HOW ICOS CAN REALLY SUCCEED
Governments around the world are experimenting with regulations that safeguard investors while allowing innovation
“Every ICO I’ve seen is a security”, U.S. Securities and Exchange Commission (SEC) chairman Jay Clayton told a US Senate hearing on February 6, 2018, before conceding that not one ICO (initial coin offering) has been registered with the SEC as a securities offering. Except for China, which banned ICOS and cryptocurrency trading platforms in September 2017, and Japan which legalised cryptocurrencies and regulated crypto exchanges from April 2017, plus a handful of forward-thinking emerging markets, the US position is typical of many jurisdictions, Hong Kong included.
The difficulty of defining an ICO leads to the challenge of regulating ICOS, and therefore providing the stability needed for them – and the projects they support – to succeed. As in other jurisdictions, ICOS in Hong Kong are typically structured as sales of utility tokens that provide access to a platform and/or a means of payment for its services. Provided that the holders will not receive a share of the return offered by the platform, these ICOS aren’t considered to constitute a securities offer, but given the range of activities that are possible with ICOS, there are plenty of grey areas to sort out. Around the world, governments are experimenting with ways to deal with this phenomenon in the hope of realising the promise of blockchain technology, without squelching it.
The wild fluctuations in the price of bitcoin and other cryptocurrencies in recent months, along with cryptocurrency thefts and ICO scams, have focused attention on regulatory matters. Surprisingly, perhaps, many of the calls for crypto regulation have come from the industry itself. “If we want this whole asset class to grow up and mature, of course, there should be more regulation,” said Ripple CEO Brad Garlinghouse.
He makes an important point. In the US and the UK for example, bank participation in cryptocurrencies is minimal. The advantage of regulation would be to bring cryptocurrencies into mainstream finance and facilitate the real development of blockchain technology and its applications. Other issues related to consumer protection and facilitating efficient capital raising for companies.
In essence, effective regulation gives legitimacy, and what is lacking now in cryptocurrency markets is legal certainty and trust. Most of us would feel more confident buying cryptocurrencies online knowing that the platform is licensed and meets basic suitability criteria. Regulation helps us distinguish legitimate ICOS from scams and Ponzi schemes, which would hopefully discourage bad actors from entering the market. The current lack of regulation, therefore, works to the detriment of legitimate ICO issuers.
Regulators worldwide are grappling with the question of whether and how to regulate cryptocurrency transactions, ICOS and cryptocurrency trading on online exchanges. Investor protection concerns are paramount, leading regulators to warn potential investors of cryptocurrencyrelated risks including fraud, theft through hacking, price volatility and potential lack of liquidity. Another major concern is that the anonymous nature of cryptocurrency transactions facilitates money laundering and terrorist financing – risks shared by national currencies and even stocks.
China and Japan, two countries at the centre of the cryptocurrency revolution, are at opposite extremes when it comes to regulation.
So far, China is alone in imposing a complete ban on ICOS and cryptocurrency trading exchanges. The ban imposed in September 2017 declared ICOS an “unauthorised illegal fundraising activity” and put an immediate stop to ICOS in the country. An announcement by the People’s Bank of China at the time estimated that some 90 per cent of Chinese ICOS were scams, providing a very real incentive to clamp down on the activity.
Tencent (like Facebook) banned advertising related to ICOS or cryptocurrency trading, and the Chinese regulators have also sought to block access to offshore cryptocurrency trading platforms and ICOS.
While China’s sharp crackdown on ICOS and crypto trading amid widespread fraud is understandable, it has also been criticised for diminishing China’s once dominant role in the cryptocurrency business. Yet China is not against the idea of a cryptocurrency and is reportedly researching the development of a sovereign cryptocurrency.
On the other hand, Japan became the first jurisdiction to legalise bitcoin as a means of payment in April 2017. Japan treats cryptocurrencies as assets that can constitute a legal means of payment – rather than as money or currencies. Some 10,000 Japanese companies now accept payment in bitcoin, including its largest budget airline.
The Financial Services Authority, Japan’s regulatory authority, responded to the 2014 theft of US$437 million worth of bitcoin from Japanese exchange Mt Gox by implementing clear regulations to govern cryptocurrency trading exchanges, rather than trying to clamp down completely. The Payment Services Act was amended to include virtual currencies as a means of payment and to require the licensing of cryptocurrency trading exchanges and their implementation of anti-money laundering (AML) controls.
Japan taxes cryptocurrencies and estimates put tax revenue from cryptocurrency businesses, including taxes on capital gains from cryptocurrencies made by individuals and corporations, in the region of JP¥1 trillion (HK$ 72 billion). Cryptocurrencies now contribute roughly 0.3 per cent to Japan’s GDP and that figure is growing, so Japan’s proactive stance makes sense.
THE HONG KONG WAY
The most common approach to regulation in jurisdictions that have not suffered widespread fraud and hacking is to regulate cryptocurrencies and ICOS with existing laws and regulations. This is the approach in Hong Kong, as with the United States, the UK and Singapore, although Singapore’s MAS is consulting on a new Payment Services Bill which would impose licensing requirements and AML and CTF obligations on cryptocurrency trading platforms.
The difficulty, however, is that existing laws were written for a very different time, and
trying to shoehorn cryptocurrencies into existing definitions may not work.
In Hong Kong, the principal regulators, the Hong Kong Monetary Authority and the Securities and Futures Commission (the SFC), regard cryptocurrencies not as legal tender, money or currencies, but as “virtual commodities”, which are not subject to regulation. That is provided that the cryptocurrency in question does not have the characteristics of a “security”.
In September 2017, the SFC issued a statement outlining possible circumstances in which a cryptocurrency could be considered a security, such as when tokens carry rights of ownership or to a share of the revenues of the projects funded. In that case, an ICO may require SFC authorisation as a security offering.
The SFC has also stated that while bitcoin is not regulated, bitcoin futures contracts traded on certain futures exchanges, including the bitcoin futures contracts launched on the U.S. CME and Cboe exchanges in December 2017, are futures contracts regulated by the SFC.
Nonetheless, the SFC’S recent warning statement appeared to confirm that utility tokens are not securities. That said, the status of a token where the platform has not been developed at the date of the ICO, or whose only potential return is a hypothetical profit on a hypothetical future sale of the token if it becomes tradable, remains a legal grey area. Ultimately, it may be up to Hong Kong courts to settle such questions, leaving investors in a potentially difficult tangle.
Despite their warning statements, Hong Kong regulators have not indicated an intention to ban ICOS or tighten regulation. This reticence is welcome, given that ICOS are providing the funding vital to the revolutionary blockchain technology with its transformative potential for economies.
Hong Kong does not provide a specific regulatory regime to allow crowdfunding, such as was implemented by the Jobs Act in the US. ICOS are filling that gap by providing a much-needed legal means of crowdsourced fundraising, particularly for start-ups in tech and disruptive industries where bank and venture capital financing may not be an option.
Governments around the world are grappling with this technology, and the updates are coming in on a daily basis.
South Korea – the third largest cryptocurrency trading nation after Japan and the United States – followed China in banning ICOS in September 2017 amid fraud and hacking by North Korea. However, South Korea’s Financial Services Commission did not outlaw cryptocurrencytrading exchanges as had been rumoured. Instead, it implemented guidelines to regulate trading exchanges in January 2018, halting anonymous trading.
A “real-name account system” took effect from January 30, 2018, which requires customers to open named accounts with the bank servicing the cryptocurrency exchange they use. New AML guidelines were imposed on banks dealing with cryptocurrencies setting reporting requirements for daily withdrawals of US$9,400 and weekly withdrawals of US$18,800.
Most recently, the South Korean government has said that it supports “normal transactions” on cryptocurrency exchanges.
South Korea’s refusal to ban ICOS is rooted in its positive assessment of the potential of
blockchain technology. South Korean Finance Minister, Kim Dong-yeon, on February 5 noted that further restrictions on crypto-trading exchanges are unlikely (except to counter negative uses) given the perceived need for cryptocurrencies to encourage individuals to participate in blockchain.
Russia aims to regulate rather than ban cryptocurrency activities. The Ministry of Finance published a draft of federal law on January 25 that would legalise cryptocurrencies and allow their trading on licensed exchanges. However, Russia will not recognise cryptocurrencies as a legal means of payment – only the ruble constitutes legal tender.
Russia plans to allow regulated ICOS, where only registered businesses and registered entrepreneurs will be permitted to conduct an ICO. Unqualified investors will be subject to a limit of RUR 50,000 (HK$6,800) on their investment in digital coins/tokens. Russia has also published proposals for accrediting issuers of ICOS that are registered as legal entities in Russia and have authorised capital of at least RUR100 million.
Like China, Russia is reported to be considering the introduction of its own national cryptocurrency – dubbed the “Cryptoruble” – which would be legal tender in Russia.
THE NEXT CRYPTO-HUBS
While developed economies are slower to act, a raft of smaller and emerging economies are fashioning themselves as crypto-friendly hubs. Belarus has legalised cryptocurrencies and ICOS and declared activities related to the creation and sale of digital tokens and cryptocurrency mining to be tax-free until 2023. The moves are part of a drive to boost private sector growth and attract foreign investment.
Cambodia is another country looking to legalise and regulate cryptocurrency transactions as a way to promote growth. It is in these emerging economies that governments are successfully implementing new regulatory regimes unhindered by the kickback from the established finance sector seen in some developed economies. Malta, too, has set out proposals for a new agency to certify blockchain platforms and verify cryptocurrency transactions with the aim of creating “legal certainty and trust”.
In some ways, a principles-based model such as the Gibraltan model may be the most suitable. The Gibraltar Financial Services Commission said recently that it might resort to a system of “authorised sponsors” to handle regulatory issues related to ICOS.
In the absence of regulation in Hong Kong, ICO issuers and crypto trading exchanges may be best advised to self-regulate by conducting anti-money laundering and counter-terrorist financing procedures, ensuring transparency of information and proofing their platforms against hackers. In practice, Hong Kong cryptocurrency exchanges are voluntarily conducting anti-money laundering and counter-terrorism financing procedures, as are most ICO token issuers.
A voluntarily adopted code of conduct, such as that adopted by Cryptouk, a selfregulatory body for crypto exchange, may be a useful model for other jurisdictions, and help give ICO issuers and crypto exchanges the legitimacy they need.