Two of the world’s biggest regulators have issued separate statements urging investors to exercise extreme caution over initial coin offerings (ICOs).
A relatively new method of backing early-stage companies or specific business ventures, an ICO typically requires investors to provide the candidate with funds in the form of a cryptocurrency – such as Bitcoin or Ether – in return for digital ‘tokens’. These represent an investor’s stake in proportion to the total funding committed.
In a standard ICO, investment also tends to be anonymous: backers of the same firm or project are unlikely to learn the identities of their fellow contributors.
At present, ICOs are by and large unregulated, and are therefore a prime example of technology quickly creating new financial models, leaving regulators to play catch-up.
As such, the Hong Kong Securities and Futures Commission (SFC) has looked into ICOs – and has found several areas of concern in key aspects of how they work.
In a special announcement of 5 September, the regulator pointed out: “While digital tokens offered in typical ICOs are usually characterised as a ‘virtual commodity’, the SFC has observed more recently that certain ICOs have terms and features that may mean that they are [in fact] securities.
“Where digital tokens offered in an ICO represent equity or ownership interests in a corporation, these tokens may be regarded as shares. For example, token holders may be given shareholders’ rights, such as the right to receive dividends and the right to participate in the distribution of the corporation’s surplus assets upon winding up.”
The SFC also stressed: “If token proceeds are managed collectively by the ICO scheme operator to invest in projects with an aim to enable token holders to participate in a share of the returns provided by the project, the digital tokens may be regarded as an interest in a collective investment scheme (CIS).”
With those broad similarities to more widespread investment models in mind, the regulator noted, “dealing in, or advising on, the digital tokens – or managing or marketing a fund investing in such digital tokens – may constitute [participating in] a regulated activity.
“Parties engaging in a regulated activity are required to be licensed by or registered with the SFC, irrespective of whether the parties involved are located in Hong Kong – so long as such business activities target the Hong Kong public.”
On an even more serious note, it warned: “As digital tokens involved in ICOs are transacted or held on an anonymous basis, by their nature they pose inherent and significant money laundering and terrorist financing risks.”
It added: “Investors should also be mindful of the potential risks involved in ICOs and investment arrangements involving digital tokens. As these arrangements and the parties involved operate online and may not be regulated, investors may be exposed to heightened risks of fraud.
“Digital tokens traded on a secondary market may give rise to risks of insufficient liquidity or volatile and opaque pricing.”
One week later, the SFC’s warning was echoed in a statement from the UK’s Financial Conduct Authority (FCA), which stressed: “ICOs are very high-risk, speculative investments.”
On that basis, the regulator explained, investors should enter these arrangements with the worst-case scenario for their contribution firmly in mind. “You should be conscious of the risks involved… and fully research the specific project if you are thinking about buying digital tokens,” it said.
“You should only invest in an ICO project if you are an experienced investor, confident in the quality of the ICO project itself (for example, business plan, technology, people involved) and prepared to lose your entire stake.”
In terms of specific risks, the FCA outlined six:
Again chiming with the SFC announcement, the FCA advises: “Businesses involved in an ICO should carefully consider if their activities could mean they are arranging, dealing or advising on regulated financial investments.
“Each promoter needs to consider whether their activities amount to regulated activities under the relevant law. In addition, digital currency exchanges that facilitate the exchange of certain tokens should consider if they need to be authorised by the FCA to be able to deliver their services.”
For further information on the underlying technology that facilitates ICOs, the FCA directs stakeholders to its recent discussion paper on distributed ledger technology.