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 1 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 2 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' <https://www.theguardian.com/technology/2018/mar/19/uber-self-driving-car-kills-woman-arizona-tempe> accessed 19 August 2018. 2 Ryan Browne, 'Elon Musk Warns A.I. Could Create An ‘Immortal Dictator From Which We Can Never Escape’' <https://www.cnbc.com/2018/04/06/elon-musk-warns-ai-could-create-immortal-dictator-in-documentary.html> accessed 19 August 2018. 3 David Mills et. al., ‘Distributed ledger technology in payments, clearing, and settlement,’ https://doi.org/10.17016/FEDS.2016.095. accessed 19 August 2018. 4 Oscar Williams-Grut, ‘Only 48% of ICOs were successful last year – but startups still managed to raise $5.6 billion’ http://uk.businessinsider.com/how-much-raised-icos-2017-tokendata-2017-2018-1 accessed 19 August 2018. 5 Francine McKenna, ‘Here’s more on KodakCoin, the planned ICO that sent Kodak’s stock surging’ https://www.marketwatch.com/story/heres-more-on-kodakcoin-the-planned-ico-that-sent-kodaks-stock-surging- 2018-01-18 accessed 19 August 2018. 3 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