Dentons: ICOs – curse or blessing?

22. Feb 2018

Dentons: ICOs – curse or blessing?A brief overview of the “cryptohype” and the (non-) existing regulatory framework

While the regulators were still discussing the most effective way to regulate crowdfunding within the EU, a new wave of alternative financing overwhelmingly took them by surprise: ICO is the new hype, and it seems like there is no other way to finance a project or a start-up than to issue a new token via blockchain technology.

Generally independent from any capital markets issues, blockchains are – simply speaking – tamper-proof distributed data structures in which transactions are recorded in chronological order and mapped in an understandable and unalterable form. Basically, they can be (and are) used not only to create new virtual currencies, but for basic technological progress (e.g. logistic track records, tramper-proof medication etc.). However, what is also possible with the blockchain technology – and what has become famous with Bitcoin – and now continues to trigger financial markets all over the world, is the creation of new virtual currencies, the so-called cryptocurrencies. The European Banking Authority defines “virtual currency” as a digital representation of value that is neither issued by a central bank or public authority, nor necessarily attached to a FIAT currency, but is used by natural or legal persons as a means of exchange and can be transferred, stored or traded electronically.”[1]

This definition is very broad and generally applicable to any kind of token. However, a closer look at the various tokens shows that there are different specific characteristics of tokens which should be distinguished: (i) tokens that are designed as a “value storage” and payment instrument (currency token, e.g. Bitcoin), (ii) tokens which grant their holders security-like rights (security or investment token) and (iii) tokens granting their owners certain access rights to functions and services within a network (utility token).

From a technical point of view, the creation of new cryptocurrencies takes place via a predetermined mathematical procedure within a computer network or by using a so-called smart-contract. In particular, an issuer can use an existing blockchain (e.g. Ethereum or NEM) in order to create its own tokens (with a smart-contract), which can then be sold to investors (“initial coin offering” inspired by the classical term “IPO.”) Such tokens are “centralized” as opposed to the so-called de-centralized tokens Bitcoin or Ethereum, which are “mined” by various network participants all around the world. In this respect, “mining” refers to a process whereby a computer solves mathematical equations generated within the respective blockchain and thereby creates units of the respective tokens. Anyone interested in participating can download software to access the network and mine tokens. The network functions as a peer-to-peer network in which all users have equal rights.

An ICO generally refers to the issuance (or creation and distribution) of a token by a central issuer. When the issuer approaches the market and the investors (including retail investors), obvious questions arise: How can an investor assess the integrity of the issuer and the business case? How to avoid fraud traps? Are there any regulatory requirements, such as transparency obligations or advertising restrictions, which the issuer must comply with? It is here that actual problems arise when assessing the existing regulatory environment and trying to classify the tokens as securities, investment products, accounting units, e-money or even something altogether different, in which case entirely new regulation would be required. Clearly, issuers would rather try to avoid regulatory implications by claiming that their tokens are completely different from any existing product and therefore not subject to any existing license, permission or other regulatory requirement. Conversely, the supervisory authorities argue that the existing regulatory environment sufficiently covers the existing types of tokens.[2]

Recently, some supervisory authorities broke their silence and issued general guidelines regarding the classification and regulatory treatment of crypto tokens. The German financial supervisory authority (BaFin) published a “reference statement” on February 20th, 2018.[3]

Although BaFin repeatedly outlines that any assessment is subject to the individual structure of the respective token and will be undertaken on a case-by-case basis, the statement provides helpful guidance for issuers and the interested market participants. Unsurprisingly, BaFin repeats its position that tokens can be classified as (i) financial instruments either in terms of the German Banking Act (KWG) or as financial instruments (having greater financial impact in the latter case) in terms of the Market in Financial Instruments Directive 2014/65/EC (MiFID II), the Market Abuse Regulation (MAR) and the German Securities Trading Act (WpHG); (ii) securities in terms of the German Securities Trading Act (WpPG); or (iii) investment products in terms of the German Investment Act (VermAnlG). Furthermore, a token can be classified as a share of an investment asset in terms of the German Investment Act (KAGB).

BaFin clearly states that when considering whether a token is a security in terms of sec. 2 (1) of the WpHG or Art. 4 (1) Nr. 44 MiFID II, the following token criteria will be taken into account:

  • The token’s transferability;
  • The token’s tradability on a financial or capital market, whereas cryptocurrency- and trading‑ platforms may be considered as financial or capital markets in accordance with the security definition;
  • The rights attached to the token, in particular shareholder or other equity rights or debt claims;
  • The token may not meet the requirements of a payment instrument pursuant to sec. 2 (1) of the WpHG or Art. 4 (1) Nr. 44 of MiFID II.

Care must be taken when involving a third party, for example an internet platform, as the mechanism for converting virtual currencies into legal tender. Not only can such activity be considered as an operation of an MTF pursuant to sec. 1 (1a) Nr. 2b) of the KWG, but also as a provision of payment services, which would be subject to a license pursuant to sec. 10 (1) of the German Payment Services Act (ZAG).

On February 16th, 2018 the Swiss financial market supervisory authority (FINMA) issued a guideline in relation to ICOs (the so-called Wegleitung)[4]. The Swiss guideline confirms the distinction between payment, utility and investment tokens and provides general guidance on regulatory classification on a case-by-case basis. In particular, investment tokens representing asset values can constitute a debt claim against the issuer or an equity right. According to FINMA, investment tokens promise a share of future corporate income or future cash flows. Dependent on its economic function, the token can represent a share, a bond or a non-derivative financial instrument. The category of investment tokens may also include tokens that make physical valuables tradable on the blockchain. Such investment tokens will usually be classified as “Effekten” pursuant to Swiss law (i.e. securities, book-entry securities, derivatives that are unified and suitable for mass trading) and accordingly be subject to the respective applicable laws and regulations. FINMA also stated that they will not consider simple utility or payment token as “Effekten”, unless there is a deviating approach from the legislator. However, in regards to utility tokens this only applies as long as such token solely confers a right to access a digital utility or service and no investment function exists. In practice, this means that the tradability of a utility token on a secondary market is highly likely to trigger classification as an investment token. Issuers must also exercise caution when issuing payment tokens, as the tradable rights to transfer tokens prior to their actual existence may be deemed as “Effekten”. In addition, payment and utility tokens are generally subject to the Swiss Anti Money Laundering Act (AML Act), as the respective ICO constitutes an issuance of payment means which is subject to the AML Act. Utility tokens, however, can be omitted if such tokens are primarily intended to provide access to blockchain technology for purposes outside of the financial industry.

Most supervisory authorities around the world have warned against ICOs. The European Supervisory Authorities (ESAs) for securities (ESMA), banking (EBA), and insurance and pensions (EIOPA) have only recently issued a EU-wide warning to consumers regarding the risks of buying virtual currencies. The ESAs warn consumers that virtual currencies are highly risky, unregulated products and are unsuitable as investment, savings or retirement planning products.[5] Such warnings seem to be confirmed by recent market research stating that more than 10 percent of ICO proceeds are lost as a result of hacker attacks.[6] In addition, we believe that more than 50% of the current ICOs are either of dubious nature or of criminal origin. BaFin has already banned unlicensed commercial activities in connection with virtual currencies (e.g. “OneCoin”[7] or GmbH)[8].

It seems however, that most of these warnings simply fall on deaf ears, as financing based on blockchain technology has raised more than US$886 million through 35 ICOs in January 2018 alone[9] and more than US$4,801 million through 279 ICOs during the entire year of 2017,[10] compared to an excess of US$96 million through 46 ICOs in 2016.[11] Currently, there are approximately 1,527 different crypto currencies circulating the market,[12] and it seems that what once began as a pure technology-movement for ”fans and freaks” is now evolving into a professional investors' market and attracting institutional investors as well as serious global players. Even established companies such as Kodak recently announced ICO/ITO projects.[13] 

Although the guidelines issued strongly emphasize the necessity of a case-by-case assessment, they are an important step in the process of building trust in regards to virtual currencies. Markets may also find it reassuring that the German and Swiss regulatory approaches do not significantly deviate from each other and the general tendency of the assessment is in line with what has been discussed over the last few months.

It is not unusual for an emerging market to require time and patience before things settle down, serious players and projects can be distinguished from frauds and honeytraps, and trust is built. Although the overall understanding of the underlying technology may take a while longer, blockchain, virtual currencies and ICOs are sustainably changing the finance industry. However, their final success will also to a large extent depend on the further development at the legislative and supervisory levels. Recent statements at least point to the existence of a loophole regarding market manipulation and insider dealings in relation to token transactions via exchange platforms.

Valeria Hoffmann

Senior Associate Capital Markets, Data Protection

Dentons Europe LLP

Robert Michels

Frankfurt Managing Partner, Co-Head Capital Markets, Europe

Dentons Europe LLP


Dentons is the world’s first polycentric global law firm. A top 10 firm on the Acritas 2017 Global Elite Brand Index, the Firm is committed to challenging the status quo in delivering consistent and uncompromising quality and value in new and inventive ways. With more than 8,800 lawyers working from 159 offices in 67 countries on six continents, Dentons is the largest law firm in the world.

The capital markets team in our Frankfurt office is highly experienced in both traditional and alternative financing. During the last several months they have successfully advised various clients with regard to the development of cryptocurrencies and ICOs. Additionally, Robert and Valeria are constantly involved in the coordination process between the market participants and the regulators at European level.

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