ESMA enters ICOs fray with cautionary note to issuers

EU watchdog echoes warnings from UK and Hong Kong regulators over risky and speculative nature of ICO fundraising schemes

Firms issuing initial coin offerings (ICOs) within the EU should review their pitches to ensure they comply with the territory’s flagship regulations, says Europe’s foremost financial watchdog.

In a special announcement of 13 November, the European Securities and Markets Authority (ESMA) became the latest regulator to signal its views on ICOs, following a surge of recent opinions from similar agencies around the world.

Indeed, The Treasurer covered two such statements in September, with the Hong Kong Securities and Futures Commission (SFC) and UK Financial Conduct Authority (FCA) both taking cautious tones.

ESMA has broadly echoed their stances, warning investors that there is a “high risk of losing all of their invested capital as ICOs are very risky and highly speculative investments”.

The watchdog also notes that ICOs are vulnerable to the risk of fraud or money laundering.

It points out: “The price of the coin or token is typically extremely volatile and investors may not be able to redeem them for a prolonged period.

“Another key risk stems from the fact that, depending on how they are structured, ICOs may fall outside of the scope of EU laws and regulations, in which case investors cannot benefit from the protection that these laws and regulations provide.”

Turning to issuers, however, ESMA says that some forms of ICOs may be structured in such ways as to bear more than a passing similarity to more standard financial instruments.

In the watchdog’s view, it is “likely” that firms behind ICOs with those features are conducting “regulated investment activities” – in which case, “they need to comply with the relevant legislation”.

Examples of such laws, ESMA notes, include the:

1. Prospectus Directive “Depending on how the ICO is structured, the coins or tokens could, potentially, fall within the definition of a transferable security, and could therefore necessitate the publication of a prospectus, which will be subject to approval by a Competent Authority.”
2. Markets in Financial Instruments Directive (MiFID) “In the case of ICOs, where the coin or token qualifies as a financial instrument, the process by which a coin or token is created, distributed or traded is likely to involve some MiFID activities/services – such as placing, dealing in or advising on financial instruments.”
3. Alternative Investment Fund Managers Directive “…an ICO scheme could qualify as an alternative investment fund, to the extent that it is used to raise capital from a number of investors, with a view to investing it in accordance with a defined investment policy.”
4. Fourth Anti-Money Laundering Directive “The Directive requires firms to carry out due diligence on customers and to have in place appropriate record-keeping and other internal procedures. Firms have an obligation to report any suspicious activity and to cooperate with any investigations by relevant public authorities.”

With regards to the first point – as the SFC and FCA noted in their statements – ICOs do not typically provide investors with detailed prospectuses explaining how their funds will be used, or how they will be rewarded.

ESMA stressed that firms involved in ICOs should give “careful consideration as to whether their activities constitute regulated activities”. It warned: “Any failure to comply with the applicable rules will constitute a breach.”

Read ESMA’s full statement to issuers here.