber risks
From the outset of things, blockchain does not seem as something too hard to grasp. Nevertheless, its application to provide real-life solutions can be quite difficult. Especially for those who are not technically gifted, the code and work-in-practice of blockchains is a high mount to climb. There is therefore a substantial barrier to entry that can be attributed to the technology’s relative young age (Bitcoin was its first conceptualization and is only 10 years old). The lack of human capital in programming additionally makes the process of mainstream blockchain adoption slower. Another technical barrier is the immutability of the ledger. Once data has been imported into a blockchain it cannot be changed. This opens up the possibility of human error and necessitates elevated degrees of caution during the process of data import. Thus, proper processing standards need to be developed in order to use blockchain in both the public and private sectors of services.
Operational risks
Blockchains are premised upon code and code needs developers to run smoothly. There will always be bugs and errors in every piece of software. With insufficient developing power, blockchains run the risk of becoming obsolete. Their rigorous maintenance is a prerequisite for
45 The Economist, ‘Voting, Russian-style’ https://www.economist.com/europe/2011/12/10/voting-russian-style 13
their efficient operation. If poorly maintained in the context of outdated or deficient code, the risks of third party intervention are very high.46 Another major operational risk relates to the concept of Key Person Risk. The inherent technical complexity behind blockchains caters to the fact that there are only a few people with the relevant knowledge on how a given network works. Especially in cases where potential weaknesses or errors materialize, KPR should not be neglected. It may be that the key person is out of office on vacation or that they fall ill, or even that they are being extorted by a third party. Such scenarios raise questions regarding accountability and liability.47 Negligent performance is another factor to consider here. Specifically for blockchains, their proper maintenance is of vital importance. Also in cases where users commit mistakes, for example when sending funds to the wrong address, it is unclear as to who is able to help them produce the initially intended outcome.
Data privacy
A higher level of transparency is one of the prerequisites of blockchain networks. While it can efficiently contribute to solve trust-related issues, enhanced transparency levels also give rise to issues relating to data privacy and insider trading or market abuse. Since blockchains operate on a distributed model, storing information on multiple computers (nodes) could violate privacy protection laws. The simultaneous storage of data, as found by Gabison, may facilitate access to private data sets, especially in the case of more transparent networks such as Bitcoin.48 The Bitcoin network reveals a substantial amount of data about its users. Considering the recent coming into force of the General Data Protection Regulation (GDPR), companies must proceed with sufficient caution if they are to use blockchain-based solutions. The immutability of the ledger is a further stress point when it comes to data privacy violations. In the example of credit score, inaccurate data submissions can negatively affect the data subject and diminish their credit worthiness. For minors, the issue is even more prevalent as illegal pictures* check to make sure* or documents will never leave the database. The newly introduced concept of ‘the right to be forgotten’ clashes this operational characteristic of blockchains. In the context of insider trading and market abuse, there are concerns in relation to the storage of sensitive information. According to the European Securities and Markets Authority:
‘shared and public features of DLT could facilitate market manipulation and other unfair practices. In the absence of proper safeguards, some could unduly exploit the information
46 See supra note 19. 47 Ibid. 48 G Gabison, ‘Policy Considerations for the Blockchain Technology Public and Private Applications’ (2016) 19 SMU Sci. & Tech. L. Rev. 327. https://scholar.smu.edu/scitech/vol19/iss3/4 14
recorded in DLT, e.g., recent trades or inventories levels of other participants, to front-run competitors or manipulate prices.’49
Scalability
As blockchains operate on a distributed model and have a network of computers maintaining them at the same, this means that all the information contained therein is also simultaneously stored on these computers. New data entries furthermore require the consent of a specific number of participants which in turn makes this process highly repetitive. Coupled with the fact that only one node is awarded at the time of completion, one could argue that much of what is being done goes to waste.50 Three main inferences stem from this mechanical peculiarity of blockchains: First, storing information on a blockchain requires, least to say, a lot of computing power when compared to its counterpart, the centralized ledger. 51 Second, blockchain networks need to reach a sufficient size before becoming fully operable. Bitcoin, for example, is currently able to process no more than 7 transactions per second. VISA, which can arguably be seen as its competitor in the area of global payment services, has the capacity to process as many as 24,000 transaction per second while averaging 150 million per day.52 The third inference is that in order to optimally work on an industrial scale, blockchains requires our energy usage to shift to eco-friendlier options. Otherwise, if contemporary systems continuously make the switch to blockchain, its energy consumption will reach record highs, thereby stripping it of its future viability.
Security
Blockchains are not limited to one particular design. While their most popular conceptualization at the moment generally revolves around increased transparency (public ledgers) , they can be utilized to serve the other end of the spectrum – increased privacy. By way of example – Monero, a better known private blockchain platform, gives its users the promise of secure, impossible to track anonymous transacting. Based on a similar premise are other higher value crypto networks such as ZCash and Dash. Previous records of exploiting the technology (not necessarily through the abovementioned cryptocurrencies) for, a.o black market trade and money laundering prove that the state of the technology has not yet reached
49 European Securities and Markets Authority, ‘Report: The Distributed Ledger Technology Applied to Securities Markets’ https://www.esma.europa.eu/system/files_force/library/dlt_report_-_esma50-1121423017-285.pdf 50 Ibid. 51 Ibid. 52 VISA, ‘Run Your Business’ https://usa.visa.com/run-your-business/small-business-tools/retail.html 15
maturity stage.53 Cases of tampering data prior to storage are also present. Since blockchain transaction typically involve two parties, let’s assume a buyer and seller, attacks can be made not against the system itself but against the weak data input link. Thus, cyberattacks that focus on the transacting parties may lure them into over relying on the network itself, thereby not realizing the inherent inaccuracies in their own transaction. One of the most notable DLT hacks in history, against the Mt. Gox exchange, employed the exact same strategy on focusing on the input point rather than the system as a whole. When it comes to security blockchain is arguably a revelation. Notwithstanding its potential benefits in the area of safekeeping however, it has a weak point of its own. The so- called ‘51% attack’, initially referred to in Satoshi Nakamoto’s Bitcoin Whitepaper, is blockchain’s very own Kryptonite. In short, the security mechanisms behind blockchain operate under a model where a 51% consensus participation of the totality of nodes is able to insert an amendment to the current blockchain protocol – the so-called forking process.54 55This ‘feature’ is one that could potentially allow hackers to access a network using brute computing force. Distributed Denial of Service Attacks (DDOS) are an additional possible risk. Especially for ledgers which are more concentrated (where smaller numbers of total nodes control mining processes), DDOS attacks prove to be a viable point of concern, resulting in network-wide operation stoppages.56
2.2 Initial Coin Offerings
Although they have only gained popularity in the past few years, initial coin offerings or also referred as token sales date back to as early as 2013, in particular with the introduction of Mastercoin (now Omni Layer) by J.R. Willett who is commonly abbreviated as the ‘Founder of the ICO’ within crypto circles.57 The amount raised in the first ever ICO was $3.15 mln, an arguably very modest amount compared to today’s standards. The number of participants in the offering was not so grand either as only 500 managed to get their hands on the world’s pilot
53 Annaliese Milano, ‘Europol Nabs 11 in Crypto Drug Money Laundering Case’ https://www.coindesk.com/europol- nabs-11-in-crypto-drug-money-laundering-case/ accessed 19 August 2018. 54 A fork represents a change in a blockchain protocol where a second version of the blockchain is formed that is incompatible with the previous one. The new version then follows a new set of rules for transacting. For example Bitcoin has been forked, thereby forming the Bitcoin Cash blockchain which follows a different coding protocol than the original Bitcoin blockchain. 55 Phil Glazer, ‘An Explanation of Cryptocurrency Forks’ https://hackernoon.com/an-explanation-of-cryptocurrency- forks-65d79efe214c accessed 19 August 2018. 56 See supra note 19 57 Laura Shin, ‘Here’s The Man Who Created ICOs And This Is The New Token He’s Backing’ https://www.forbes.com/sites/laurashin/2017/09/21/heres-the-man-who-created-icos-and-this-is-the-new-token- hes-backing/#7145ce2b1183 accessed 19 August 2018. 16
token sale.58 Following the years after their introduction to the world in 2013 token sales have attracted various interest from private and institutional investors alike. The interest in trading with crypto has been so high as to have even reached a point where the Chicago Board Options Exchange introduced exchange-traded fund options for Bitcoin.59 Undoubtedly the ‘crypto boom’ took place in 2017 when blockchain-based token sales accounted for almost $6 billion worth of financing for entrepreneurs.60 Figure 1 below presents an overview of the top coin offerings of 2017, seeing projects such as EOS and Tezos raise amounts north of $200 million. Bancor, as exemplified, managed to raise a whopping $153 mln. This was done in the short period of only three hours.61
FIGURE 1
58 Jay Preston, ‘Initial Coin Offerings: Innovation, Democratization and the SEC’ https://scholarship.law.duke.edu/cgi/viewcontent.cgi?article=1324&context=dltr accessed 19 August 2018. 59 Thomas Franck, ‘Cboe files to list 6 bitcoin ETFs after being first major exchange to trade cryptocurrency futures’ https://www.cnbc.com/2017/12/22/cboe-files-to-list-6-bitcoin-etfs.html accessed 19 August 2018. 60 J Rohr, A Wright, 'Blo‘kchain-Based Token Sales, Initial Coin Offerings, and the Democratization of Public Capital Markets’ (2018) 527 Cardozo Legal Studies Research Paper https://poseidon01.ssrn.com/delivery.php?ID=0920930291050960810010280951251201120200520900290400710 00079014029082100124065125094062054007100062009029091068017082015015075020021043003048095002 12209101409511702702908303509706810402210107810108500407812100402109910903009607409400506802 7118094102017&EXT=pdf accessed 19 August 2018. 61 Wassim Bendella, ‘Broken Record: Bancor Raises $153 Million in Less Than Three Hours’ https://cointelegraph.com/news/broken-record-bancor-raises-144-mln-in-less-than-three-hours accessed 19 August 2018. 17
The year 2018 holds great hope for the development of the ICO. The ‘hottest’, most grand expected ICO of for the year was that of Telegram - the messaging service which is supposedly planning to create the next Ethereum via the introduction of its Telegram Open Network (TON). Amidst the hype of late 2017 and the copious amounts of capital being poured into blockchain projects, TON was (and still is) projected to be the most marquee of all platforms by raising an amount in the likes of $1.2 billion, an unprecedented number in the industry.62 However, the beginning of 2018 was marked by a grand market crash, where the vast majority of all Coinmarketcap listed cryptocurrencies lost at least half of their previously accumulated value.63 Bitcoin for example was being traded around the $20,000 mark and saw its value drop to as little as $6,000 in February.64 Ethereum was flirting with a price tag of above $1000 before the crash saw its value drop in the $400-500 range. The market capitalizations of the Top ICOs of 2017, as illustrated above, were reduced dramatically as well, seeing for example lose as much as 80% from its total value over a 7 month period.65 The last few spring months have seen the market steadily recuperate. What is peculiarly interesting is the increasing popularity of initial coin offerings despite individual cryptocurrencies’ volatile prices and the market crash of the beginning of the year. In January alone, during the massive price decrease, less than 35 total coin offerings raised nearly $800 Mln. The total amount of capital raised through token sales in 2017, which stood at $5.6 bln., has been surpassed too – already in April this year.66 With the current volume of ICOs being offered to the public, this figure is bound to surpass the $10 bln. mark amid the year’s third quarter. According to data from Howmuch and Coindesk, at the current time of writing (July 2018) the total amount of funds raised through initial coin offerings nears. Figure 2 below represents an illustrative overview of the token sale ecosystem in terms of overall capital raised. Even Telegram’s initial plans of holding a $1.2B fundraising round have expanded as the messaging giant seeks to collect a total of $1.7B in blockchain-based funding, up $500 from its late 2017 announcements.
62 Jon Russell, ‘Inside Telegram’s ambitious $1.2B ICO to create the next Ethereum’ https://techcrunch.com/2018/01/15/inside-telegrams-ambitious-1-2b-ico-to-create-the-next-ethereum/ accessed 19 August 2018. 63 Jonnie Emsley, ‘ICO Contributions In 2018 Already Surpass the $5.6 Billion Raised in 2017’ https://cryptoslate.com/ico-contributions-in-2018-already-surpass-2017/ accessed 19 August 2018. 64 Cryptocurrency Market Capitalizations https://coinmarketcap.com/ accessed 19 August 2018. 65 Ibid. 66 Ibid. 18
FIGURE 2
19
The popularity of ICOs is not fading despite the dip in the overall value of the cryptocurrency market. The increased activity of regulatory bodies in increasing numbers of jurisdiction effectively points towards a validation of the blockchain model and its uses in various other industries outside capital markets and access to finance. An initial coin offering is a new form of a venture financing mechanism that establishes a newly created blockchain where a new cryptocurrency is formed and traded vis-à-vis a type of legal tender or any other existing cryptocurrencies, most commonly Bitcoin and Ethereum.67 There is currently no standalone legal definition for what particular capital raising tool token sales actually are. A main factor to consider when discussing their legal classification is the nature of the token with the distinction usually being made between security and utility tokens. 68The common meeting of the minds of regulators worldwide suggests that they stand between the traditional IPO and crowdfunding, where greater similarity is found towards the latter.69 Currently the majority of ICOs take place on the Ethereum blockchain and are based on the currency’s ERC20 token which has become the go-to industry standard choice for new coin issuing rounds.70 More concretely, empirical data suggests that slightly more than 55% of all projects are Ethereum-based whereas just above 20% have developed their own blockchain to sell tokens. Only a mere 5% of the ICOs examined by Adhami et al made use of the Bitcoin blockchain. The preference to issue on Ethereum is because the ERC20 standard makes crypto assets easier to trade and ensures their viability with other blockchain-based apps alongside making available tokenization features such as voting rights or equity-based reward systems.71 Although deemed as ‘initial’, ICOs can normally be the second or even third distribution of tokens within a project’s individual blockchain. What makes them ‘initial’ is their offering to the public. According to Zetsche et al, roughly 70% of ICO tokens have been offered to a private investor before enabling unlimited public access.72 Venture capitalists, business angels and institutional investors are the most common forerunners when it comes to these pre-initial offers. After the initial token sale, many cryptocurrencies end up being traded on the secondary market, more specifically on crypto exchanges, notable examples being Coinbase, Binance,
67 Crowdholding, ‘How to create an ICO – Part 1 – The building blocks’ https://medium.com/@crowdholding/how- to-create-an-ico-part-1-the-building-blocks-ee1e7a2834b7 accessed 19 August 2018. 68 Investopedia, ‘Initial Coin Offering (ICO)’ https://www.investopedia.com/terms/i/initial-coin-offering-ico.asp accessed 19 August 2018. 69 Ibid. 70 Hira Saeed, ‘What is ERC20 Token standard and why is it useful for your ICO?’ https://www.coinschedule.com/blog/erc20-token-standard-ico/ accessed 19 August 2018. 71 Deloitte, ‘ICOs – The New IPOs?’ https://www2.deloitte.com/de/de/pages/innovation/contents/ICO-funding- innovation-in-the-crypto-age.html accessed 19 August 2018. 72 D Zetzsche et. al., ‘The ICO Gold Rush: It’s a scam, it’s a bubble, it’s a super challenger for regulators’ (2018) 18 EBI Working Paper Series https://poseidon01.ssrn.com/delivery.php?ID=5910080920020670901141130830220740240570830470110930571 24027018005121014070081124076006012033059126097000026125123076124005002019037091041086075079 09602106510806400504606308412409902006609012312601912411312503012400412400309909312510908411 0117088027&EXT=pdf accessed 19 August 2018. 20
HitBtc, Bitfinex etc.73 The environment of secondary market transactions has not reached a maturity stage and optimal regulation is yet to be developed in most jurisdictions. Large scale instances of asset losses are a further point of concern. Cases such as the $460 million worth hack of the former Japanese MountGox exchange which was handling nearly 70% of all Bitcoin transactions in 2014 signifies the dangers of the market and its vulnerability towards third party hacking intervention.74
2.2.1 The benefits of ICOs
The current bank-based financial system has the tendency of steering new businesses into lending money from banks rather than making use of capital markets.75 After severe financial crises in the past few decades (think the end of the last Millenium, the Internet Bubble and the most recent 2009 financial crisis), banks have introduced tighter checks for borrowers. Small firms are therefore often rendered unable to tap into funding, because public debt financing is typically unsuitable for earlier stage startups or simply too expensive due to rising interest rates and overregulation. ICOs can thus be considered a safe harbor for SMEs and entrepreneurs as they provide a platform for more efficient capital formation, especially in a digital age where the democratization and globalization of markets is fostered.76 Raising capital through an initial coin offering gives issuers the opportunity to tap into a worldwide pool of investors.77 Virtually anyone with a computer is able to directly partake in a coin offering and at a later stage in the secondary market, with the aim of purchasing a network’s native token, be it with for profit or to access a service being offered. Many ICOs often end up being oversubscribed with there being significantly more demand than actual supply. The secondary market for cryptocurrencies on exchanges (Binance, Coinbase, Kraken being notable examples) is also quite dynamic and the volume of trading has steadily grown over the past years.78 While many investors often do not succeed in participating in the ICO
73 See supra note 58. 74 Robert McMillan, ‘The Inside Story of Mt.Gox, Bitcoin’s $460 Million Disaster’ https://www.wired.com/2014/03/bitcoin-exchange/ accessed 19 August 2018. 75 Dmitri Boreiko, Navroop Sahdev, ‘To ICO or not to ICO – Empirical Analysis of Initial Coin Offerings and Token Sales’ https://poseidon01.ssrn.com/delivery.php?ID=8500200980891050710000181210910291200280370090790510311 09073096074027029000110014026118058007012054120046022087068087110075097007085094078038067065 12300711402409006209302007802300600503000500108210903010906812700707406709512412110108707511 2013082025&EXT=pdf accessed 19 August 2018. 76 See supra note 72. 77 I Barsan, ‘Legal Challenges of Initial Coin Offerings (ICO)’ (2017) 3 Revue Trimestrielle de Droit Financier (RTDF) https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3064397 accessed 19 August 2018. 78 S Cohney et. al., ‘Coin-Operated Capitalism’ https://poseidon01.ssrn.com/delivery.php?ID=6250201261160110150000661140951141100190340890650860860 21
round, issuers typically have the goal of having their token traded on exchanges. The secondary market provides unmatched liquidity for entrepreneurs as ICOs are usually priced at a discount at the time of an offering with their value experiencing considerable leaps afterwards, especially upon announcements of exchange listing.79 The low costs of transacting within blockchain networks furthermore incentivize the public’s participation in initial coin offerings as well as in the overall market for cryptocurrencies. A perfect example of these low costs can be seen in a transaction using Litecoin, where 99 Million USD was transferred for the crypto equivalent of 0.40 USD in fees.80 Contrastingly, for the secondary market of corporate stock, exchange fees drive away smaller interested investors who have less capital to begin with.81 For issuers the cost savings come in immense amounts as well. Not only do they need to produce less documentation due to lack of regulatory requirements, but they are furthermore not required to use a third party assisting with token distribution. When raising funds in a traditional way through an IPO, companies typically employ an underwriter tasked with securing the distribution of shares.82 The costs of underwriting tend to be in the 3% to 7% range (usually around 7% for larger companies).83 For an IPO of similar scale to Telegram’s coin offering, this would translate into a service fee of over 50 million USD. On the blockchain, Telegram would realistically have to pay none or a significantly smaller fraction of these costs. Additionally, ICOs other major benefit is their accessibility. The current financial system is by no means designed in a way that promotes the inclusion of all the world’s citizens. Participating in an ICO is predominantly only subject to a KYC process, thereby enabling the participation of remote investors, regardless of their geographic location. Many people looking to enter financial markets are further barred by requirements of hiring external experts. IPO participation for example can be quite difficult without the use of a broker. In an ICO setting one is able to directly transact with the issuer without relying on a third party.84 For more remote parts of the globe where the technological revolutions of broadband and the internet in the late 1990s/early 2000s was not so strongly felt, the transition to a mobile-based economy empowers the locals by granting access to various applications which
05093103087101096099073125030117004043063053096045103000084112086120104107073033081079074000 12210000109806603903703810111208702409709411312501000412010202502309610908410409410101500109 6079118116&EXT=pdf accessed 19 August 2018. 79 Hugo Benedetti, Leonard Kostovetsky, ‘Digital Tulips? Returns to Investors in Initial Coin Offerings’ < https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3182169 accessed 19 August 2018. 80 Maja Rogic, ‘A $99 Million Transaction with Litecoin (LTC) and the Lightest Fee’ https://globalcoinreport.com/a- 99-million-transaction-with-litecoin-ltc-and-the-lightest-fee/ accessed 19 August 2018. 81 Investopedia, ‘Brokerage Fee’ https://www.investopedia.com/terms/b/brokerage-fee.asp accessed 19 August 2018. 82 Investopedia, ‘Underwriter’ https://www.investopedia.com/terms/u/underwriter.asp accessed 19 August 2018. 83 Investopedia, ‘Underwriting Fees’ https://www.investopedia.com/terms/u/underwriting-fees.asp accessed 19 August 2018. 84 See supra note 58. 22
can be used to collect funds or participate in the global financial markets. African farmers for example are capitalizing on the prevalent use of mobile to fund their business needs and improve their agricultural capacity.85 ICOs thus enable the participation of such remote investors from developing states, thereby additionally promoting the globalization of financial and capital markets. Another main reason why increasing numbers of entrepreneurs opt for an ICO is to escape regulatory oversight in a space where access to capital is often barred by overregulation. While many jurisdictions are actively trying to develop ICO-specific frameworks, the majority of legislative bodies around the world have not yet developed additional ICO- specific laws.86 As a result, token sales are predominantly regulated by the application of existing measures in the areas of crowdfunding, AML/KYC and ATF. Those laws are not yet optimized or tailored to capture the variety of risks associated with ICOs, especially considering the strictly digital environment where blockchain transactions take place.87 Given the fact that lawmakers often struggle to catch up with difficult to understand technologies, many opportunistic issuers are rushing to sell their tokens before launching a working product/service or even before an MVP or a Beta has been developed. This new ‘Gold Rush’, as referred by various academics, is one of the core problems of the contemporary ICO ecosystem – there is an abundance of profit hungry ‘entrepreneurs’ giving the public false promises of future returns or product development.88 The lack of legislative protections is the reason why so many projects have been able to raise cosmic amounts of funds. As Figure 2 above illustrates, there is an abundance of ICOs raising amounts north of $50 million in 2018 alone. Typical processes of fundraising would require the submission of a variety of documentation to the relevant authorities. With an ICO, entrepreneurs are able to bypass a part of these requirements. Another benefit for entrepreneurs is found in the post-ICO process. Together with pre- filing compliance duties, publicly traded companies are further expected to issue regular
85 A R Chachhar, S Hassan, ‘The Use of Mobile Phones Among Farmers for Agriculture Development’ (2014) International Journal of Scientific Research 2(6) https://www.researchgate.net/publication/244484894_The_Use_of_Mobile_Phone_Among_Farmers_for_Agricult ure_Development accessed 19 August 2018. 86 Philipp Hacker, Chris Thomale, ‘Crypto-Securities Regulation: ICOs, Token Sales and Cryptocurrencies under EU Financial Law’ https://poseidon01.ssrn.com/delivery.php?ID=5730030971241080310990160170970741020040310540520300661 03127107126127081090025069007006034063101028059032067024099009126064096046016071077042066001 08208606412607509606808005708902200208706409000309312706812308707000111303000602802612707710 1019110086104&EXT=pdf accessed 19 August 2018. 87 Christian Fisch, ‘Initial Coin Offerings (ICOs) to Finance New Ventures: An Exploratory Study’ https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3147521 accessed 19 August 2018. 88 See supra note 72. 23
accounting and financial reports to the relevant authorities.89 For token sales, there are not yet any additional requirements once the token has been sold. Issuers are therefore again able to reduce compliance costs as well as the time, effort and human capital necessary to achieve these goals. The funds can in turn be re-invested in R&D, innovation and product development. Additional barriers to entry on capital markets which ICOs solve relate to Venture Capital. Venture capital is an alternative to loan financing for innovative small and medium enterprises, but getting VC backing is becoming more and more difficult for idea-stage startups.90 Many VCs impose stringent requirements upon startups and as a result very few companies make the final cut of VC funding rounds. As high as VC activity in the crypto space is, ICO funding in 2017 is 3.5x times higher. The chart below represents the share of funding raised from blockchain startups through ICO compared to VC in the period between 2012 and February 2018. Figure 3 is an additional exemplification between the volume differences of VC and ICO funding.
FIGURE 3 – Blockchain startups prefer ICO over VC
89 Morris, Manning & Martin LLP ‘The Consequences of Going Public’ https://www.mmmlaw.com/media/the- consequences-of-going-public/ accessed 19 August 2018. 90 Bijan Khosravi, ‘Early Stage Startups Are Struggling, While VC Investment Dollars Are At All Time High’ https://www.forbes.com/sites/bijankhosravi/2018/06/03/early-stage-startups-are-struggling-while-vc-investment- dollars-are-at-all-time-high/ accessed 19 August 2018. 24
As previously explained in the chapter on blockchain, the network operates under a model that has a high degree of security. In the context of ICOs, this translates into the safe recordkeeping of personal assets. The possibility of theft is here highly negated even under the current state of the technology. Given it is still early in its development, the security benefit will be greatly enhanced in the upcoming years. For investors, additional benefits include getting a discounted price. Most ICOs typically sell at a discount to attract backers. Based on the time frame, investors are able to purchase tokens at prices as low as 20% or even 30% of the token’s future price tag.91 Participating in a pre-sale provides an even higher financial incentive. Data suggests that ICOs are typically underpriced, with price surges after the first day of trading being a common occurrence.92 Thus, ICO participation has a significant upside when considering future returns. Especially in cases where the viability of a service increases, investors can realize huge profits.9394
2.2.2 Risks & concerns
Lack of regulation is a double-edged sword – as much as it can help ‘real’ entrepreneurs raise funds and gain traction, it can potentially be used by poachers for exploitation purposes. Existing laws are not sufficient to provide investors with enough protection of their digital assets, rendering the latter helpless in cases of fraud or theft and hacking. For the most part, ICOs require issuers to conduct background KYC checks. Those are becoming an obvious necessity, but can nevertheless still be abused, for example in the case of the Sentinel Chain ICO where a technical glitch resulted in personal information being leaked. However, despite the presence of KYC checks, ICOs generally do not subject potential backers to the requirement of proof of income. As a result, ICOs can be associated with the promulgation of illicit activities.9596 Without any legal safeguards to protect investors, token issuers are able to capitalize on
91 See supra note 75. 92 Cryptocurrency Market Capitalizations https://coinmarketcap.com/ 93 See supra note 75. 94 Paul Momtaz, ‘Initial Coin Offerings’
25
information asymmetries in order to lure in backers. Similarly to any other new business aiming to raise capital, coin offerings typically include a document outlining their business model, team, proprietary technology, capital allocation, etc. For ‘normal’ businesses this document is a business plan, for companies going public it is a Prospectus, for token sales it is a Whitepaper.97 The ICO whitepaper is ideally comprised of all the elements of a classical business plan. Except in the context of ICOs, it also includes a description of the code. Given the technical complexity behind blockchains, most backers are unable to understand what they are buying into, paving the way towards potential information asymmetries regarding the actual work in practice of the code and the issuers’ promise. Zetzsche et al have conducted a study to identify potential information asymmetries within ICO projects. The sample included 1005 total token sales. Per the study, Whitepapers showed significant shortages of vital investor information. It was found that a whole 5th of the examined sample only provided technical information about the product.98 Potential participants are therefore given only a small fraction of the necessary information to produce a sound investment judgment. The study had further concluded that almost a whole third of the ICOs under scrutiny did not include any information about the issuers or their partners.99 Again this is a significant barrier for experienced investors, but for those simply looking to participate in an ICO because of hypo or FOMO it leaves space for potential fraud on the side of the ‘entrepreneur’. Venture capitalists or any other seasoned investors for that matter usually pay attention to how their money will be spent. Whether it is on product development, marketing or community building, it is imperative for any successful business to have a definitive plan on how to use the proceeds from funding. The study by Zetzsche et al additionally concluded that 25% of the sample ICOs did not include any information regarding the capital allocation, nor a roadmap explaining how much will be invested in each development stage.100 The lack of sufficient legal protection further caters to the problem of escaping liability. Zetzsche’s findings also support this correlation, pointing towards the fact that a whole third of the researched ICOs did not contain information relating to the applicable law in case of disputes.101 Nor did a whopping 55% of the whitepapers give investors information about the project initiator.102 As a result, private persons are able to escape liability simply because they can claim they have never been affiliated with the ICO in the first place, their name was after all not mentioned anywhere.
97 Bisola Asolo, ‘What Is a Whitepaper?’< https://www.mycryptopedia.com/what-is-a-whitepaper/> accessed 19 August 2018. 98 See supra note 72. 99 Ibid. 100 Ibid. 101 Ibid. 102 Ibid. 26
Although the ICO and cryptocurrency market is slowly maturing, a further point of concern remains the abuse made by entrepreneurs in using blockchain technology to quickly raise funds. The field is still in a stage where Ponzi schemes and incompetent teams continue to push investors away.103104 Many projects conduct token sales with the sole purpose of profit and pour vast amounts into marketing with the goal of luring inexperienced backers. One could claim it nears a pay-to-play type of game. Some of them do not even have a functioning Beta or Alpha to speak off, but nevertheless succeed in raising high amounts. Chatbots are spamming Telegram and Slack groups, and Twitter, together with other social media platforms commonly used by issuers, provide a forum for ‘influencers’ and ‘experts’ to promote affiliated offerings. Paying off ICO rating agencies for pumped-up evaluations is another common occurrence within the scene.105 Headlines such as ‘Exit scammers run off with $660 million in ICO earnings’ often graze the front pages of renown crypto news provides such as Coindesk, CCN and Cointelegraph. TechCrunch, a premium tech and startup news outlet, furthermore reports on various instances of fraudulent ICOs. Similarly to the Internet Bubble in the early 2000s, there is a variety of coin sales which are solely made with the purpose of putting ‘blockchain’ into the name of a business for the sake of attracting FOMO investors and hypetrain riders.106 The bizarreness of this is perfectly encapsulated in an endeavor made by the truly honest issuer of the ‘Useless Ethereum Token’. Having literally no use whatsoever, as specified by its inceptor, the UET managed to raise almost $150,000 with the message:
‘This is real—and it's 100% transparent. You're literally giving your money to someone on the internet and getting completely useless tokens in return.’
Reality is that a significant majority of projects should include a similar disclaimer as well rather than hide behind a façade of marketing tricks and 5-star teams. On the same note, a reoccurring issue is for some ICOs to provide false or unauthorized identities on their websites under the section of ‘Team’. Using the name of well-known player in the field is not too rare. Some even resort to celebrities such as Ryan Gosling (famous
103 John Biggs, ‘Another day, another $50 million ICO exit scam’ https://techcrunch.com/2018/04/18/another-day- another-50-million-ico-exit-scam/ accessed 19 August 2018. 104 John Biggs, ‘Exit scammers run off with $660 million in ICO earnings’ https://techcrunch.com/2018/04/13/exit- scammers-run-off-with-660-million-in-ico-earnings/ accessed 19 August 2018.
105 Markus Hartmann, ‘This Is How Easy It Is to Buy ICO Ratings – An Investigation’ https://medium.com/alethena/this-is-how-easy-it-is-to-buy-ico-ratings-an-investigation-13d07e987394 accessed 19 August 2018. 106 Arie Shapira, Kailey Leinz, ‘Long Island Iced Tea Soars After Changing Its Name to Long Blockchain’ https://www.bloomberg.com/news/articles/2017-12-21/crypto-craze-sees-long-island-iced-tea-rename-as-long- blockchain accessed 19 August 2018. 27
Hollywood actor) to attract more backing.107 Another problem precluding mainstream ICO adoption is the current high level of complexity connected to participation therein. As previously noted, understanding blockchain necessitates a certain degree of technical knowledge. To be involved in an ICO you need to create a wallet and properly manage the transactions you do. At the moment, wallets are a mere combination of letters and numbers and their use is by no means easy by someone taking their first steps in ICO investing.
2.2.3 Existing regulation applicable to initial coin offerings
The current regulatory regime for initial coin offerings and cryptocurrencies at large varies significantly among global actors in the sphere. Legislators employ an array of different strategies in this continuously changing domain with the aim to provide a safe space for investors and a level playing field for new companies. Logically, despite its relatively young age the field is not completely exempt from regulatory norms already in place. On most occasions, issuers must at the very least abide by KYC, AML and CFT measures when evaluating their potential investors and source of income.108 The first step in determining the law applicable to a token sale is to establish whether there is legally relevant conduct which can be subjected to existing regulatory frameworks.109 Depending on the token being issued, ICO backers are granted a set of rights based on the issuer’s choice. Some tokens are meant to accrue higher financial value as time goes on (security-like tokens) whereas others bear similar characteristics to a license to participate in a service (commonly referred to as utility tokens). Either way, a promise to the public is an essential element of an initial coin offering which can give rise to contractual or even trust obligations.110 Thus, accepting consideration from any type of an investor and providing a promise to perform gives rise to liability in virtually any jurisdiction.111 When ICO participants are consumers, that is private non-professional or accredited investors, private international law will come into play and limit issuers’ in their choice of applicable law.112 The contemporary regimes of PIL suggest that within such a contract between the issuing entity and backers, consumer protection laws of the consumer’s country of
107 Tyson O’Ham, ‘The Ryan Gosling ICO Wasn’t the First with a Fake Team. Protect Yourself.’ https://bitsonline.com/ryan-gosling-ico-protect/ accessed 19 August 2018. 108 See supra note 72. 109 Ibid. 110 See supra note 19. 111 Ibid. 112 Ibid. 28
residence are applicable.113 For ICO teams this translates into an array of legal obligations and precautions. After having received KYC information for example, ICOs will have to make sure they comply with the laws of virtually every country their investors are coming from, a hurdle to say the least. In some cases, depending on the peculiar design of an ICO, the applicability of financial law can be invoked. This is predominantly in the context of tokens with currency aspects. Many jurisdictions worldwide have protections in place in regard to payment services and those may extend to cryptocurrencies as well. In the concrete case of tokens traded vis-à-vis fiat money, it is very likely for the ICO to be subjected to financial law requirements.114 At the moment the major concern among issuers is the classification of their token as a security. Tokens which bear characteristics similar to equity instruments (such granting e.g. voting rights or rights to future cash flow) are generally regarded as securities and therefore subjected to securities regulation. The requirements of securities regulations are a lot tighter than other areas of law and subject issuers to a variety of obligations.115 That being said, the remainder of this chapter will provide an overview of the specific stances taken by a number of jurisdictions throughout the globe. The choice of countries is by no means random and will be backed by an explanation of its importance. Despite the differences in the approaches under review, the overview will also show how some states adopt relatively similar stances, in particular regarding the treatment of the classification of tokens.
2.2.4 The world’s legislative responses
United States
The United States is the world’s largest financial market. Figure 4 below illustrates global ICO activity in accordance with their raw number per country for the past year.116
113 Ibid. 114 Ibid. 115 Ibid. 116 W Kaal, ‘Initial Coin Offerings: The Top 25 Jurisdictions and Their Comparative Response’ https://poseidon01.ssrn.com/delivery.php?ID=1750311000040921030791251180921010021270840290810490781 20117102110125029069030065071102061063097020028117125090123090065113126024026024023001028103 09406611806501105002100902112600911409101112108512008708709400406509512012402611500008402109 2027031013&EXT=pdf accessed 19 August 2018. 29
FIGURE 4
Roughly 20% of all token sales worldwide have taken place in the United States.117 The US’ status as a leading global actor in finance and innovation as well as the presence of leading startups in hubs such as Silicon Valley make the country a valuable data subject. The relevant authority for capital formation and markets in the US is the Securities Exchange Commission (SEC). Created in 1934 in response to the grand market crash of 1929, the SEC’s mission is to ‘protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.’118 To determine the nature of tokens, the SEC employs its famous ‘Howey test’, which includes four elements:
1. An investment of money 2. Expectation of profit by the investor 3. The investment is in a common enterprise 4. Profit is derived from the efforts of a third party or a promoter119
Tokens that satisfy the above requirements will generally fall within the security umbrella and be subjected to federal regulation. Any security issuer is additionally expected to register with the SEC, thereby disclosing information about:
117 Ibid. 118 U.S. Securities and Exchange Commission, ‘What We Do’ https://www.sec.gov/Article/whatwedo.html accessed 19 August 2018. 119 FindLaw, ‘What Is The Howey Test?’ https://consumer.findlaw.com/securities-law/what-is-the-howey-test.html accessed 19 August 2018. 30
1. Its properties and business purpose 2. The security being offered 3. The company’s management 4. Corporate financial statements audited by an independent auditor120
According to a recent statement from SEC Chairman Jay Clayton, the majority of ICOs taking place do indeed qualify as securities despite issuers’ regards as utilities. In his statement, Clayton further denotes the practicality and innovativeness of this new fundraising method.121
Switzerland
Figure 5 below represents the amount of ICO funds raised in the abovementioned countries.
FIGURE 5
Despite coming in fourth in total ICO production (Figure 4), Switzerland is by far the country with the most successful token sales in terms of amounts raised for 2017. Besides, Switzerland is notorious in the space for its own ‘Crypto Valley’ around the city of Zug – a hub
120 U.S. Securities and Exchange Commission, ‘Registration Under the Securities Act of 1933’ https://www.sec.gov/fast-answers/answersregis33htm.html accessed 19 August 2018. 121 Jack Mathis, ‘ICOs are Securities, ‘Don’t Know How Much More Clear I Can Be’: SEC Chairman’ https://www.ccn.com/icos-are-securites-dont-know-how-much-more-clear-i-can-be-sec-chairman/ accessed 19 August 2018. 31
mirroring the US’ Silicon Valley, at least for crypto startups.122 The country is one of the preferred destinations for issuers, especially within continental Europe as it has specifically addressed the legal treatment of tokens and improved the legal uncertainty. Due to these peculiarities Switzerland makes up for another valuable data subject. The Swiss regulatory authority for financial markets is FINMA. FINMA recently published guidelines in regard to the nature of tokens, classifying them as three types.
Type 1 – Payment tokens
Payment tokens are treated by FINMA in an identical way to cryptocurrencies. This type of tokens has no further functions or links to other development projects – they are solely meant to be used as a means of payment (similar to fiat currencies).123 In some cases this type may only develop the necessary functionality and become accepted as a means of payment over a period of time, based on the general public’s value attribution and usage rate. Issuers of payment tokens which are transferrable are required to comply with anti-money laundering regulations.124 Contrary to the US’ stance of considering the majority of tokens securities, FINMA does not see payment tokens a securitized asset.
Type 2 – Utility tokens
Utility tokens are by definition intended to provide digital access to an application or a service. For FINMA, if these tokens’ sole purpose is to confer digital access rights to an application or a service, they are not considered securities. Here it is also crucial for the token in question to provide access to an already existing service at the point of issue.125 This is an important point to consider since many projects are raising funds without offering a functional product. Thus, the Swiss are offering a greater degree of protection for investors looking to partake in a utility token offering. For utility tokens to qualify as securities, FINMA imposes the requirement of their (also partial) functionality as an investment in economic terms – similar to the type 3 asset tokens.126
Type 3 – Asset tokens
This type of tokens represents participations in real physical underlyings, companies or earning streams, or an entitlement to dividends or interest payments. Bearing characteristics
122 Oscar Williams-Grut, ‘Here’s what it’s like to visit ‘Crypto Valley’ – Switzerland’s picturesque blockchain version of Silicon Valley’ https://www.businessinsider.com/what-its-like-in-zug-switzerlands-crypto-valley-2018-6> accessed 19 August 2018. 123 FINMA, ‘FINMA publishes ICO guidelines’ https://www.finma.ch/en/news/2018/02/20180216-mm-ico- wegleitung/ accessed 19 August 2018. 124 Ibid. 125 Ibid. 126 Ibid. 32
similar to equities, bonds or derivatives (all having the element of profit expectation on the side of the investor), these tokens fall within the classical definition of a security.127 Issuers must therefore comply with securities regulation if their token is traded on financial markets. Furthermore, issuers are subjected to the civil requirements of the Swiss Code of Obligations – for example including liability for untrue statements, prospectus requirements, etc). Per FINMA, one of the main factors to be weighed for asset token classification is whether the token is standardized and suitable for mass standardized trading.128 Lastly, securities token offerings are additionally subjected to a licensing practice if conducted within an issuer’s professional capacity.129
Singapore
Singapore is considered to be one of the current major hubs for ICOs in the world due to its open stance towards innovation. In fact, Singapore ranks 3rd worldwide and is the ICO leader in Asia, making it another valuable data subject.130 While China and South Korea had previously adopted rather negative stances towards this fundraising method, Singapore was one of the first Asian states to embrace its disruptive capabilities.131 Singapore is an established FinTech leader in Southeast Asia and is planning to incubate blockchain technology in the area of fundraising. According to a statement from the Monetary Authority of Singapore (MAS) Managing Director Ravi Menon:
“MAS does not regulate virtual currencies; in fact, we welcome them as an innovation that can potentially reduce the cost of financial transactions. But we regulate the activities that surround virtual currencies if these activities pose specific risks.”132
The MAS is furthermore introducing a regulatory sandbox regime for ICOs where potential issuers will be partially exempt from regulatory oversight with the aim of reducing the burden of compliance and providing a testing environment for token sales’ viability for fundraising.133 The country is also en route to develop ICO-specific legislation to properly tackle the associated risks.134 When it comes to the classification of tokens, Singapore currently draws the distinction
127 Ibid. 128 Ibid. 129 Art. 3 para. 2 SESTO 130 Fintechnews Singapore, ‘Singapore: Asia’s Leading ICO Hub?’ http://fintechnews.sg/14927/blockchain/singapore-ico-asia-hub/ accessed 19 August 2018. 131 Fintechnews Singapore, ‘ICO Regulation in Asia: An Overview’ http://fintechnews.sg/16303/blockchain/ico- regulation-asia-overview/ accessed 19 August 2018. 132 Fintechnews Singapore, ‘Singapore ICO Guidelines Released’ http://fintechnews.sg/14418/fintech/singapore- ico-guidelines-released/ accessed 19 August 2018. 133 Ibid. 134 Ibid. 33
between two token types – securities and non-securities, similar to the US stance. While the former is subjected to securities trading laws, the latter will be regulated through existing anti- money laundering and counter terrorism financing rules, as well as through the upcoming ‘New Payments Framework’ (the targeted legislation in question).135
Honorable mention - Malta – ‘the blockchain island’
Malta is one of the few countries which have already taken the path of developing ICO- specific regulation. The small Mediterranean state is actively trying to incubate blockchain- based fundraising and as such attract potential issuers as a crypto-friendly destination. Besides the increasing volume of ICOs, the blockchain island is also home to reputable cryptocurrency exchanges such as Binance, OKex and BitBay due to the legal certainty around the ecosystem. 136 Malta is pioneering the space as the world’s first country to have an upcoming set of tailor-made legislation. Approved unanimously in parliament earlier in June, the three bills on DLT and blockchain employ a ‘Technology First’ regulatory approach.137 Rather than focusing on the financial implications of token sales, the Maltese regulators first and foremost focuses on the technology behind blockchain projects, thereby carefully evaluating their code and Whitepaper.138 ICOs are then subject to governmental approval and if approved granted the status of a ‘Technology Arrangement’, signifying they are fit for investment.139 Despite its small size, Malta is a true innovator in the space and continues to attract issuers – their approach to handling new technology should be seen as an example for other jurisdictions having even more resources.
135 Ibid. 136 Ana Alexandre, ‘Ripple Partners With Three Crypto Exchanges as Part of XRapid Solution’ https://cointelegraph.com/news/ripple-partners-with-three-crypto-exchanges-as-part-of-xrapid-solution accessed 19 August 2018. 137 Jimmy Aki, ‘Malta Approves Favorable Cryptocurrency Bills in Next Step as a Blockchain Island’ https://bitcoinmagazine.com/articles/malta-passes-favorable-cryptocurrency-laws-next-step-blockchain-island/ accessed 19 August 2018. 138 Rachel Wolfson, ‘Maltese Parliament Passes Laws That Set Regulatory Framework For Blockchain, Cryptocurrency and DLT’ https://www.forbes.com/sites/rachelwolfson/2018/07/05/maltese-parliament-passes- laws-that-set-regulatory-framework-for-blockchain-cryptocurrency-and-dlt/#ace47f49ed2f accessed 19 August 2018. 139 Ibid. 34
3. The current state of the ICO market: a case study from a law firm consulting ICO projects
The following part will report my findings on the current ICO market. For the past five months I have been working at Watson Law, a newly established law firm in Den Bosch. The lawyers at Watson are above others specialists in the areas of corporate law, insolvency, restructuring and corporate finance. Nevertheless, one of their main lines of business involves exploring new technologies, in particular AI and blockchain, and their implementation within Dutch Law. Watson Law furthermore advises token issuers on the legal matters surrounding the ICO process – applicable law, token definition, KYC & AML, etc. My involvement in their daily operations has given me invaluable insights into the (legal) needs of ICO projects and in general about the current state of the market. As a result of heavy research on the topic, coupled with interviews with the lawyers at the firm, I have managed to develop a set of data encapsulating trends and directions within the ICO market. I have furthermore managed to identify reoccurring issues as well as positive inferences connected to the operational and business peculiarities and needs of token sale teams. The case study represents a summary of interviews conducted with Camiel Vermeulen and Willem-Jan Smits who are responsible for the ICO consultancy within Watson Law. The data gathered represents the state of the market in the period between April and July, 2018. One of the most commonly observed trends in the current ICO market is a move towards self-regulation after the abovementioned significant market crash from earlier this year in January. While many projects were hesitant to conduct KYC checks, the crash wiping out more than half of the total market value diminished investors’ trust and they started to more carefully pick their investment targets. As a result, issuers have indeed started to ‘work harder’ and developed measures to gain back the trust of investors. The legal aspect behind ICOs is increasingly becoming one of, if not the, major concern among customer-centric issuers. Projects have also found that the number of investors they attract is closely correlated with this positive move towards compliance. Despite the space’s initial appeal as an unregulated Wild West, abiding by the law is slowly but surely becoming the industry standard, especially for those looking to attract institutional and private accredited investors such as venture capitalists or fund managers. Not only have issuers started to stress the importance of background KYC checks, but practice also points towards a move to AML checks. Initial efforts were done to check the customer (investor) only while now more and more issuers are checking the source of income as well in order to present themselves as compliant. This of course has a positive ‘filtering-out’ effect of investors who have only entered the space with the aim to launder or embezzle funds through cryptocurrency trading. All in all, there is a trend of improved quality not only on the issuer side, but on the investor side as well –
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which is also conforming to the trend of lowered price and market maturity. Nevertheless, the lack of legal certainty around KYC and AML checks has caused some issues regarding the availability of investors. Many issuers struggle with the development of such processes resulting in the formation of waiting lists for the approval of potential ICO (and pre-sale) backers. Neglect towards the legal aspect of token sales and not hiring adequate legal support has therefore manifested a barrier for licensing investors. This again pinpoints the move towards a more compliance-oriented business model for most issuers. The development of efficient KYC and AML processes is at the moment one of two major challenges that issuers are facing. With the move towards more compliance-based ICOs, the latter’s other point of legal concern is connected to the qualification of their token. As blockchain’s possible applications continue to be explored, the offered services and products are becoming increasingly creative and the available legal definitions often do not suffice to adequately place a token within a pre-defined class. Consequently, issuers find themselves in an arduous situation where lack of legal certainty is forcing them to change their product or service to correspond to the current regulatory regimes. Issuing security tokens by itself is additionally linked to a higher burden of compliance which makes it even more difficult for some to penetrate the market and attract investors. Moreover, there is a general trend of reducing investment caps. Many projects are beginning to realize that oversubscription of an ICO in itself poses a great problem. While the token sale craze is still ongoing, raising more money than needed is no longer a go-to industry practice. Teams are showing signs of more careful evaluation of their investment needs in order to satisfy the increasingly stringent needs of both private and institutional investors. In the context of Whitepapers, practice again shows an evolutionary trend. While Whitepapers used to focus on the technical aspect of blockchain projects, business and investor materials are now becoming more and more ‘businessy’ – that is they more carefully evaluate the associated business risks, governance structure and investment allocation. Technical descriptions are also becoming increasingly simplified as investors are more susceptible to descriptions that are difficult to understand. The reason behind this for issuers is to improve their reach and tap into wider pools of worldwide investors. As investors begin to understand the technology better, complex technical Whitepapers have shown to reduce their appeal. The information gathered strongly denotes the validity of the hypotheses I have developed throughout the paper. A major claim I have continuously made is the move towards a market with more quality ICOs and a reduction of more questionable value propositions as a result of investors’ increased awareness and ‘think twice’ investment practices. Despite some significant technological, legal, economic and purely business shortcomings, the field continues to mature and build up on its issues to create a level playing field for all the stakeholders involved. The Watson Law team furthermore shares the view that a tailor-made approach in the
36
context of blockchain-based fundraising is the preferable method of regulation. From day-to- day practice and their experience in consulting it is clear that existing regulatory frameworks (not only limited to Dutch law) come short in tackling the real-world issues associated with token sales. Alternatively, their adaptation will be at a pace significantly slower compared to the rapid developments in the field. Issuers are for example struggling to clearly define the nature of the token due to the lack of sufficiently clear legal classification structures. Thus, developing ICO-specific laws will be able to better ensure investor protection as well as improve clarity and legal certainty for issuers and governments alike. A further validation is connected to the claim that the market crash should not be seen as a negative occurrence. Despite the huge losses in value, the crash, per Watson Law, signified a move towards a more mature market where both investors and issuers have grown to abide by best practices rather than blindly ride the hype train and make questionable moves based on fear of missing out.
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4. Promoting the development of blockchain-based fundraising and initial coin offerings
The following chapter will serve as this paper’s main value proposition – outlining a design to cultivate blockchain technology (in the context of token sales). Thus, the chapter will include my personal recommendations as to how governments can properly innovate the space without stifling innovation. The proposed approach is not solely centered around developing a regulatory framework, but also includes ‘soft tips’ and practices that can be used to further explore the technology with the help of experts, companies and influencers in the field. Every recommendation will additionally include an overview of the associated benefits and shortcomings it brings to the table. Besides providing a framework for governments, the chapter will further include considerations aimed at potential coin issuers. As the market continues to mature, ICO projects often face considerable difficulty in adequately presenting their product to the public. A good piece of code and a scalable solution are not the sole drivers of success. ICOs are first and foremost startups and as such need adequate support not only in execution, but also in the areas of marketing and business development, above others. While many projects are able to excel in these areas, the aspects of community building remain grossly neglected. And while some have actual viable products without much coverage, others flood community websites with chatbots and endless promotions of many a time unpromising business models. The last part of the final chapter will aim to provide a sort of a guideline for those interested in investing in ICOs and cryptocurrencies at large. By no means do I claim to be an expert in the field, but my professional experience and out-of-school activities are often tied to ICOs and the surrounding blockchain space. Together with the research I have conducted on the topic and the investments I have done in the space, I have managed to identify some potential red (and also green flags) when it comes to investing. Working in the tech space together with a former venture capitalist and current seed investor has additionally enhanced my perspective from a purely business point of view. Therefore I believe that my recommendations will, at the very least, provide value for anyone without any prior experience in either startups or crypto itself.
4.1 Designing a regulatory framework for government action – the options
As with any other technology, regulation can either promote innovation in the space or contribute to its eventual demise. Legislators must therefore tread very lightly when dealing with technology, a simple move may impose disproportionate burdens on businesses, resulting in demotivation to continue researching.
4.1.1 A complete ban for blockchain-based funding
38
As noted in an earlier chapter, China and South Korea had imposed in toto bans for initial coin offerings. This was primarily in response to the SEC’s warnings relating to ‘pump and dump’ ICO schemes.140 After the SEC statements, ICOs were given the status of ‘unauthorized illegal fundraising activities’ and widely considered fraudulent, pyramid-like methods.141 Although a decision to introduce an outright ban can be considered as radical, it may also come with certain benefits.
Advantages
First and foremost a blanket ban is a definite clear cut approach on how to ensure a high degree of legal certainty while at the same reducing the costs of regulation, at least in the short term. In such a scenario, governments do not need to produce any additional legislation on how to treat ICOs. Their only concern would be enforcing compliance.142 Furthermore, anyone with interest in technology is provided with a concrete answer regarding their activity in the scene. There is no middle ground – you either comply with the ban or end up being sanctioned. Second, a complete ban in the context of ICOs can be seen as a protectionist measure. Given the abundance of cases of scams and fraud, a ban serves the interest of inexperienced retail investors and shields them from participating in an illicit ICO project. This was one of the main reasons why China took the path of total restriction – a designated committee had voiced its concerns over the increasing use of token sales for financial scams and pyramid schemes.143
Disadvantages
First, despite eliminating the costs of producing a specific framework, a complete ban means that legislators would have to switch their focus to enforcement. Policing non- compliance could therefore produce extra enforcement costs.144 Specifically in the digital age, policing criminals may prove to be considerably difficult due to their increasing creativity. An issuer may thus be still able to produce an ICO from China while hiding under a false identity or an IP address situated elsewhere. What is more, introducing bans has historically proven to give rise to resistance movements. Human nature is based on the premise of seeking the forbidden fruit. Banning something, let us assume a substance such as alcohol during the dry regime in the US, may
140 Julian Hosp, ‘The ICO world is full of pumpand-dump schemes – don’t be a victim’ https://venturebeat.com/2017/08/26/the-ico-world-is-full-of-pump-and-dump-schemes-dont-be-a-victim/ accessed 19 August 2018. 141 See supra note 72. 142 Ibid. 143 Jon Russell, ‘China has banned ICOs’ https://beta.techcrunch.com/2017/09/04/chinas-central-bank-has-banned- icos/?_ga=2.65802922.503962049.1532778643-1155660365.1526076874 accessed 19 August 2018. 144 D Zetzsche et. al., ‘Regulating a Revolution: From Regulatory Sandboxes to Smart Regulation’ [2017] 71 UNSWLRS 39
incite the citizenry to take a deeper look therein and increase consumption despite regulatory warnings. Thirdly, banning a potentially innovative technology with widespread use may create a negative image towards a government, both from a local and a global standpoint. China in particular has a history of taking a diverging approach compared to its Western counterparts, giving it the status of a non-progressive state. A complete ban can potentially signal that a government is backward looking and regressive. Invoking the reason of lack of understanding is a further sign of weakness, in particular in an age where technological advancement often mirrors a state’s ability to compete on global markets. Fourth and most important, a blanket ban puts the development of a new technology to a standstill. Businesses are unable to test new solutions and the citizenry is limited to the use of previously developed mechanisms which can often be outdated. In the era of digitalization innovations must be fostered and trial and error experiences should by no means be discouraged. There are other means to test the waters besides introducing bans – such as regulatory sandboxes and case by case exemptions (the practice of licensing).
4.1.2 Introducing a regulatory sandbox regime for ICO projects
In the finance space a regulatory sandbox is described as a ‘regulatory safe space for innovative financial institutions and activities underpinned by technology’. The idea behind the use of a regulatory sandbox is to provide an environment for companies to test their products or services without complying with the full range of applicable legislation. As a result, the risk of sanctions for ‘illegal’ activities is greatly diminished.145 Though a sandbox is not only one sided – companies must nevertheless comply with a set of standards, specifically tailored to insulate the market from risks related to the business’ operations. Participation in the sandbox is logically subject to predetermined conditions developed by the legislator.146
Advantages
The pre-defined conditions for participation in a sandbox hold the benefit of providing certainty for interested startups. The standards used are typically disclosed online and companies can adapt their business model in order to gain entry. There is the additional benefit of a level playing field – every participant is subject to the same conditions as its ‘competitors’. Moreover, the use of pre-defined standards ensures a high degree of transparency surrounding the work in practice of the sandbox. As the standards are publicly disclosed, the chances of
145 Ibid. 146 Ivo Jenik, Kate Lauer, ‘Regulatory Sandboxes and Financial Inclusion’ http://www.cgap.org/sites/default/files/Working-Paper-Regulatory-Sandboxes-Oct-2017.pdf accessed 19 August 2018. 40
irregular entry are virtually zero.147 Sandboxes are by their very nature controlled experiments. They give the legislator a chance to change variables and efficiently track the results of any introduced changes. Such a trial-and-error approach has the ability to extract the most benefits and it helps identify potential points of concern. In a nutshell, a sandbox enables governments to properly assess a company’s ability to be innovative whilst identifying any potential risks connected to their operations.148 A further benefit of a regulatory sandbox is enhanced communication between the participants and the regulatory body in charge. Companies are given considerable leeway to communicate more openly with the regulator which in turn enables the latter to predict and identify risks before they have actually materialized.149 The use of the practice is additionally a signal of a regulator’s dedication to stimulate innovation and competition in a given sector. Sandboxes have some positive spillover effects on non-participants as well – they incentivize previously licensed actors to provide more innovative solutions.
Disadvantages
Sandboxes bear the distinctive characteristic that activity therein is not subject to the full scope of regulation. They can therefore potentially send a negative signal to the market. Consumers could make the inference that the participating companies have not yet reached a stage where their product or service is marketable. As a result the general public may refrain from establishing a relationship with a given participant.150 Second, although companies within the sandbox are subject to the same rules, non- participants are still expected to strictly abide by the rules and norms governing the industry. This creates a controversial situation where one group may be considered to have a competitive edge over the other simply because of their participation in the sandbox.151 Lastly, a sandbox regime may cater to the materialization of extra financial and labor costs for the regulator. In order to optimize sandbox operations, regulators must introduce new approaches on a steady basis. Additionally, it is necessary to redirect human capital towards the sandbox. This may have a negative effect on other activities such as the regulation of non- participants and enforcement.152
147 See supra note 142. 148 Ibid. 149 Ibid. 150 Ibid. 151 See supra note 146 152 See supra note 142. 41
4.1.3 Case by case exemptions: the path of licensing
When dealing with new technologies regulators often employ a licensing approach where candidate companies are able to apply for partial compliance exemptions or dispensations. An alternative in the context of ICOs is to subject every token sale to a governmental audit before any tokens are sold to the public. This is probably one of the most sought after approaches to ICOs given the proprietary nature of the technology and the move towards a digital economy.
Advantages
Subjecting ICOs to a licensing requirement would have the obvious benefit of filtering out Ponzi schemes and fraudulent projects out of the ecosystem. The financial regulator in Malta has already introduced a similar approach where ICOs must first obtain the status of a ‘Technology Arrangement’ before conducting a sale to the public. In Malta, the authorities have agreed upon a technology first approach and introduced a regime where every Whitepaper must first be audited by the government. The potential upsides of this are various – it enables investors to direct their funds into more scalable projects with real value.153 Another potential benefit can be reaped by the regulatory body itself – that of enhanced communication. When companies apply for a license they are typically required to disclose any material information regarding their business model and product or service. This gives regulators the unique opportunity to broadly enhance their knowledge in the area and identify potential risks before they materialize, similarly to a sandbox-based approach. The case-by-case way of auditing is further able to provide governments with vital data that can be used to improve future applicants in cumulative manner.154 If standardized between different state actors, case-by-case licensing has the ability to introduce a common regional regime to handle ICOs. Specifically in political unions such as the EU, a greater level of harmonization will provide more legal certainty and transparency for both potential issuers and retail investors.155
Disadvantages
The main disadvantage of such an approach to ICOs is associated with significant extra costs and its inability to scale efficiently. Considering the growing volume of token sales worldwide, regulators will bear the burden of reviewing every case on its own merits. This translates into heaps of and necessitates additional human as well as financial capital. The field is additionally quite complex already and finding knowledgeable experts is in itself an arduous
153 Ibid. 154 Ibid. 155 Ibid. 42
task. Moreover, some projects have tight schedules and an already established roadmap. Case- by-case exemptions can lead to massive queues for applicants, thereby diminishing innovation levels and barring businesses from following their pre-determined business plan.156 Another major barrier is the legitimacy of the standards developed by the regulating bodies. For example, the regulator may propose a risk-based approach where projects with bolder goals will not make the cut. Such a standard can hinder innovation and reduce the incentives for businesses to go crypto. Similarly, country-specific standards within state aggregations such as the EU may be contested by the rest of the Union members on basis of their inadequacy.157 Lastly comes the issue of liability. For every ICO that does not live up to its potential or ends up a fraud case, investors will seek redress. If the regulating bodies issue licenses and put their stamp of approval on projects, it follows naturally to hold them accountable in such cases. In order to escape liability, governments may develop higher standards for processing requests which in turn additionally impairs innovation and reduces the total number of applicants.
4.1.4 The technical solution: DAICOs as an alternative to ICOs
DAICOs are an alternative to ICOs that aims to correct information asymmetries between issuers and investors. It builds up on the ICO model by incorporating some of the features of Decentralized Autonomous Organizations (DAOs).158 Suggested by Vitalik Buterin (Ethereum founder) earlier in January, DAICOs are based on the premise of involving investors the initial project development process.159 DAICOs provide more security for investors because they can potentially enable them to take away their investment in case a project is not reaching its milestones as pre-specified or promised. This method building on the traditional ICO model is associated with higher degrees of accountability on side of the developers and therefore more transparency investors.160 DAICOs include a ‘tap mechanism’ whereby investors are able to set limits on how much of the contributed funds are being used by the project developers – this creates an enhanced trust relationship between investors and issuers, hence improving on one of the major current shortcomings in the sphere. Having the legal requirement to incorporate some of the mechanisms behind a DAICO (the tap mechanism for example) into ICOs can have significant benefits to improve the blockchain space. As mentioned above, this alternative greatly enhances the trust factor between investor and issuer and can be a preferable method of tackling some ICO-related issues
156 Ibid. 157 Ibid. 158 Chrisjan Pauw, ‘What is a DAICO, Explained’ https://cointelegraph.com/explained/what-is-a-daico-explained accessed 19 August 2018. 159 Ibid. 160 CoinStakes, ‘What is a DAICO and what are the Benefits?’ https://www.coinstaker.com/what-is-daico-and-what- are-the-benefits/ accessed 19 August 2018. 43
by technical design. The technology behind DAICOs could further be used by blockchain projects to ensure and save on compliance via for example creating an alternative coin (similar to stock) class that is meant for the regulator, hence containing all relevant compliance datasets of the respectable business.
4.2 How can all relevant stakeholders contribute to the formation of a more mature ICO market?
4.2.1 Recommendations for governments
It is a commonly recognized issue that legislation lacks behind technological advancements. Especially in the digital age when innovation occurs almost daily, established regulatory frameworks are severely outdated to tackle contemporary issues and risks. The move to a digital-based economy signifies that the legal domain is ripe for disruption and new ideas. In my view, the growing volume of ICOs and the lack of understanding in relation to blockchain (especially on government level) preclude the use of regulatory sandboxes or case- by-case exemptions. Rather than promoting innovation in the sector, the two options might stifle it. Case-by-case exemptions have the obvious upside of providing the citizenry with a governmental stamp of approval, but they nevertheless call into question the adequacy behind the standards being developed. The sheer expected workload is another point of concern here. What might be an additional problem is the so-called practice of ‘shopping jurisdictions’. The practice is commonly used by companies as well as in private litigation in order to mitigate local laws which do not necessarily favor the plaintiff party. Shopping jurisdictions is especially common when foreign laws and courts show more leniency in a certain area (for example establishing a corporate headquarters in a tax-favored jurisdiction as in the case of Apple in Dublin, Ireland). For ICOs this would mean that the majority of token sales will be directed to jurisdictions with more favorable terms. Given their disruptive capabilities this will have a severe negative effect on smaller jurisdictions with less favorable rules and insufficient resources and human capital. An outright ban, on the other hand, is in my view the most secure way to stop innovation in its roots. The approach taken by two of the most relevant players in Asia (China and South Korea) signifies their fears of the technology. Especially in China, a country premised on tradition and conservatism, the penetration of new technology is barred from the government’s stance towards ‘trying new things’. Although the protectionist argument can successfully be invoked here, the potential upsides of incubating blockchain technology in the context of capital formation massively outweigh the downsides. In an increasingly democratized and interconnected world, countries risk to fall behind if they make the choice of not embracing innovation. South Korea itself also recently announced its plans to lift its blanket ban on ICOs, followed by the introduction of a specific regulatory framework. A ban, considering the track
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runner that technology is, may only waste time for experimentation. Therefore I believe that the most efficient way to incubate blockchain technology (not even limited to its financial applications) is to develop sets of targeted legislation, just as Malta, South Korea, Lithuania and a number of others are doing. Although some aspects of existing laws (e.g. Prospectus liability, securities, etc) do indeed provide investors with some level of protection, the technology has left regulators scratching their heads while its first practical conceptualization was only 10 years ago. Some other principles from financial, crowdfunding, consumer protection laws apply interchangeably as well, but developing such a mixture of applicable laws will only lead to the creation of a ‘legal amalgam’ – a sort of a Frankenstein comprised of many legal parts. As a result, the field will experience a significant shortage of legal certainty and require the constant adaptation of laws developed to tackle issues of other kinds. Given the fact that blockchain continues to evolve on an almost daily basis, specific legislation will be able to provide answers to reoccurring issues. What is more, a tailor-made approach (considering it is designed to provide a balance between the interests of all the relevant actors involved) would require less maintenance in the long run. Once established, it could serve a country’s blueprint of the future of new technologies. The paper has identified a plethora of issues in relation to ICOs. The major shortcomings however are associated with the lack of a clear liability regime in cases of, above others, fraud. In such scenarios it is also not clear as to which state law applies, resulting in a massive legal certainty gap. Cases of fraud are most commonly caused by information asymmetries. In the IPO market, such asymmetries are corrected through Prospectus liability. For ICOs, legislators should first and foremost introduce liability for untrue statements in the Whitepaper where most issuers try to trick (inexperienced) investors. Not only must countries develop their own specific regulatory frameworks, but global organizations (in this case most likely the World Bank or the EU on a regional level) should also propose at the very least soft law mechanisms such as guidelines to promote the development of blockchain-based funding and eliminate legal uncertainty on the global fora. Such a progression will provide inexperienced jurisdictions with a general path to follow if state-level legislation is absent. It will furthermore enhance cooperation in the field and at least to some extent serve as a standard to abide by. Though it must be noted that regulation by itself is not enough to propel innovation and create a safer investment environment. Governments and global institutions alike must signify their dedication to innovate the sector via other ‘softer’ methods. Local legislators should for example establish assigned task forces with the aim to better understand blockchain technology. The introduction of a specific task force will naturally help governments better understand what they are dealing with. The identification of risks will become easier and the whole innovative process will run in a smooth way once the objectives and tasks have been
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properly outlined. Such an initiative will further provide communication channels between government officials and experts in the field of blockchain and ICOs in particular. Another helpful ‘soft law’ practice would be to publish guidelines aimed at issuers. Such guidelines may ideally introduce a standard to abide by if they are well executed, regardless of their status of non-enforceable. Similarly, repeat ‘offenders’ are to be allocated to public blacklists where potential backers are able to see in which areas a company excels and in which it needs to improve. Such a practice of naming and shaming will further incite startups in the field to develop their service or product accordingly in order to improve their marketability. A further recommendation is to promote initiatives which establish a dialogue between the government and the most relevant players in the ICO sector – issuers, (institutional) investors, venture capitalists, finance professionals, etc. Such a dialogue will help governments better understand the technology while at the same time they will be given the opportunity to gain practical insights into the real world implications of token sales. An active communication channel between all the relevant stakeholders will broadly enhance the efficiency of legislative measures as well. Examples of ‘a dialogue’ would be collaboration with startups in the field or even government-funded competitions or pitch sessions where ICOs can not only promote their product or service, but also come in contact with the regulator to discuss potential concerns about compliance, execution, etc. On the same note, governments should actively strive to organize blockchain and ICO- related events, again with the aim of reaching out to all the relevant stakeholders. Successful events and conferences will furthermore attract foreign stakeholders who can additionally contribute to the development of a well-oiled ICO and blockchain ecosystem within a given state. The coming together of the brightest minds in the sector will surely result in the incubation of new innovative ideas. The most significant downside to the proposed approach are financial costs and the need for (expert) human capital. Developing a specific regulatory framework will not only take time, but also necessitate the use of governmental resources. Especially considering the introduction of conferences and events, the short term financial implications may prove unbearable for some governments, specifically those from less developed countries where public investments are rightfully targeting different development areas. Throughout the paper it has been stressed that the blockchain space is very technical and requires considerable expertise. The lack of technical laborers may prove to be a further barrier for the adoption of the proposed approach. High demand and low supply will again contribute to extra costs. Nevertheless, some studies expect that blockchain adoption will contribute to savings in the area of 30-40% for some industries.161 Specifically for finance and capital formation the
161 Sandeep Soni, ‘After Internet, it’s Blockchain Internet 2.0’ https://www.entrepreneur.com/article/288715 accessed 19 August 2018. 46
potential future upsides for companies as well as investors should massively outweigh the associated costs.
4.2.2 Recommendations for issuers
Logically, actions taken solely from the government will not suffice to properly foster the development of ICOs. The consequences of the imminent bubble burst may further be negated by the actions of issuers themselves. The following part of this chapter will thus provide a blueprint that can be used by token sale initiators to ease the burden on their local legislator or even their own. The recommendations are derived from personal experience in the field (unsuccessful investments, work for the ICO consultancy law firm, dialogues with blockchain affiliates in the field) and from the previously made inferences in this thesis relating to the shortcomings of ICO projects.
Token definition and applicable law
The first step for every issuer should be to determine the extent to which their token is covered by regulation. While at the moment some may be partly exempt from regulatory scrutiny, those that fall within the scope of the law are normally compared to traditional types of securities such as corporate stock or bonds. They bear certain characteristics that differentiate them from their non-regulated counterparts and require issuers to comply with an array of legislative measures posing appreciable barriers to entry. In a nutshell, from an EU law point of view, tokens that fall within the scope of securities are transferrable assets with a reliance element whereby the creditor relies on the debtor’s performance with the aim of future returns. Under contemporary EU legislation, issuers of crypto tokens with similar ‘share-like’ elements are required to comply with Directive 2001/34/EC, often referred to as the Prospectus Directive. The Directive obliges every security issuer to draw up a prospectus that is later subject to approval from a Member State’s local asset trading laws. Although it may not seem like a big deal, writing a bulletproof prospectus is by no means an easy job. Prospectuses are quite lengthy (reputable ones can go on for more than 200 pages) so they are least to say time and effort consuming. Setting one up will further require the use of a team of lawyers seasoned in the field. Finding those guys can be tricky in itself, needless to mention the fact that issuers will have to untie the purse to lock them in. Given also the inferences from the included case study, the legal aspect behind ICOs is becoming more and more important. It is therefore imperative to stress out the vitality of having quality legal support. Most crypto issuers usually have the aim of listing their token on an exchange. Something to take into account here is that the majority of cryptocurrency exchanges escape scrutiny under securities trading laws by way of excluding securities-like tokens from being
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traded on their platform. Qualifying as a security would therefore not only subject your coin to legislative oversight, but additionally impair the exchange listing possibility. This might change very soon though as Coinbase has recently announced it is has been cleared by regulators to list security tokens.162 Lastly, issuers should always consider the future outlook of a project. If the current plan is to initiate the offering in a particular jurisdiction that does not automatically point towards compliance exemptions in other markets. US regulatory reach for example is oftentimes considered overarching as the establishment of even the slightest connection to American markets can be enough to invoke jurisdiction due to the Alien Tort Statute.163 As previously mentioned, token sales to foreign investors may also subject issuers to the laws of the respective state. Especially in cases where coins end up listed on exchanges, the regulatory burden comes in many forms and from various sources.
Know-Your-Customer (KYC) and Anti-Money-Laundering (AML) rules
Given the move towards more compliant token sales, every reputable ICO needs to have a KYC & AML system in place to gain the legislator’s and investor’s favor. The absence of analogous measures brings about a number of associated risks. In the crypto market this is of particular concern due to the sometimes anonymous identity of ICO backers. As tokens can be (as well as have been) used to propel money laundering initiatives, bribery, illegal black market trade, etc., KYC/AML systems help solve this problem through investor background checks, fund tracking and subsequent reporting of sketchy projects.164 Another mitigated risk is the possibility of investor pooling and market manipulation. Common practice among ICOs is to have a personal investment cap for each investor with the aim of diversifying the investor portfolio. However, some investors are able to bypass this requirement by purchasing tokens from ‘borrowed’ accounts or under different identities (the so-called practice of identity shopping). KYC measures mitigate this risk and ensure a level playing field for all potential backers.
Privacy
As we continue to store the bulk of our data digitally and become more aware of the challenges stemming from that, transparency and accountability is the name of the game. In light of the General Data Protection Regulation (GDPR), the EU regulator is introducing a tighter
162 Wolfie Zhao, ‘Coinbase Says It Now Has Regulatory Approval to List Security Tokens’ https://www.coindesk.com/coinbase-claims-it-now-has-regulatory-approval-to-list-security-tokens/ accessed 19 August 2018. 163 The Alien Tort Statute (28 U.S.C. § 1350; ATS) 164 Wolfie Zhao, ‘Japan’s Exchange Report 669 Cases of Suspected Crypto Money Laundering’ https://www.coindesk.com/japans-exchanges-report-669-cases-of-suspected-crypto-money-laundering/ accessed 19 August 2018. 48
regime for the handling of personal data which is expected to affect businesses worldwide. With the idea to enhance private persons’ control over their own data, the law recently came into force on May 25th and translates into a number of obligations for ICO project leaders.165 First, issuers must be aware of the requirement of having a sufficient legal base to conduct KYC/AML background checks. Most governments will expect ICOs to conduct these, but in cases where the law does not explicitly provide it, issuers need to ask for the data subject’s consent. Consent can no longer be inferred or shadily obtained under the GDPR – it needs to be asked for explicitly in a clear and intelligible manner. In an increasingly self-regulated environment the privacy aspect should be a priority for every issuer. Second, any collected data must be safe and secure. Internal drives and encryption are a few commonly used methods to achieve this end, but what matters for the EU regulator is the existence of operational and technical safeguards to prevent potential third-party intervention. Further requirements include categorizing the data and conducting internal audits with the aim of identifying potential risks of breach. Third, users are to be clearly and visibly made aware of their rights regarding their data. Among others, those include rights of access, erasure (‘right to be forgotten’) and data modification. Long story short – users should be able to get a hold of any personal details in a timely, organized and widely accessible manner. Something to consider here is setting up a “data hotline” similar to a feedback form on a website where users can file requests regarding their data. Such a measure signifies a company’s commitment to comply with GDPR expectations to backers and regulators alike.
The ICO purchase agreement
Between every issuer and ICO backer stands the ICO purchase agreement. Similar to a Terms of Service which naturally everybody takes the time to read in full, it contains all the relevant terms governing the contract between the two parties, for example on matters relating to applicable law, choice of court, personal investment cap etc. The main idea behind the agreement is to create sufficient transparency and correct any information asymmetries between you and your backers. Here it is of utmost importance to clearly define the product and specify any risks associated with it. The trend towards more ‘businessy’ Whitepapers here again denotes the importance of writing these in a way that every investor is able to understand it. With the increasing focus on compliance, ICOs must be as transparent as possible here in order to avoid regulatory scrutiny and attract as many investors as possible.
165 General Data Protection Regulation (EU) 2016/679 49
4.2.3 Recommendations for investors
This part will focus on providing private investors with some guidelines for investing in ICOs and cryptocurrencies at large. Again coming back to the previous risk factors identified, the recommendations will focus on a number of contemporary red flags around token sales. The inclusion of these red flags could contribute to ‘smarter’ investments in the sphere and again serve to the achievement of the end goal of ICO incubation and loss of capital minimization.
The product and the solved problem
When looking at the main idea behind an ICO project there is a few questions every reasonably circumspect investor should ask themselves.
Is blockchain really necessary to achieve such a goal? Is this thing going to be relevant 5 years from now?
Many founders tend to use buzzwords such as blockchain and decentralization to lure in inexperienced backers with the promise of something grandiose whereas in reality the project does not have much real-life use. Consider the following, Long Island Iced Tea Corp. (yes, it is an ICE TEA company) changed its name to Long Blockchain Corp. and saw its stock rise with as much as 289% after the announcement. As much as blockchain is useful and ice tea enjoyable, such a sudden spike in share value is virtually unheard of, especially when attributed to a simple name change. In other projects, the problem being solved is simply too small or non-existent. While some try to make online purchase of high quality sand possible, others clearly underline the uselessness of their token, as exemplified above with the Useless Ethereum Token example. Some ICOs begin to even raise money without a product, nor even a Beta or an Alpha. The absence of a prototype of any kind is a huge red flag and definitely a negative sign of a team’s ability to pull off their plan. Lack of GitHub activity should also make investors think twice.166 On the same note, similar projects without a real value proposition tend to overspend on marketing. Digital advertising here comes in abundance and mechanics such as the use of bots and influencers are used regularly to try and attract investors.
Team & Community
166 Most blockchain-based projects are open source and their code is made widely available. GitHub is the main developer platform where blockchain codes are imported and checked by the community. GitHub makes it possible for anyone interested to check development activity levels. The lack of such activity on a weekly basis signifies that some teams are not working hard enough to develop their product. 50
Every self-respected ICO project has a detailed list of its team on their webpage – that includes a clear description of the partners, advisors and developers associated therewith. Investors should make sure to do a background check of every team member that is included – Google them with the aim of finding the skeletons in their closets, check out their previous experience and background on LinkedIn and so on. If there is someone distinguishable (e.g. Vitalik Buterin listed as advisor), try and contact the person to see if their involvement is authentic rather than a mere PR stunt. Compliance is another major stress point when it comes to token sales. The inclusion of a legal team with relevant experience in securities law and corporate governance is always a big plus. Try to also find out if the main team is working full-time, if the coin launch is just a side hustle for a crucial team member it might be wise to back off.167 Further identify if there is any venture capitalist involvement. In the crypto sphere, VC-backing is commonly considered as a stamp of approval. The community dimension of an ICO is one of the most important, yet often neglected, points when considering an investment. Wide social media coverage and engagement on platforms such as Reddit, Telegram and BitcoinTalk is hardly always a good sign. It is often the case for ample token communities to be purely focused on the process of claiming coins and recruiting backers, resulting in neglect towards constructive discussion about the product itself. Such a scenario can give you a clear idea on where founders’ priorities lie. The included case study has shown that ICOs typically excel in the community dimension. Finding one that has low activity levels or one that tends to not answer more ‘uncomfortable’ questions is considered a huge red flag.
Website, Whitepaper and Code
Although it can easily be used as a bamboozling trick, a trendy website is always a must for any good ICO. The devil is in the detail and examining every corner of a company website is surely a must for every potential ICO backer. If they couldn’t even make a WOW website, what would make investors think they’ll be able to pull anything else off? A Whitepaper’s main goal is to correct any information asymmetries between issuers and buyers. Good whitepapers are sensible, easy to read and not overflowed with technical details. If the team is business and tech savvy, they should be able to provide a description of their product that anyone can understand. Some projects even develop two separate Whitepapers – a technical one and a ‘normal’ one. This is a clear sign of the team’s commitment to adequately present their idea to the public. Information on applicable law and liability concerns should be made available as well. Small specifics like these make up a great Whitepaper and positively enhance investors’ trust.
167 Again checking GitHub activity helps in such cases. 51
Financials
First, ICO issuers should have a clearly defined fundraising cap. Wider differences in this amount (e.g. soft cap 2 million and hard cap 15 million) should make investors wary of a team without a proper product roadmap and inability to calculate expenses. Second, there should be a clear fund allocation structure. Investors should know what their money is being spent on. A disproportionate reward to the team at the expense of reduced spending on product and business development could often be a sign of profit hungry issuers. Third, most ICOs have a bonus system in place to reward earlier backers. A 50% discount on tokens for the token sale opening week, followed by a 25% discount the week after may raise some eyebrows about the value of one’s investment. Being an early investor, on the other hand, can be particularly profitable when further batches of tokens are sold. Lastly, there are issuers who prefer to reserve an X amount of tokens to a particular investor. In an ideal crowdfunding setting, businesses will try to diversify their investor portfolio as much as possible. Allocating a fixed amount to a specific investor could potentially pave the way towards possible monopolistic market behavior and token price manipulation. In a market defined by volatility, such external adverse changes are anything but welcome, especially considering the lack of adequate safeguards.
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6. Conclusion
The aim of this paper was to put the spotlight on blockchain-based fundraising and stress out the need for some improvements to continuously improve the field with the inclusion of all relevant stakeholders. It was subsequently argued that ICOs hold many advantages for both issuers and investors, especially considering their wide reach and their potential to include people from all around the world in the global financial markets. The main goal of the research was to underline the disruptive capabilities of ICOs and argue that, besides government action, all other relevant stakeholders (issuers and investors) must be actively involved and well- informed to properly incubate blockchain in the context of fundraising. Given the complexity and young age of the technology, issuers should aim to produce products with sufficient value propositions while investors must carefully pick their investments in order to contribute to this natural process of sorting out the market. While it indeed holds true that token sales are a significant innovation in the area of fundraising, the space is still in a very early stage where many actors are inevitably fighting for the same piece of the pie. In reality there is an abundance of projects which are essentially mirroring each other and all those projects are receiving funding on a steady basis. The technology is also in a relatively early stage, having still a variety of shortcomings. The grand market crash from earlier this year wiped great amounts of value and a variety of tokens have reached prices nearing the 0.00 USD mark. Vast numbers of issuers have also chosen to abandon their projects, seeing that competitors are progressing in a faster pace and as a result have left investors without returns on their investment. Ponzi and pyramid schemes are a further problem that perfectly encapsulates the similarity of the current ICO market to other historic economic bubbles such as the .com one from the beginning of the century. Nevertheless, the steady crash of the market from the year should be embraced as it shows that the blockchain ecosystem is showing signs of maturity. In order to minimize the negative financial consequences of future market cap losses and properly incubate blockchain- based fundraising, the paper’s main value proposition in Chapter 4 revolved around providing a framework for governmental action in the area of ICOs. A previous part additionally provided an overview of a number of legal systems around the world, thereby signifying the diverging stances of regulators around the globe. However, the approach taken by Malta was highlighted as an ideal example for a country embracing ICO as an alternative method of finance and therefore one other jurisdictions can ‘borrow’ from if they are to improve the local ICO ecosystem. Throughout the paper one inference was made clear – investors are showing great interest in the field and the ICO market is now simply too big to ignore. The path of a complete ban is furthermore not advised considering the innovative potential of token sales for both investors and entrepreneurs. Therefore it was proposed that the legal action against ICOs must
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follow a path that ensures innovation while at the same time it should provide adequate safeguards for those looking to invest. Adapting outdated legislation to this innovative field is furthermore not advised as current problems, e.g. on investor protection, will continue to resurface due to the inherent complexity of blockchain. Governments should thus work closely with experts and businesses in the field to arrive at an optimal regulatory framework that is able to encapsulate the needs of all relevant stakeholders. The establishment of specific task forces for research and development should also contribute to the incubation of blockchain-based fundraising as well as to the exploration of the technology’s benefits in other areas. On the same note, legal action on its own merits is at the moment insufficient to adequately address the contemporary issues surrounding the ecosystem. Regulation always tends to lack behind innovation and simply waiting for it will have further negative consequences for all relevant stakeholders and the ICO space as a whole. Thus the paper stressed out the importance of equal contribution of all the actors involved in blockchain-based fundraising. Not only must governments develop new laws to tackle deficiencies. Issuers and investors alike must also contribute their due. For the former this translates into providing better products or services which properly correct information asymmetries between them and their backers. This can be done through continuous engagement with the community and increased levels of transparency. From a technical point of view, adopting ICO governance structures with inferences from DAICOs could prove to correct the issues relating to investor trust. Incorporating such a standard into regulation must be considered by legislators to provide safety ‘by design’. Investors should also become more aware of the current risks associated with ICO investing. While more and more issuers are moving towards compliance-based ICOs, there will always be such that are trying to capitalize on the current hype or out of fear of missing out. Smart investing with careful evaluation of a token’s product or service should therefore be a priority for potential backers. The part on investor recommendations thus acts as a base blueprint to identify any red flags for those without any prior experience in investing in the blockchain space. The case study further denoted the validity of the paper’s hypotheses that ICO funding has disruptive capabilities and must be specifically tackled by new legislation and a tailor-made approach. More and more entrepreneurs are indeed opting out for an ICO to quickly raise funds and improve their project’s traction. Investors’ interest is also on a steady growth curve as regulation continues to level the playing field and positively enhance the issues of transparency. The ecosystem is slowly maturing and the market crashes are effectively acting as a filter for actual value propositions. In spite of this, however, there is much yet to be done, especially from the side of the regulator. Tailor-made legislation should be a top priority considering both the volume of ICOs and the move towards a digital economy.
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