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Regulation of the ICO: sitting in the waiting room

3 July 2018
– 8 Minute Read

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Although the debate about whether or not to regulate initial coin offerings (ICOs) is in full swing, many key regulators are hot on its heels, and even if we are in the first paragraph, ‘in summary’, they are going to be regulated. The challenge, of course, will be to regulate appropriately without stifling growth and innovation.

The volatility of certain tokens (also traditionally referred to as cryptocurrencies or coins) can be quite alarming. It is one of the predominant factors in the drive to regulate this space and protect the ordinary investor. There is also the fact that ICOs are usually initiated by start-ups, and participants who are not used to venture capital investing stand to lose all of their investment if the project is unsuccessful.

As things stand, it is generally standard for the issuer of a new token to produce a white paper, although the related process and its content are unregulated. It is good practice – though not mandatory – for a white paper to outline the status of the project, along with its prospects, key leaders, founders and advisors as well as the financial, commercial and technical information of its blockchain project. It has also become common to publish the source code for the public, online, in order for participants to assess its security and functionality at an early stage. However, ICOs being unregulated, the issuer may include or omit information as it sees fit.

There are likely to be obvious problems in regulation. One of the main difficulties with regulating this area is that an ICO does not commonly accept fiat currency (government-declared legal tender) in its fundraising process. Although it is understandable why the public would want to see the token issued in an ICO being regulated, the regulators cannot ignore the fact that ICOs are almost always conducted to receive predominantly Bitcoin and Ether: the most difficult-to-regulate tokens on the market, because of how decentralised they inherently are. It is virtually impossible to properly regulate specifically those two, because no one person or entity can control either of them. Simply put, how do you regulate only half of the relevant process?

US announcement provokes reaction

One of the common concerns raised in all interested jurisdictions is whether or not tokens amount to securities.

A few weeks ago, the United States Securities and Exchange Commission (SEC) announced that it does not consider Bitcoin and Ether to be securities. It is not clear why this announcement hit the media with the force that it did (and why it impacted the price of Ether the way that it did), since Ether had already been declared as virtual currency in statements made by the SEC a year ago in July 2017 in “the Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO”.

However, what has been made exponentially clearer in recent SEC statements is that the level at which a coin is decentralised could cause it to be declared not to be a security in the US. This introduces the potential for a new way of thinking, in which a token which could start out as a security during a capital raise, could later in its life cease to be a security.

For the most part, over the past year or two, the rest of the world has indicated that it finds the US approach too strict under the “Howey” test, which “Venus fly traps” almost every cryptocurrency into a security, since most models of cryptocurrencies are seen to create investment contracts. This triggers the need for expensive regulatory filings that are not feasible for start-ups on many levels.

In the event that South Africa takes a similarly strict approach, there is definite scope for some cushioning from IPO consequences in having Simple Agreements for Future Tokens (SAFTs) which are akin to private placings, provided that only accredited investors become involved and all of the funds be raised only from a few investors who are willing to commit to a take-up of a minimum of R1 million each. Although this should not be a challenge for the larger players in the market, it still fails to resolve the issue for start-ups who may find it challenging to get enough uptake from only sophisticated investors. We would not want regulation that is a poor fit to disrupt something that is already disruptive. If we land up with a blanket approach of applying existing legislation to all ICOs, it could end up feeling like fitting a square peg into a round triangle.

Tokens in the capital markets space

It would be puzzling to treat ICOs in exactly the same manner as IPOs. There are differences in the manner in which digital currency exchanges and stock exchanges operate, the most apparent being that traditionally, stock exchanges are designed to give an issuer access to the market in a particular jurisdiction, whereas digital currency exchanges aim to provide access to several jurisdictions at the same time. In addition, the process of an ICO, in practice, is not designed to be slotted into most IPO mechanics, largely because ICOs are a start-up haven, whereas IPOs of the same size are reserved for the established elite.

That is not to say no universe is available in the capital markets crypto-space for large corporates and stock exchanges.

The New York Stock Exchange appears to be taking a bullish move in creating a digital currency exchange of its own. There has been no indication of similar activity taking place on the South African horizon.

As for the corporates, maybe the future is in the futures. Activity on the Chicago Boards Options Exchange involves futures contracts, where investors can bet on whether they believe the price of Bitcoin will rise or fall, allowing investors to bet that the price of Bitcoin will drop (known as shorting). If well-established stock exchanges like the JSE venture into a similar arena and allow for trading of products based on the value of underlying cryptos, it could open up a whole new market. For the time being, we are all just a pack of mongooses: wide-eyed, watching and waiting.

Are we there yet? #inthistogether

At the launch on 5 June 2018 of the Project Khokha report on emerging technological innovations in South Africa’s financial sector, it was evident that the South African Reserve Bank (SARB) has taken the time to appreciate, sandbox and roll out use of blockchain that will introduce efficiencies. The introduction of the tokenised Rand, which grants the holder a palpable claim against SARB, could well soon be used in closing deals in M&A activity, which will eliminate the delays transactors are used to in “pushing the button”.

Although it will take a considerable amount of time before the long-term South African regulatory approach to ICOs is settled, I have been impressed with the responsible approach of many of the regulators in following a systematic process in its initiative to assimilate blockchain into the national payment system and understand ICOs. This complimentary response has been echoed several times in recent public forums, where the financial regulators have invited the public to speak freely regarding cryptos: outright, unprompted appreciation, and we all know that the public does not do that easily. All that being said, in the ICO space, sceptics do exist and a lot of people think it is too soon for regulation, since barely anyone has a proper understanding of what the blockchain really is and the extent of its capabilities.

Where we are for the time being is that the tax position has been expressed (income tax and CGT will apply), the financial markets regulations are being carefully considered, and we are being directed away from referring to tokens as “currencies” (“crypto-assets” being SARB’s preference).

The Companies and Intellectual Property Commission (CIPC) has not yet had any visible public interactions in this space, but we look forward to seeing if they will take an approach as responsible as the financial regulators, dedicating special teams to investigate and properly understand the nature of tokens, how they are used, and precisely where the risk areas are. Sure, there are several fraudulent ICOs out there, and they must be prevented, but not every ICO is sinister. We hope that the CIPC succeeds in pitching it appropriately when they do become publicly involved in this space, and that they give it a measured response in order to avoid over-regulation. Where this has not happened in other jurisdictions, the ICO industry has been crippled, and with it, the potential for job creation, attracting international investment activity and economic growth. Closing off that potential, without careful consideration of all relevant factors, would be an inappropriate regulatory response. The public awaits the next regulatory steps with anticipation, and is hopeful for the end result of applicable fintech legislation to be a world-class South African regime.