Policing the ICO highway

The last year have seen a surge in initial coin offerings, with hundreds of blockchain companies issuing their own cryptocurrencies. Regulators are rushing to curb the worst excesses of this nascent market

Regulators around the world are struggling to grapple with increasing demand for digital tokens
Regulators around the world are struggling to grapple with increasing demand for digital tokens  

Daniel Wang, an ex-Google software engineer, is one of the pioneers of the blockchain community in China. After being involved in several start-ups in the sector, he founded Loopring in 2016, a Shanghai-based non-profit organisation. Loopring aims to build a protocol that will help cryptocurrency users shift from one cryptocurrency to another through a virtual order book. The end product will be similar to a decentralised cryptocurrency exchange, over which Loopring will have limited oversight.

To fund its ambitious plans, Loopring raised approximately $45m through an initial coin offering (ICO) in August 2017. This fundraising mechanism is often used by blockchain start-ups to finance their projects. Through ICOs, companies create and auction digital tokens, which can later be used on their platforms or sold on cryptocurrency exchanges.

China cracking down 

Everything was going according to plan for Loopring until September 4, when the Chinese central bank announced a ban on China-based ICOs. Although rumours of an imminent crackdown had already been making the rounds in the local blockchain community, the announcement sent shockwaves through the market. Few people thought that the authorities would take such drastic measures, as Wang explained: “We didn’t expect a complete ban on ICOs in China. We believed our regulators were more open-minded, given [that] China’s mobile payment and internet-based financial start-ups were flourishing. So when the ban was announced, we were shocked.”

What is viewed as a threat by some regulators is an opportunity for others. Companies that were planning to issue tokens in China and South Korea have tacitly relocated to other jurisdictions

The ban sparked fears of a heavy-handed crackdown, as Wang recognised: “Many people I know worried about being restricted from travelling abroad, or even taken into custody. As in many other countries, there is no proper law in China for regulating cryptocurrencies, so the term ‘penetration regulation’ used by regulators leaves a lot to [the] imagination regarding the potential penalties and their severity.”

Many investors asked for a refund, which the company promptly processed. Loopring is now getting ahead with its original plans. But the ban served as a reminder that regulators can throw a spanner in the works anytime they want. Shifting from one token to another has become difficult for China-based users, with the authorities closing down several exchanges.

Even non-Chinese blockchain companies were severely affected. Loi Luu, co-founder of the Singapore-based blockchain start-up Kyber Network, which conducted its own ICO in September, said: “We had to exclude Chinese [investors] from participating in our token sale event. As a platform that thrives on traffic, the exclusion of Chinese supporters was a huge loss.” Eventually, the company got around the problem by issuing a non-transferable token available exclusively to registered users.

Chinese authorities justified the ban as a precautionary measure against fraud and Ponzi schemes. The risk to financial stability is real. Andrew Sheng, Chief Advisor to the China Banking Regulatory Commission, told World Finance: “There is no deposit insurance scheme covering such currency, but if there is widespread loss, the public will claim that regulators have been silent on the product’s dangers and [that] they have acknowledged that it is permissible to invest in such products. Shifting from legal currency into cybercurrency can be very fast, and therefore the risk is systemic.”

Even for blockchain enthusiasts such as Wang, the crackdown can be helpful if proper regulation is on its way. He noted:  “The ban of ICOs is very necessary as there are so many people in this country who don’t have a good sense of risk, and some of them even believe a tenfold profit on their initial investment is guaranteed.” Chinese officials have indeed signalled that the measure is temporary until a licensing scheme for exchanges and ICOs is put into place. In the meantime, the ban may crash the speculative bubble that has given ICOs a bad name, as Wang observed: “More companies were planning ICOs, but some of them had nothing to do with blockchain technologies and were designed as pyramid schemes. The ban will not force true blockchain believers to quit, so I’m still optimistic about the Chinese blockchain ecosystem.”

For Luu, the ban may even have positive side effects. He explained: “The adversity will likely force people to think outside the box, and the determined ones will find ways to get around it. Some might register in countries like Singapore or Switzerland, where there is established infrastructure, stable politics and abundant talent. That might force them to get out of their comfort zones and introduce higher-quality projects in order to stay relevant.”

To ban or not to ban

China is not the only country reining in the cryptocurrency frenzy. Regulators around the world are struggling to grapple with increasing demand for digital tokens (see Fig 1), partly prompted by low interest rates and diminishing margins in other markets. As of mid-November, more than $3.2bn had been raised through ICOs in 2017, according to data published by CoinDesk, a website covering cryptocurrencies. Furthermore, some ICOs themselves were valued at over $200m (see Fig 2).

The valuation of most tokens is volatile, spurring concerns of an uncontrollable bubble. Speculation is rampant according to Luu: “Most ICO projects don’t have a working product, let alone a revenue stream, so investors are putting money on the promises of these projects, many of which have a high probability of not working out.”

For some regulators, an all-out ban is the easiest way to tackle uncertainty. In October, the South Korean financial regulator effectively prohibited South Korean companies and investors from getting involved in ICOs.

The regulator’s decision came as a surprise to insiders who expected South Korea to take the lead in the Asian market. Leon Song, Communications Manager at Proof Suite, a blockchain start-up registered in Estonia but primarily operating in South Korea, said:  “Although there were growing concerns over the growth of fraudulent cryptocurrency projects within the country, it was never expected that they would pull an all-out ban on ICOs like China did.” Proof Suite, which develops blockchain-based investment platforms and helps users tokenise real-world assets, has a global outreach and was not directly affected by the ban, although it launched its own ICO a few weeks after the ban. That being said, it had to adjust its business model in South Korea. Song added: “It did affect our plans to help tokenise Korean companies. We are now focusing less on business operations within South Korea as companies and individuals are now not allowed to host any form of ICOs.”

As with many other blockchain enthusiasts, Song believes that the ban will be temporary, especially since the local cryptocurrency community is coming together to lobby the regulator. But some damage has already been done in Song’s view: “Fraudsters will always remain, and companies can even register in other countries and still host ICOs within South Korea. This regulation will not only slow down the nation’s overall process of understanding and leveraging this new, innovative technology, but it also ultimately results in the nation losing valuable and legitimate companies.” If anything, the ban will be ineffective, with Song believing that “it is the equivalent of banning the consumption of pepperoni in order to regulate the consumption of pizzas”.


Amount raised through ICOs in 2017 (as of November)


of central banks may use blockchain applications over the next decade

Many experts believe that the decision was driven by political considerations. Professor Sooyong Park, Director of the Blockchain Research Centre at Sogang University and former President of the National IT Industry Promotion Agency, said: “The Korean Government is afraid that investors – who in general are Korean citizens – may lose money and will start complaining. To avoid those kinds of problems, the government took the easy road and banned ICOs instead of improving regulation. There was no need for a ban. From my point of view, they overreacted.”

Opportunities still abound

What is viewed as a threat by some regulators is seen as an opportunity for others. Companies that were planning to issue tokens in China and South Korea have tacitly relocated to other jurisdictions, notably Hong Kong and Singapore. The latter is attracting innovators through its regulatory sandbox, which permits fintech experimentation for a limited period of time. Ravi Menon, Managing Director of the Monetary Authority of Singapore, told the Financial Times in November that Singapore is interested in hosting non-speculative ICOs.

Similarly, Japanese regulators have taken a light-touch approach. Japan was one of the first countries that recognised bitcoin as legal tender and has since become a major cryptocurrency trading centre. The regulator, the Financial Services Agency, has warned investors of potential risks associated with ICOs. Nonetheless, it has recognised 11 cryptocurrency exchanges and has endorsed a plan by a consortium of Japanese banks to issue J Coin, a digital currency to be used for payments and money transfers.

Despite the relatively favourable regulatory framework, few firms have issued tokens. Shirabe Ogino, a board member of the Fintech Association of Japan and founder of the fintech companies Zaisan Net and Phantom AI, said: “Many Japanese companies are thinking to do an ICO, but only a few have done it so far. Perhaps next year we will see more. There is not much know-how on ICOs, so everybody wants to see what is going on elsewhere first.”

Alarmists have warned that Japan may follow the path of other Asian countries and ban ICOs altogether. However, Ogino dismissed these claims: “I don’t believe the regulator will do that in the near future. They are supporters of cryptocurrencies. But they will probably issue a more clear message on ICOs, specifying which ones are legal and which [are] not, and which qualify as securities.” That being said, speculation that Japan may become a safe haven for blockchain companies fleeing other Asian countries is also unfounded, according to Ogino. “Due to the language barrier, we cannot attract many foreign companies to issue tokens here,” he said.

Tightening EU and US regulations 

Regulators in the developed world rarely adopt a heavy-handed approach to digital affairs, and banning ICOs is not a feasible option for them. However, they have to walk a tightrope between inertia and overregulation.

The problem is more complex for policymakers in the EU, where member states may have different views, delaying unified action. Some national regulators, including the ones in Germany and the UK, have issued warnings over the risks associated with ICOs, while others have skipped the issue, waiting for European watchdogs to act first.

The European Commission has set up a taskforce to look into fintech innovation, including blockchain and cryptocurrencies. Several stakeholders have lobbied the commission to consider newly minted cryptocurrencies as a “novel asset class” that would require light-touch regulation. Others have called for strict rules that will stop ICOs being used as a conduit for money laundering and other illegal activities.

At the core of the regulatory debate is a battle over the future of blockchain, said Anna Felländer, visiting fellow at the Swedish House of Finance and an advisor to the Swedish minister of digitalisation: “There is a balancing act between an open blockchain, that is more efficient and democratic, and closed systems, that can be more easily regulated but may favour oligopolies. At the moment, closed blockchains are gaining momentum through increasing investment.”

Creating a level playing field for all parties is paramount, said Felländer: “EU regulators should come together with blockchain start-ups and financial institutions to create a regulatory sandbox and agreed standards at the EU level. There has to be a flexible governance system that maintains the blockchain’s robustness. Then you need to open a dialogue with non-European countries on international standards.”

A hint about the EU’s thinking on the matter came in November when the European Securities and Markets Authority (ESMA), the EU’s financial regulator, issued two statements on the risks for investors and issuing companies. The agency warned investors that they may lose “all of their invested capital, as ICOs are very risky and highly speculative investments.”

The watchdog also stressed that firms involved in ICOs that qualify as financial instruments will be subject to relevant legislation. This includes the recently updated Markets in Financial Instruments Directive (MiFID II), the strict conditions of which are seen as onerous in parts of the financial world. “ESMA is just emphasising that investor protection should prevail and that some ICOs fall under regulation already in place,” said Emilie Allaert, Head of Operations and Projects at  the Luxembourg House of Financial Technology, a platform backed by the Luxembourg Government that supports fintech companies.

Regulators in the developed world rarely adopt a heavy-handed approach to digital affairs, and banning ICOs is not a feasible option for them

ESMA’s statement could be a first step towards a more robust regulatory framework, according to Allaert: “It is important for the EU to position itself, because many countries have already done that. Existing regulation such as MiFID and the Alternative Investment Fund Managers Directive (AIFMD)  are all about protecting investors, but right now they are leaving investors in the dark on ICOs.” Crucially, the watchdog warned investors that putting their money into ICOs registered outside the EU would leave them without any legal protection. This is a conundrum for regulators, said Allaert: “With ICOs you never know which jurisdiction you are in. Is it the country of the founder or the country where the ICO is registered? And are ICOs really registered anywhere? This is a truly global market, which is something we have never seen before.”

In the US, memories of the subprime loan crisis have stoked fears of another speculative bubble, this time on the blockchain. Jordan Belfort, the notorious ex-financier whose story inspired the film The Wolf of Wall Street, warned last year that ICOs are the “biggest scam ever”.

Responding to these concerns, last summer, the Securities and Exchange Commission (SEC) issued a statement warning investors that some cryptocurrencies issued through ICOs might be deemed securities, and therefore would be subject to relevant US regulation. This is a reasonable approach, according to Dr David Andolfatto, Vice President in the research department at the Federal Reserve Bank of St Louis: “It is people raising funds in exchange for promises, which is an old human activity already regulated in the US and elsewhere. The fact that this is happening through ICOs simply means that the securities issued are slightly different in the sense that they exist on the blockchain. But this shouldn’t detract regulators from intervening as they see fit.” In November 2017, SEC went one step further, warning against ICOs endorsed by celebrities and charging two token-issuing companies with fraud and selling unregistered securities.

States can do it too

If start-ups can create digital money, why can’t central banks do the same? This question, first posed by several economists, is not merely academic anymore. Chinese officials have signalled that China may soon issue its own state-run digital currency in an attempt to control the cryptocurrency market. Several other countries – including Estonia, a pioneer in digital innovation, and Uruguay – are also experimenting with digital currencies. In a survey by the Cambridge Centre for Alternative Finance, 40 percent of central banks said that they may use blockchain applications, including cryptocurrencies, over the next decade.

Issuing digital money is not something new to central banks. Their reserves have long been more electronic than physical in form and are also cryptographically secured. Opening their digital coffers to the public is an idea that many experts endorse, as Andolfatto explained: “I see a lot of merit in the idea of central bank digital currency, that is, letting people and businesses open accounts at a central bank. People already have paper accounts with central banks—that’s what money in your wallet is. So why not permit digital accounts as well?”

But a full-blown cryptocurrency would be trickier, Andolfatto explained: “Issuing digital money in the form of a cryptocurrency like bitcoin is an entirely different matter. Regulators would worry whether this anonymous digital cash would be used for criminal purposes. I don’t see any major central bank issuing such a cryptocurrency in the foreseeable future.”

Riksbank, Sweden’s central bank, is exploring the possibility of issuing a digital currency, the e-krona, as an alternative option to cash. The bank is still investigating whether this could be a
blockchain-powered cryptocurrency. Felländer, who is closely following the discussions, said: “We need to build financial infrastructure that could be easily adapted when blockchain technology is fully adopted in the banking sector.” An e-krona directly issued by the central bank will open up the system to new players, Felländer added: “This means that traditional banks will not be the obvious intermediary for the e-krona. New intermediaries, such as wallet providers, would be able to compete.”

Some have even suggested that the European Central Bank (ECB) could create its own cryptocurrency; an e-euro for everyone to use. It’s a distant but not unrealistic goal, according to Felländer: “The question is not whether that will happen, but when it will happen. Sweden is very mature in digital affairs, but this could take longer for nations that depend on cash and use it in other ways. They have a different emotional relationship with it and the anonymity it provides. So it could take years until the ECB does it, and there are bumps along the way.”