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Over the past year, the hype around initial coin offerings (ICOs) has significantly died off – some of the supposedly revolutionary businesses that raised capital through ICOs have quietly vanished while others got stuck in the regulatory battle and in many cases eventually gave up. Despite the arguments made that the industry of ICOs is still very much active and is simply flying under the radar due to regulatory strain on advertising, there is undoubtedly a noticeable downward shift in the public interest in ICOs. This begs a question: was the ICO boom just an ephemeral, somewhat opportunistic craze, or do ICOs still have potential to reemerge and are in fact something worth looking into?
Before we begin, we must note that even though this article is about ICOs, Blockchain, as the underlying technology of ICOs, is an inseparable part of the topic, and thus we discuss it in this article as well. However, even though ICOs is certainly the most prominent application of Blockchain and therefore is relevant to us and our clients, it is still only a very limited way of utilizing the technology, and it would be a mistake to conflate the two concepts.
In the following paragraphs we cover the most recent developments and news in the ICO industry as well as key aspects discussed in the 5 hour-long public forum hosted by the U.S. Securities and Exchange Commission’s (SEC) FinHub staff on distributed ledger technology (DLT) and digital assets on May 31, 2019 (the full webcast of the public forum may be accessed here). In an effort to get to the roots of the problem, we first analyze the key reasons for the slowdown in the ICO industry over the past year. Afterwards, we point out the main hurdles currently standing in the way of successful execution of ICOs and utilization of Blockchain technology in the financial industry to its full potential: classification of digital assets as securities, shortcomings of utility token ICOs as well as KYC and AML processes.
During the rise (or rediscovery) of Blockchain technology, many entrepreneurs and innovators got involved in new promising and exciting projects premised mainly on the opportunity to quickly and effortlessly raise capital through an ICO. At the time, ICOs seemed like lucrative, no-brainer financing opportunities due to their perceived ability to basically serve as an unregulated, expedited, and affordable initial public offering of securities (IPO). However, it did not take too long for regulators to catch up with the technology and begin fining companies for violations of financial markets regulations (and abuse of the lack of regulation of digital assets). As a result, the trend got buried under legal and regulatory strain and eventually died off. In many parts of the world regulators did, however, realize the potential of Blockchain technology and ICOs, and therefore still continuously strive to adapt regulation to the developing technologies in order to encourage innovation.
Over the past few years, regulators in various countries have made an effort to establish regulatory sandboxes where they could work together with innovators, developers and entrepreneurs to figure out the best and most efficient ways to regulate the ever-developing technologies based on Blockchain. However, due to the fact that the development is extremely fast and there are new functionalities available every day, to keep the situation under control, in most cases regulators ended up restricting the activities they were unable to regulate efficiently and only then started looking for alternative regulation methods.
This, in simple terms, is what is currently happening in the ICO industry: regulators are continuously trying to come up with efficient ways to regulate the digital asset industry that would both encourage innovation and protect general public from being taken advantage of as a result of financial fraud (for example, UK Financial Conduct Authority’s newest Guidance on Cryptoassets of July, 2019). However, due to many issues stemming from the current set up of ICO execution (anonymity, high risk for investors, limited means of policing and intervention), the regulatory efforts have been mostly of restrictive nature and unfortunately did not really help to move the idea forward.
Despite many efforts to prove otherwise, over time it became quite clear that more than anything else, digital assets issued during ICOs are securities. This, from the very beginning, was extremely problematic in the U.S. given the strict securities regulation implemented by the U.S. Securities and Exchange Commission (SEC). As already discussed in our article, all issuances of securities in the U.S. must be registered with SEC or must qualify for an exemption. Furthermore, in accordance with SEC’s explanations, a platform that offers trading of digital assets that are securities and operates as an exchange as defined by securities laws must also register with SEC as a national securities exchange or be exempt from registration. This applies not only to exchanges operated from the U.S. but also to exchanges managed and located outside the U.S. but providing services to U.S. persons.
Knowing the abovementioned and seeking to stay out of SEC’s scope of regulation, many ICOs and exchanges started excluding U.S. persons from their activities by including a representation that one is “not a U.S. person” during the registration process or in a similar manner. For a while it seemed to somewhat work, however eventually SEC’s regulation and many others similar thereto all over the world placed a burden on the innovative ICO startups that the companies were not able to bare. This was and to this day is the main issue related to ICOs. As the initial idea behind ICOs was to make the investment (or crowdfunding) process easier and faster as well as enable regular people to invest into large scale projects in small fractions, the categorization of tokens issued during ICOs as securities eliminated such possibility. This categorization discouraged many entrepreneurs from trying to issue digital assets as compliant securities and forced them to look for alternative ways to utilize the ICO model.
For the longest time during the rise of ICOs many companies believed that they can avoid the strict regulation applicable to securities by labelling their digital assets as utility tokens. Some did not put much more effort into it other than simply labelling the tokens as “utility”, others worked harder and in their white papers actually attempted to describe the utility nature of the digital assets to be issued, describing them as a token providing access to a certain service or product once the company is up and running. The truth, however, is that the purpose of almost all digital assets being issued by companies in its essence is raising capital and merely attaching the digital asset to some future service or product does not annul its security-like nature. Furthermore, in order to be considered utility tokens, tokens should not be much different from loyalty points collectible within the system of one product or service provider, which does not really provide for lucrative future prospects for such digital assets.
As a result, many companies that tried to avoid falling under securities regulations by labelling their digital assets issued during ICOs as utility tokens, eventually ended up being categorized as securities issuers anyway. Those that managed to consult with regulatory authorities in advance might have avoided serious consequences, however, that was not always the case. Eventually it became clear that claiming the utility token status is really not a great solution to the regulatory burden placed on ICO companies and the demand for a more effective regulation method remained.
Another key issue concerning ICO companies is the regulation and worldwide practices regarding the prevention of financial fraud. The regulated industry of financial services, especially in the European Union, is well known for its Anti Money Laundering (AML) and “Know Your Customer” (KYC) practices triggering certain procedures that must be carried out each time assets enter or exit the financial system. For the purposes of financial security and prevention of fraud, KYC and AML processes, among other things, include personal identification and clarification of source of funds processes thus preventing “anonymous” money and funds of unknown sources from entering financial institutions and companies that accept payments. The discussed practices are extremely relevant in the ICO industry not only due to the fact that the main purpose of ICOs is financing, and thus certain movement of assets and financial transactions are always involved. In the very beginning of ICOs one of the greatest advantages Blockchain provided was easy and fast asset transactions which, of course, did not include any KYC and AML.
For this and many other reasons, regulators eventually started issuing (mandatory) recommendations to financial market participants to disassociate themselves from any activities related to digital assets – given the nature of digital assets, the lack of KYC and AML processes made it impossible for regulated financial institutions to fulfill their legal obligations. It then suddenly became clear that the biggest problem of digital assets was the extremely difficult conversion thereof to traditional recognized currencies as financial institutions started refusing to accept funds originating from digital assets due to their unknown trail and source. Being unable to implement KYC and AML as transactions on most blockchains are anonymous, financial institutions, including banks, had no choice but to refuse to accept any funds originating from digital assets.
The solution to the issue in question, some may argue, is simple – implement KYC and AML at the time of ICO, before allowing any transactions on the blockchain, and the industry will be compliant. That is also what most regulators are now requiring financial service providers and companies that issue digital assets to do. However, is implementing KYC and AML upon initial sale of digital assets enough? For example, if a company is financing its business through an ICO and carries out a proper KYC and AML upon initial sale, who is responsible for the compliance with regulators’ requirements of transactions in secondary markets? Is an exchange then responsible for the implementation of KYC and AML? Furthermore, in many cases, information on blockchains being publicly accessible, and taking into account the supposedly fast and convenient nature of digital assets, would not such burden entirely negate the benefits of using Blockchain technology for storage of financial assets?
Despite the discussed issues related to ICOs, many still argue that it is a very promising and functional way of financing. If effectively regulated and policed, way of financing through ICOs offers many advantages and definitely brings the financial service industry a step forward. In the age of internet and modern technology, ICOs can provide exceptional opportunities to entrepreneurs based in remote parts of the world not having much capital available, to reach investors located all over the globe. At the same time investors could have more opportunities to invest into promising projects lacking local capital. As a result, ICOs could help accelerate innovation, research and development all over the globe, provide new trade opportunities and overall ease financial transactions. Furthermore, in case government-issued digital assets ever do come to effective existence, Blockchain technology is believed to have the capacity to change the entire industry of financial services, possibly even cutting the role of traditional banks and other financial institutions.
Notwithstanding various myths and misconceptions, ICOs are definitely not an easy and smooth way to raise capital for startups – at least not yet. The concept of ICOs is still developing and changing and even though undoubtedly having a lot of potential, is still very much restrained by traditional regulation. For ICO companies and anyone interested in the field: try to work and consult with regulatory authorities as much as possible. Furthermore, be prepared to have long discussions with your lawyers – as discussed in detail in this article, regulation of ICOs is still very restrictive thus creating numerous obligations for companies involved in ICOs (which also includes exchanges and other alternative platforms dealing with digital assets). Finally, the more clarity you are able to provide to investors – the better. The times of generic white papers are far in the past and the investors must be continuously updated on the development of the ICO company they invested into. The key takeaway for companies actually seeking to innovate and develop new functionalities of available technologies in financially transparent ways by utilizing Blockchain and ICOs is this: regulators are open to discussion, in most cases flexible to the maximum extent allowed by law and will work with you to ensure compliance and further growth of your business. For individuals, however, with no such pure intentions – the times of easy financial manipulation, fraud and enrichment are coming to an end.
