The European Securities and Markets Authority ( ESMA ) has issued two Statements on Initial Coin Offerings (ICOs) – and it is not the first:
- on the risks of ICOs for investors
- on the rules applicable to firms involved in ICOs.ESMA commented that “it has observed a rapid growth in ICOs globally and in Europe and is concerned that investors may be unaware of the high risks that they are taking when investing in ICOs. Additionally, ESMA is concerned that firms involved in ICOs may conduct their activities without complying with relevant applicable EU legislation“.
What is an ICO?
An ICO, or Initial Coin Offering, resembles an IPO (Initial Public Offering), but with complications. The first is that each ICO is wrapped in cryptographical and cryptocurrency complexities. The second, unlike IPOs which are regulated, is that ICOs lack regulatory obligations plus transparency. While the latter might be about to change nothing has yet happened.
At its simplest, an ICO is a mechanism for attracting investors to provide funds for ‘corporate purposes’ (most ICO are issued by companies registered somewhere, rather than individuals). In essence, a company attracts investors looking for the next big ‘thing’ by selling digital currency based ‘securities’.
In an ICO, a business issues coins or ‘tokens’. It puts these up for sale in exchange for either fiat currencies (the US$ or Euro) or (more often) virtual currencies such as Bitcoin or Ether. According to ESMA, “the features and purpose of the coins or tokens also vary across ICOs:
- “some coins or tokens serve to access or purchase a service or product that the issuer develops using the proceeds of the ICO;
- “others provide voting rights or a share in the future revenues of the issuing venture
- “some have no tangible value
- “some coins or tokens are traded and/or may be exchanged into fiat or virtual currencies at specialised coin exchanges at some point after issuance” (usually at the discretion of the issuer rather than the investor).
From all this it should be apparent that ICOs are fraught with risk,. This explains why ESMA has issued its two statements.
ESMA on ICOs for investors
“ESMA is alerting investors of the high risk of losing all of their invested capital as ICOs are very risky and highly speculative investments. The price of the coin or token is typically extremely volatile and investors may not be able to redeem them for a prolonged period.
“Another key risk stems from the fact that, depending on how they are structured, ICOs may fall outside of the scope of EU laws and regulations, in which case investors cannot benefit from the protection that these laws and regulations provide. ICOs are also vulnerable to the risk of fraud or money laundering.”
ESMA on ICOs for firms
“Where ICOs qualify as financial instruments, it is likely that firms involved in ICOs conduct regulated investment activities, in which case they need to comply with the relevant legislation, including for example:
- “the Prospectus Directive
- “the Markets in Financial Instruments Directive (MiFID)
- “the Alternative Investment Fund Managers Directive (AIFMD)
- “the Fourth Anti-Money Laundering Directive.
“ESMA stresses that firms involved in ICOs should give careful consideration as to whether their activities constitute regulated activities. Any failure to comply with the applicable rules will constitute a breach.”
What does this mean
The numbers of ICOs used to raise funds for projects is rising. According to Coinschedule, 200+ ICOs have raised more than US$3B in 2017 alone. Many of these leverage the blockchain or Distributed Ledger Technology (DLT).
For individuals the depth of risks involved in investing in ICOs should be obvious. Nevertheless, the lure of apparently easy money is great. After all, one Bitcoin went from just under US$1300 equivalent at the start of 2017 to over US$7000 (briefly) in November 2017. That is a rise of over five times.
For enterprises the risks are more diverse, especially any with involvement in securities issuance and processing. Here enterprises must take great care that inadvertently they do not overstep existing regulatory frameworks.
All in all, and irrespective of whether ICO-mania is akin to Dutch tulip mania, the ICO arena is fraught with dangers. If ever caveat emptor applied it is to ICOs. Understand that you may well lose your wallet before proceeding further. And that is before considering the existential risks involved in cryptocurrencies themselves: for example, forget your access credentials, forget your investments.
