Blockchain & Cryptocurrency Alert
In the last month, UK and European politicians have been vocal about the regulation, or lack thereof, in the virtual currency sphere. While their comments and recommendations are not legally binding, and are some distance from becoming so, they can provide an indication of where lawmakers may be heading. Currently there is no EU-harmonized approach for the specific regulation of virtual currency.
UK Treasury Committee Report
On September 19, 2018, the UK's Treasury Committee released a report on crypto-assets as a part of its ongoing Digital Currencies Inquiry, in which the Committee strongly and unanimously recommended that the UK regulate virtual currencies and initial coin offerings ("ICOs") as a matter of priority. The Committee noted that while crypto-assets were originally designed as an alternative system of making payments, the evidence suggests that they would be unlikely to replace traditional payment systems. The Committee also was cautious of the blockchain technology that underpins the crypto-asset network, concluding that while it supports innovation, "blockchain should not be pursued for its own sake," and encouraged the Government and industry to look at whether blockchain is the best solution for current problems.
The report highlighted that crypto-assets were particularly risky investments as they were subject to fluctuations on the basis of sentiment, rather than any inherent value. The Committee was also concerned that exchanges used by crypto-asset investors have been hacked in the past and there are currently no schemes in place to compensate investors for resulting loss of their investment. The Committee was also troubled by the lack of regulation around ICOs, which are not regulated if the coin is not considered a security. While the Committee acknowledged that ICOs involving utility tokens promise no financial reward, but instead the future right to access something, it stated that nevertheless investors would expect to be able to sell their tokens for financial reward; thus, the Committee considers these ICOs to be "exposing a regulatory loophole." Marketing of crypto-assets is also not subject to the same regulations as financial instruments, and the committee was made aware of instances where advertisements were made in very public forums which stated only the positives of crypto-asset investment. It viewed the investor protections available in the United States as ones that the UK should adopt.
The Committee recommended to the Government that ICOs be brought within the regulatory framework as a matter of urgency and that this should be done by extending the Regulated Activities Order, as opposed to adopting an entirely new framework. The exact activities which would be covered by this will need to be considered, but the Committee was clear that, at a minimum, the issuance of ICOs and provision of crypto exchange services should be included. The Committee also stated that the FCA needs more power to control the marketing and advertising of crypto assets and the clear money-laundering concerns that stem from the anonymity and lack of regulation in this sphere.
The Committee concluded that while regulation of the crypto-asset sphere would provide opportunities for the industry, the current "wild west" situation and the ambiguity around the regulatory position is unsustainable. By regulating crypto-assets now, the Committee suggested, the crypto-asset market could move to a mature business model, attract institutional investors and enable sustainable growth, making the UK a center for crypto-asset activity.
It is generally accepted in the cryptocurrency community that regulation is required in order to provide gravitas, stability and growth. The 5MLD changes to include wallet providers and exchanges are a big step forward in this direction. Bringing crypto exchanges within the licensing regime would be a further step in the right direction and should be welcomed.
Of concern is the wording highlighting the need for more investor protection similar to the States. This provides a warning that any UK regulation is likely to restrict promotions of all tokens (including utility tokens) to non-retail investors. The EU has not proposed a similar restriction, and jurisdictions such as Gibraltar, Malta and France are bringing out blockchain- and ICO-friendly regulations and requirements. It will be important for the UK not to be too restrictive as this could drive innovative business away from the UK.
EU Parliament's All-party Innovation Group Proposal
The EU Parliament's All-party Innovation Group has drafted a proposal examining potential new rules that would bring ICOs within the scope of the EU-wide harmonizing crowdfunding regulation that is currently being drafted. If approved, the crowdfunding regulation is expected to come out in March 2019. The proposal includes a call for an €8 million cap on token sale proceeds, along with KYC and anti-money laundering requirements. The proposal also looks to create a standard for ICOs that would allow fundraising in any of the member states. Members of the European Parliament were invited to submit amendments to the proposal by September 11.
As ICOs are, in our view, a form of crowdfunding, it is no surprise and makes sense that this Group is proposing to link ICOs and crowdfunding together. The EU-wide crowdfunding regulation would only cover ICO raisings up to €8 million, which is the threshold for the Prospectus Directive. Prospectus Directive issues would still apply to share token offerings and asset-backed tokens above the €8 million level.
It would be beneficial to the marketing of ICOs if, as it appears, the EU considers the UK's crowdfunding regulations when drafting the EU ICO legislation, as it would permit marketing of and access to ICOs to a broader range of individuals. Currently, equity crowdfunding can be marketed to high net worth individuals and sophisticated investors, as well as individuals who have self-certified that they are not putting more than 10 percent of their net assets in non-readily realizable investments in a specific calendar year.
Following this example would allow for the restrictions on marketing and the protection of consumers to strike a balance: the restrictions would not be too onerous while still protecting those who may wish to invest all their savings in ICOs. There would also be requirements for those placing the tokens, to ensure that marketing material is fair, clear and not misleading, and disclosures and risk warnings would need to be included in marketing material in order to fulfil this requirement. AML checks would also apply.
Many in the ICO world believe that a harmonized EU approach will necessitate growth in this area, and delay in such regulation would be discouraging. Unfortunately, the EU Finance Ministers have recently agreed to take longer to consider regulating crypto markets in Europe, preferring a methodical approach to blockchain regulation and cryptocurrencies. Not bringing ICOs within the crowdfunding regulation will be a missed opportunity to do something quickly in a balanced way.
While it is certain that any regulation needs to be carefully considered, the lack of a harmonized approach to regulation of ICOs will lead, as is happening currently, to a piecemeal approach across member states that will hamper blockchain developments. This piecemeal approach could also drive innovative business from the UK, if it proposes a more restrictive regime than other member states.
It will be interesting to see how this plays out.
A version of this piece was published in Law360 on November 1, 2018.