An Initial Coin Offering (ICO) is a low-cost and time-efficient type of crowdfunding which is facilitated through the use of distributed ledger technology. For more information on distributed ledger technology and its most common form, blockchain, read our blog on the topic.

What is an Initial Coin Offering?

In much the same way that an initial public offering involves the issue of shares to investors in exchange for fiat currency, an initial coin offering involves the issue of transferable tokens to investors typically in exchange for cryptocurrency such as Bitcoin or Ether. Some tokens may resemble traditional securities such as shares or debt securities, while others may represent a right to access or receive future services. It is the legal status of such tokens and the cryptocurrency used to purchase them which needs to be explored.

Advantages and disadvantages of an Initial Coin Offering

The rights attaching to tokens vary widely. Some tokens may resemble traditional securities such as shares or debt securities, while others may represent a right to access or receive future services. A key appeal of ICOs is that tokens are easily tradeable. This means that investors can, assuming sufficient liquidity, buy and sell tokens on cryptocurrency exchanges, unlike more traditional venture capital investments, which may not be easily traded.

Other benefits of ICOs compared to more traditional fundraising models are seen to include:

  • The ease and speed with which tokens can be issued and funds raised, in many cases without the use of intermediaries.
  • Low transaction and settlement costs.
  • A perceived lack of regulatory barriers.
  • For many issuers, the formation or augmentation of a wide and motivated user base of the underlying product or service.

Commonly cited disadvantages of initial coin offerings when compared to traditional fundraising models include:

  • The price volatility of the most popular cryptocurrencies. ICO issuers will commonly seek to exchange cryptocurrencies subscribed by investors into fiat currency following the ICO, therefore incurring substantial exchange rate risk. It may be prohibitively expensive or difficult to mitigate this risk effectively.
  • A lack of clarity regarding numerous legal issues relating to the underlying distributed ledger technology, including the enforceability of code-based smart contracts.As you can see in our blog such uncertainty in the UK, although untested in court, is likely to be overcome.
  • An uncertain and evolving regulatory position globally. Combined with the absence of any industry standardisation, this increases the advisory costs and slows the speed at which a compliant ICO may be carried out.
  • Cyber security risks, compounded by the irreversibility of many cryptocurrency transactions.

What ICOs are being used for?

The earliest ICOs were used to launch new cryptocurrencies but increasingly they have been used by early stage companies to fund the development of other projects or services and, in particular, the development of decentralised software applications that run on existing blockchain platforms, such as Ethereum.

However, an ICO can be executed by any company looking to issue tradeable rights to investors in exchange for capital, regardless of the sector in which it operates or the product that it wishes to develop. In September 2017, Kik, an established social media platform, raised approximately $98 million through an ICO of “Kin” tokens to support the development of its existing messaging ecosystem. It remains to be seen whether other non-blockchain centric businesses will use ICOs as a means of raising funds.

How do you launch an ICO?

To launch an initial coin offering, an issuer will generally produce a white paper, which is analogous to the prospectus that a company is required to produce in connection with the admission of securities to trading on the Main Market of the London Stock Exchange. A subscriber will subscribe for tokens by transferring consideration to a specified account, and in doing so it is deemed to have accepted the terms and conditions applicable to that ICO. The tokens themselves are typically created, allocated and distributed through a pre-existing blockchain platform, such as Ethereum, in each case without requiring an intermediary.

Regulation of Initial Coin Offerings

A lack of regulatory barriers is seen by some participants as one of the primary attractions of carrying out ICOs. However, while there is no regulatory framework in the UK which is specific to ICOs, or which refers to the specific technology or terminology used in ICOs, it is a common misconception to say that all ICOs are unregulated. Issuers and their advisers must therefore consider carefully the applicability and effect of the full range of relevant legislation.

Regulatory perimeter

An initial coin offering may or may not fall within the Financial Conduct Authority’s (FCA) regulatory perimeter depending on the nature of the tokens (the terms used by the FCA to denote different types of cryptoassets) issued, and the legal and regulatory position of each ICO proposition must be assessed on a case by case basis.

Although many ICOs will fall outside the regulated space (depending on how they are structured, such as exchange and utility tokens), some ICOs (such as security tokens) may involve regulated investments, and firms involved in an ICO may be conducting regulated activities (such as arranging, dealing or advising on regulated financial investments).

The FCA outlines perimeter issues relating to ICOs in CP19/3 on perimeter guidance on cryptoassets. It explains that the majority of tokens that are issued through ICOs to the market tend to be marketed as utility tokens (non-regulated). The perimeter guidance being proposed by the FCA will focus on this area to make sure that firms are aware when their tokens may be considered securities, and therefore fall within the FCA’s regulatory perimeter. The FCA explains that it will be paying increasing attention, especially where those preparing ICOs attempt to avoid regulation by marketing securities as utility tokens.

Other points to note about the regulation of ICOs include:

  • The features of some ICOs are parallel with initial public offerings (IPOs), private placement of securities, crowdfunding or even collective investment schemes (CISs) which need to be examined individually in order to comply with regulation.
  • Some tokens may also constitute transferable securities and therefore may fall within the FCA’s prospectus regime.
  • Digital currency exchanges that facilitate the exchange of certain tokens should consider whether they need to be authorised by the FCA to be able to deliver their services.

Risks if ICO’s outside regulatory perimeter

  • Unregulated space: Most ICOs are not regulated by the FCA and many are based overseas.
  • No investor protection: You are extremely unlikely to have access to UK regulatory protections like the Financial Services Compensation Scheme or the Financial Ombudsman Service.
  • Price volatility: Like cryptocurrencies in general, the value of a token may be extremely volatile – vulnerable to dramatic changes.
  • Potential for fraud: Some issuers might not have the intention to use the funds raised in the way set out when the project was marketed.
  • Inadequate documentation: Instead of a regulated prospectus, ICOs usually only provide a ‘white paper’. An ICO white paper might be unbalanced, incomplete or misleading. A sophisticated technical understanding is needed to fully understand the tokens’ characteristics and risks.
  • Early stage projects: Typically ICO projects are in a very early stage of development and their business models are experimental. There is a good chance of losing your whole stake.

FMLC paper on ICOs

The Financial Markets Law Committee (FMLC) published a paper outlining issues of legal uncertainty arising from ICOs in July 2019. The FMLC outlines how existing laws apply to ICOs and looks at some of the challenges for regulators, providers and market participants. These challenges include a lack of international and regional harmonisation relating to the categorisation of tokens issued in ICOs, as well as in their regulatory treatment.

FCA consumer warnings on ICOs

The FCA has warned consumers of the risks of ICOs. The FCA warns that ICOs are very high-risk, speculative investments due to, among other things, their price volatility, lack of access to UK regulatory protections such as the Financial Services Compensation Scheme (FSCS) or the Financial Ombudsman Service (FOS), potential for fraud, and the lack of adequate documentation.

Financial crime risks of ICOs

The FCA wrote to CEOs of banks in June 2018 warning of the risk of abuse of cryptoassets, which arises from the potential anonymity and the ability to move money between countries that crypotassets allow. Banks were warned to take reasonable and proportionate measures to lessen the risk that they might facilitate financial crimes that are enabled by cryptoassets.

An often unregulated area

Unregulated initial coin offerings are not considered safe investments by the FCA and should therefore always be treated with caution. On the other hand they offer businesses a quicker and easier way to raise capital. If you are looking to invest in an initial coin offering you should always be aware of such risks. If you are a business looking to raise capital through an ICO then the extent to which you may be regulated needs to be considered.

ICO’s is an area likely to develop alongside the recent increase in legal certainty granted to cryptoassets and smart contracts under English law. As it stands, however, ICO’s are yet to be addressed in such a direct manner.

EM law are experts in technology law. Please contact us if you have any question on the above.