China banned initial coin offerings in September as "a form of unapproved illegal public financing behavior." South Korea followed suit a few weeks later. Regulators in Hong Kong, Singapore, the U.S. and other countries have also expressed concerns. What is it that has them so worried?
Initial coin offerings raised more than $2 billion worldwide in the first nine months of 2017, according to CoinDesk, a cryptocurrency data provider. In an ICO, investors purchase virtual "coins" -- programs coded on a blockchain or a similar distributed digital ledger -- that can be used to pay for an online service the issuer is developing.
ICOs are typically crowdfunding for technology projects. This is potentially valuable in Asia, which lacks regulatory frameworks allowing peer-to-peer lending or equity crowdfunding of the sort that have been established elsewhere. With no restrictions on who can buy into ICOs in most jurisdictions, these offerings enable technology companies to fund projects by appealing directly to potential users.
ICOs are similar in many ways to presale crowdfunding projects of the type offered in the U.S. by Kickstarter, where prepayments for finished products fund their development. The key difference is that coins are tradable, if a coin exchange accepts them. As well as representing access rights to the technology, coins may then have an intrinsic value and can be traded for either traditional currencies or cryptocurrencies such as bitcoin and ether.
For cash-strapped technology startups, ICOs are a dream come true. With banks reluctant to lend to startups and a shortage of available venture capital, an ICO can raise large amounts of funds in a matter of hours -- sometimes minutes.
For coin issuers, the costs are reasonable -- a document known as a "whitepaper" sets out the technical detail of the project and the mechanics of the coin offer. This is very different from the doorstop tomes issued for initial public offerings of listed company shares, and the consequent legal and bankers' fees. There are no accounts for ICOs, let alone audited accounts. Coin subscription and payment occur online. It is quick and easy, so what is the catch?
As with other startups, there is a chance that any given ICO-funded project will fail. A coin holder can end up with nothing. The platform may not materialize, the holder may acquire no economic benefit from using it, and it may be that no one will want to buy the coins. But the same can happen to listed shares. If the market turns and a company flops, its investors can be left with nothing. Worse still, an ICO could be a sham, a Ponzi scheme.
Regulators in in several jurisdictions have warned that ICOs may be regarded as offerings of "securities" subject to securities laws. Even if coins are not subject to securities laws, ICOs remain subject to basic criminal laws, and those who defraud coin buyers are likely to be guilty of fraud or theft.
Nevertheless, the regulation of ICOs is a legal gray area, not least because the practice in jurisdictions such as the U.S. and Hong Kong is to structure ICOs in such a way that they fall outside regulatory definitions of securities. In most cases, coins are akin to prepayment vouchers, like the prepayments made for Kickstarter-funded products. Typically, they are structured to provide coin holders with the right to use a blockchain technology once developed, but no right to share the platform's revenues.
There is no reason why such coins should be regarded as securities, any more than should a Kickstarter-funded coffee machine, and the latest guidance from the Monetary Authority of Singapore, published on Nov. 14, confirms that this will be the approach taken in the island state. Only coin offerings that are essentially just securities offers in digital form will be subject to securities regulation.
But it is true that not everyone piling into ICOs wants access to platforms whose uses are somewhat esoteric. Some buy on the assumption that as the platform's value increases, so will that of the coins. Critics say ICOs encourage speculation, and that prices are driven up by a squeeze on the supply of coins rather than the perceived value of the underlying project.
With bitcoin prices venturing into bubble territory, encouraging more investors to chase a slice of the crypto action, should regulators be putting the brakes on ICOs now before the bubble bursts? Or is this a harmless way of raising funds from consenting adults?
In Hong Kong, where this issue is a matter of hot debate, the Securities and Futures Commission could designate ICOs as securities subject to local law. If it did, digital coins could be sold only under existing exemptions (e.g. only to professional investors) and only by an SFC-licensed intermediary, like hedge funds and other investment products.
But do ICOs really need to be regulated? The government does nothing to stop us rushing out on Jan. 2 each year to throw away money on gym memberships we will never use, or to prohibit gyms from enticing us with promises of lean bodies and eternal youth. Is that really any different from buying into an ICO, never using the technology (if it is developed) and selling the coins, possibly at a profit?
Most governments do not regulate what we spend our money on, and do not stop us buying houses, cars, or other goods and services that may drop in value. Likewise, there is little logic in regulating our purchases of coins just because they also may turn out to be worthless.
Some say that regulating ICOs as securities offerings would achieve little, except to deny anyone who is not a "professional investor" the opportunity to invest. But if done sensibly, ICO regulation could create a much-needed crowdfunding regime for Hong Kong and other Asian markets, like those introduced in the U.S. and U.K.
Rather than restricting coin purchasers to professional investors, investor-protection concerns could be met by limiting the amount that individual coin purchasers can invest and the aggregate amounts that coin issuers can raise through ICOs. Greater transparency for investors could be achieved by setting minimum disclosure standards for offer documents, including financial disclosure, the required extent of which could be linked to the amount being raised. If there is to be regulation, it should be light-touch to ensure it does not kill off the market.
This type of regulation would probably be welcomed by coin issuers for providing regulatory clarity and legitimizing ICOs. It could also deter Ponzi schemes. But regulators may be reluctant to create such regulatory frameworks, given that a single serious problem could damage a market's reputation, and by extension that of its regulators.
If that is the case, coin issuers must themselves adopt standards aimed at protecting buyers and ensuring proper disclosure of relevant information. That would promote healthy growth of ICO activity in Asian markets. Many coin issuers are doing this already, and everyone stands to benefit.
With no existing framework for crowdfunding in Hong Kong, and reports that proposals for a new stock exchange board for technology startups may be dropped, Hong Kong must do more to encourage innovative companies. The best way would be to allow these companies to source funds from outside traditional funding channels.
Kim Larkin is a solicitor focusing on corporate finance with the law firm Charltons in Hong Kong.