12 April 2018

Goodbye ICOs, hello ILPs?

The gold-rush mentality currently surrounding the use of initial coin offerings (ICOs) has at times led to projects being used irresponsibly and investors suffering harm as a result. To date, no jurisdiction has provided a bespoke set of legal and technical controls to manage this risk. Instead, some have acted retrospectively by either banning ICOs or applying existing regulatory frameworks relating to other asset classes that are not necessarily compatible. To avoid an innovative and disruptive space being stifled, whilst offering protections to investors, regulators must act swiftly or risk losing opportunities to newly envisaged 'Crypto Nations'.

Blockchain technology offers a secure, transparent, immutable and globally accessible environment in which businesses can achieve unrestricted access to crowdfunding opportunities by way of the ICO. During 2017, ICOs became recognised in the world of Fintech not merely as a rival buzzword to "cryptocurrency", but as a legitimately effective means of raising capital.  

Put simply, an ICO is a process adopted by tech start-ups (predominantly within the digital currency sector), whereby a new virtual coin or token will be created and offered for public sale. It is, in essence, a hybrid of the traditional initial public share offering and crowdfunding.                                       

The value of newly-created tokens differs significantly and is determined by such variables as the coin's utility, the number of coins in circulation (and proposed medium and long-term increases in coin supply) and the demand of the public (typically driven by speculation).  

In December 2017, Fabric Ventures, a VC fund, and TokenData, a platform that tracks data on token sales and ICOs, published a report titled, 'State of the Token Market', which indicated that start-up companies and projects had raised US$5.6 billion in 2017 exclusively from ICOs.  In contrast, there had only been $1 billion of 'traditional' venture investing in blockchain start-ups in the same timeframe (such as loans and share purchases). The biggest ICO of last year was Filecoin, a project aiming to build a decentralised data storage solution on the blockchain. Filecoin raised US$257 million in September 2017 from its ICO. To demonstrate the inherent volatility of such assets, however, the token price during the ICO was $5; reached an all-time high of $30.15 in January 2018 and, at the time of writing, is now $19.90.

The majority of those investing in ICO-funded projects are retail companies and small-scale investors. However, institutions are becoming increasingly attracted to ICOs due to the potential for high returns, the likes of which are unparalleled by other investment products and opportunities.

According to TokenData research, on average in 2017, tokens returned 1,280% of initial investments, versus 770% for Ethereum and 490% for Bitcoin

Regulatory position

The regulatory stance in respect of ICOs varies from jurisdiction to jurisdiction. Outright bans are in place in South Korea and China, whereas Singapore, Japan, Gibraltar and the Isle of Man seek to welcome ICOs and exploit opportunities.

In recent months, however, the ICO model of raising capital has come under a great deal of scrutiny. ICOs have been established for the sole purpose of extorting money from unsophisticated investors searching for the next Bitcoin. In such cases, the models are very similar; a pretence of genuine and viable products which immediately disappear once the ICO closes, leaving investors with nothing more than a token with little to no value. Regulators are now, quite rightly, seeking to protect investors from such deceptive schemes.

Having said that, it is important that business owners and investors are not shackled by regulations which ultimately prohibit economic and technological growth. A complete ban of ICOs or punitive taxing policies (as seen in instances in the US) are examples of such prohibitive measures.

The Channel Islands have issued statements on the issue of ICOs, highlighting their unregulated nature and the risks involved. On 2 February 2018, the Jersey Financial Services Commission (JFSC) issued a statement on the regulation of ICOs, having become concerned with claims that certain ICOs were regulated when, in fact, they were not. In its statement, the JFSC confirmed that a Jersey company issuing digital coins or tokens from Jersey, just like any other Jersey company raising capital through the issuance of shares, would need to obtain consent from the JFSC to set up the company (pursuant to the Control of Borrowing (Jersey) Order 1958, known as COBO).

The grounds on which the JFSC would determine whether or not to grant consent under these circumstances is limited by statute, and the focus is primarily on whether potential investors have been provided with sufficient information about the company and the risks of investing in it. In addition, the JFSC would consider applying conditions to any consent granted, which may include a clear consumer warning on any marketing materials produced (for instance, that it is a highly speculative form of investment, the investor may lose the entirety of their initial investment, and the fact that the investment is not subject to existing capital market regulations).

First mover

On 12 February 2018, the Government of Gibraltar and the Gibraltar Financial Services Commission (GFSC) confirmed they were developing legislation relating to tokenised digital assets. After taking into account stakeholder feedback, work has now begun on drafting legislation to regulate: (a) the promotion, sale and distribution of tokens by persons connected with Gibraltar; (b) secondary market activities relating to tokens, carried out in or from Gibraltar; and (c) the provision, by way of business, in or from Gibraltar of investment advice relating to tokens.

In a statement, Sian Jones, Senior Advisor on distribution ledger technology (DLT) at the GFSC said. "Token regulation is the natural progression following the regulation of DLT Providers, being vital to the protection of consumers. One of the key aspects of the token regulations is that we will be introducing the concept of regulation authorised sponsors who will be responsible for assuring compliance with disclosure and financial crime rules."

We keenly await the implementation of the legislation, as it will undoubtedly offer guidance to other offshore financial centres such as the Channel Islands. 

An alternative to ICOs

While debate around the use of ICOs continues, Initial Loan Procurements (ILPs) have emerged as a new fundraising method. Similar to an ICO but in the form of loans rather than coin acquisitions, ILPs enable borrowers and creditors to enter into a loan agreement through legally binding smart contracts. With an ILP, a creditor's investment is contractually tied to the performance of the company and eliminates the wild swings of volatility that have been associated with a vast number of ICOs. In simple terms, as long as the company makes a profit, the creditor gets annual returns.

Two Estonia-based companies, Blockhive and Agrello, have formed a partnership to provide the first ILP of its kind, 'Blockhive'. Blockhive's model removes the issuance of tokens (in the anticipation of future appreciation of those tokens) and replaces it with a contractual entitlement to 20% of their annual operating profits.

Agrello is a legal technology start-up that builds legally-binding, self-aware agreements on blockchain. The use of Agrello ID, a digital identification and signature solution, provides the support for necessary KYC and anti-money laundering solution, ensuring that the system fulfils all legal requirements. The agreements from Agrello ensure that creditors' data is encrypted and stored unalterably in the blockchain. To access and transact on the Blockhive platform, users must fully register and receive the protocol's Future Loan Access Tokens (FLAT) (transferrable loans that can be assigned to third parties) as soon as they lend funds to the company. This could go a long way to alleviate regulators' concerns about fraud and money-laundering.

The ultimate objective is to continue the decentralised crowdfunding opportunities that are similar to ICOs, only this time, with improved functionality and without restrictions imposed by regulatory bodies. 

For businesses that don't need tokens, ILPs provide an attractive alternative whereby more time and energy can be spent on business development, rather than creating tokens with no actual use.

Authored by senior associate Luke Sayer, an original version of this article was first published in Business Brief.

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