ICOs – a wealth of opportunities

Initial Coin Offerings (ICOs) are by-products of the larger cryptocurrency phenomenon, which began with the conception of Satoshi Nakomoto’s Bitcoin back in 2009. With blockchain technology on the rise, we are continuously seeing an increase in start-up and mature companies pursuing a novel path to raise capital: the so-called ICOs, sometimes referred to as a ‘token generating events’ or simply ‘token sales.’

An ICO is an application which enables organisations of any size to raise money, in a peer-to-peer manner akin to crowdfunding, by offering cryptocurrency tokens in a new venture, project or network. Developers draw up a ‘whitepaper’ in which they outline their business idea to potential buyers and then sell tokens to those willing to contribute. Contributors participate in the fundraising by transferring fiat currencies like the euro, or cryptocurrencies like bitcoin and ether, to the issuer in exchange for a token. The very first token ‘Maidsafe’ was launched via an ICO in 2013 on the Mastercoin blockchain, but most ICO tokens which followed were created through the deployment of a smart contract built on top of an already existing blockchain. Currently, the most popular blockchains used for ICOs are the Ethereum, Waves NEO and the new EOS platforms. The issuing company then designs digital tokens that can grant any bundle of rights and obligations for the token holders. When the rights which stem from tokens embody rights to profits or voting rights, the ICO may be likened to a traditional Initial Public Offering (IPO).

The attractiveness of ICOs was spurred by the sudden rise in the value of bitcoin and the strong expansion of the overall cryptocurrency market, which resulted in a widespread media coverage of the blockchain space. The staggering increase in price which some tokens experienced following their launch on secondary market exchanges, continued to serve as an attraction for businesses and investors with a risk appetite to invest in these innovative technologies. Nevertheless, the great decline in the value of the cryptocurrency market since its high in December 2017, coupled with the continuing increase in the number of ICOs currently taking place, is clear evidence that the opportunities of ICOs extends far beyond market speculation. As ICOs provide a facility for leveraging cryptocurrencies and smart contract technology, it has now become possible to replace traditional venture capital and other funding models with a more direct, automated, and decentralised solution. As a result, blockchain-based ventures have turned to ICOs as a mechanism for funding, realising these are easier, faster and cheaper than pursuing seed rounds through traditional venture capital models. From a token purchaser’s perspective, ICOs have also presented an opportunity of gaining access to technology companies at their very early stages; an opportunity which has traditionally been limited to venture capitalists and accredited investors.

The turning point for ICOs occurred in July 2017, when the United States Security and Exchange Commission (SEC) issued an investigative report cautioning market participants partaking in ICOs, that such activities are subject to the requirements of the federal securities laws. The SEC’s report was issued in response to the tokens offered during ‘The DAO’1 ICO and which were consequently held to qualify as securities that must necessarily comply by US securities legislation. The ramifications of this seminal decision led regulators and policy-makers worldwide to issue similar warnings and opinions on the legal requirements, future enforcement actions and the potential dangers pursuant to ICOs. Within the European Union, the European Securities and Markets Authority (ESMA) issued a statement stressing that firms involved in ICOs qualifying as financial instruments, are carrying out regulated activities and must comply with EU investment services legislation such as the Prospectus Directive, the Markets in Financial Instruments Directive (MiFID II) and the now Fifth Anti-Money Laundering Directive (5AMLD).

Malta was and is the first and only Member State to go a leap further than just publishing warnings, consultation documents and discussion papers. The Maltese Government revealed its ambitious legislative plan back in February 2018 when it proposed the introduction of three pieces of legislation which would regulate the Maltese blockchain ecosystem as a whole. These are the Malta Digital Innovation Authority Act, the Innovative Technology Arrangements and Services Act and the Virtual Financial Assets (VFA) Act which were consequently adopted by the Maltese Parliament on the 4th of July 2018 and are expected to come into force in October of the same year.

The main legal instrument regulating ICOs issued in or from within Malta is the VFA Act. This Act distinguishes between three types of tokens (referred to as ‘DLT assets’): (1) the ‘Virtual Token,’ (2) the ‘Virtual Financial Asset’ (VFA) and (3) a ‘Financial Instrument.’ A Virtual Token is defined as ‘a form of digital medium recordation that has no utility, value or application outside of the DLT platform on which it was issued and may only be redeemed for funds on such platform directly by the issuer of such DLT asset’ and excludes electronic money. Such tokens fall outside the scope of the VFA Act. ‘Financial Instruments’ are also not caught by the VFA Act but fall within the remit of Maltese rules which transpose the abovementioned EU investment services legislation.

Therefore, the ICO-specific rules contained in the VFA Act apply only the issuers of VFAs (referred to as an ‘Initial Virtual Financial Asset Offering’). The Act defines a VFA as ‘any form of digital medium recordation that is used as a digital medium of exchange, unit of account, or store of value and that is not – (a) electronic money; (b) a financial instrument; or (c) a virtual token. The litmus test which will distinguish between Financial Instruments and a VFA is the so-called ‘Financial Instruments Test’, which explicitly requires that a VFA functions as a means of exchange and therefore has a payment function and does not create any rights which may be exercised by the VFA holder against the issuer. Under these rules, the issuer of such an ICO must comply with high level principles and necessarily draw up a ‘whitepaper’ to be registered with the Malta Financial Services Authority. The First Schedule of the Act prescribes disclosure requirements which must feature in the whitepaper including, inter alia, a detailed technical description of the protocol, platform and/or application, the characteristics and functionality of the VFA, the project, the issuer and its team, the VFA agent and any service providers used by the issuer, as well as the applicable exchange rate of the VFA and any proposed security safeguards. Auditors should in particular take note of Part VIII of VFA Act, in which they are imposed reporting obligations in their auditor reports on the accounts of the issuer.

Furthermore, under the MFSA’s very recent Virtual Financial Assets Regulations, it is being proposed that VFA issuers must pay a one-time registration fee of €4,000 for their whitepaper, as well as an annual supervisory fee of €1,000, upon the submission of a certificate of compliance.

According to one of the leading news portals in this space, globally ICOs have raised over $5billion in 2017 and over $6billion in the first quarter of 2018. Considering ICOs a wealth of opportunities is an understatement. Malta, being one of the first jurisdictions to regulate ICOs has a great potential of attracting a large share of them over the coming months and years.

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