“If you are considering investing in ICOs or have already done so, be aware of the many risks this may entail, including the total loss of your investment”, the European Securities and Markets Authority (ESMA) warns in a public statement published on Monday 13 November, addressing both investors and the companies involved in the new phenomenon of cryptocurrency.
Cryptocurrency initial coin offerings (ICO) are a way of raising funds by issuing digital assets that can be exchanged for cryptocurrencies (usually Ether or Bitcoin) during the start-up phase of a project. These digital assets, known as 'tokens', may then be bought or sold on trading platforms and, in some cases, may be used in the project financed by the ICO in question.
ICOs are most commonly used to fund the launch of decentralised applications that run on 'blockchain' technology, which is secured data storage technology that rapidly verifies and documents financial transactions despite the absence of a central counterparty. Along similar lines to crowdfunding, any Internet user may therefore invest in a project initiating an ICO, as long as he or she possesses cryptocurrency.
Between January and September 2017, it is estimated that this technique has raised more than €1.5 billion (equivalent to the real amount in cryptocurrency) throughout the world, according to the French financial markets authority (AMF).
The European supervisor considers that this method of fundraising brings with it many risks, of which investors are largely unaware. “The information that is made available to investors (…) is in most cases unaudited, incomplete, unbalanced or even misleading”, ESMA stresses.
An increased risk of losing the capital invested. In its statement, the authority highlights the increased risk of losing the capital invested, describing ICOs as extremely risky and highly speculative investments.
Most ICOs are launched by businesses at a very early stage of development and with a very high risk of failure, it explains. Furthermore, most of the tokens issued have no intrinsic value other than the possibility of using them to access the service or product developed by the issuer, it stresses, with no guarantee that the service or product will be successfully developed. And even supposing the project succeeds, there is also a considerable risk that any profit will be far lower than the capital invested.
An unregulated space with an increased risk of fraud. Another major risk comes from the fact that depending on their structure, ICOs may fall outside the scope of application of the European standards, in which case investors do not benefit from the protection the rules offer. According to the authority, this increases the risk that this method may be used for fraudulent or illegal activities, for instance money-laundering.
However, ESMA also has a warning for businesses involved in ICOs, reminding them of their obligations under the EU rules. “It is the duty of the firms themselves to consider the regulatory framework, seeking the necessary permissions and meeting the applicable requirements”, it writes.
Depending on their structure, ICOs may fall outside the scope of application of the existing rules. However, if tokens are considered financial instruments, it is likely that the companies involved in the ICOs are carrying out investment activities regulated at EU level, for instance by the 'Prospectuses' directive, the markets in financial instruments directive (MiFID), the fourth anti-money laundering directive or the alternative investment fund managers directive (AIFMD). “Any failure to comply with the applicable rules will constitute a breach”, it warns.
Legally, ICOs raise many questions concerning the qualification and interpretation of these operations in light of national laws. Different countries have, moreover, adopted extremely different approaches. China and South Korea, for instance, have decided to ban the model, having noted many cases of fraud. The American regulator considers that the tokens issued constitute financial assets and consequently, ICOs are governed by US federal laws. Others, such as Australia, have announced that they do not currently regulate ICOs. In late October, the French regulator launched a public consultation to run until 22 December, to look at this issue.
Readers may recall that last year, the European Parliament took a position against European rules on virtual currencies and 'blockchain' technologies, calling instead for a working group to be set up to monitor their development (see EUROPE 11559). Under impetus from the European authority responsible for supervising the financial markets, the debate may now be reopened at European level. (Original version in French by Marion Fontana)