A Critical Appraisal of Initial Coin Offerings : Lifting the Digital Token's Veil [1 ed.] 9789004416581, 9789004416574

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A Critical Appraisal of Initial Coin Offerings

International Banking and Securities Law Editors-in-Chief Armin J. Kammel (Lauder Business School Vienna; California Lutheran University) Sandra Annette Booysen (National University of Singapore) Christian A. Johnson (Widener University Commonwealth Law School) Associate Editors Douglas W. Arner (The University of Hong Kong) Christopher CHEN Chao-hung (Singapore Management University) Alexander F.H. Loke (City University of Hong Kong) Sébastien Neuville (Université Toulouse 1 Capitole) Ruth Plato-Shinar (Netanya Academic College) Holly Powley (University of Bristol Law School) Poonam Puri (York University)

Volumes published in this Brill Research Perspectives title are listed at brill.com/rpbs

A Critical Appraisal of Initial Coin Offerings Lifting the “Digital Token’s Veil” By

Dominika Nestarcova

LEIDEN | BOSTON

This paperback book edition is simultaneously published as issue 3.2 of International Banking and Securities Law, DOI:10.1163/24056936-12340008. Library of Congress Control Number: 2019946229

Typeface for the Latin, Greek, and Cyrillic scripts: “Brill”. See and download: brill.com/brill-typeface. ISBN 978-90-04-41657-4 (paperback) ISBN 978-90-04-41658-1 (e-book) Copyright 2019 by Dominika Nestarcova. Published by Koninklijke Brill NV, Leiden, The Netherlands. Koninklijke Brill NV incorporates the imprints Brill, Brill Hes & De Graaf, Brill Nijhoff, Brill Rodopi, Brill Sense, Hotei Publishing, mentis Verlag, Verlag Ferdinand Schöningh and Wilhelm Fink Verlag. Koninklijke Brill NV reserves the right to protect the publication against unauthorized use and to authorize dissemination by means of offprints, legitimate photocopies, microform editions, reprints, translations, and secondary information sources, such as abstracting and indexing services including databases. Requests for commercial re-use, use of parts of the publication, and/or translations must be addressed to Koninklijke Brill NV. This book is printed on acid-free paper and produced in a sustainable manner.

Contents A Critical Appraisal of Initial Coin Offerings Lifting the “Digital Token’s Veil” 1 Dominika Nestarcova Abstract 1 Keywords 2 Introduction: the Rise of the Crypto-Ecosystem 2 (i) Emergence of a Crypto-Ecosystem 2 (ii) Rise of the Crypto-Economy 4 (iii) Paper Structure 5 (iv) Literature Review 6 Part A: ICO Anatomy, Disruption and Benefits 10 (i) Anatomy of an ICO 10 (ii) A Disruptive Financing Model 17 Part B: Risks and Systemic Challenges 25 (i) Risks Associated with the Funding Model 26 (ii) Technology-Related Risks 32 (iii) Regulatory and Legal Risks 36 (iv) Market Risks and Market Dynamics 45 Part C: Enforceability and Applicable Legal Regimes 60 (i) Enforceability and Issuer Liability 61 (ii) Applicable Legal Regimes 66 (iii) Contract Law 66 (iv) Securities Regulation 68 Part D: Token Characterization 72 (i) Digital Token Taxonomy 73 (ii) Digital Tokens and Securities Law in Singapore 84 (iii) Issues in Classifying Tokens 90 (iv) A Framework for Token Characterization 94 Part E: Regulation and Challenges 101 (i) Why Regulate Securities? 101 (ii) Regulatory Approaches to ICOs 108 (iii) Recommendations – a Way Forward 121 Conclusion 124 References 127 Appendix 1: Glossary of Terms 149 Appendix 2: Regulation of ICOs across Jurisdictions 151

A Critical Appraisal of Initial Coin Offerings Lifting the “Digital Token’s Veil” Dominika Nestarcova

Associate Spartan Group [email protected]

Abstract Initial Coin Offerings (ICOs) emerged in 2017 as a revolutionary form of raising capital by technology companies and investment vehicles. ICOs enable start-up companies to issue blockchain-based assets (‘digital tokens’) to the public in return for a payment in cryptocurrencies or fiat money. The fundraising objective is to finance technology projects carried out by the ‘ICO issuer’. The ICO funding model represents a financial revolution as it provides additional pools of liquidity for capital formation purposes and a powerful tool for incentivizing communities through network effects. More importantly, the latent value of ICOs lies in the usage of the raised funds to develop cutting-edge distributed ledger technologies (DLTs). The advent of ICOs mushrooming worldwide promises to democratize financing, yet the commonly unregulated space in which ICOs operate, opens up a Pandora’s Box of investment and legal risks. The present paper argues that regulation needs to be goal-orientated and for that purpose, it is crucial to identify the nature of the ICO funding model, the cryptoeconomics behind it and the legal nature of digital tokens. With ICOs, academia, economists and regulators are at ground zero. Practitioners’ first instinct is to apply the knowledge of capital markets, but ICOs are a fundamentally new model of raising funds that have spawned different dynamics from ‘traditional’ capital markets. If we can establish how to approach ICOs within their own right, then choosing the correct regulatory stance will become a matter of identifying how ICOs and markets interact and how the investment risks can be allocated. Keeping with the spirit of ICOs as a financial innovation, the paper proposes self-regulation by ICO issuers to be a suitable regulatory approach, while limiting the role of regulators to policing the secondary market of crypto-intermediaries. For the purpose of fully rationalizing this position, the paper outlines the process of carrying out an ICO, relevant benefits and risks to the model, the current state of ICO regulation, digital token characterization and merits of different regulatory approaches.

© Dominika Nestarcova, 2019 | doi:10.1163/9789004416581_002

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Keywords initial coin offerings – digital tokens – token sale – cryptoeconomics – blockchain – securities regulation



Introduction: the Rise of the Crypto-Ecosystem1

i Emergence of a Crypto-Ecosystem The 21st century has witnessed the emergence of a number of disruptive technologies, among which distributed ledger technologies (DLTs) have created an ecosystem, in which digital assets and ICOs flourish. Blockchain technology, a type of a DLT, is built upon a set of combined technological solutions, which enable a single, sequenced, cryptographically-secure and distributed record of any specific activity among a network of participants.2 The peer-to-peer architecture, open-source accessibility and privacy through encryption create a network that allows participants to exchange value without a centralized oversight. Blockchain technology dates to Satoshi Nakamoto’s Bitcoin paper, in which the technology was used to facilitate the transfer of a decentralized digital currency – bitcoin.3 Nakamoto proposed a solution to the doublespend problem in a trust-less environment, where an electronic payment system based on cryptographic proof of trust would allow parties to transact with each other without a trusted third party.4 In its purest form, bitcoin (the 1  The author extends particular thanks to Professor Sandra Annette Booysen and Professor Hans Tjio for their assistance and comments on earlier drafts. I am also grateful to the Centre for Banking & Finance Law, National University of Singapore for supporting the research on which this paper is based. All errors and omissions are my own. 2  Presently, there is no consensus on the definition of ‘blockchain’ as blockchain technologies may differ in the consensus mechanism and protocols employed. For general descriptions, see: ASTRI (commissioned by the Hong Kong Monetary Authority), Whitepaper on the Distributed Ledger Technology (Whitepaper, 2016) para 2.1 or Accenture, Blockchain-Enabled Distributed Ledgers: Are Investment Banks Ready? (Capital Markets Report, 2016) Available at: accessed 10 February 2018. 3  Satoshi Nakamoto, ‘Bitcoin: A Peer-to-Peer Electronic Cash System’ (2009) Available at: accessed 15 February 2018. 4  The transactions between parties are recorded on a ledger and every person using the blockchain has an identical copy of the ledger. Transactions take place between two bitcoin addresses, when the sender initiates the transaction by signing it with a private key. The pseudonymous key pairs are used as de facto identities and the transactions are messages that are broadcasted to the Bitcoin network. The Bitcoin ‘software’ controls the supply of bitcoins and coordinates the manner of transaction validation. This is carried out in form of a pre-determined protocol that enables members to reach a consensus as to the validity

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cryptocurrency of the Bitcoin protocol) is a code that represents ownership of a digital concept, which is secured through cryptography and runs on Bitcoin’s native blockchain. Cryptocurrencies are digital representations and encrypted mediums of exchange that are used for the purpose of verifying transactions or control the creation of monetary units.5 In technical terms, they represent a programmable currency unit, which functions on top of a blockchain. Apart from their utility function, investors today utilise cryptocurrencies to invest in ICOs, whereby an ICO issuer will exchange the cryptocurrencies for a proprietary digital medium of exchange (‘digital token’) that has a functional utility on the ICO issuer’s blockchain technology. Bitcoin-inspired tokens run on separate blockchains and differ in their properties and the underlying code. In the prequel to ICOs, we have seen the emergence of the Ethereum platform, which has its own blockchain. Ethereum protocol allows for the execution of ‘smart contracts’ (computer code, which controls the transfer of assets on the blockchain) to settle transactions and has become the building block of the majority of ICOs. Instead of each ICO project developing its own decentralized platform with its own codebase, the developers can build their applications (also called ‘DApps’) on top of the Ethereum platform, as Ethereum is not application-specific, and can execute any arbitrary code. Ethereum platform has become the preferred basis on which developers chose to initiate an ICO.6 Ethereum allows an ICO issuer to create its own token, which is a representation of a value. In order to standardize the creation of tokens and the ICO process, the Ethereum developers use the ERC framework, which is a standardized code that functions to issue, distribute and control the digital tokens deployed of the bitcoin transaction and whether it should be recorded on the blockchain. The ‘miners’ check the validity of the transaction through a validation process called mining. Mining computers collect pending transactions to be validated (group them into blocks) and turn them into a mathematical puzzle that the miners need solve by deploying significant computational power. In turn, they are rewarded in bitcoins. Essentially, bitcoin miners are verifying previous bitcoin transactions. All confirmed transactions are recorded on a shared public ledger, which is immutable. In other words, Bitcoin’s ledger keeps track of user balances in form of unspent transactions balances, recording the movements of its native currency bitcoin. Bitcoin’s ledger has the following properties: distributed, cryptographic and immutable. See in detail: Arvind Narayanan et al., Bitcoin and Cryptocurrency Technologies (Princeton University Press, 2016). 5  The legal characterization of cryptocurrencies is outside the scope of this paper. For present purposes, it is important to point out a divergence in the characterization, which is evident in different regulatory characterizations among jurisdictions. 6  Ethereum network is a peer-to-peer network governed by an open-source protocol. Ethereum is capable of processing smart contracts in the Ethereum Virtual Machine and anyone can access it and trigger an execution of a smart contract by sending an ether transaction.

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during an ICO.7 Together with the ERC20 token contract, the ICO issuer will use ‘the ICO smart contract’, which will allow for the distribution of tokens according to pre-determined rules. The Bitcoin blockchain, together with the Ethereum protocol have created the essential infrastructure for the ICOs, past and present.8 With the popularized use of cryptocurrencies, emergence of new crypto-exchanges and increased interest in DLT from financial institutions, the stage was set for Internet-based crowdfunding that would finance new start-up projects. The blockchain technology was an ideal use case for the funding model, given that it relied on the initial support of blockchain-enthusiasts who welcomed the decentralized funding approach, with the hope that the model would eventually bring accountability and transparency to retail investors.9 ii Rise of the Crypto-Economy In this respect, ICOs – also referred to as ‘token sales’, ‘token generation events’, ‘digital token offerings’ or ‘initial token offerings’ can be viewed as an utilisation of blockchain technology coupled with crowdfunding targeting both retail and institutional investors looking for new financing models to invest in the technology sector.10 ICOs are fully digitalized, use the distributed ledger technology (blockchain) to issue digital tokens, which are released for public offering and sold either for cryptocurrency or fiat currency.11 Each issue of tokens is characterized by specific conditions, which dictate the rights or utility the investors derive from the purchased tokens. Digital token (or simply ‘token’ or ‘cryptographic token’) is a unit of account on blockchain. The token itself may grant the investor a right to use the (future) product of service being developed, the right to sell the token on secondary markets, voting rights, a right 7  E RC20 Token Standard, Available at: https://github.com/ethereum/EIPs/blob/master/ EIPS/eip-20.md. 8  Other non-Ethereum protocols that are employed for token offerings include NEM, Waves, NEO or Stellar. 9  I COs are not the only form of financing available for the funding of blockchain-related projects. Apart from the traditional forms of financing that include raising equity/debt or crowdfunding, alternative ways of raising funds have developed. These include forks and airdrops. 10  There are numerous pro forma names for the ICOs. For clarity and consistency, the paper will use the term ICO as a shortcut for ‘initial coin offering’ without any underlying normative or substantive meaning as to the characterization of tokens. 11  In practice, the ICO process is not fully digitized apart from the fundraising element, which is fully automated. Steps leading up the token issuance are carried out manually and may require significant paperwork for the purposes of carrying out know-yourcustomer procedures.

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to receive the company’s future income or a right to derive interest for invested funds. In turn, investors will have different objectives in purchasing the token, such as to support the ICO project, to become involved in the management of the project or to receive a return on the rising price of the token through resale in the secondary market. iii Paper Structure The present paper’s focus on ICOs is warranted given the increasing number of and interest in ICOs between 2017–2018.12 The market capitalization of all cryptocurrencies and tokens – including Bitcoin – as of June 2019 ranges between 250–325 billion USD in value.13 Market capitalization is an oft-stated metric, used to illustrate the size of the crypto-economy for comparative purposes. Despite being a popular metric for traditional securities, in the crypto market, market capitalization reflects the value of digital tokens issued on the secondary market, not the actual value of the total digital tokens issued.14 The number of ICOs launched world-wide in 2017 reached 343.15 In 2018, Coindesk reported a total of 560 ICOs with a $16.7 billion raised in funding.16 If we are to leverage on the new ICO funding model as a credible means to giving technology start-ups early liquidity and develop a healthy cryptoecosystem, it is important that we have a thorough understanding of the model, the underlying technology and identify any newly-introduced risks. Upon closer analysis, the nascent nature of the ICO funding model for start-up 12  See Dominika Nestarcova, Report on the Blockchain Economic Forum and Initial Coin Offerings in Singapore, Centre for Banking & Finance Law, Faculty of Law, National University of Singapore, February 2018, report number CBFL-Rep-SAB [https://law.nus .edu.sg/cbfl/pub_reports.html]. 13  Coinmarketcap, ‘Total Market Capitalization’ (December 2018) Available at: accessed 15 December 2018. For other market data providers, see Tokendata https://www.tokendata.io/, ICOTracker https://icotracker.net/ and ICOStats https://icostats.com/. 14  As a traditional securities metric, market capitalization is usually arrived at by multiplying the outstanding shares with the current share price. In crypto-terms, the market capitalization stands for the amount of tokens in circulation (issued in an ICO) multiplied by the price. There is a difference between the two metrics, as the latter can only account for the circulating amount. In that sense, it can appear misleading at first sight, as it does not include the coins privately held by the ICO issuers. Another issue arises with what perceived value or insight that market capitalization can offer us. With traditional securities, such as shares the market capitalization is associated with the right to dividends, which is not the case with digital tokens – instead, prima facie the market capitalization reflects the future utility value of the network developed by the ICO issuer. 15  Coindesk, ‘ICO Tracker’ Available at: https://www.coindesk.com/ico-tracker/. 16  Coindesk, ‘ICO Tracker’ Available at: https://www.coindesk.com/ico-tracker/.

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companies reveals a number of legal risks for investors and on a macro-level systemic risks for the capital markets, both of which are traditionally addressed by securities regulation and consumer protection. The present paper is structured to address the issues outlined above as follows: Part A outlines the process of carrying out an ICO on a stage-by-stage basis and looks at the benefits that the funding model provides for start-ups at a seed-stage of development. It also gives an account of the disruptive potential of the ICO funding model on traditional capital markets and venture capital and it looks at the importance of understanding the cryptoeconomics behind the ICO model. Part B provides a non-exhaustive list of risks associated with an investment in ICOs and the potential long-term risks ICOs may have on the financial stability of capital markets. The risks can be classified as those (i) associated with the ICO funding model (ii) technology-related risks (iii) regulatory and legal risks and (iv) market-related risks. Part C considers the applicable legal regimes and probes whether the investors have any means of legal redress for misrepresentation, fraud or market manipulation. Part D is devoted to the characterization of digital tokens and the applicability of securities regulation. Part E makes a case for ICO industry self-regulation and a light-touch approach by the regulator. Finally, the paper concludes with recommendations and future predictions. The Appendix includes a glossary of terms (Appendix 1) and a comparative table of 46 jurisdictions and their regulatory treatment of ICOs (Appendix 2). iv Literature Review The present paper examines the ICO funding model in light of recent developments in the ICO market and the increased attention by regulators worldwide. The academic literature in the crypto-space has seen an increased interest in the topic of ICOs since 2017, including the characterization of digital tokens, the disruptive potential of ICOs and the related risks and regulatory uncertainties.17 As the present paper makes clear, conceptualizing the ICO anatomy and attempting to provide a working taxonomy are the first steps before regulators can efficiently address ICO-related risks and allocate them accordingly. In this spirit, Zetzsche et al. (2018) offer a taxonomy of ICOs based on the analysis of a database of 450 ICO white papers. They highlight the importance of conceptualizing digital tokens prior to designing relevant regulatory responses.18 In 17  Based on papers published on SSRN and ResearchGate – large majority of which dates to 2017–2018. See https://www.ssrn.com/index.cfm/en/. 18  Dirk A Zetzsche, Ross P Buckley, Douglas Arner and Linus Föhr, ‘The ICO Gold Rush: It’s a Scam, It’s a Bubble, It’s a Super Challenge for Regulators’ (February 15, 2018) University of

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order to effectively conceptualize digital tokens and the legal nature of ICOs, it is crucial to situate the debate within a broader topic of cryptocurrencies, their application and economic benefits. Nica et al. (2017) acknowledge the risks posed by the adaptation of cryptocurrencies, analyse their efficiency and stability issues.19 At a more fundamental level, Sahdev (2017) points out that no systematic study of ICO business models, agent incentives and economic implications has been undertaken so far.20 A number of working papers attempt to provide clarity on this matter and contribute to the new discipline of cryptoeconomics. Specifically, Catalini and Gans (2018) analyse how ICOs can be used to fund venture start-up costs, they show that the ICO funding mechanism allows entrepreneurs to generate buyer competition for the token, which, in turn, reveals token value without the ICO issuers having to determine the consumers’ willingness to pay prior to the ICO. In considering cryptoeconomics, they emphasize the importance of monetary policy in developing an effective economy model.21 Chuen (2018) and Li and Mann (2018) both emphasize decentralized innovation, networks effects and the wisdom of the crowds as concepts inherently linked to value creation behind the cryptoeconomics of an ICO and as the solution to a coordination failure in the markets.22 ICOs cannot escape the forces behind cryptoeconomics and as Conley (2017) makes clear, designing a digital token is crucial for any ICO issuer, as it needs to account for certain aspects of monetary theory, financial economics, and game

Luxembourg Law Working Paper No. 11/2017; UNSW Law Research Paper No. 83; University of Hong Kong Faculty of Law Research Paper No. 2017/035; European Banking Institute Working Paper Series 18/2018. Available at: accessed 20 February 2018. 19  Octavian Nica, Karolina Piotrowska and Klaus Reiner Schenk-Hoppé, ‘Cryptocurrencies: Economic Benefits and Risks’ (October 26, 2017). University of Manchester, FinTech working paper no. 2, October 2017. Available at: accessed 21 February 2018. 20  Navroop K Sahdev, ‘The Tokenization of the Economy: ICOs and the Implications for Cryptoeconomics’ (August 24, 2017) Available at: accessed 23 February 2018. 21  Christian Catalini and Joshua S. Gans, ‘Initial Coin Offerings and the Value of Crypto Tokens’ (March 2018) NBER Working Paper No. 24418 Available at: accessed 18 March 2018. 22  David Lee Kuo Chuen, ‘Decentralization and Distributed Innovation: Fintech, Bitcoin and ICO’s’ (October 25, 2017) Available at: accessed 22 February 2018 and Jiasun Li and William Mann, ‘Initial Coin Offering and Platform Building’ (January 31, 2018). Available at: accessed 27 February 2018.

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theory.23 As Adhami et al. (2017) illustrate, if an ICO issuer is able to customize a model for digital token issuance to his needs, he will be able to leverage on the benefits offered by the ICO model.24 Besides the perceived benefits for both start-ups and investors, the ICO funding model exposes investors and markets to a myriad of risks. This is one of the most common themes explored in the academic papers. Kaal and Dell’Erba (2017) outline the core risk factors for investors and flag ICO practices that require regulators’ attention.25 Keidar and Blemus (2018) highlight the presence of market abuse, which has not been eliminated in ICOs and argue that due to the unregulated nature of ICOs, the danger of market abuse is even greater.26 More worrisome on a global scale is the possibility of enabling money laundering and other illicit activities, which has benefited from the anonymity offered by the ICO ecosystem.27 The regulatory responses to these risks have varied and as Clements (2018) argues, there is an inherent difficulty in regulating the

23  John Conley, ‘Blockchain and the Economics of Crypto-tokens and Initial Coin Offerings’ (2017) No. 17-00008, Vanderbilt University Department of Economics Working Papers, Vanderbilt University Department of Economics Available at: accessed 25 February 2018 Also see Christian Catalini and Joshua S Gans, ‘Some Simple Economics of the Blockchain’ (September 21, 2017) Rotman School of Management Working Paper No. 2874598; MIT Sloan Research Paper No. 5191-16 Available at: accessed 5 March 2018. 24  Saman Adhami, Giancarlo Giudici and Stefano Martinazzi, ‘Why Do Businesses Go Crypto? An Empirical Analysis of Initial Coin Offerings’ (October 20, 2017) Available at: accessed 11 March 2018. See also David Cerezo Sancher, ‘An Optimal ICO Mechanism’ (September 9, 2017) Available at: accessed 10 March 2018. 25  Wulf A Kaal and Marco Dell’Erba, ‘Initial Coin Offerings: Emerging Practices, Risk Factors, and Red Flags’ (November 8, 2017) in Florian Möslein, Sebastian Omlor and Verlag CH Beck (eds.) Fintech Handbook (forthcoming) (2018) U of St. Thomas (Minnesota) Legal Studies Research Paper No. 17-18. Available at: accessed 28 February 2018 and Usman Chohan, ‘Initial Coin Offerings (ICOs): Risks, Regulation, and Accountability’ (November 30, 2017). Discussion Paper Series: Notes on the 21st Century. Available at: accessed 18 March 2018. 26  Roy Keidar and Stéphane Blemus, ‘Cryptocurrencies and Market Abuse Risks: It’s Time for Self-Regulation’ (February 13, 2018) Lexology. Available at: accessed 7 March 2018. 27  See Marc Pilkington, ‘The Emerging ICO Landscape – Some Financial and Regulatory Standpoints’ (February 8, 2018). Available at: accessed 11 March 2018 and Octavian Nica, Karolina Piotrowska and Klaus Reiner Schenk-Hoppé, ‘Cryptocurrencies: Economic Benefits and Risks’ (October 26, 2017). University of Manchester, FinTech working paper no. 2, October 2017. Available at: accessed 21 February 2018.

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crypto market.28 Similarly, Robinson (2017) proposes argument that the current (U.S.) securities law framework is ill-equipped to handle the new world of decentralized, global, pseudonymous fund raising on public blockchains.29 Brummer and Yadav (2017) develop the argument further in pointing out that by applying traditional regulatory strategies to new technological ecosystems, such as ICOs, is conceptually difficulty, as the regulators will have to balance the trade-offs involved in regulating innovations that could both help and hurt market participants including consumers.30 Similarly, Iris Chiu argues that policy makers should develop their approach to regulating ICOs and their secondary markets in view how to best balance investor protection, whereby the primary markets should be governed by proportionate consumer protection and the investor protection should play a greater role through the regulation of secondary-market participants.31 In light of uncertain regulatory treatment and risks associated with ICOs, increasing quantitative research has been pursued to shed light on determinants of ICO’s success, investor value, role of disclosure or importance of decentralized governance. For example, Bourveau et al. (2018) examine the role of disclosure regime and find that disclosure practices by ICO issuers impact market quality whereby the likelihood of successfully raising funds is positively associated with the measure of disclosure given prior to the ICO.32 Similarly, Howell et al. (2018) find a correlation between voluntary disclosure and a liquidity and trading volume on secondary markets.33 28  Ryan Clements, ‘Assessing the Evolution of Cryptocurrency: Demand Factors, Latent Value and Regulatory Developments’ (February 3, 2018). Forthcoming, Volume 8, Michigan Business & Entrepreneurial Law Review Available at: accessed 22 March 2018. 29  Randolph Robinson, ‘The New Digital Wild West: Regulating the Explosion of Initial Coin Offerings’ (September 1, 2017) U Denver Legal Studies Research Paper No. 18-01. Available at: accessed 17 February 2018. 30   Chris Brummer and Yesha Yadav, ‘Fintech and the Innovation Trilemma’ (October 17, 2017) Vanderbilt Law Research Paper No. 17-46. Available at: accessed 19 February 2018. 31  Iris HY Chiu, ‘Decoupling Tokens From Trading: Reaching Beyond Investment Regulation for Regulatory Policy in Initial Coin Offerings’ (April 4, 2018) International Business Law Journal/ Revue de Droit des Affaires Internationales (Forthcoming) Available at SSRN: accessed 29 June 2018. 32  Thomas Bourveau, Emmanuel T De George, Atif Ellahie and Daniele Macciocchi, ‘Initial Coin Offerings: Early Evidence on the Role of Disclosure in the Unregulated Crypto Market’ (May 2018). Available at SSRN: accessed 4 July 2018. 33  Sabrina Howell, Marina Niessner and David Yermack, ‘Initial Coin Offerings: Financing Growth with Cryptocurrency Token Sales’ (June 21, 2018). European Corporate Governance

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The regulatory responses to ICOs have differed as to the level of scrutiny and enforcement. Blemus (2018) compares the current regulatory trends in selected countries.34 Hacker and Thomale (2017) and Barsan (2017) offer an analysis of digital tokens and ICOs from a legal perspective of EU securities regulation.35 Rohr & Wright (2017) offer a deep insight into the applicability of U.S. securities regulation to ICOs.36

Part A: ICO Anatomy, Disruption and Benefits

i Anatomy of an ICO Defining an ICO An ICO is a funding mechanism for start-up technology projects which superficially resembles an initial public offering (IPO) and an open crowdfunding. Notwithstanding the apparent similarity, IPOs and ICOs are fundamentally different. In an ICO, the purchase of a token confers a form of stake in the project’s future service or product (issued through a distributed ledger), while in an IPO, a company publicly sells equity via a regulated exchange and the investors through the purchase of stocks, spend cash for an ownership in the operation of a company, which generates an economic activity that rewards the investors Institute (ECGI) – Finance Working Paper No. 564/2018. Available at: accessed 20 July 2018. 34  Stéphane Blemus, ‘Law and Blockchain: A Legal Perspective on Current Regulatory Trends Worldwide’ (January 17, 2018) Revue Trimestrielle de Droit Financier (Corporate Finance and Capital Markets Law Review) RTDF N° 4-2017 Available at: accessed 15 February 2018. Also see Wulf A Kaal, ‘Initial Coin Offerings: The Top 25 Jurisdictions and Their Comparative Regulatory Responses’ (February 2, 2018). Available at: accessed 26 March 2018. 35  Philipp Hacker and Chris Thomale, ‘Crypto-Securities Regulation: ICOs, Token Sales and Cryptocurrencies under EU Financial Law’ (November 22, 2017). Available at: accessed 5 March 2018 and Iris M Barsan, ‘Legal Challenges of Initial Coin Offerings (ICO)’ (November 2, 2017) Revue Trimestrielle de Droit Financier (RTDF), n° 3 Available at: accessed 5 March 2018. Also see Philipp Maume and Mathias Fromberger, ‘Regulation of Initial Coin Offerings: Reconciling US and EU Securities Laws’ (June 15, 2018). Available at SSRN: accessed 1 July 2018. 36  Jonathan Rohr and Aaron Wright, ‘Blockchain-Based Token Sales, Initial Coin Offerings, and the Democratization of Public Capital Markets’ (October 4, 2017) Cardozo Legal Studies Research Paper No. 527; University of Tennessee Legal Studies Research Paper No. 338 Available at: accessed 5 March 2018. Also see Lawrence J Trautman, ‘Bitcoin, Virtual Currencies, and the Struggle of Law and Regulation to Keep Pace’ (May 30, 2018) Marquette Law Review (Forthcoming) Available at SSRN: accessed 2 July 2018.

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with dividends. In other words, an IPO confers ownership rights in the company, while a purchase of tokens does not generally confer ownership rights in the parent ICO company, unless explicitly stated. Crowdfunding is an umbrella notion used to describe a financial model where a start-up raises external financing via the Internet from individuals contributing often small amounts that can either be a donation or in exchange for a future product or service.37 Despite the shared element of raising finance from ‘crowds’, ICOs today are distinguishable in using DLT to emit digital tokens to investors, which do not confer ownership of a stake in the start-up.38 Conversely, in the crowdfunding model, the financing is either in the form of a loan, donation or equity investment.39 In the crowdfunding model, the crowdfunding platform serves as an intermediary with varying levels of engagement in the contractual relationship between the lenders and borrowers, whereas in the ICO model, the blockchain technology functions as a market-maker without the need for a middleman.40 As for the accessibility, ICOs are capable in theory to function on a global scale, while crowdfunding is most often limited to a pre-determined jurisdiction or region. More crucially, there is a difference as to the product development stage. While in crowdfunding, the investors have a clear idea on the investment potential of the product/service, while in ICOs the product/service is merely ideational. The above differentiation makes it clear that an ICO funding model, unlike IPOs and crowdfunding is an altogether different creature. It is therefore 37  Paul Belleframme, Thomas Lambert and Armin Schwienbacher, ‘Crowdfunding: Tapping the Right Crowd’ (2014) Journal of Business Venturing 29(5), 585. Also see a detailed analysis of the crowdfunding regulation in Singapore in Christian Hofmann, ‘An Easy Start for Start-ups: Crowdfunding Regulation in Singapore’ (2018) 15 Berkeley Bus. L.J. 219. 38  This is not to suggest that ICOs cannot confer or convey more tangible rights. Indeed, depending on the regulatory approval – ICOs may issue asset-backed tokens or offer ownership rights. 39  The most prominent forms of crowdfunding include lending-based crowdfunding and equity crowdfunding. Among the lending-based crowdfunding, the most common models are client-segregated account, notary model and guaranteed return model. In a clientsegregated account model, the money invested is held on an escrow and the contractual relationship is between the lender and borrower. In a notary model, the funds raised are transferred to a partner bank that originates the loan to a borrower. In a guaranteed return model, the crowdfunding platform plays the most active role, whereby it guarantees a rate of return for lenders. Among the equity crowdfunding, the most common models are a direct shareholder model and nominee model. In a direct shareholder model, the lenders hold shares in the crowdfunding project. In a nominee structure, the crowdfunding platform or a third party acts a nominee to hold shares on behalf of the investors. 40  Where traditional market-makers may come into play is in providing liquidity to issued digital tokens on secondary markets.

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essential to look at the procedural aspects of carrying out an ICO in order to fully understand what it is. Most commonly, start-ups or early-stage tech companies opt for the ICO funding model. With no prior financing and no functioning product, an ICO is a rational choice, especially for those projects which would not be able to attract financing from institutional investors or angel/ venture capital funds. Legacy companies have also recently opted to raise funds via an ICO, in recognition of the model being a quick and efficient financing tool. These are traditionally-funded tech companies that have already gone through financing rounds and have built up a user-base.41 ICO Process: Start-Ups Given that ICOs are a novel phenomenon, there are currently no clear government regulations on how to structure an ICO in any jurisdictions.42 Generally, the ICO structure will depend on the financing model chosen by the ICO issuer. Most ICOs follow a certain modus operandi, which can be summarized as follows: 1. Incorporation: The ICO issuer is a corporate entity that uses blockchain technology to issue tokens to investors. Most commonly, this entity is a foundation or a company limited by a guarantee, which is a separate and distinct entity from the operating entity that represents the founders and the management team behind the project. The dual structure creates a separate legal liability. The business entity’s corporate structure is chosen for the purposes of carrying out an ICO most effectively, especially with regard to legal liability, taxation, incorporation costs and the relevant jurisdictional considerations.43 For example, in Switzerland, the most common business entity used by ICO issuers is a foundation, as it is a non-profit organization, with no owners and managed by council members for a specific purpose or to benefit of the founders. In Singapore, ICO founders opt for a company limited by guarantee (CLG), which is similarly managed by a board of trustees, has a separate legal status and limited liability for its members. 2. Pre-announcement: The first step for the ICO issuer will be to make a pre-announcement of the planned ICO via social networks and online channels such as Medium, Telegram, Reddit or Facebook. Social media 41  These are often referred to as ‘reverse ICOs’ and their legal implications will be elaborated on in Part B (iii) covering the interaction between ICO and venture capital financing. 42  Some jurisdictions have published guidelines and best practices on how to conduct an ICO – see Appendix II. 43  A number of commentators have pointed out an uneasiness with a shell entity being used for the purposes of conveyancing the funds to the parent company.

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and tech-related news sites are the preferred advertising method. The objective of the pre-announcement is to establish market sentiment and determine the level of interest. The pre-announcement is followed by an announcement of the start-up’s business idea, its goals and the rationale behind using an ICO funding model. Marketing and Whitepaper: The ICO issuer will release a whitepaper, which describes its product, business model and the terms of the ICO, together with the description of the token’s utility. A whitepaper is a document that states the technology behind the ICO project, the issue it targets and proposes a solution with a detailed description of the system architecture and interaction with the users. It will also contain information pertaining to the market capitalization, anticipated growth and technical details like the terms and conditions regarding the use of the tokens. The whitepaper will refer to separate terms and conditions on the ICO sale. The majority of whitepapers will include a disclaimer stating that in no manner is the whitepaper to be construed as a prospectus. The purpose of a whitepaper is to familiarize the investors with the ICO project and solicit funding. Currently, there are no official pronouncements as to the legal status of a whitepaper. One may view a whitepaper as akin to a prospectus, as ultimately both documents allow the investors to make an investment decision based on the presented information. More sophisticated ICOs will also produce a so-called Yellowpaper, which is an advanced technical description of the technology being developed. What follows is further marketing process that will usually involve social media outreach, conferences and road shows. AML and KYC compliance: The ICO issuer is subject to carrying out antimoney laundering laws and KYC compliance prior to the ICO.44 The investors need to pass the KYC checks, upon which the ICO issuer adds the investor to the list. Investor participation: In order to participate in an ICO, the participants must register for the sale and state their wallet address – where they want to receive the purchased tokens. Pre-token sale: Some ICO issuers will run a pre-ICO or a ‘pre-token sale’ in order to raise funds to cover expenses leading to the ICO. The pre-sale is private and will most often involve accredited investors, venture capitalists or hedge funds. Indirectly, the funding raised during a pre-sale will serve to entice the public’s interest and ‘legitimize’ the business product offered. The pre-sale investor will send funds to the ICO issuer – most

44  See Part B on risks related to illicit activities.

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commonly off-chain. Upon receipt of the funds, the ICO issuer initiates the ‘ICO contract’ smart contract which calls on the ERC20 smart contract to mint the tokens, as specified in the ICO contract. The ERC20 contract issues the tokens, which are subsequently deposited with the investor.45 The majority of ICO tokens are issued on Ethereum blockchain. In order to participate in the ICO, an investor needs a ‘digital wallet’. The wallet needs to be compatible with the Ethereum ERC20 smart code. As the owner of the wallet, the investor will have a set of private keys (a secure digital code known only to the user – whoever has access to an address’ private key controls the coins or tokens inside it) and public keys (a public digital code connected to a certain amount of tokens), which will enable him to send and receive coins/tokens. In other words, the keys are necessary for an interaction with smart contracts to transfer and receive tokens. The cryptocurrencies are not stored in the wallet – instead, the wallet stores the private and public keys and acts as a form of a ledger. Each digital wallet has an address, which is given out in order for the investor to carry out transactions. The ERC20 smart contract has two main functions, to create a new digital token and move it from one person to another. Token sale: The token sale takes place in accordance with the stipulated whitepaper. The ICO contract calls on the ERC20 smart contract and instructs it to send the appropriate amount of ICO tokens to the investor. From a legal perspective, the token sale agreement constitutes an offer – usually in an online form – to conclude the agreement for the purchase and use of digital tokens. The acceptance on part of the investor takes place upon the purchase of tokens. By purchasing the digital tokens, the investor agrees and accepts the offer and its conditions for purchase. The offer will often incorporate the white paper and T&Cs by reference, in which case the investor unconditionally accepts their terms.46 ICO format: ICO issuers continue to explore different token issuance formats. The sale can either be capped or uncapped as to the number of tokens being offered and the way tokens are distributed can also vary based on ‘tiers’, which can be time-based or amount-based.47 More

45  The issuance of tokens may happen at a later stage, as indicated in Terms & Conditions of the sale. In many cases, the tokens are not transferred to the token purchaser immediately, but are instead issued at a later date upon pre-determined trigger events. 46  See Part C Section (iii). 47   Time-based tiers: The ICO issuance is divided into tiers based on stipulated date, whereby during each period the investors may be allocated a specific volume of tokens. Amount-based tiers: the tiers function based on how much of the overall hard cap has

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recently, a Dutch-auction sale format has been explored. In a reversed Dutch-auction model, the ICO sale opens at a high price and then gradually decreases to find the optimal market price. Prior to the ICO sale, an investor would first decide what he considers to be the highest valuation of the token. When the sale starts, instead of immediately buying the token, the investor waits until the valuation drops below the pre-determined level, upon which he concludes the transaction. 9. ICO triggered: The majority of ICOs run on the Ethereum network and use the ERC20 token standard in order to program how the created tokens should function during the ICO. ERC20 defines a standardized set of rules that the tokens must follow and allows for a set of functions – such as how the token should be transferred or what data can be accessed. Similar to a pre-sale, once the ICO issuer triggers the token sale, a specific number of tokens is released. Participants in the token sale purchase the tokens through an online portal in exchange for permitted cryptocurrencies. This process is carried out through the use of ‘smart contracts’ on a blockchain – a set of functions written in code. The participants instruct their wallets to subscribe to a desired number of tokens, transfer the digital currency into the issuer’s wallet address, which in turn registers tokens into the participant’s account. 10. ICO closure: Upon completion, the ERC20 contract is locked, preventing a further issuance or tampering by the ICO issuers. 11. The proceeds from the token sale: The proceeds go directly from the ICO vehicle to the ICO founders who use them in accordance with the investment plan outlined in the whitepaper. Most ICO issuers will reserve a pool of tokens, which are not distributed, but kept by the management for either personal use or a future token re-issue event. Vesting the reserved tokens with ICO founders serves the purpose of aligning the interests of the management team. 12. Post-ICO trading: The distributed tokens become non-redeemable upon the sale completion and are generally not subject to transfer restrictions although the ICO issuer may impose certain transfer restrictions and a hold-up period. The token buyers can either hold on to their tokens and derive whatever future utility they offer or may trade them on secondary market cryptocurrency exchanges. 13. Crypto-exchanges: The exchanges will list tokens depending on their admission rules and thereby turn the tokens into liquid assets. Some been sold off to investors. Tiers are a popular mode of distributing tokens, as they encourage investors to participate early.

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tokens are subject to hold up periods, but generally the token holders are free to sell or speculate on the market value of the acquired token. Crypto-exchanges create an active secondary market for tokens – a form of financial intermediation that allows customers to trade digital tokens for other digital tokens or conventional fiat money. They may offer a range of services, such as wallet providers, remittance services or conversion of cryptocurrencies into fiat currencies.48 Each crypto-exchange has a discretion as to which digital tokens it will list. With regards to digital tokens, crypto exchanges may only list utility tokens and not security-like tokens (see Part E). Some of the well-known crypto-exchanges include Poloniex, Kraken, Gemini, itBit, GDAX, Bitstamp or Bittrex. Crypto-exchanges will not only differ in the services provided and the number of digital tokens they admit to list, but also in the extent to which they comply with regulations. Exchanges such as Bitstamp or Gemini will offer fewer digital tokens with a preference for tokens with an established operating history. Crypto-exchanges will store the clients’ digital tokens either in a hot or cold wallet. The difference between a hot and cold wallet lies in whether it can be accessed through the Internet. If it can, it is a hot wallet, and vice versa. The storage of digital tokens does not refer to actual storage of tokens, but instead to the storage of private keys that allow the token holder to sell the tokens to another holder. Crypto-exchanges may/may not require access to the private keys with a varying level of security imposed on their custody and protection from a hack. 14. Product or service development: Having raised the funds, the founders use the funds to work on their product/service. Most commonly, the start-up does not have a revenue stream besides the ICO funds. 15. Product deployment: Once the product/service is deployed, the company enters the marketplace and develops an ecosystem around the product/service. ICO Process – Legacy Company Legacy companies have recently opted to raise finance via the ICO model. These are traditionally-funded tech companies that have already gone through financing rounds and have built up a user-base. The procedural aspects of a legacy ICO are akin to a traditional start-up ICO. A recent example is the Kodak 48  The crypto-exchanges either charge a transaction commission for their services or fees for operating a market-making platform. See Nirupama Devi Bhaskar and David LEE Kuo Chuen, ‘Bitcoin Exchanges’ in David LEE Kuo Chuen (eds.) Handbook of Digital Currency: Bitcoin, Innovation, Financial Instruments and Big Data (Elsevier, 2015).

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company raising funds via an ICO to distribute KodakCoins (its native digital token), which will be used by customers and photographers for digital rights management services. Legal risks associated with this model of financing will be explored in Part B. ii A Disruptive Financing Model Developments in the ICO Market The popularity of the ICO funding model is evident in the exponential rise of ICOs conducted worldwide. In 2016, the total number of ICOs was 45, the number quadrupled to 211 in 2017.49 Blockchain infrastructure and financial services are the most common ICO project areas.50 Research conducted by Elementus suggests the initial surge in Q3 and Q4 in 2017, with the highest cumulative funding raised in March 2018.51 Some of the largest ICOs include Tezos, which has raised $232 million and messaging app provider Telegram which has raised $850 million in its first ICO round, aiming to surpass the $1 billion mark.52 The Gnosis ICO illustrates how efficient it is for a start-up company to raise millions within minutes, proving that ICOs are indeed capable of injecting liquid capital investment in record time compared to other forms of funding. Gnosis has raised around $12.5 million by opting for a Dutch auction model, which opened at a high price and then gradually decreased to find the optimal market price, giving the project a valuation of USD $300 million.53 What is interesting to note is that this valuation was based on

49  CoinSchedule, ‘Cryptocurrency ICO stats 2017’ (CoinSchedule, 207) Available at: accessed 11 February 2018. 50  LAToken, ICO trends (Report, 2017) Available at: accessed 3 February 2018. 51  Elementus, ‘The ICO market is not collapsing. It’s maturing.’ (Elementus.io, 27 September 2018) Available at: accessed 28 September 2018. 52  Paul Vigna, ‘Tezos Raised $232 Million in a Hot Coin Offering, Then a Fight Broke Out’ (The Wall Street Journal, 19 October 2017) Available at: accessed 7 February 2018.  Jon Russell, ‘Telegram has raised an initial $850M for its billion-dollar ICO’ (TechCrunch, 16 February 2018) Available at: accessed 20 February 2018. 53  Alyssa Hertig, ‘ICO Insanity? $300 Million Gnosis Valuation Sparks Market Reaction’ (CoinDesk, 26 April 2017) Available at: accessed 7 February 2018.

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nothing more than a 49-page whitepaper.54 Despite increased regulatory scrutiny, the ICO trend has not haltered and in the first quarter of 2018, ICOs have raised more funding than in 2017.55 A Market for ICOs ICOs offer an alternative way for start-up companies to raise capital from public capital markets without having to rely on traditional means of funding such as IPOs or venture capital. The typical ICO issuer will be an early-stage company with a high-risk model, seeking to eliminate barriers to capital by utilizing the power of crowdfunding where no venture capital (VC) funding is available. ICO issuers benefit from (i) engaging the community by enabling an ordinary blockchain-enthusiast to directly contribute to the business idea, (ii) lowering transactions costs associated with the ICO – no need to hire investment bankers or underwriters, instead the only costs involve marketing and overseeing the ICO execution, (iii) raising capital efficiently and avoiding the VC funding pitfalls of raising capital at the expense of suffering a dilution, and (iv) community creation, whereby the digital outreach coupled with the current ICO hype offers a greater marketing exposure and concurrently engages early adopters who in order to profit from their early investment will strive to market the business idea to expand its adoption (and capitalize on network effects).56 A New Funding Paradigm What we are witnessing with ICOs is a new funding paradigm based on an entirely different set of premises that goes against the mainstream conception of how start-ups raise finance. Key concepts that enable the success of ICOs are: tokenization, network effects, decentralization and democratization of fundraising. 54   Whitepaper Database, ‘Gnosis (GNO) – Whitepaper’ (Whitepaper Database, 24 October 2017) Available at: accessed 18 February 2018. 55   David Floyd, ‘$6.3 Billion: 2018 ICO Funding Has Passed 2017’s Total’ (CoinDesk, 19 April 2018) Available at: accessed 19 April 2018. 56  Howell et al. single out the following benefits of the ICO funding model: to finance decentralized networks, to raise financing from future customers, to establish immutable and non-negotiable governance, to provide rapid liquidity, to hasten network effects and to reduce transactions. See Sabrina Howell, Marina Niessner, and David Yermack, ‘Initial Coin Offerings: Financing Growth with Cryptocurrency Token Sales’ (June 21, 2018) European Corporate Governance Institute (ECGI) – Finance Working Paper No. 564/2018. Available at: accessed 16 July 2018, 7.

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The process of tokenization enables the creation of a medium of exchange – digital tokens. In simple terms, it is a privately issued currency or a medium of exchange, where the ICO issuer can set its terms, its utility function and create a self-sustainable mini-economy with the ICO project at its heart. Not only can a token (which has no intrinsic value) be used as a medium of exchange in this micro-economy, in specific use-cases, it is an intrinsic part of the blockchain technology itself, as it allows users to participate in the newly-created economy.57 Tokenization also enables fractionalizing of ownership and diversifies the financing sources, while creating a community that has a vested interest in the project. In majority of cases, the project that is financed by the ICO aims to create a platform, which is a solution to a stated problem in the form of a service/product and the digital tokens offer access to it. Tokenization of financing incentivizes new token owners to contribute to the network, as by purchasing the token, token holders obtain a vested interest in the network’s future success. By tokenizing their early-stage business models, ICO issuers can now raise funds efficiently and capitalize on the network effects.58 Fully digital and open worldwide to any Internet user, ICOs have unlocked a model that sustains its success on the network effect. Three main factors feed into the network effect: (i) the current investor hype in the ICO ecosystem, fuelled by the investment expectation of tokens being tradable on secondary markets, (ii) expectation that the token value will increase as the volume of users increases and (iii) incentive for other users to join early in order to increase the value of their potential ownership. An interplay between the network effects and early liquidity in the form of de facto ‘helicopter money’ reinforce each other to create token economics. If an ICO project can attract early support, the token sale lays the foundation for network effects.59 A platform user gains from others joining the platform due to the network ownership effect. The users’ incentive is to work together towards the common goal of growing the network, as with the growth of the network, the token utility increases and it adds value to the platform, thereby accelerating the network effects. A successful project will have a model that makes the token utility necessary for the functioning of the network. An analogy can be drawn to the network effects described by Robert 57  Digital tokens themselves are not intrinsic to the underlying blockchain technology and blockchains can exist without them. This is especially the case with permissioned blockchain technologies. 58  More on network effects see William Lin Cong, Li Ye, and Wang Neng, ‘Tokenomics: Dynamic Adoption and Valuation’ (2018). 59  Jonathan Rohr and Aaron Wright, ‘Blockchain-Based Token Sales, Initial Coin Offerings, and the Democratization of Public Capital Markets’, 18.

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Metcalfe, whereby the utility of the service/product offered increases when new users join (Metcalfe’s Law).60 If the users holding on to tokens believe that the platform’s utility will attract more users, their participation will be justified. As Li and Mann note, the combination of the ICO funding model with the network effects helps to overcome the strategic complementarity.61 Blockchain entrepreneurs leverage on the democratization of the investment space by unlocking the liquidity injected by small investors. An ICO aligns the incentives and needs of users for a specific service/product and joins them together via the blockchain technology to leverage on their numbers. An ICO is a reflection of a public demand around the world, which would otherwise be costly to reach. The investors who believe in the utility of the digital token and the platform being built are the future users – the ICO sells them a digital token and a stake in the network ownership alike. Li and Mann highlight the compelling benefit of building a community of users, which is inter-linked to building networks and platforms for other use-cases.62 Every ICO’s goal is to build a community, which will invest in the project and support its mission. This form of community building may resemble Kickstarter, but unlike Kickstarter, it gives the ICO participants a direct stake in the future of the company. The democratizing element of the funding model brings value capital into the technology’s ecosystem and creates a form of a positive feedback loop, whereby the community can support the project’s mission, and the project can capitalize on their support. The prospective utility that the investors derive from their investment fosters a community. With more users, the demand for the capped tokens increases and hence the value of their ownership. In theory, the decentralization of the funding model allows anyone with access to the Internet to participate. The role of borders diminishes and the ICO issuer leverages on the access to a global capital.63 Simultaneously, the decentralized manner of issuing (pre-minting) of tokens creates an assurance for ICO investors that the funding process will not be tampered with by the ICO issuer regardless of where the ICO sale is taking place. The perceived value in the ICO funding model is that investors can bring early capitalisation into their project with pre-revenue traction, without having to embark on lengthy fundraising roadshows and are instead allowed the freedom to focus on building up the network and their product/service. 60  Robert M Metcalfe, ‘It’s All In Your Head’ (Forbes, 20 April 2007) Available at: accessed 21 March 2018. 61  Jiasun Li and William Mann, ‘Initial Coin Offering and Platform Building’ 4. 62  Jiasun Li and William Mann, ‘Initial Coin Offering and Platform Building’ 3. 63  David Lee Kuo Chuen, ‘Decentralization and Distributed Innovation: Fintech, Bitcoin and ICO’s’, 18.

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Start-up companies which would otherwise be considered as too risky for VC funds or angel investors have access to finance through an ICO, where the democratizing fundraising pools the risks. This is particularly beneficial to startups developing a blockchain – based technology, as the projects are commonly without a functioning product. Low barriers for entry ensure that even start-up projects at a concept stage can raise funding. Carrying out an ICO is a costeffective way of raising funds for a start-up; it is shorter than preparing for an IPO and substantially cheaper.64 Dell’Erba and Kaal go even further to say that ICOs are the most efficient means of financing entrepreneurs in the entire history of capital formation.65 That said, ICO issuers are experiencing increasingly higher costs. With a proliferation of ICOs and an uneven regulatory landscape, ICO issuers are forced to spend more in preparation for an ICO.66 Nevertheless, it is undeniable that ICOs enable start-ups to access previously inaccessible pools of untapped finance and leverage on the distributed power of online networks. The funding is immediately available after the ICO is finished without the ICO team having to sacrifice equity for financing. Conversely, the investors enjoy early liquidity, as the majority of digital tokens is tradable on secondary markets with an immediate effect, making an ICO an early liquidity event. Disrupting Capital Markets The long-term disruptive impacts of the ICO funding model on our understanding and conceptualization of capital formation are yet to be seen. The foundations of our societies have been built on institutional and centralized pedestals preventing us from fully grasping how and whether ICOs will disrupt traditional capital formation mechanisms. By analogy, the world witnessed the Internet developing in the 1990s, yet very few would have predicted the rise of Facebook or Amazon and the paramount impact these companies have on our 64   Marc Pilkington, ‘The Emerging ICO Landscape Some Financial and Regulatory Standpoints’ (February 8, 2018) Available at: accessed 9 February 2018, 7. 65  Wulf A Kaal and Marco Dell’Erba, ‘Initial Coin Offerings: Emerging Practices, Risk Factors, and Red Flags’. 66  Often, the more sophisticated the ICO is, the higher the expenses. For example, Jason Goldberg from Simple Token ICO gives a first-hand example of having to spend about $2M on preparations for their token sale, with the largest proportion of costs going to technology, legal matters, security and marketing. On legal fees alone, the token sale cost $500,000. The costs will reflect on the complexity and the number of jurisdictions targeted. See Jason Goldberg, ‘Insider Reflections on the ICO Bubble, Part II: What it takes to ICO’ (Hackernoon, 23 December 2017) Available at: accessed 5 March 2018.

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daily lives today. We may not know which ICO will develop the killer application or how will the funding model change capital market dynamics, but we can establish with certainty that ICOs are presenting to us a fundamental shift in the concept of digital ownership and investing. Tokenization and cryptoeconomics will challenge the way we perceive ownership and regulation. Prima facie, the ICO funding model allows for efficient capital formation targeting start-up companies. Even though a funding model based on blockchain technology may not currently be a suitable model for all companies, it holds a promise of disrupting capital markets more broadly, including; capital formation, exchanges, middlemen. The age-old issues of information asymmetry, lack of liquidity and market makers, insider trading and market abuse in the capital markets can be dealt with by using blockchain technology. Whether it is blockchain used as part of a funding model or a ledger, it is the art of cryptoeconomics that can address the vices of capital markets.67 Cryptoeconomics To develop an understanding why cryptoeconomics holds the potential to disrupt capital markets and before defining what cryptoeconomics stands for, it is useful to consider the Byzantine General’s Problem.68 The hypothetical scenario involves a Byzantine army surrounding an enemy city with several generals who need to reach a consensus on the timing of the attack. There is no centralized command, they can only communicate via messengers and there is a possibility of imposter generals actively disturbing the attack. This scenario clearly represents a situation of information asymmetry – a problem of achieving consensus in a decentralized system in the presence of adversaries. The Byzantine General’s Problem resembles today’s capital markets – how do we coordinate economic activity on a global scale in an ecosystem replete with information asymmetry, where the communication between participants is imperfect and some participants are opportunistic in exploiting 67  Among the numerous use-cases, the ones applicable in capital markets would include; efficient and immutable transactions, pre-designed permissioning rules allowing market participants to control their data, coordination of economic activity, regulatory oversight over KYC and AML compliance, market-making function or elimination of more efficient gatekeepers with access to financial statements transparently and immutably available on blockchain. 68  Described in relation to the topic of Byzantine fault tolerance in computer system by Lamport et al. as an agreement problem in Leslie Lamport, Robert Shostak and Marshall Pease, ‘The Byzantine Generals Problem’ (1982) ACM Transactions on Programming Languages and Systems, Vol. 4, No. 3, 382–401 Available at: accessed 12 February 2018.

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it? Securities regulation responds precisely to this scenario. While we historically sought to address these issues through regulating institutions, markets and individuals constitutionally, computer scientists found a way how to ­algorithmically achieve a Byzantine fault tolerance (BFT) by treating the problem as an incentive problem. This is what Berg et al. refer to as the ‘Byzantine political economy’.69 Blockchain technology is designed with cryptoeconomics in mind by taking an engineering approach to designing economic mechanisms and incentives in order to achieve a Byzantine fault tolerance system. Cryptoeconomics is about designing an economic structure powered by economic incentives and cryptography in an adversarial ecosystem.70 Bitcoin is an example of a cryptoeconomics system – the blockchain technology was designed in order to transfer value in a decentralized and trustless network and a mechanism to reliably reach a consensus about the state of the Bitcoin’s blockchain. The proof-of-work mechanism incentivizes miners and simultaneously makes the hashing power required for a successful attack too expensive for adversaries. Like other blockchain technologies, Bitcoin too, uses a set of incentives, penalties and cryptographic tools as part of its design.71 In this context, ICOs play a crucial role not only in embedding a financing model with the cryptoeconomics logic, but more importantly ICOs are helping to fund the future blockchain technologies, where the high-risk and nascent nature of the product would not attract sufficient funding. More fundamentally, ICOs are helping to fund open-source projects of the future. Despite ICOs becoming an additional regulatory headache, there is an angle to seeing ICOs and the technology they are funding as the future decentralized economic layer of 69  On Byzantine political economy: “… computer science and economics – somewhat simultaneously working on a structurally similar problem – namely, decentralised coordination – and arriving at the same type of solutions – namely, consensus protocols and market institutions.” See Chris Berg, Sinclair Davidson and Jason Potts, ‘Byzantine political economy’ (RMIT University Blockchain Innovation Hub, 24 October 2017) Available at: accessed 17 March 2018. 70  BlockchainHub, ‘Cryptoeconomics’ (BlockchainHub) Available at: accessed 22 March 2018. 71  Bitcoin’s economic incentives reward miners with bitcoin, while they penalize potential attackers through high costs in terms of hashing power and electricity to attack the network. Public and private key cryptography is used to give network users control over their bitcoins and the hash function is used to achieve immutability and integrity of the data on the blockchain. Josh Stark, ‘Making Sense of “Cryptoeconomics”’ (Hackernoon, 17 November 2017) Available at: accessed 16 March 2018.

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capital markets.72 As for regulation, cryptoeconomics can be the new form of regulating markets with an engineering approach to information asymmetry or market manipulation.73 Challenge to VC Funds or State of Flux? The disrupting power of the ICO funding model is evident in the inter-play between ICOs and VC funds. It is an indication that ICOs are not merely a fad, but are seen as a novel way of capital formation. The token economics together with the democratization of funding create new market dynamics, positioning the ICO model as a more cost-effective form of financing. The ICOs’ new funding model is on a path to disrupt private investments, in particular venture capital funding. Following the impact that the Global Financial Crisis had on lending activities and the emergence of a shadow banking system, including VC funds or hedge funds, early-stage entrepreneurs with no functioning product or a proof-of-concept are incentivized to opt for ICOs, rather than traditional VCs. Traditional VCs target seed or start-up stage companies – the rationale is to invest in a company’s balance sheet and infrastructure, with a long-term exit strategy for the VC fund (5–10 years). Similarly to ICOs, VCs buy a stake in the entrepreneur’s idea and nurture it, but their main objective is to capitalize upon their exit with the help of an investment banker. VC investment is based on a cautious validation of the company’s business plan, product prototype and team validation, unlike in an ICO, where the funding is based on a whitepaper and more often than not a limited transparency as to the future governance and product development. The ICO issuers are not forced to dilute their equity in order to raise funds and the inclusive crowdfunding together with an efficient ICO process and a better timing when the capital is most needed, are more facilitative to capital formation than a traditional VC funding.74 In VC funding, the investment risk is borne by a single entity, whereas in an ICO, the risk is diluted among the vast pool of investors. ICOs lack a working product, 72  Within the context of ICOs, cryptoeconomics is expected to play a greater role in the way we design the token sale format. 73  A perfect example of this is the prediction market technology Augur that functions on a set of incentives and rewards for those users who behave according to rules making a decentralized prediction market viable. Josh Stark, ‘Making Sense of “Cryptoeconomics”’ (Hackernoon, 17 November 2017) Available at: accessed 16 March 2018. 74  Wulf A Kaal and Marco Dell’Erba, ‘Initial Coin Offerings: Emerging Practices, Risk Factors, and Red Flags’ (November 8, 2017). Forthcoming, Fintech Handbook, Florian Möslein & Sebastian Omlor eds., Verlag CH Beck (2018) U of St. Thomas (Minnesota) Legal Studies Research Paper No. 17–18 Available at 12.

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while VC engage with companies that have, at a minimum, a working product. Instead of devoting time to persuade VCs to invest in their business idea, startups can rely on their supporters who become invested in the business idea and not in capitalizing upon exit, once the company has been built-up for a sale or IPO. The collective ownership element that ICOs create is missing in VC funding, where the centralized funding model is at odds with the open-source blockchain technology. The numbers are reflective of this trend, with 2017 being the first year when ICOs overtook VC funding. Capital raised via ICOs has surpassed VC seed stage investment.75 Nevertheless, it is mistaken to say VCs failed to innovate themselves, instead what we are seeing is a greater interaction between the ICO market and VC funds. VC funds are gradually seeking new ways to capitalize on the ICO disruption to benefit them within their own business model. Currently, there are three ways in which VCs engage with ICOs: (i) VC funds invest in tech companies, which at a later stage decide to carry out a reverse ICO, (ii) VC funds may directly invest in an ICO, most commonly at a pre-sale at a significant discount and enjoy the early liquidity and (iii) VC funds invest in a tokenized VC fund. A tokenized VC fund is by far the most progressive form of VC funds reacting to ICOs. A tokenized fund is a hybrid between an ICO and a traditional VC investment. This hybrid model was launched by a VC firm Blockchain Capital in 2017, when Blockchain Capital set up a separate Blockchain Capital III Digital Liquid Venture Fund incorporated in Singapore, which under its subsidiary Blockchain Capital Tokenhub Pte Ltd launched an ICO to raise funds in order to invest in blockchain start-ups.76 The investors would be buying a digital token that represents a fractional ownership in the new fund and would in turn receive a portion of profits earned by the fund.77

Part B: Risks and Systemic Challenges

Despite the lure of ICOs as the progressive funding model of the 21st century, it does not escape scepticism and cause for concern. The majority of regulators 75   E Y, ‘Initial Coin Offerings (ICOs)’, (EY Research, December 2017) Available at: accessed 10 February 2018 2. 76  See Blockchain Capital http://blockchain.capital/. 77  See http://blockchaincapital.tokenhub.com/.

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have issued warnings on ICO-related risks and the International Organization of Securities Commissions (IOSCO) has labelled investments in ICOs as highly speculative.78 On the other hand, a study conducted by Adhami et al. at the Bocconi University on 253 ICOs carried out between 2014–2017 found that 81% of the projects achieved a fundraising success rate.79 However, to what extent this figure is indicative of the investment risk is debatable given the very recent trend in ICOs and the lack of transparency as to post-ICO product development. As a novel form of funding, ICOs come with a new set of challenges and risks. Small start-ups with few employees raise sometimes hundreds of millions of dollars, which inflate the potential risks for both investors and markets. Mixed with the current investment bonanza promising a high return, an understanding of these risks becomes important for industry participants and policymakers alike. The following sections describe a number of risks associated with investing in ICOs and more systemic challenges that may develop with a wider adoption of the funding model. The first category concerns the myriad of risks associated with the funding model itself, which include risks arising either from malpractices or due to the inherent characteristics of the ICO process. The second category concerns risks related to the blockchain technology used to distribute digital tokens (protocol-related risks, open-source risks, and data privacy). The third category includes regulatory and legal risks pertaining to the cross-border nature of ICOs, ICOs as disguised Ponzi schemes and scams, but also the cost of regulatory uncertainty in many jurisdictions. The fourth category covers market-related risks including illiquid secondary markets, ‘pump and dump’ schemes and the risk of devaluation and/or dilution of digital tokens. The fifth category considers of broader systemic challenges and the danger of the ICO market creating a financial bubble. i Risks Associated with the Funding Model Lack of Due Diligence ICOs operate in an unregulated space, targeting a wide spectrum of investors, from pre-teens investing their pennies, to quantitative hedge funds using artificial intelligence to trade digital tokens. The investors in ICOs do not enjoy comparable investor protection safeguards as investors in equity sales. Given 78   I OSCO, ‘IOSCO Board Communication on Concerns Related to Initial Coin Offerings (ICOs)’ (Media Release IOSCP/MR/01/2018, 18 January 2018) Available at: accessed 18 March 2018. 79  Saman Adhami, Giancarlo Giudici and Stefano Martinazzi, ‘Why Do Businesses Go Crypto? An Empirical Analysis of Initial Coin Offerings’ (20 October 2017). Available at: accessed 11 February 2018.

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the vast number of investors participating in an ICO, only a fraction will likely be familiar with the nuances of the technology they are investing in and with the myriad of investment risks they are exposing themselves to. The underlying projects are often of high technical complexity that require expertise to make an informed decision. With an increasing number of ICOs and lacking good practices, it has become difficult for investors to evaluate the projects’ soundness and the viability of the project’s token economy. No Tangible Product In a traditional start-up backed by a VC fund, the product development would have reached, at a minimum, a proof-of-concept stage or demonstrated its functionality. Based on the product or service offered, both VC fund analysts and investors can make an informed judgment on the future profitability of the company. This stands in contrast with ICO issuers, where the majority of start-ups rely on a mere concept or idea outlined in the published whitepaper. Essentially, token investors are investing in a business idea or a future promise of the idea associated with the platform, not a tangible product or service. The rationale behind the ICO funding model is to provide financing for early stage technology – this can include developing a network underpinned by blockchain technology or software applications – all of which will be at an initial development stage at the time that an ICO launches. Some of these technologies may prove in the process of product development to be unsuitable for the designated purpose and/or fail to deliver the expected utility for the users. There is always the risk that many ICO issuers will struggle post-ICO to fulfil their vision as outlined in a whitepaper in accordance with the investors’ expectations. For example, Tezos Foundation, following its $232 million ICO has found itself in a class action pursued by their investors who alleged little progress in developing the Tezos product and misleading the investors on material facts.80 ICO participants may consider themselves as investors, to whom ICO issuers may be required to disclose any information, which would have a material impact on their investment decision. Across the industry, a whitepaper is generally not considered to have an equal standing to a prospectus. By default, the ICO issuers are not subject to disclosure requirements, unless the digital tokens can be characterized as securities. In comparison, in traditional VC or equity financing models, investors receive equity in the company, which in turn 80  Anna Irrera and Steve Stecklow, ‘Tezos organizers hit with second lawsuit over cryptocurrency fundraiser’ (Reuters, 16 November 2017) Available at: accessed 9 February 2017.

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entitles them to a protection under various regulatory regimes and gives them legal redress against the company. This risk underlines the reversed nature of ICO funding as an early liquidity event – first the start-up does the funding and only later the product is developed. Indeed, Token Report, a company specializing in keeping a record of ICOs and token sales, stated that of the 226 ICOs analysed, only 1 in 10 tokens was being used in practice with a utility purpose, while the rest only carried an investment and speculative function, underling the reality that the product development stage is risky.81 Lack of Transparency The lack of transparency on the credibility of the business idea and the team behind it does not allow for investors to make an informed decision. The lack of transparency conceals many investment risks, which may materialize during the product development, since the team attempts to market their business idea in the most favourable light. Not all whitepapers will guarantee a standardized description of the structure of the business model or the tokens to support it on a par with prospectus requirements which must include all information that would materially influence the investor’s decision. Fuelled by the interest to invest early and reap benefits, investors are forced to carry out their own due diligence. With the lack of disclosure requirements and no auditing by an independent authority, the steps ICO investors take to scrutinize the ICO become crucial in order to build up credibility not only in the product itself, but in the overall ICO market.82 As not all investors will have expert technical knowledge of the blockchain technology, they will rely heavily on the information provided in the ICO’s whitepaper, the team, and its advisors behind the project. Missing Gatekeepers In capital markets, the traditional gatekeepers are a set of actors and institutions, including credit rating agencies, auditors and securities analysts, who evaluate a company’s creditworthiness, finances and business prospects. In the ICO market, there are no auditing requirements and such external advisors as there are, have little or no expertise in advising on an ICO and are often found 81  Olga Kharif, ‘Only One in 10 Tokens Is In Use Following Initial Coin Offerings’ (Bloomberg, 23 October 2017) Available at: accessed 11 March 2018. 82  Wulf A Kaal and Marco Dell’Erba, ‘Initial Coin Offerings: Emerging Practices, Risk Factors, and Red Flags’ (November 8, 2017). Forthcoming, Fintech Handbook, Florian Möslein & Sebastian Omlor eds., Verlag CH Beck (2018); U of St. Thomas (Minnesota) Legal Studies Research Paper No. 17–18. Available at 6.

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to be engaged with multiple ICO projects. Instead, investors rely on promises made in whitepapers to be encoded by smart contracts. As this section aims to demonstrate, there is little evidence in practice to affirm that indeed the governance of the issuance is encoded to protect the investors. The role of traditional intermediaries is to give the project credibility, given the lack of transparency highlighted earlier. Yet, their advice is given on an ad hoc basis with no credible guidance given to the project team. Investors may be misled to invest by teams with short-term objectives that merely seek quick liquidity in order to move on to another project. Such an approach is in contrast to the traditional funding models, where diligent vetting takes place and the team is expected to have a vested interest in carrying out the project in a long-term. The early liquidity based on a potentially low-transparency may be linked to the post-ICO volatility.83 By analogy, the function of credit rating agencies to rate the creditworthiness of traditional securities and act as information intermediaries, is fulfilled in the ICO market by websites claiming to list ICOs and their ‘token-worthiness’. The seemingly transparent and objective assessment they offer is often at odds with the listings being either sponsored by ICOs issuers themselves or demands for ICO tokens in return for a favourable rating. Instead of serving a mediating role in the information asymmetry, entities offering vetting and rating service may end up exacerbating the information asymmetry. A similar issue plagues the credit-rating agency industry, which is based on an issuer-pays model. Currently, self-policing by market participants is resurfacing on an ad hoc basis, whether through research think-tanks or proprietary solutions are being developed by websites and crypto-exchanges.84 A counterargument suggests that with the entry of VC funds into the ICO market, they may take on the gatekeeper role, given their breath of knowledge on start-ups. This argument is valid only if we assume that all VCs have the identical strategic objective to develop the ICO product and push for an exit strategy down the road. Instead, however, VCs may have no interest in the ICO product and opt to diversify their portfolio and leverage on the early liquidity offered through crypto-exchanges. Sheer speculation instead of constructive engagement may be the leading objective. 83  Wulf A Kaal and Marco Dell’Erba, ‘Initial Coin Offerings: Emerging Practices, Risk Factors, and Red Flags’ (November 8, 2017). Forthcoming, Fintech Handbook, Florian Möslein & Sebastian Omlor eds., Verlag CH Beck (2018); U of St. Thomas (Minnesota) Legal Studies Research Paper No. 17–18. Available at 16. 84  Coinschedule, a leading ICO website has developed a proprietary algorithm Coinschedule Trust Score, which uses artificial intelligence to determine ICO scoring and the level of ‘trust’ in each ICO project being listed. See Coinschedule, https://www.coinschedule .com/.

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Lack of Corporate Governance and Accountability The traditional expectation on the part of ICO investors would be that a startup has a solid team, which is gradually building up its business model upon the completion of the ICO. The opposite is often true and the team behind a whitepaper may be an ad hoc assembled project team. To complicate matters further, there is virtually no corporate governance framework in place, as opposed to a company with shareholders who are entitled to exercise control/ influence over the company’s management team. A successful ICO rests on an incentive alignment between the ICO issuers and the investors. Misalignment of incentives or disagreement on the business strategy can adversely impact investors’ expectations. In addition, it is not uncommon for ICO issuers to change the direction of their business strategy, once they enter the product development stage. The investor expectations based on a whitepaper are likely to be frustrated and lead to capital inefficiency. The same applies to the postICO developments, when the lack of mandatory disclosure results in a lack of transparency. A failure to disclose material information during the project development may be construed as de facto misleading. Unfortunately, the ICO funding model is not currently under disclosure requirements and disclosure remains a matter of good practices. The matters can be aggravated by the management’s execution abilities and a non-existent revenue stream. In a traditional VC funding, the VC side provides operational experience and guidance for the start-up team. In contrast, following an ICO completion, the start-up begins to burn cash on product development. There is no revenue to offset the costs and it is only with prudent financial forecasting that the ICO issuer will cater for its future expenditure until the product/service is developed. Theoretically, governance-related risks may be elevated either by investors asserting control over the ICO issuer or the ICO entity having a decentralized governance structure instead of having a centralized management team, such that decisions are taken upon the approval of token holders. Alternatively, the post-ICO governance model may improve and borrow ideas from the typical venture capital milestone-based financing, whereby the ICO proceeds would be distributed to the ICO issuer in milestones through the use of smart contracts. Dilution Linked to corporate governance is the risk of dilution. The ICO issuers may decide to raise more funds by issuing another round of tokens or alternatively, altering the functionality of the token. Such decisions cause uncertainty and increase the volatility of the token valuation, while exposing investors to

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significant risk, which often is beyond their control or prediction. The ICO investors may not have anti-dilution protection or recourse to control the ICO management team’s decision-making, unless having negotiated for such control prior to the ICO. Opportunistic dilution could be managed either through stronger governance safeguards or escrow accounts, which would prevent the stored tokens from being released, thereby minimizing token price volatility and the effect on diluting the existing investors’ tokens. Additional rounds of token offerings may be ‘a signal that the management team is losing confidence and planning to cash out, or that the project is costing more than anticipated’.85 Marketing and ICO Sale Format The ICO sale format and the marketing that precedes it have a crucial impact on subsequent token valuation and may either introduce or manage investor risk. Prior to the ICO, the ICO issuers are commonly engaged in aggressive marketing tactics, making representations, which would otherwise be subject to the traditional securities regime’s disclosure requirements. Furthermore, unaccountable parties including, celebrities, marketing companies, online promoters induce prospective investors, while falling below the standards of disclosure requirements. The ICO sale format may vary depending on the needs of developers and influence the token price discovery, leading to either high volatility or underpricing of the token. As the traditional market mechanisms of price discovery are not applicable, the sale format may play a greater role in price formation. There is disagreement between practitioners which sale format yields the most efficient token price discovery. The ICO sale format has evolved, with the most common types being ‘capped’ or ‘uncapped’ sales, and more recently the so-called ‘reverse Dutch auction’. Each has a different impact on the token valuation – a capped token sale is more likely to lead to oversubscription, increasing the token valuation post-ICO, as the supply cannot keep up the demand. In an uncapped sale, the ICO participants have a higher uncertainty about the valuation of the token, as the number of tokens released is unknown. Darryl Morris argues that the reverse Dutch auction model may be a more orderly format for token sales and a means to eradicate the irrational behaviour

85  John Conley, ‘Blockchain and the Economics of Crypto-tokens and Initial Coin Offerings’ (2017) No. 17-00008, Vanderbilt University Department of Economics Working Papers, Vanderbilt University Department of Economics Available at: accessed 10 August 2018, 10.

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surrounding ICOs.86 Each format has its own advantages and disadvantages, which are subject to an on-going debate.87 Regardless of the merit of each ICO format, Vitalik Buterin offers an overview of what an ideal token sale format should look like: there should be a certainty of valuation for the investors and a certainty as to the number of tokens being issued and retained by the ICO issuer, a certainty of participation in the sale, a capping on the amount being raised and the token sale issuer should not retain a large percentage of the tokens.88 Such a model may ensure efficiency and investor protection, however as Buterin notes, some of these elements are in practice contradictory and the quest for the killer-token sale format is not over.89 Another element of the sale format that influences the token value volatility is the pre-sale discount. Prior to an ICO, a start-up may engage in a token pre-sale, targeting larger investors. The token value is subject to a discount. These investors often buy in bulk and once the ICO is over, are free to dump the discounted tokens on the market, causing the token value to crash. ii Technology-Related Risks No Utility behind the Blockchain With blockchain and cryptocurrencies being the latest hype among investors, a new tech project will immediately attract the attention of investors, even though the real utility of the blockchain technology or of the token as an integral element to the blockchain may be non-existent. Without expert knowledge in blockchain technology, it is difficult for investors to assess the business rationale for the blockchain or for the token. EY has analysed 372 ICO projects

86  In a Dutch auction model the investor decides first what he considers to be the highest valuation and when the sale starts, instead of immediately buying the token, the investor waits until the valuation drops to below that level, upon which he instructs the transaction. Darryl Morris, ‘Direct To Market Reverse Dutch Auction on Intrinsically Tradable Tokens’ (Medium, 13 June 2017) Available at: accessed 11 February 2018. 87  For a detailed overview of the ICO sale formats, see Vitalik Buterin, ‘Analyzing Token Sale Models’ (Vitalik Buterin, 9 June 2017) Available at: accessed 18 February 2018. 88  Vitalik Buterin, ‘Analyzing Token Sale Models’ (Vitalik Buterin, 9 June 2017) Available at: accessed 18 February 2018. 89  Vitalik Buterin has been a proponent of the so-called DAICO sale format, which combines an ICO with a decentralized autonomous organization model (DAO), offering an arguably more accountable model. For an in-depth assessment of DAICO, see Andras Kristof, ‘DAICO Attack Vectors and Solutions’ (Medium, 13 March 2018) Available at: accessed 21 March 2018.

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and concluded that ‘the need for a blockchain and token is often unjustified’.90 Without functional utility, the investment in the token and the future utility for the token holder may be worthless. Open-Source Risk The majority of ICOs rely on open-source software that carries inherent security risks. Open-source software is made available to the public that can read its code line-by-line. There is always a danger of individuals maliciously attempting to exploit the code’s weaknesses in order to extract sensitive information or misappropriate digital tokens. Researchers at the National University of Singapore analysed 19,366 smart contracts in the Ethereum network and found that 8,833 contracts (46%) had potentially documented bugs.91 This is a significant number, given that the majority of ICOs use the Ethereum platform. Protocol-Related Risks Another functional risk that may impact the viability of the product development is the use of the underlying platform, as the projects are blockchainbased. Whether it is a malfunction, forking or other technical fault affecting the functioning of the underlying protocol, it will have adverse effects on the product development and the issuance of tokens.92 The majority of ICOs run on the Ethereum public blockchain, which continues to suffer from scalability issues. The number of transactions that can be carried out on public blockchains is limited and the burden to execute an increasing number of ICO-related transactions translates into longer transaction execution and overloading of the

90   E Y, ‘Initial Coin Offerings (ICOs)’, (EY Research, December 2017) Available at: accessed 10 February 2018, 2. 91  Loi Luu et.al, ‘Making Smart Contracts Smarter’ (24–28 October 2016) CCS ’16 Proceedings of the 2016 ACM SIGSAC Conference on Computer and Communications Security, 254– 269, 255. 92  Forking is a technical term that describes the process of a blockchain splitting into two branches. Forking occurs as a result of significant changes or ‘divergences’ to a blockchain. We distinguish between and ‘hard fork’ and a ‘soft fork’. Hard fork occurs when the code underpinning the technology is changed, in particular when there is an update to the consensus rules that govern the blockchain nodes’ behavior. Hard fork is a substantial and permanent change and the new blockchain is no longer compatible with the former blockchain for transactional purposes. In contrast, following a soft fork, the new blockchain remains compatible in a manner that the transactions on the old blockchain are recognized by the new nodes as valid.

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network. Network over-congestion remains an on-going issue to be addressed by the Ethereum Foundation.93 The technical functionality of a token is defined in smart contracts, which are prone to coding errors.94 Similarly, cryptography is a continuously developing field and subject to code cracking. Quantum computing puts the immutability of blockchain technologies to question, as quantum mechanics holds the promise of cracking the public key cryptography, upon which today’s blockchain technologies rely.95 Cyber Security Risk Cyber security risks are not unique to ICOs and may inflict any internetconnected systems and networks. ICOs and other crypto-related providers can protect themselves from cyberattacks by operationalizing a solid cyber security framework or best practices methodologies. The constantly evolving nature of cyber risks requires market participants to efficiently identify the major risks and protect the system components that are the most vulnerable to attacks. In the crypto market, Investors are exposed to cyber security risks during the digital token issuance, post-ICO completion and while trading their tokens on secondary markets through crypto-exchanges. The risks may include disruption of business, reputational damage and financial loss due to the operating systems functioning without adequate safeguards. At every point of managing, transferring or storing tokens, there is an exposure to financial loss. Most commonly, it is the crypto-exchanges and investor’s wallets which are exposed to malfunctions, theft or simply technical deficiencies.96 To ensure 93  Continuous efforts to address scalability are underway. Investors are advised to keep abreast of new developments. 94  For an overview of technical issues associated with public blockchains, see: EY, ‘Initial Coin Offerings (ICOs)’, (EY Research, December 2017) Available at: accessed 10 February 2018. 95  Blockchain technologies use cryptographic protocols that imbue the network with security. Theoretically, quantum computers may break the blockchain’s security either by cracking the nodes’ cryptographic keys or by mining. See Divesh Aggarwal et al., ‘Quantum attacks on Bitcoin, and how to protect against them’ (18 October 2017) Centre for Quantum Technologies, National University of Singapore Available at: accessed 10 May 2018. 96  Discussed in detail in Kevin V Tu and Michael W Meredith, ‘Rethinking Virtual Currency Regulation in the Bitcoin Age’ (2015) 90 Washington Law Review 271 and EBA, EBA Opinion on ‘Virtual Currencies’ Available at: accessed 10 March 2018 25–33 Available at: accessed 11 March 2018.

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liquidity, crypto-exchanges may request access to the investors’ private keys.97 Buying or selling cryptocurrency through an exchange may entail the surrender of private keys to the user’s wallet. Some of the largest crypto-exchanges including Coinbase or Poloniex hold the users’ funds on their servers. Crypto-exchanges prefer to hold the users digital tokens in custody in order to ensure sufficient liquidity at all times which comes at the expense of security. In 2018, one the largest crypto-exchanges, Coincheck, was hacked with 260,000 users affected and causing a loss of $500 million to its users.98 Coincheck is a centralized crypto-exchange and having kept its customers’ assets in a hot wallet, it exposed them to increased cyber risk.99 A live ICO is a prime target for hackers, which can take the form of malicious denial of service to disrupt the sale, exploitation of a weakness in a smart contract code, cyber-attack through company employees or IT infrastructure, hacking of the official website or phishing. The ICO of TenX illustrates the volume of scammers attempting to disrupt and exploit the ICO process. Prior to and during the ICO, the scammers attempted to duplicate the TenX website, listing their own contribution address and attempted to impersonate the ICO team by directly contacting the ICO participants.100 The digital token issuance may also become susceptible to network attacks – most commonly the denial of service attacks. EY in its report analysed 372 ICO projects and found that more than 10% of the proceeds were intercepted and stolen by hackers. There have also been instances of data leaks where hackers got access to investors’ personal information, which was provided to ICO issuers.101 Security loopholes pose a major risk for investors who are at risk of losing money and having their data privacy breached. CoinDash suffered an ICO hack in which $7 million was stolen from investors trying to participate in the company’s ICO. The hackers copied the ICO’s website and instructed investors to send funds to

97   Izabella Kaminska, ‘Time to re-evaluate blockchain hype’ (FTAphaville, 3 August 2016) Available at: accessed 27 February 2018. 98  Coincheck, Available at: https://coincheck.com/. 99  Unlike cold wallets, hot wallets are connected to the Internet. Hackers cannot steal digital tokens in a cold wallet, as they are commonly stored on external hardware. Hot wallets are vulnerable to hackers as they are online. 100  TenX, ‘Reflecting on a highly successful TenX tokensale’ (TenX Blog, 26 June 2017) Available at: accessed 7 February 2018. 101   E Y, ‘Initial Coin Offerings (ICOs)’, (EY Research, December 2017) Available at: accessed 10 February 2018.

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their fraudulent token sale smart contract address.102 In such scenarios, investors bearing losses may want to seek re-compensation from the ICO issuer for breach of contract or negligence in executing the ICO. To what extent there is an avenue for legal redress depends on the ICO’s Terms & Conditions. In the majority of cases, ICO issuers are protected from legal action by a series of warranties and refrain from making any disclosures or representations in their whitepaper, leaving investors with little legal redress.103 Data Security Prior to an ICO, the ICO issuers obtain personal data of the investors for KYC purposes. ICO issuers must comply with data protection obligations whenever they collect, use or disclose the personal data of residents of particular jurisdictions. Compliance with the personal data protection obligations is costly and requires robust information governance, data security and disaster management frameworks to be implemented by the ICO issuer.104 A prospective investor is not in a position to know whether a required data security framework has been implemented and runs the risk if that is not the case. For example in the European Union, the General Data Protection Regulation (GDPR) (EU) 2016/679 will be applicable with its extra-territorial effect to those ICO issuers which capture and process personal data of subjects residing in EU regardless of where the ICO issuer is incorporated outside of EU.105 iii Regulatory and Legal Risks There is a spectrum of legal risks that investors may be subject to, starting from the ICO sale format to the ICO issuer’s liquidation. Given the commonly unregulated space in which ICOs operate, ICO issuers are subject to the possibility of future regulatory intervention. Apart from more sophisticated ICOs which receive professional legal advice, there is a general lack of legal transparency and 102  Alexandria Arnold, ‘CoinDash Says Hacker Stole $7 Million at Initial Coin Offering’ (Bloomberg, 18 July 2017) Available at: accessed 11 February 2018. 103  There is room for an argument that the ICO’s Terms & Conditions are subject to contract law, see Part C Section iv. 104  More on data protection in Singapore see Simon Chesterman (ed.), Data Protection Law in Singapore: Privacy and Sovereignty in an Interconnected World (2nd edition; Singapore: Academy Publishing, 2018). 105  Regulation (EU) 2016/679 of the European Parliament and of the Council of April 27, 2016 on the protection of natural persons with regard to the processing of personal data and on the free movement of such data, and repealing Directive 95/46/EC, [2016] OJ L119/1 (adopted on April 27, 2016, entered into force 25 May 2018) (GDPR).

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as Zetzsche et al. note, in 85.8% of ICOs analysed by their research, there was no information as to the regulatory status of the ICOs.106 The regulatory, legal and criminal activity-related risks arise in the context of: regulatory uncertainty, ICOs’ cross-jurisdictional nature, uncertainty over liquidity preference in case of an ICO issuer’s bankruptcy, the legal standing of investors in a so-called ‘reverse ICOs’, ICOs disguised as Ponzi schemes and scams, money laundering and other illicit activities, insider trading and market manipulation. Regulatory Uncertainty Regulatory uncertainty is a double-edged sword for the ICO market. On one hand, ICOs are taking advantage of regulatory arbitrage by carrying out token issuance in markets where there is either no direct regulation of ICOs or the regulators are taking a wait-and-see approach.107 On the other hand, regulatory uncertainty opens the door to the so-called ‘Black swan risk’, which refers to the possibility of an unexpected event exposing the investor to market risk.108 The exposure of the ICO market to black swan risk is magnified by the concentration of crypto-exchanges and crypto-enthusiasts in particular jurisdictions. This was the case in China in 2017, when the government prohibited the trading of cryptocurrencies and the issuance of digital tokens with a major impact on cryptocurrency prices. Jurisdictional Uncertainty and Arbitrage ICOs operate through online channels and their target markets span across national borders. The difficulty in applying rules in a transnational context is evident in the way that regulators are struggling to regulate an activity that is digital in nature and that takes advantage of jurisdictional arbitrage. The jurisdictional scope becomes relevant when attempting to pinpoint the law of the jurisdiction applicable to a given ICO. Is it the law of the jurisdiction where the ICO issuer is incorporated, where the token purchasers are located or where the tokens are meant to be issued? By virtue of operating in a legally grey area, the ICO issuer can take advantage of the jurisdiction with a lighter 106  Dirk Zetzsche, Ross Buckley, Douglas Arner and Linus Föhr, ‘The ICO Gold Rush: It’s a Scam, It’s a Bubble, It’s a Super Challenge for Regulators’ (February 1, 2018). University of Luxembourg Law Working Paper No. 11/2017; UNSW Law Research Paper No. 83; University of Hong Kong Faculty of Law Research Paper No. 2017/035; European Banking Institute Working Paper Series 18/2018. Available at: accessed 7 February 2018, 10. 107  See Appendix 2. 108  Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable (Random House, 2017).

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regulatory burden. There is an inherent difficulty in regulating an entity with a cross-border corporate structure and a technology that is virtually everywhere. A simple matter such as the sale of tokens on secondary markets may become problematic. For example, the legal requirements pertaining to an assignment of tokens will differ across jurisdictions and may pose an obstacle in instances where the digital tokens are being transferred across borders. The legal basis for the transfer of digital tokens is not clear and it is open to a future dispute whether a new token holder would be in a position to enforce a proprietary right over a digital token against a third party in circumstances when the digital token was misappropriated or stolen. Likewise, the principles of contract and title may differ significantly, leaving the investor in an un-known. Unless the parties agree on the inclusion of an exclusive governing law and jurisdiction clause in advance, it is open to question how the parties will determine which laws apply or which forum will handle the dispute. Whether the determination will be by reference to the location of ICO issuers’ servers or the location of the investors themselves is yet to be seen in practice. Generally, an ICO’s whitepaper and/or Terms & Conditions will have a clause limiting the jurisdictions in which the digital tokens may be offered. Nevertheless, unless the ICO runs a pre-sale KYC, there is nothing preventing investors in the excluded jurisdictions from participating. IOSCO has released a similar warning on the amplification of risk to investors if home regulators cannot effectively pursue bad actors.109 Pre-Sale ICO and Saft With increased interest from accredited investors and VC funds, more ICO issuers are opting to run a pre-ICO or a pre-token sale in the form of a private sale. The most important legal consideration for investors is whether the presale constitutes a regulated investment activity and how it differs from a digital token sale. The question is further complicated by the way ICO issuers decide to structure the pre-sale. Given the variety of pre-token sales, investors are in a better position if they consider the substance, rather than the form of the sale, as regulators are more likely to judge on a case-by-case basis. There are three ways to approach the pre-token sale: (i) if the main token is a security or another regulated product and the pre-sale agreement gives the investors 109   I OSCO, ‘IOSCO Board Communication on Concerns Related To Initial Coin Offerings (ICOs)’ (Media Release IOSCO/MR/01/2018, 18 January 2018) Available at: accessed 15 March 2018 Also see generally IOSCO report on the challenges which the Internet enabled technologies create for regulators: IOSCO, ‘Report on Securities Activity on the Internet III’ (IOSCO, 2003) Available at: accessed 18 March 2018.

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rights to the main token, the pre-sale may constitute an offering of securities, (ii) the pre-token sale may be structured as a separate instrument convertible to tokens once they are issued, or (iii) through a legal framework developed in the U.S. called a ‘simple agreement for future tokens’ (SAFT).110 SAFT has been developed as a compliant framework for token sales in line with U.S. securities regulations. Despite the promise to offer compliance with securities laws, investors need to be aware that SAFT may not be legally recognized in the same manner as in the U.S. or given the promised level of legal protection. SAFT was published as a whitepaper by law firm Cooley LLP and Protocol Labs as a self-regulatory legal document that is designed for accredited investors. The ICO developers enter into a SAFT contract with the accredited investors who buy the right to the future digital tokens once the project is completed, while relying on the exemption under Rule 506(c) of Regulation D of the Securities Act (allows for a general solicitation to verified accredited investors). The SAFT contract is treated as an investment contract that relies on the exemption from registration of securities, hinging on the expectation that once the digital tokens are issued, they will not be legally treated as securities.111 Cooley LLP’s case for SAFT’s compliance rests on a reasoning that pre-functional utility tokens are vulnerable to being treated as securities, while a functional token is less so. Functionality is a key element allowing SAFT to satisfy the Howey test for establishing whether a token is a security.112 The Howey test has four prongs which need to be satisfied: (i) whether there exists an investment of money, (ii) whether there exists a common enterprise, (iii) whether there exists an expectation of profits, and (iv) whether the expectation of profits is solely from the efforts of others. If all prongs are satisfied, then a contract, scheme, or arrangement passes the Howey test and the token in question will constitute a security. Cooley LLP’s interpretation of the Howey test states that two elements of ‘the expectation of profits’ and ‘solely from the efforts of others’ can be avoided if the SAFT is limited to a sale of prefunctional tokens.113 This reasoning has been subject to numerous criticisms, 110  See ‘The SAFT Project’ https://saftproject.com/ The SAFT contracts have been modelled akin to the Simple Agreement for Future Equity (SAFE) contracts used in the start-up sector. 111  Juan Batiz-Benet, Marco Santori and Jesse Clayburgh, ‘The SAFT Project: Toward a Compliant Token Sale Framework’ (SAFT Project, 2 October 2017) Available at: accessed 10 March 2018. 112  Securities and Exchange Commission v. W. J. Howey Co., 328 U.S. 293 (1946). 113  The reasoning is that with a pre-functional token, an expectation of profit predominates over the expectation of utility and the investors are relying on the efforts of the ICO developers to deliver the functionality. However, once the tokens are issued, they cannot be considered as security tokens, if they acquire utility with the functioning network. The

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most commonly pointing out that SAFT proponents are relying on an expectation that the future tokens will be characterized by the regulators as utility tokens.114 The purchase of tokens through a SAFT, rather than a direct issuance does not, however, affect the analysis carried out to determine whether tokens are securities, and may be misused as a mechanism to circumvent securities regulation later on. A mere reliance on an exemption pre-token development does not guarantee investors that upon issuance, the tokens will not constitute securities. From this point of view, SAFT appears nothing more than another symptom of regulatory uncertainty. Liquidation Preference and Asset Classification Prima facie, the token holders in a case of the ICO issuer’s bankruptcy do not have the advantage of a liquidation preference. Most often, the ICO whitepaper is silent on asset classification upon bankruptcy and the investors are left with little to no recourse after the debt holders or third party creditors are satisfied during the liquidation. ICO bankruptcy proceedings have not been reported as of May 2018 and given the legally grey area in which ICOs operate, it is not surprising that there is no framework for bankruptcy proceedings. Theoretically, if the utility token holders can establish a contractual claim against the ICO issuer, they may be considered as unsecured creditors. If the tokens can be construed as securities, then the liquidity preference will be governed under the relevant statutory insolvency provisions. In such case, token holders who can be construed as unsecured creditors would be in a better position to recover their initial investments rather than as shareholders. The priority waterfall of claims will apply. However, the status in insolvency proceedings will depend on token type and the rights it confers. It is beyond doubt that by virtue of being a token holder, one cannot enjoy a status of a secured creditor. Nevertheless, there is room for arguing that if the token holder is being owed a service or good, the utility owed creates some form of debt obligation, thereby giving him a status of an unsecured creditor. market dynamics will substitute the ICO developers and the investors will no longer rely on their efforts as the supply and demand of the market will determine the expectation of the profit. 114  For a comprehensive analysis and critique of the SAFT, see: Cardozo Blockchain Project, ‘Not so fast – risks related to the use of a “SAFT” for token sales’ (Research Report #1, 21 November 2017) Available at: accessed 11 March 2018. The authors are correct in pointing out that the SAFT framework does not work for tokens which can be classified as securities and is over-reliant on the pre-sale token being classified as a utility token.

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Reverse ICOs and Legal Risks Reverse ICOs are conducted by established mid-size or large companies, whereby token-based equity is sold via an ICO, despite the company having obtained prior VC or angel funding. Kik Interactive Inc. has been reported to have completed a reverse ICO raising $100M USD.115 Interestingly, Kik has previously raised financing through a number or funding rounds with a unicorn valuation of $1 billion USD.116 The reverse ICO is particularly suitable for VC portfolios with ‘middle-performer’ companies with a solid customer base, but with little potential to be either acquired or go public. A reverse ICO offers better valuation for tech companies with a high product utility, but weak revenue model. These companies benefit from the token economics modifying their business model, but also attracting additional financing. Reverse ICOs may be a new VC tool for investors to exit their portfolio companies, but existing legal agreements in the VC sector will need to be revised to account for the possibility of reverse ICOs. In situations where VC investors do not exercise control over the company’s board, it remains to be seen whether the VC investors have protective rights under a Certificate of Incorporation or whether they are in a position to prevent the company pursuing a reverse ICO. A reverse ICO may become a diluting event if a company decides to issue equity tokens after an IPO.117 The main concern here is with the existing equity investors who need to ensure that the ICO does not dilute their existing interest, impact the valuation of the underlying business and effect the pre-existing exit strategy. Taxation Neither investors nor ICO issuers should be under an illusion that tax considerations are not applicable to an ICO or to trading tokens on secondary markets. Not all jurisdictions will have addressed the taxation of digital tokens and the ICO proceeds. Indeed, tax law is reactive in nature. Nevertheless, if ignored, both groups may face a hefty tax bill and/or fine. How the ICO issuer will be 115  John Russell, ‘Kik raises nearly $100M in highest profile ICO to date’ (TechCrunch, 27 September 2017) Available at: accessed 10 February 2018. 116  Steve Tweedie, ‘Messaging app Kik just raised $50 million to become the newest member of tech’s billion-dollar unicorn club’ (Business Insider US, 18 August 2015) Available at: accessed 15 March 2018 and Erin Griffith, ‘Kik, a messaging app that’s popular with teenagers, is now worth $1 billion’ (Fortune, 18 August 2015) Available at: accessed 15 March 2018. 117  This would be the case if the equity tokens issued would have voting rights or dividends rights attached to them.

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taxed for the funding obtained in an ICO will depend largely on the corporate structure of the ICO, the jurisdiction of incorporation and the jurisdiction of issuance. In practice, taxation has become a determinative factor for choosing a jurisdiction for incorporation and the issue of tokens. Proceeds from an ICO may be taxable as income or a capital gain. To establish whether the token issue will be taxable, the token structure has to be determined a priori. Similarly, the nature of the token itself may be determinative of the tax regime applicable. For example in Singapore, the tax treatment of cryptocurrencies, their issuance and trading have been partly addressed by the Inland Revenue Authority of Singapore (IRAS). The IRAS maintains that businesses that buy and sell cryptocurrencies in the ordinary course of their business will be taxed on the profit derived from trading in the virtual currency.118 When trading cryptocurrencies for long-term investment purposes, the business will be exempted from taxes, as there are no capital gains taxes in Singapore. Whether the ICO proceeds are taxable will depend on characterizing the ICO proceeds as income or capital gain (Income Tax Act (Cap. 134)). To determine whether the proceeds constitute income, the IRAS will most likely look at the nature of the tokens and whether the ICO proceeds are from a corporate entity based in Singapore or foreign-sourced.119 As for the nature of the tokens, the distinction between utility tokens and other non-utility tokens may result in the sale proceeds of the former being considered as income and the latter as capital gain. If an investor purchases a utility token, it is open to question whether the token constitutes a form of pre-payment and consequently, whether the tax authority will tax it at the point of purchase or point of delivery of the service/ product being developed. This uncertainty is a direct result of the utility tokens not being of a use to the purchaser until the blockchain product/service has been developed. At what point are utility tokens taxable will depend on caseby-case basis and the wording of the whitepaper or related documents that accompanied the purchase. The ICO issuer may also be subject to GST under the Goods and Services Tax Act (Chapter 117A) for any supply of goods or services carried out in Singapore. As for individuals that are trading cryptocurrencies, 118   I RAS, ‘Income Tax Treatment of Virtual Currencies’ (IRAS) Available at: accessed 17 March 2018. Singapore’s tax system is semi-territorial in nature and the ICO issuers will need to make the case that the ICO proceeds have been a foreign-sourced income. IRAS will consider territoriality based on the ICO issuer corporate structure, where the main functions are performed and the source of the income. 119  The taxability of income will depend on where the ICO proceeds were sourced and received.

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the buying and selling is viewed as a personal investment (capital income) and is not taxable in Singapore. Ponzi Scheme and Scams The most notable investor risk is often the result of the ICO participants’ actions themselves. Scams and Ponzi schemes concealed as ICOs threaten the health and credibility of the ICO market. Satis Group produced a report suggesting that 78% of ICO projects launched in 2017 were scams.120 A lot of ink has been spilt on calling ICOs Ponzi schemes or outright scams, operating in an unregulated ecosystem with very few checks and balances.121 In 2018, a Vietnamese company Modern tech disappeared upon ICO completion with $660 million USD, which it raised from approximately 32,000 investors, many of whom were retail investors.122 Retail investors are unlikely to pursue actions and with a low number of institutional investors, only few cases have been reported in the media. Given the cross-border nature of ICOs, investors run an additional risk of their investment monies travelling abroad, with regulators left unable to effectively pursue bad actors and recover funds.123 Given the lack of transparency and gatekeepers attesting to the credibility of the ICO project, bad actors have the opportunity to abuse the missing regulatory 120   Satis Group, ‘Cryptoasset Market Coverage Initiation: Network Creation’ (11 July 2018) Available at: accessed 18 July 2018. 121  David Z Morris, ‘The Rise of Cryptocurrency Ponzi Schemes’ (The Atlantic, 31 May 2017) Available at: accessed 17 February 2018 Brian Kean, ‘Don’t believe the hype. The five largest “ICO exit scams”: Expert Take’ (Cointelegraph, 19 February 2018) Available at: accessed 20 February 2018 Camila Russo, ‘A Clue to the Latest ICO Scam May Have Been Hidden in the Name’ (Bloomberg, 30 January 2018) Available at: accessed 16 February 2018 Pavel Kravchenko, ‘is the ICO market currently a Ponzi?’ (Medium, 16th September 2017) Available at:

accessed 18 March 2018 Chris DeRose, ‘Dear SEC: ICOs & “Tokens” are killing innovation’ (Hackernoon, 31 March 2017) Available at: accessed 18 March 2018. 122  See Pincoin, https://news.pincoin.io/ and John Biggs, ‘Exit scammers run off with $660 million in ICO earnings’ (TechCrunch, 13 April 2018) Available at: accessed 18 April 2018. 123   S EC Chairman Jay Clayton, ‘Statement on Cryptocurrencies and Initial Coin Offerings’ (Public Statement, 11 December 2017) Available at: accessed 20 March 2018.

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checks by fraudulently presenting a project and disappearing with the collected funds. Since late-2017, the U.S. Securities and Exchange Commission (SEC) has been actively pursuing fraudulent ICOs. For instance, in January 2018, the SEC has halted an allegedly fraudulent AriseBank ICO that targeted retail investors to fund what it claimed to be the world’s first ‘decentralized bank’ on the basis of a fraudulent offering and risk of asset dissipation. AriseBank used celebrity endorsement and social media among others to raise its $1 billion USD goal, falsely stating that it purchased a FDIC-insured bank and that it would offer VISA cards to spend cryptocurrencies.124 Money Laundering and Illicit Activities Money laundering and other illicit activities including dark web dealing or terrorism financing will plague those ICOs and crypto-exchanges which suffer from poor AML and KYC practices. The main concern is the pseudonymous nature of investing, with buyers hiding behind encrypted wallets. Money launderers can invest in ICOs and benefit from the instantaneous transfers and anonymity. Money launderers cash in illegal proceeds by buying tokens from ‘clean token holders’ and cash out on tokens, which are not tied to their criminal enterprise. This process is further enabled by the functioning of cryptoexchanges with poor internal practices and those crypto-exchanges that list tokens which allow for either complete anonymity or do not require registration with personal details. Wall Street Journal’s investigation tracked wallets associated with criminal activity and estimated that nearly $90 million has been laundered through crypto-exchanged thus far.125 The convertibility of digital tokens and various degrees of anonymity heighten AML/CFT risks with the global nature of crypto-markets. The potential for harm has been recognized by the Financial Action Task Force, Europol and Interpol, which have been increasingly monitoring developments in cryptocurrencies.126 Illicit 124   S EC, ‘SEC Halts Alleged Initial Coin Offering Scam’ (Press Release, 30 January 2018) Available at: accessed 15 March 2018. 125  Justin Scheck and Shane Shifflett, ‘How Dirty Money Disappears Into the Black Hole of Cryptocurrency’ (Wall Street Journal, 28 September 2018) Available at: accessed 28 September 2018. 126  Europol, ‘Global workshop for financial investigators on detection, investigation, seizure and confiscation of cryptocurrencies’ (Press Release, 28 January 2018) Available at: accessed 10 March 2018 and FATF, ‘Virtual Currencies: Key Definitions and Potential AML/ CFT Risks’ (FATF Report, June 2014) Available at: accessed 10 March 2018. 127  Octavian Nica, Karolina Piotrowska and Klaus Reiner Schenk-Hoppé, ‘Cryptocurrencies: Economic Benefits and Risks’ (October 26, 2017) University of Manchester, FinTech working paper No. 2, October 2017 Available at: accessed 21 March 2018 24–29. 128  Tom CW Lin, ‘The New Market Manipulation’ (July 3, 2017) Emory Law Journal, Vol. 66, 1253, Temple University Legal Studies Research Paper No. 2017–20. Available at: accessed 12 April 2018. 129  Berk v Coinbase, Inc. et al, Case No. 4:18-cv-01364, California Northern District Court.

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may have a long-term impact on the financial stability of the ICO market and potentially fuel a financial bubble. With a lacking due diligence and transparency, a flawed token valuation increases the post-ICO token volatility and puts the ICO participants’ investments at risk. The valuation depends on a number of parameters, which due to the lack of due diligence are difficult to determine prior to the ICO. If tokens were to be valued as financial instruments, the means of valuation could be based either on the asset backing the token or the prospective cash flows. However, there are four main issues, which pose difficulty with token valuation; (i) the traditional demand and supply dynamic is not present, (ii) the dual nature of the token valuation, (iii) the ICO marketing and sale technique employed and (iv) the liquidity of secondary markets. The crypto-community and academics are in the process of shedding light on what influences the token valuation on secondary markets. For example, a study by Liu and Tsyvinski shows that there is statistically no correlation between the price for cryptocurrencies and the price of stocks or commodities.130 Market Liquidity and Bankability In traditional VC funding, investors rely on the best-case scenario that the VC fund will ultimately exit the company once it is built-up and cash-in on their previous high-risk/high-return investment. Upon ICO completion, tokens have a liquidity premium (except those subject to a lock-up period). ICO investors may either hold onto their tokens, trade them on secondary markets or hope to eventually exchange them for fiat currency. For those not holding onto their tokens, the expectation behind the investment is that the tokens will have sufficient liquidity immediately upon the ICO’s completion. There are currently a number of hurdles affecting token liquidity. The ease with which the tokens can be transferred or exchanged will depend on their acceptance for trading by crypto-exchanges. An active secondary market of cryptocurrency exchanges has emerged, which allows customers to trade cryptocurrencies and tokens. Crypto-exchanges take a bid-ask spread as a transaction commission or charge fees for acting as an intermediary matching platforms. Each exchange will have its own standards for token admissibility. A purchased token may not be accepted by exchanges, whether due to insufficient public demand or poor performance, thereby negatively impacting the 130  Yukun Liu and Aleh Tsyvinki, ‘Risks and Returns of Cryptocurrency’ (August 2018) NBER Working Paper no. 24877 Available at: accessed 10 August 2018.

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liquidity of tokens. Poorly performing tokens may even be subsequently delisted. Despite the presence of numerous crypto-exchanges, token holders may not be able to exit their token investments where the crypto-exchanges are running thin books and the bid-ask spreads are too wide. Despite the overheated ICO market, what becomes clear is that unless a large secondary market with recognized standards for token admissibility develops, the investors will be at risk of their token becoming illiquid. Liquidity is a crucial factor for investors – Kostovetsky and Benedetti analysed 4,003 ICOs and found that the average digital token rose 179 percent from its ICO sale price to its opening price after achieving listing on a crypto-exchange within a holding period that lasted an average of just 16 days.131 Furthermore, secondary market liquidity is insufficient for an overall market liquidity without the element of bankability. Both token holders and token issuers need to be able to effectively convert their cryptocurrencies into fiat currency. Bankability will depend either on the jurisdictional regulation preventing/allowing the conversion or on the internal policies of a particular bank. Banks tend to approach cryptocurrencies as a high-risk activity, especially due to KYC concerns and money laundering regulation. The anonymity and difficulty in tracing the cryptocurrency’s previous owners imposes on banks an additional burden of monitoring the AML and KYC compliance. For that reason, banks may be reluctant to allow ICO issuers or investors to open a bank account. Token Value and Metrics Even if the purpose of the token is functional, the token valuation will experience volatility, as is it divorced from the value of the underlying project. The underlying project does not have a revenue, nor other metrics that would mirror and tie down the token valuation. Potential investors have little guidance on which metrics to use to value tokens, and even less so if they lack a finance background. To avoid market risk, investors need to be able to carry out a substantive market analysis. Given the nascent nature of the ICO market, new standards and models for token valuation will emerge and as Goldberg predicts, Token Demand Flow or similar models can be expected to emerge.132 131  Leonard Kostovetsky and Hugo Benedetti, ‘Digital Tulips? Returns to Investors in Initial Coin Offerings’ (May 20, 2018). Available at: accessed 22 May 2018. 132  Jason Goldberg, ‘Insider Reflections on the ICO Bubble Part III: 2018 is when crypto begins to move from speculation to utility’ (Hackernoon, 30 December 2017) Available at:

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Traditionally, in venture financing, we are in a better position to identify the stage of development for the tech start-up (angel, seed, Series A, B, C, D, E, F and IPO) and analysts are accustomed to metrics such as the discounted cash flow, price to earnings ratio, revenue, net income or earnings per share ratio, which they use to develop a business strategy for the start-up, but also to rationalize and justify market capitalization. Comparing the performance of tokens to traditional securities is not advisable in light of the early maturity of tokens. Nevertheless, new crypto metrics or ones akin to the traditional ones are expected to emerge.133 Currently, institutional investors are using their own customized metrics, while little has been done to standardize the practice across the market. A few attempts have been made among commentators and ICO market experts, among which Chris Burniske and Jack Tatar’s attempt to offer a token valuation framework stands out.134 Burniske outlines the concept of token supply and token velocity – token supply is akin to the issuance of shares which determines valuation and token velocity refers to the rate at which cryptoassets (digital tokens) are exchanged and how that impacts their value.135 If token holders and ICO project developers want to see the project’s network expand, enabling their ability to leverage on network effects, there needs to be a thorough analysis of the underlying value of each token. ICO issuers will need to carefully consider the funding model they choose, the number of tokens issued and the valuation of tokens. Token behaviour after issuance will be affected by the underlying product being offered, the token issuance struc accessed 30 March 2018. 133  For valuable inputs from market commentators please see Chris Burniske, ‘Cryptoasset Valuations’ (Medium, 2017) Available at: accessed 20 March 2018, Mike Sall, ‘Valuing Cryptoassets from the Ground Up’ (Medium, 24 April 2018) Available at: accessed 26 April 2018, John Pfeffer, ‘An (Institutional) Investor’s Take on Cryptoassets’ (Medium, 30 December 2017) Available at: accessed 27 April 2018, Vitalik Buterin, ‘On Medium-of-Exchange Token Valuations’ (Vitalik Buterin’s website, 17 October 2017) Available at: accessed 26 April 2018 and Alex Evans, ‘On Value, Velocity and Monetary Theory’ (Medium, 19 January 2018) Available at: accessed 26 April 2018. 134  Chris Burniske and Jack Tatar, Cryptoassets: The Innovative Investor’s Guide to Bitcoin and Beyond (McGraw-Hill Education, 2017). 135  Chris Burniske, ‘Cryptoasset Valuations’ (Medium, 2017) Available at: accessed 20 March 2018.

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ture and the external market factors. Hence, token economics should not be underestimated, as a poorly-structured token may negatively expose both the investors and ICO issuers to greater market risk. Dual Nature Tokens have a dual nature which complicates their valuation for investors. The dual nature is a result of the ICO model itself. Since the token is not a share, nor does it represent some underlying asset of the issuing company, the token valuation is torn between the token’s market capitalisation value and the equity capitalisation of the ICO issuer. How one values the underlying business from the perspective of profit and loss is divorced from how the market influences the value of the tokens. An ICO participant is buying a token whose value may or may not be linked to the product/service, depending on whether the token is indispensable to the functioning of the blockchain technology. The variable value of the token is based on the market perception (influenced by supply and demand) and the success of the product development, but also of the company behind the ICO. Another risk associated with the dual nature of the token is dilution. Despite the mantra that ICOs are preferable to traditional financing, as ICOs don’t dilute the start-up’s equity, there is a hidden fallacy in this oft-stated advantage of the ICO model. Traditionally, dilution is associated with shares – a share representing a part ownership in a company. In comparison, a token has a dual functionality – it represents the future value of a product or service and has a utility value, whereby it gives the holder access to the product. Selling tokens can be a dilutive event. For example, company A wants to develop a blockchain network. It engages an angel investor, to whom it sells 50% of company A, following which it conducts an ICO pre-sale, where it sells 50% of its tokens. Another 25% of tokens is to be sold in a public ICO and 25% is to be retained by company A. Following the public ICO, the market capitalisation of all tokens is $200 million. What is the value of the company A? If we consider tokens to be ‘assets’, then the market cap is $50 million. At this point, company A depends on revenue either from the product or from the value creation via the appreciation of token value. If it is the latter, and company A decides to sell its 25% of tokens, it will become worthless to the initial angel investor. If the company depends on value creation via the appreciation of token value and doesn’t get paid for providing a service, it won’t have revenue at all. In this scenario, the token sell-off can be characterized as a dilutive event. If it is the former, regardless of a sell-off, company A will obtain revenue from the developed product. From this perspective, tokenization of a business strips away economic value

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from the company’s shares. This is an element that investors should be aware off when investing in tokens. Token and Market Interaction The way digital tokens interact with the market and their users once the project has reached product deployment stage creates a market risk for token holders that is inherent to the dual nature of the token. ICO issuers design the ‘micromonetary policy’ of their digital tokens. As it currently stands, there is no perfect monetary policy. By analogy, central banks have monetary policy tools to manage interest rates and the total supply of money. However, in practice, monetary policy interacts with the fiscal policy of the government. Therefore, adjusting monetary policy is a continuous process. Similarly with ICOs, the ICO developers may outline their monetary goals and how many tokens they will issue and in what ways will they control the token value. Unfortunately, tokens do not operate in a vacuum and need to interact with the outside market. What complicates matters further is the dual nature of tokens. Lior Yaffe and Andras Kristof refer to ‘the duality problem’ that is inherent to digital tokens.136 A token has to be both an investment and a utility medium. The two elements of tokens – functional and speculative – cause a conflict of interests between investors who prefer a cap on token issuance, which leads to token price volatility and increase due to an artificially-created scarcity. Whereas the network users, wanting to leverage on the network effects of using the product/service, would prefer an unlimited issuance. The duality problem is further complicated by the ICO business model. If the underlying company is to become profitable, the token needs to interact with its business strategy and not be merely at the mercy of its users and investors. The dynamic between users and investors becomes problematic the moment that the product is deployed and more users are drawn to it through network effects. While investors will want to hold onto their tokens with the expectation of their value increasing, the ICO issuers and users will experience a higher demand for tokens – a constraint of supply causes a conflict of interests between the two groups and frustrates the business strategy geared towards expansion.137 Monetary policy of the ICO funding model may be its Achilles heel and the ICO management team cannot escape 136   Lior Yaffe, ‘The Token Duality Problems’ (Medium, 21 January 2018) Available at: accessed 30 March 2018 and Andras Kristof, ‘The Duality Problem’ (Medium, 1 November 2017) Available at: accessed 30 March 2018. 137  Andras Kristof, ‘The Duality Problem’ (Medium, 1 November 2017) Available at: accessed 30 March 2018.

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it, only mitigate it. To an extent, the monetary policy may be controlled by the ICO structure and token design. The manner in which ICOs will optimize the token interaction with the market will influence the subsequent market risk for investors.138 Therefore, investors should be warned to carefully scrutinize the ongoing interaction between token issuance and its supply. Supply/Demand and Token Volatility Market demand and supply would determine the token valuation, taking into account a number of variables, such as the number of tokens or the volume and price of services forecasted. The demand and supply is strongly influenced by the ICO market hype, while a limited supply of tokens cannot meet the demand and skyrockets the token valuation. This is a market dynamic wellknown to capital markets. However, one should not be too quick to equate tokens with equities. The crucial difference lies in the token’s dual nature as both an investment instrument and an integral functioning element of the blockchain’s ecosystem. If a token is indispensable for the project generating revenue, the volatility of its market price will deter users as transactions become too expensive. In other words, a token is both an investment instrument that allows for a creation of a digital economy and simultaneously, it sustains the exchange of services performed on the blockchain. An additional level of complexity is added due to the velocity problem. The traditional concept of velocity of money which concerns the frequency at which money is exchanged between parties over a period of time (turn-over) is a significant measure when assessing an economy. Similarly, token velocity refers to the number of times that a token changes ownership. Token velocity can be an indicator of speculative trading, token hoarding, the utility of a token or on the general efficiency of the token economy created. If a token is indeed an integral element to the functioning of the ICO issuer’s project, then there must be a reason why token holders will hold on to their tokens in a long period. If it is in ICO issuer’s interest to encourage users to hold on to their tokens, he will have to grapple with both low and high velocity implications. On one hand, 138  It is worth emphasizing here that the ICO funding model is still in its infancy and the market continues to experiment with its structure – the model optimization is a continuing effort. There is currently no perfect way of eliminating market risk with regards to how the tokens interact with market participants. As Vitalik Buterin made clear, even a careful design of the token sale structure cannot be perfect. See Vitalik Buterin, ‘Analyzing Token Sale Models’ (Vitalik, 9 June 2017) Available at: accessed 18 February 2018 and Reuben Bramanathan, ‘The perfect token sale structure’ (GDAX, 19 May 2017) Available at: accessed 18 March 2018.

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low velocity is said to create true long-term value, encouraging long-term appreciation. However, if a large number of investors hoard the tokens without using them, the token velocity drops dangerously low and destroys the utility value of the tokens. Conversely, high velocity tokens will create risk for token users. It is desirable to achieve a balance between the need for token holders to use the token and encourage the token value appreciation in a long-term. ICO issuers need to understand the interplay between token use, trading and velocity and have a working strategy in order to manipulate the token velocity by incentivizing the token holders to hold on to their tokens. Investors should play close attention to whether there is such a strategy in the whitepaper and through which protocol designs do the ICO issuers intend to foster a healthy token economy. In a similar manner, Catalini and Gans question whether a single token can both be a medium of exchange and an investment asset simultaneously.139 Token velocity can be managed by deploying a number of protocol design features that create an artificial constraint. These include: a profit share mechanism or through a staking function.140 Bitcoin is able to control bitcoin velocity through proof-of-mechanism using the hash puzzle. Solving the hash puzzle requires substantial computing power that is costly. This cost is continually recalculated in a way that the average time between blocks added to the blockchain is around 10 minutes. If more miners come into the ecosystem, the Bitcoin’s nodes will readjust the difficulty in solving the hash puzzle. This process of readjustment creates an economic equilibrium.141 Likewise, the possibility that the ICO issuers will issue more tokens in the future, thereby diluting the investors’ token value may directly influence the token valuation. The dynamics of demand and supply influence the token valuation and contribute to market risk. The nascent nature of tokens makes them incredibly volatile. While traditional securities depend on the demand and supply in capital markets that have matured over the years, digital tokens have been actively traded for only a few years. Their volatility is higher than that of securities, as they are traded in thin markets. As Burniske and Tatar aptly note ‘when cryptoassets are first launched, they have relatively thin order 139  Christian Catalini and Joshua S Gans, ‘Initial Coin Offerings and the Value of Crypto Tokens’ (June 25, 2018). 140  Staking tokens involves the locking up of tokens for a pre-determined period therefore decreasing their velocity to zero. 141  On token volatility see informative pieces by Chris Burniske, ‘Cryptoasset Valuations’ (Medium, 24 September 2017) Available at: accessed 21 March 2018 and Vitalik Buterin, ‘On Medium-of-Exchange Token Valuations’ (Vitalik Buterin’s website, 17 October 2017) Available at: accessed 21 March 2018.

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books because the investor base is typically smaller’.142 The thin order books may in turn become victim of large trades that will result in significant price movements.

Speculative ‘Pump and Dump’ Behaviour and Market Manipulation As noted, market risk also offers opportunities for speculative behaviour, whereby market participants will take advantage of the token volatility and engage in ‘pump and dump’ practices. In contrast to investors, speculators are influenced by short-termism and capitalize on the movements in the market, instead of basing their investment on the token’s fundamentals. Prima facie not considered to be illegal, speculative behaviour can be labelled as abusive and in the case of ICOs, speculating on token valuation can lead to increased volatility and de facto market abuse. It is not an understatement that upon issuance, tokens exponentially increase in value and create a fertile ground for speculation, often with a 500 to 1000% fold increase in value.143 Speculation is not unique to digital tokens and has been historically an accompanying negative externality associated with new asset classes. The high liquidity premium has attracted speculators and no longer is it merely the token supporters who see a utility value in the token purchase. Regardless of whether we refer to the incomers as investor or speculators, what is clear is that their arrival has not only increased token volatility, but has become an added consideration for the ICO issuers. Initially, ICO issuers knew that to gain traction, the token had to hold sufficient utility for its supporters to participate in an ICO. With the arrival of speculative investors, tokens need to be structured in a way that promises a financial gain, too. Speculative behaviour becomes undesirable when inexperienced retail investors flood the market. Unfortunately divorcing the utility and speculative function of the token is impossible – they are both inherent elements that underpin the mechanism behind the success of the ICO funding model. The speculative element is inflated due to the artificial scarcity, as most ICOs have a capped token sale and early investors purchase tokens in a hope that their value will increase post-ICO. This speculative expectation is also based on an assumption that the 142  Chris Burniske and Jack Tatar, Cryptoassets: The Innovative Investor’s Guide to Bitcoin and Beyond (McGraw-Hill, 2018) 93. 143  After its ICO, TenX (a Singapore-incorporated company) saw a price increase per token that was at its highest by 500%. See Coinmarketcap, ‘Cryptocurrency Market Capitalizations’ Available at: https://coinmarketcap.com/currencies/tenx/#charts.

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product or service developed will become gradually more popular and as new users are on-boarded, an early purchase will reward those who acquired tokens before a mass adoption. It is clear from the above picture that the ICO funding model creates a negative externality, whereby it allows for speculative behaviour, in particular for ‘pump and dump schemes’. The U.S. SEC has described such schemes in one of its investor alerts, as schemes where ICO issuers urge prospective buyers to buy tokens through misleading messages in order to pump the market into a buying frenzy. Once the ICO is over, they either disappear with the collected funds or dump their tokens for a large profit, leaving other investors to lose money on the falling token value.144 Using insider information to exit their risky positions and transfer the investment risk on to other, less-knowledgeable investors could amount to insider trading. A similar practice occurs in pre-token sales followed by an early dumping. Early investors such as hedge funds or VC funds participate in the ICO pre-sale at a discounted rate. While the preferential discounts are legal, they resemble practices during the IPO bonanza in the 1990s, where preferred investors would resell their shares for large profits.145 Pre-sale investors are driven by short-term profits and cash-out immediately after the ICO, when tokens become liquid. For example, the ICO of a messaging app, Kik Interactive Inc, raised $100 million. Kik had conducted a pre-sale ICO, in which it raised $50 million from private investors, who obtained a 30% discount on their ‘kin tokens’. Interestingly, only 10% of the total supply of kin tokens was sold during the ICO.146 One of the investors, participated in marketing the public ICO without disclosing the terms on which it obtained kin tokens during the pre-sale.147 Such practices reveal the lack of transparency in the funding process and may in the long-term discourage retail investors from participating in ICOs. Institutional 144   U.S. Securities and Exchange Commission, ‘Public companies making ICO-related claims’, (Investor Alert, 28 August 2017) Available at: accessed 17 February 2018. 145   Olga Kharif, ‘Hedge Funds Flip ICOs, Leaving Other Investors Holding the Bag’ (Bloomberg, 3 October 2017) Available at: accessed 16 February 2018. 146  Frank Chaparro, ‘Messaging app Kik is launching its own cryptocurrency to raise $125 million’ (Business Insider US, 29 August 2017) Available at: accessed 10 February 2018. 147   Kadhim Shubber, ‘Crypto-bailouts for struggling startups’ (Financial Times, 30 August 2017) Available at: accessed 11 February 2018).

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investors, in particular hedge funds, have the capital and technical skills including quantitative analytics, artificial intelligence and machine learning to make high-tech powered speculative choices and thereby accumulate significant positions that may not only crush the small retail investors’ holdings, but endanger the existence of the ICO project. Despite nothing being inherently illegal about the pump and dump schemes carried out by investors, it is undeniable that their sole purpose is speculative and if left unchecked may negatively affect the overall health and integrity of the ICO market. At a fundamental level, this practice goes against the crowdfunding and democratizing ethos of the ICO funding model. As Li and Mann suggest, the raison d’etre of the ICO funding model rests on network effects.148 If we remove or marginalize the retail investors from the market, the ICO market will start to resemble a pump and dump scheme and in the long-term will undermine the functioning of the ICO model. Therefore, from a perspective of an ICO ecosystem, such behaviour is indirectly abusive, as it engenders an unhealthy practice that in the long run puts the technology being developed at peril and punishes retail investors who did not purchase tokens at a discounted rate. Pilkington calls such pump and dump schemes massive market manipulations by undermining ‘the ecosystem of valuable tokens, and keeping the opportunity to make money out of the hands of the individual and the entrepreneur’.149 Indeed, speculative investing defeats the purpose of democratizing the market for funding and leaves the retail investors ‘holding the bag’ after pre-sale investors cashed in on their investments. Zetzsche et al. having analysed 400 ICOs and their respective whitepapers concluded that in 71.1% of the cases, the ICO documentation revealed that the tokens were offered in a pre-sale to a private investor group.150 In other words, as the U.S. Commodity Futures Trading Commission (CFTC) warned, pump and dump schemes are

148  Jiasun Li and William Mann, ‘Initial Coin Offering and Platform Building’ (January 31, 2018). Available at: accessed 27 February 2018, 41. 149   Marc Pilkington, ‘The Emerging ICO Landscape Some Financial and Regulatory Standpoints’ (February 8, 2018). Available at: accessed 9 February 2018, 10. 150  Dirk Zetzsche, Ross Buckley, Douglas Arner and Linus Föhr, ‘The ICO Gold Rush: It’s a Scam, It’s a Bubble, It’s a Super Challenge for Regulators’ (February 1, 2018). University of Luxembourg Law Working Paper No. 11/2017; UNSW Law Research Paper No. 83; University of Hong Kong Faculty of Law Research Paper No. 2017/035; European Banking Institute Working Paper Series 18/2018. Available at: accessed 7 February 2018, 7.

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nothing more than another form of a scam that ‘deploys an emerging technology to capitalize on public interest in digital assets’.151 Aside from pump and dump schemes, other manipulative behaviours have been observed in the crypto-markets, akin to behaviours traditionally observed in capital markets. Market manipulation is any form or market behaviour that purposely and artificially inflates or deflates the price of digital tokens for personal gain. This form of behaviour is particularly rampant in a young market for digital tokens where the value of digital tokens is sensitive to market sentiment, publicity and fear of missing out. Market participants may employ a number of manipulative behaviours which result in unnatural price movements, including whale trades, shilling or wash trading. Mistaken Market Dynamics The economics of using an ICO funding model needs to be sustainable in order to prevent damaging the credibility of the model, protect investors and most importantly encourage innovation. However, the current market displays worrisome characteristics of being overheated and a fertile ground for ‘bad lemons’. Compared to a traditional model of financing, such as VC funding, where investors carry out a thorough vetting and unilaterally decide on their investment, crowdfunding models such as ICOs are based on the premise of the ‘wisdom of crowds’. The concept is based on a belief that collective decision making through an ICO is better suited at selecting a good token in comparison with traditional funding models. Behind an ICO is an aggregate of ‘a diverse set of views from entities that are independent and decentralised, in order to arrive at a view that is closer to the truth than that of any one entity’.152 The argument is that since token holders are interested in token utility and platform quality, it does not matter that their views are dispersed, as long as ‘the user base incentivizes each user to learn the wisdom of the crowd so as to make more informed participation decisions’.153

151   U.S. Commodity Futures Trading Commission, ‘CFTC Issues First Pump-and-Dump Virtual Currency Customer Protection Advisory’ (Press Release: pr7697-18, 15 February 2018) Available at: accessed 16 February 2018. 152  Avtar Sehra, ‘ICOs and the Insanity of Crowds’ (Medium, 17 August 2017) Available at: accessed 19 February 2018. 153  Jiasun Li and William Mann, ‘Initial Coin Offering and Platform Building’ (January 31, 2018). Available at: accessed 27 February 2018, 3–4.

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However, not all social networks facilitate efficient markets and social influence can undermine the premise of the wisdom of crowds.154 This is particularly the case in the ICO market, which has historically been influenced by high-profile influencers and so-called ‘crypto-advisors’, who may have been incentivized to market tokens irrespective of their credibility. What follows is herding, in an over-heated market where token sales often last only a few minutes – a poisonous cocktail for market stability.155 This social influence is further inflated by the overhyped interest in blockchain technology.156 When the Long Island Ice Tea Company changed its name to Long Blockchain Corp, its stock value climbed by 500%.157 Similarly, oversubscription is common to large ICOs, as a direct result of aggressive marketing and the so-called FUD. FUD stands for ‘Fear, Uncertainty and Doubt’ – in other words, a fear of missing out and a market panic to be first to participate in an ICO. The wisdom of the crowds premise can only work when individuals are allowed to make investment decisions independently and not under the influence of the crowds. Market For Crypto Lemons The effect of self-motivated social influence becomes even more damaging in a market exhibiting information asymmetry. As previously noted, the ICO market is currently lacking a mechanism to ensure transparency for investors. 154  Jan Lorenz, Heiko Rauhut, Frank Schweitzer and Dirk Helbing, ‘How social influence can undermine the wisdom of crowd effect’ (2011) Proceedings of the National Academy of Sciences May 2011 Available at: accessed 11 February 2018. 155   E Y cautions in their report on the investors’ ‘fear of missing out’, which is visible in the unprecedented rush prior to an ICO. “The 10 projects with the lowest durations attracted funds at an average speed US$300,000 per second.” EY, ‘Initial Coin Offerings (ICOs)’, (EY Research, December 2017) Available at: accessed 10 February 2018, 26. 156  A contrary opinion is given by Li and Mann who make an argument that an investment decision to participate in an ICO may have a rational foundation, as it accelerates the built-up of the network effects and resolves the coordination problem. Instead of being an irrational exuberance, participating early in an ICO addresses the issue of a coordination failure. See Jiasun Li and William Mann, ‘Initial Coin Offering and Platform Building’ (January 31, 2018). Available at: accessed 27 February 2018, 18. The present paper disagrees with this position to the extent that it places emphasis on greed and fear as motivating factors to participate in ICOs, rather than perceiving it as a means to coordination. Motivations for investing in token sales cannot be limited only to utility and must account for speculative objectives. 157  StreamSpace, ‘The Wisdom and Herd Behaviors of Crowds’ (Medium, 30 January 2018) Available at: accessed 7 February 2018.

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Upon closer examination, one can see how the ICO market becomes a fertile ground for ‘a market for lemons’. George Akerlof in his seminal work ‘The Market for “Lemons”’ illustrated the impact of information asymmetry on the state of a market.158 The ICO market displays conditions that lead to a lemon market; (i) information asymmetry – the ICO participants cannot make an independent judgment of the value of the token prior to the ICO, as the only information on the token is the one offered by ICO issuers through a whitepaper or through social media communication. Naturally, (ii) it is in ICO issuers interest to market their tokens in order to attract funding, despite the fact that they lack a working prototype, which may technologically not be feasible to develop – in that sense, there are skewed incentives on issuers’ part to push their product as high-quality without any knowledge of the actual future utility of the technology being developed. As mentioned, (iii) there is no disclosure framework and low-quality tokens are hard to distinguish from high-quality tokens. Finally, (iv) there is lack of assurance as to the quality of start-ups backing the ICO, as there is a low transparency on the post-ICO success rate. In the long-term, a market of crypto-lemons will have two systemic impacts. Firstly, high-quality ICO issuers will be forced to leave the market, as they cannot compete and obtain a fair valuation for their tokens, while the low-quality ones remain. Secondly, a market full of crypto-lemons distorts the market stability and may result in a crypto-bubble, whereby tokens are being issued and traded above their fundamental value, which is further distorted by market participants acting on speculative short-term impulses.159 These will be discussed in the following section. Bubbles What the investment risks reveal is that unregulated ICOs and high volatility in token valuations are a direct cause of information asymmetry in the market. If ICOs become a widely-used funding model, their capital formation will impact capital markets. ICOs and in particular the blockchain technology behind them made it easy for actors to create and trade a new class of assets in an unprecedented way. As Rohr & Wright note, ‘the distributive power of the Internet is being combined with the raw power of a blockchain to manage and 158  George A  Akerlof, ‘The Market for “Lemons”: Quality Uncertainty and the Market Mechanism’ (August 1970) The Quarterly Journal of Economics, Vol. 84, No. 3. 159  The Economist, ‘The market in Initial Coin Offerings risks becoming a bubble’ (The Economist, 27 April 2017) Available at: accessed 13 February 2018.

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transfer assets globally’.160 With the current volume of ICO tokens circulating the market, the ICO market may be too small to justify regulation targeting financial stability to protect investors and ensure a healthy market. In 2018, the Financial Stability Board (FSB) reported to G20 that crypto-assets do not pose a material risk to global financial stability, but vigilant monitoring continues being pursued.161 Nevertheless, systemic risk concerns may one day materialize, as the barriers to investing in ICOs gradually erode and more institutional investors enter the market.162 The more inflated the valuations become and more investors become involved, ICOs will begin to impact the market dynamics as we know them, making them unstable. A combination of media marketing, uncertainty and overabundance of liquidity fuel a speculative bubble. More liquidity is pumped into the ICO market with the potential of creating the next tech bubble, which readily resembles the DOTCOM bubble that was preceded by an IPO frenzy in the 1990s.163 Nevertheless, there is room for an argument that a financial bubble may be necessary if new technologies are to stabilize, and may serve an acceleration purpose in technology cycles.164 Currently, many ICO investors speculate on the future utility of blockchain technology, and regardless of whether malpractices fuel a tech bubble, there is a lot to be gained. For one, the capital influx and the ICO bonanza has pushed blockchain technology into the spotlight. Despite the negative press they receive, today’s ICOs may be the building 160  Jonathan Rohr and Aaron Wright, ‘Blockchain-Based Token Sales, Initial Coin Offerings, and the Democratization of Public Capital Markets’ (October 4, 2017). Cardozo Legal Studies Research Paper No. 527; University of Tennessee Legal Studies Research Paper No. 338. Available at: accessed 8 February 2018, 23. 161  Financial Stability Board, ‘Crypto-assets: Report to the G20 on work by the FSB and standard-setting bodies’ (Report, 16 July 2018) Available at: accessed 18 July 2018, 1. 162  Steven Schwarz, ‘Systemic Risk’ (2008) 97 Georgetown Law Journal 193. 163  Mark Carney, the Governor of the Bank of England is among many who made a similar observation, pointing out that ‘many cryptocurrencies have exhibited the classic hallmarks of bubbles including new paradigm justifications, broadening retail enthusiasm and extrapolative price expectations’. In Mark Carney, ‘The Future of Money’ (Speech to the inaugural Scottish Economics Conference, 2 March 2018) Available at: accessed 5 March 2018. 164  Jason Goldberg, ‘Insider Reflections on the ICO Bubble Part III: 2018 is when crypto begins to move from speculation to utility’ (Hackernoon, 30 December 2017) Avail­able at: accessed 30 March 2018.

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blocks for tomorrow’s blockchain networks. An argument that there is meaning in technology-driven bubbles has been put forward by Carlota Perez in relation to the development of the web in the 1990s.165 Technology bubbles may be necessary if a true paradigm shift is to occur. In the similar manner that the DOTCOM bubble gave rise to tech giants such as Amazon or Facebook, today’s ICOs funding blockchain projects could be the future breakouts. Joel Monegro at Union Square Ventures describes this as boom-bust-boom scenario.166 ICOs today are building the infrastructure for the next generation of ICO 2.0, whereby the relationship between the token and the underlying infrastructure in which it is supposed to function will have a stronger utilitarian linkage. The infrastructure is being built in the form of a network between developers and entrepreneurs.

Part C: Enforceability and Applicable Legal Regimes

In view of the risks and systemic challenges that ICOs face, the role of regulators becomes increasingly important and so is the availability of legal redress for investors. In traditional capital markets, investors rely on disclosure regime, enforcement powers of securities regulators or remedies offered within the doctrine of contract law. This is not always the case in the crypto-markets. Although ICOs are not regulated by specific legislation, the ICO funding model together with the security-like characteristics of the token, may make them subject to specific regulatory regimes.167 The following sections outline the feasibility of legal action against the ICO issuers and address the application 165  Carlota Perez, ‘The Double Bubble at the Turn of the Century: Technological Roots and Structural Implications’ (July 2009) Cambridge Journal of Economics Vol. 33, Issue 4, 779–805 Available at: accessed 19 March 2018 and Carlota Perez, ‘The advance of technology and major bubble collapses: historical regularities and lessons for today’ (Engelsberg Seminar on “The future of capitalism” Ax:son Foundation, Sweden, June 2010) Available at: accessed 20 March 2018. 166  ‘Both aspects of irrational speculation – the boom and the bust – can be very beneficial to technological innovation. The boom attracts financial capital through early profits, some of which are reinvested in innovation (how many of Ethereum’s investors were re-investing their Bitcoin profits, or DAO investors their Ethereum profits?), and the bust can actually support the adoption long-term adoption of the new technology as prices depress and out-of-the-money stakeholders look to be made whole by promoting and creating value around it.’ In Joel Monegro, ‘Fat Protocols’ (Union Square Ventures Blog, 8 August 2016) Available at: accessed 1 April 2018. 167  This is subject to a number of jurisdictions that opted to directly regulate the process of carrying out an ICO. An example being Malta, see: https://www.mfsa.com.mt/fintech/.

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of relevant regulatory regimes, including consumer protection and financial regulation.168 i Enforceability and Issuer Liability Every participant in the token issuance accepts the Terms & Conditions linked to the ICO’s Whitepaper, the moment s/he purchases tokens. Following the ICO, it becomes evident that based on the risks outlined in Part B, investors may suffer financial loss as a result of ICO-related risks. If the loss is substantial, it is in the investors’ best interest to find a ground upon which they may pursue an action, especially given that the whitepaper does not afford investors legal protection.169 This is not surprising given the nature of the whitepaper – it is not a disclosure document and the representations made are purely as to the 168  It is outside the scope of the present paper to delve into the application of private law as a legal recourse in instances of theft and misappropriation. Whether due to theft, loss of private keys or misappropriation, token holders will want to recover the economic value of their lost tokens. In order to establish whether principles of property law apply and whether tokens can be owned and traced, a court would have to first establish whether a token can be characterized as property. For the discussion on above see Ross Anderson, Ilia Shumailov and Mansoor Ahmed, ‘Making Bitcoin Legal’ (Cambridge University Computer Laboratory) Available at: accessed 20 July 2018 and Kelvin FK Low & Ernie GS Teo, ‘Bitcoins and other cryptocurrencies as property? (2017) Law, Innovation and Technology, 9:2, 235– 268. The common concern and focus tend to be with the regulation of digital tokens. Nevertheless, their place also belongs to the common law of property. The raison d’etre of initial cryptocurrencies has been to create autonomous systems within the confines of the virtual world for carrying out transactions outside the oversight of state. Indeed, the very technical design of decentralized peer-to-peer protocols have been designed to function outside the control of the state. It is not uncommon to read or hear about ‘owning tokens’, ‘theft’ or ‘tokens held as collateral’. These phrases are concepts of property law doctrine. Property law is about third parties, simplified – how a transaction between two parties affects the rights of a third party. Professor David Fox has advanced an argument that indeed digital tokens (in his instance bitcoin) can be characterized as property if a third category of personal property aside from choses in possession and choses in action would be recognized by a court. Fox makes an argument that digital tokens make a suitable objects of property with fungibility in cryptocurrency design, their scarcity and exclusivity. Fox goes on to suggest that we may be able to characterize cryptocurrencies as intangible property, which in turn allows us to by analogy to apply the rules of derivative transfer of title and tracing. (views expressed in David Fox, ‘Cyber-currencies as Property’ (Centre for Banking and Finance Law Seminar Series Faculty of Law National University of Singapore, 23 August 2018)). 169  Some of the issues that may prompt legal action by investors include: misrepresentations or omission of material information in the whitepaper, product development hurdles, mis-distribution of collected funds, unplanned dilution through additional ICO rounds, change in the product design, security issues, insider trading or fraudulent activities.

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project’s conception/idea. Therefore, there is a conflict between how ICO issuers and investors perceive their participation in an ICO. Given the rationale behind the ICO funding model, ICO issuers will perceive the participation in the ICO akin to ‘joining a club’ with a common interest in the future of the project. The majority of ICOs are conducted in an unregulated space and the sale is concerned with developing experimental, often early-stage technologies that may not materialize or achieve their goals as initially stated in the whitepaper. Similarly, the field of blockchain technology and cryptography is constantly evolving and the ICO issuers are not in a position to warrant the use of the tokens. There is nothing inherently wrong with this position, as an ICO is a different beast compared to an IPO or another form of a public offering that have to comply with disclosure requirements and regular financial reporting. On the other hand, investors will expect IPO-like legal privileges the moment something goes wrong and they suffer financial loss. This illustrates the difficult task regulators face if one is to apply securities regulation that does not fit the rationale behind ICOs.170 If investors are to pursue legal action, they will need to establish a legallybinding contract with the ICO issuer, or argue that the digital tokens amount to a form of assets that should have been subject to a specific regulatory regime that gives them a ground to pursue a legal action. The relationship between the token issuer and holder by itself does not afford token holders any rights, unless the token holders can prove that the legal characterization of the tokens falls into specific regulated categories. This section looks at whether a whitepaper is a legally-binding document and outlines the regulatory regimes that may apply to tokens. Whitepaper – Legally Binding? The majority of whitepapers are not legally binding documents that give investors rights merely by virtue of being token holders. Historically, whitepapers were known to be technical documents that would offer a detail description and discussion over a specific area of interest. In the ICO context, they have been adapted to serve as promotional documents made available to public. As previously mentioned, a whitepaper will not only serve to inform the investors on the token function and rights attached to it, but will also include information as to the product development timeline, manner in which ICO funding is 170  Imposing securities regulation on all ICO issuers would significantly shift the regulatory burden on ICOs and may possibly be detrimental to the ICO funding model which is predicated on raising funds for ideas. It is a funding model specifically targeting early-stage start-ups. This argument is further elaborated on in Part E.

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to be used and other information on the management/business strategy of the project. Investors will purchase tokens based on this information, which in an IPO would be construed as a set of representations that are material to the investor’s decision making. In ICOs, the opposite is true and there is no indication on part of the ICO issuer that the project will go ahead as planned in the whitepaper. In practice, business plans may change, technical elements of the token may have to be altered or the project may fail to develop the product. ICO issuers will aim to legally protect themselves both through the whitepaper and the Terms & Conditions. ICO issuers will argue that the ICO whitepaper and Terms & Conditions have a series of disclaimers, whereby the ICO issuer is not liable for any losses associated with the investment in the ICO and the ICO participants agree to make a warranty as to the risks associated with the investment. As the whitepaper is not subject to stringent disclosure requirements, it is unlikely that investors can impose issuer liability for the claims made.171 Moreover, ICO participants are made to agree and acknowledge that the whitepaper is not be construed as a prospectus, nor does it serve as an indication as to the merits of the ICO.172 ICO issuers will commonly have a Terms & Conditions document incorporated by reference to the whitepaper that will include a series of risk mitigation clauses that the investors accepts by purchasing the token. Investors should be advised to look out for clauses on risk mitigation, in particular on the limitation of liability and disclaimers of representations. Disclaimers of liability will include liability for any direct, incidental or consequential loss whether in contract or tort, such as loss of revenue, profits or 171  Even though issuer liability for claims made in the whitepaper may not be established, issuer liability for the claims made may be found if the tokens are found to be securities or in instances when the ICO issuers’ conduct was fraudulent. 172   See example: TenX, ‘TenX Payment Platform Whitepaper’ (TenX, 21 June 2017) Available at: accessed 6 February 2018 pp. 3–6 with a detailed section on disclaimers and warranties:  “There are risks and uncertainties associated with TenX and/or the Distributor and their respective businesses and operations, the PAY tokens, the TenX Initial Token Sale and the TenX Wallet (each as referred to in this Whitepaper).” … “you agree and acknowledge that this Whitepaper does not constitute a prospectus or offer document of any an indication of the merits of the TenX and/or the Distributor, the PAY tokens, the TenX Initial Token Sale and the TenX Wallet (each as referred to sort and is not intended to constitute an offer of securities in any jurisdiction or a solicitation for investment in securities and you are not bound to enter into any contract or binding legal commitment and no cryptocurrency or other form of payment is to be accepted on the basis of this Whitepaper;” … “you agree and acknowledge that this Whitepaper, the undertaking and/ or the completion of the TenX Initial Token Sale, or future trading of the PAY tokens on any cryptocurrency exchange, shall not be construed, interpreted or deemed by you as in this Whitepaper)”.

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loss of data in reliance on the whitepaper. Disclaimers of representations in this context purport to protect the ICO issuers from making any binding representations or warranties as to the project’s development and the product as described in the whitepaper or as marketed prior to the ICO. The risk mitigation may seem harsh in view of the legally-grey area in which ICOs operate and the missing investor protection framework. However, from the ICO issuers’ perspective, the statements in a whitepaper are purely forward-looking and therefore may involve unknown risks that could potentially impact the project’s viability and performance. The Terms & Conditions or the whitepaper will have an elaborate section on representations and warranties by the buyer.173 With purchase comes acceptance of Terms & Conditions, whereby the investors agree and acknowledge, inter alia, that the tokens do not constitute securities, that s/he has a basic understanding of the technology described in the whitepaper or that the whitepaper is not a prospectus. The representations by the buyer are standardized, not subject to negotiation and the investors accept them by default.174 The documents will commonly include the following non-exhaustive list of clauses: (i) Mandatory arbitration clause (ii) Choice of law clause (iii) Class action waivers (iv) Jurisdictional limitations on sale (v) Separate disclaimer on securities (vi) Disclaimer on financial advice or solicitation (vii) No contract clauses175 173  Note that not all whitepapers will have clauses on risk mitigation and liability. As there is no whitepaper standard in the industry, it is entirely up to the ICO issuers and their legal counsel how detailed the whitepaper is. 174  Indeed the representations and warranties that the investor is made to accept and/or acknowledge can be substantial. They tend to cover areas where the ICO issuers feel pose legal risk, which in case of ICOs is paramount. These may include acknowledgment of following; (i) the purchased tokens do not constitute securities, (ii) the whitepaper does not constitute a prospectus, (iii) no regulatory authority has examined or approved the whitepaper, (iv) the whitepaper distribution does not imply that it is compliant with the regulatory requirements of given jurisdictions, (v) future tradability of tokens on cryptoexchanges is not guaranteed, (vi) the tokens are not to be classified or treated as any kind of currency, debentures, rights, options, derivatives, units in a collective investment scheme, units in a business trust or any other class of securities, (vii) that the investor is aware of his eligibility to purchase tokens, (viii) that the investor has a basic understanding of the token’s functionality and of the blockchain-based systems or (ix) the risks related to the purchase of tokens. 175  The purpose of a no-contract clause when the token purchase is a straight-forward sales and purchase contract is either a sign of poor drafting, a speculative/risk-averse position

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The question whether a whitepaper can have a legally-binding effect will likely depend on its contents and drafting. If a whitepaper contains conditions of sale or descriptions as to the product/service (amounting to contractual warranties), these may have a contractual significance, thereby inducing a legally binding effect. The investors should be advised to pay attention to the substance of these documents. The publishing of a whitepaper/T&Cs can be construed as an offering of the sale and the payment constitutes acceptance of the terms and conditions implied. In a similar manner, the terms of contract formation apply as in e-commerce or in other form of digital contract formation. In an instance where a whitepaper is drafted in a future tense, outlining future aspirations or promises, these clauses may not have a contractual effect and the regime of consumer protection law will apply. Most commonly, whitepapers will include both clauses with a contractual significance and forwardlooking statements, which demonstrates the tension between the technical legacy of whitepapers and the temptation to make them binding due to the consequence of being integral to the ICO’s sale pitch. Feasibility of a Legal Action In view of the terms and warranties that the investor accepts, what remains to be answered is whether there are any grounds for civil or class action by investors. Retail investors who have invested small amounts in the token issuance will in practice feel dissuaded from pursuing a legal action given the costly nature of filling a claim. In addition, investors may find it difficult to identify binding representations in a whitepaper, upon which they could rely in breach of their rights given the presence of legally binding warranties and other terms and conditions. Therefore, finding enforceable contractual representations may not be possible and could only be pursued along with a statutory claim in securities and contract law. Which statutory claim the investors will chose to rely on will depend on a case-by-case analysis and whether they can establish that a particular legal regime applies to the token in question. on part of ICO issuers or a plain attempt by the ICO issuers to ensure that the sales and purchase contract does not amount to more than what it states and there is no additional investment element nor a guarantee of profit to it. An example of such a clause may read: ‘No person is bound to enter into any contract or binding legal commitment in relation to the sale and purchase of the tokens’. This particular clause was taken from a randomly chosen whitepaper where the particular no contract clause was labelled as ‘no legal contract or contract of sale’ clause. The wording of the clause invites one to conclude that neither the ICO issuer nor the investor are under an obligation to conclude the sale, especially in circumstances when the ICO funding cap is not reached and the ICO issuer reverts the purchased tokens back to investors.

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ii Applicable Legal Regimes Breach of Statutory Duty The number of legal avenues upon which aggrieved investors can rely on is limited. The majority of actions have been pursued in the U.S. where the investors, conscious of the unlikelihood of succeeding on contractual grounds, sought to bring actions relying primarily on a breach of statutory duty. It is argued that given the legally grey area and regulatory uncertainty in which ICOs operate, the first wave of claimants will pursue litigation by maximising the number of claims presented and will rely on a number of legal regimes. These legal regimes will include securities law, consumer protection law and common law for misrepresentation. The reliance on these regimes will follow in a sort of a ‘cascade’ whereby the first choice of avenue will be on securities law. If a claimant can present a strong case that the purchased tokens can be construed as securities, he may rely on the statutory provisions of securities law. If the token does not have characteristics of a security or the claimant fails to make the case, he has to rely on consumer protection and common law. A seemingly straight-forward case will hinge on the court’s willingness to step in and assess the contractual fairness of the agreement between the ICO issuer and token investor. The court will have to determine substantive unfairness in view of standard terms and conditions. iii Contract Law In cases where the securities law cannot be relied upon as a means of legal redress, the investors would be advised to construct their case in reliance on contract law. In order to do so, a contractual relationship between the ICO issuer and the token investors must be established on the facts. For that purpose, the terms of the whitepaper, Terms & Conditions and other accompanying token sale documents will be instructive. Generally, the token sale takes place in accordance with the stipulated whitepaper. The ICO contract calls on the ERC-20 smart contract and instructs it to send the appropriate amount of ICO tokens to the investor. From a legal perspective, the token sale agreement constitutes an offer – usually in an online form – to conclude the agreement for the purchase and use of digital tokens. The acceptance on part of the investor takes place upon the purchase of tokens. By purchasing the digital tokens, the investor agrees and accepts the offer and its conditions for purchase. The offer will often incorporate the white paper and T&Cs by reference, in which case the investor unconditionally accepts their terms. Based on this reading, token investors would presume that there is an intention to create legal relations between

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the parties, pointing out that an ICO’s whitepaper makes it clear that the token purchaser is contractually bound by its terms. Upon a closer inspection, a number of issues arise as to whether a contract has indeed been consummated between the parties. Firstly, it is not uncommon to find a no-contract clause in the Terms & Conditions or an explicit disclosure that the whitepaper or related documents are not to be construed as a legally-binding contract. Additionally, questions arise whether a whitepaper can be characterized as a unilateral offer, despite the presence of clauses stating that the investors is not bound to enter into legal relations with the ICO issuer. Thirdly, if we presume that a contract has indeed been intended, a question of enforceability arises. With their digital form, enforceability may be achieved through the incorporation of a unilateral acceptance clause. Nevertheless, laws on the acceptance of a digital contract may vary across jurisdictions. It is outside the scope of the present paper to delve deeper into the contractual nature of an ICO investment. The following sections will work under the presumption that a contract has been formed. If that is the case, under contract law, a claimant may bring an action on ground of misrepresentation and unfair contractual terms and seek damages. Such claim will be either based on statutory or common law provisions, depending on the particular jurisdiction. For illustrative purposes, in Singapore, the claimant would rely on the Unfair Contract Terms Act Cap 396, 1994 Rev Ed Sing (the UCTA), the Consumer Protection (Fair Trading) Act Cap 52A, 2009, Rev Ed Sing (CPFTA) and the Misrepresentation Act Cap 390, 1994 Rev Ed Sing (the MA).176 The CPFTA targets unfair contractual practices, between a consumer who is an individual not acting in the course of a business (Section 2(1)) and a supplier who in the course of his business provides or promotes goods or services (section 2(1)). CPFTA provides a list of unfair practices, among which is omission, false claims or taking advantage of a consumer (section 4).177 The court will determine whether the supplier has engaged in an unfair practice based on the reasonableness of the supplier’s conduct (section 5(3)a). The remedies for the finding of an unfair practice include damages, specific performance, variation of the contract and restitution (section 7(4)).178 The claimant will need to address exclusions of liability for misrepresentations and general exclusions of liability 176  For a detailed analysis see Dominika Nestarcova, Regulation of Initial Coin Offerings in Singapore, Centre for Banking & Finance Law, Faculty of Law, National University of Singapore, October 2018, report number CBFL-Rep-[URL]. 177  This list is complemented by a list of specific unfair practices under Schedule 2 that serve as examples. 178  The claim limit is capped at $30,000 SGD (section 6(6)).

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with reliance on established common law principles. The three pieces of legislation form a means of protection the institution of contract. Any false or misleading statement in the whitepaper or other documentation offered in marketing and solicitation prior to the ICO could be the basis for a claim in misrepresentation, if the token holders purchased tokens in reliance on the misrepresentation. In Singapore, the claimant relies on common law misrepresentation based primarily on English common law and claims damages under the statutory misrepresentation under section 2(1) of the MA.179 Whether a claim based on misrepresentation will be successful will depend on case-by-case basis. The feasibility of success is complicated by the nature of the ICO model and the whitepaper. Given the early-stage nature of the project, ICO issuers will face a difficult position of having to balance between making realistic representations and being able to induce investors as to the best potential of the project. Holding ICO issuers liable for every representation made in the whitepaper that could have materially induced investors to participate would be too onerous. However, faced with a financial loss, investors are in a position of information asymmetry, whereby they can only rely on the issuer’s information and have no external objective input to help them invest. Indeed, the future unknown of how courts will apply contract law principles to token sales reveals the underlying question whether regulatory solution is needed to manage the way investors engage with ICOs. If on the facts, the court can establish a fraudulent behaviour or misrepresentation, contract law tools have the capacity to handle such behaviour, while performing a role in safeguarding investors against unfair practices. Where contract law’s role becomes problematic is in intervening in the investment decisions and the risk allocation. iv Securities Regulation Securities Regulation Aside from the use of tokens to settle and record transactions in securities markets, some tokens may have characteristics resembling securities especially in cases when they are purchased as a form of investment to be traded on secondary markets. ICOs have been the target of regulators, with the potential applicability of securities regulation as a particular area of interest. The ICO token sale may constitute an issuance, purchase and sale of securities. If that is the case, the booming trend of ICOs and the associated risks need to be

179  At 461 in Andrew BL Phang and Goh Yihan, Contract Law in Singapore (Wolters Kluwer, 2012).

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addressed vis-à-vis investor and consumer protection and the overall health of capital markets. The ICO issuers will attempt to argue either that the token in question should be characterized as a utility token (see Part D) and therefore outside the scope of securities regulation, or that the ICO is donation-based crowdfunding. The reasoning behind the claim that the ICO proceeds are made in form of donations is due to the practical reality that many ICO issuers chose the corporate structure of a foundation. In Switzerland, which is a popular destination for ICOs looking to incorporate, a foundation under Swiss law is a segregated legal entity without members and an automatic tax exemption.180 Proceeds raised by a foundation are treated as a non-refundable donation to a team and its project.181 The difficulty with this argument is that in Singapore, the closest corporate structure that resembles a foundation is a public company limited by guarantee (CLG). Under section 17 of the Companies Act, CLG is used to promote non-profit causes with a separate legal status and limited liability for its members.182 A CLG structure prevents claimants from claiming to be shareholders in the company. From a practical perspective, donations are considered to be a gift without a reciprocal exchange. It becomes evident that receiving a token in exchange for a monetary contribution, and the token’s liquidity premium upon issuance, are at odds with the legal conception of making a donation. Despite ICO issuers hoping to characterize funds received in an ICO as donations, it is improbable that a court would agree with them. Moreover, given the cross-border nature of ICOs and the complex corporate structure of ICO-financed start-ups, jurisdictional differences in what 180  Dominique Jakob and Goran Studen, ‘Foundation Law in Switzerland – overview and current developments in civil and tax law’ Chiara Prele (ed.) Developments in Foundation Law in Europe (Springer, 2014) Available at: accessed 27 March 2018. 181  A foundation being an old corporate structure is now structured with the help of lawyers to ensure that the funds are used to the project’s development and to protect developers from any liability. For instance, MME, a renowned Swiss law firm rationalizes the non-refundable donations based on an argument that the purchased tokens only become property with enforceable rights once the blockchain technology is launched. See Luka Müller, Stephan D. Meyer, Christine Gschwend and Peter Henschel, ‘Conceptual Framework for Legal & Risk Assessment of Blockchain Crypto Property (BCP)’ (MME, 2017) Available at: accessed 26 March 2018 and Brenna Hughes Neghaiwi, ‘Top Swiss cryptocurrency lawyer questions “stupid” ICO structure’ (Reuters, 22 January 2018) Available at: accessed 26 March 2018. 182  Companies Act (Cap 50, 2006 Rev Ed).

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constitutes a donation will differ, making it difficult for prospective claimants to pursue legal action.183 The claimant will want to establish that the purchased tokens fall within the definition of financial instruments regulated under securities laws, which in turn would provide him with a legal avenue for civil remedies available to security holders. An exemplary case in the U.S. has been the lawsuit against the Tezos ICO, which demonstrates that investors will try to rely on securities law for civil remedies, such as for failure to comply with securities laws, misrepresentation, fraud and insider trading. To the extent that token holders can prove that the token in questions falls under the definition of security under the applicable legislation, the claimants may have a claim under such legislation. Tezos Foundation, a Swiss-incorporated company raised over $230M in an uncapped ICO in 2017 promising to develop a decentralized blockchain that governs itself by establishing a true digital commonwealth and facilitates formal verification.184 The foundation was created to purchase the technology developer, Dynamic Ledger Solutions, with the ICO proceeds. Prior to the lawsuits, the Tezos founders and the developers found themselves in a dispute, which further delayed the launch of the blockchain technology and caused the value of the Tezzies (the project’s tokens) to drop. Prior to the ICO, the Tezos network has not been developed and the tokens had no functional utility. In 2017, four class action lawsuits were filed against Dynamic Ledger Solutions, Inc., the founders of the Tezos project, and the Tezos Foundation that was established to conduct the Tezos ICO.185 The class actions based their alleged complaints on various causes of action, with a primary focus on allegations 183  Whether CLG is a suitable corporate structure for carrying out an ICO is outside the scope of this paper. For the purposes of this paper, it is important to point out that under the CLG structure, the ICO funds collected cannot be transferred or distributed to its shareholders as is stated in the Memorandum and Articles of Association. Nevertheless, despite the restrictions on the distribution of capital to members of CLG, a CLG may still distribute the collected ICO proceeds to the parent company that is developing the project. In practice, the CLG is used as the main vehicle which collects the ICO proceeds and the project is being developed by a separate operating company that is supported by CLG through grants. The latter can be in form of a private limited company. For instance, Litecoin Foundation is a CLG incorporated in Singapore that has carried out of the largest ICOs in the jurisdiction, whereby the CLG supports the Litecoin development team. See Xinxi Wang, ‘Litecoin Foundation is successfully incorporated’ (Litecoin Foundation, 3 April 2017) Available at: accessed 26 March 2018. 184  Tezos, Available at: https://www.tezos.com/. 185   G GCC, LLC v. Dynamic Ledger Sols., Inc., Case Nos. 17-cv-06779-RS, 17-cv-06829-RS, 17-cv06850-RS, 17-cv-07095-RS, United States District Court For The Northern District Of California, 2018 U.S. Dist. LEXIS 43728; Fed. Sec. L. Rep. (CCH) P100,054 and Alejandro

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of securities law violations and investor fraud. The foundational claim alleged that Tezos evaded securities law by carrying out an unregistered offer and sale of securities in violation of section 5(a) and section 5(c) of the Securities Act of 1933. The class actions made a thorough case for why Tezzies should be characterized as securities. Based on this allegation, the investors claimed a fraudulent inducement to invest, in violation of section 17(a) of the Securities Act, arguing that the Tezos representatives carried out a scheme to defraud investors by making false and misleading statements of material fact and omissions. In relation to this claim, the claimants alleged that the defendants misrepresented: how the ICO proceeds would be distributed, when the Tezos network would be functional, the relationship between the defendants, made false statements on the adoption of Tezos by well-known companies, failed to disclose the terms of the Dynamic Ledger Solutions purchase, and misrepresented the benefits investors would obtain from their investments in tokens. Thirdly, the claimants alleged a violation of section 17(a)(2) and 17(a)(3) of the Securities Act on marketing and solicitation of unregistered securities. On the marketing point, claimants alleged that Tezos made numerous statements exaggerating the progress of the network and the tokens’ rise in value. The Tezos class actions are a case study of how investors who suffered a financial loss would pursue a claim against the ICO issuers.186 How would aggrieved investors approach a lawsuit against an ICO issuer in Singapore? What is the feasibility of pursuing such a claim? As in the U.S., the investors will have to establish that the ICO falls under the regulatory oversight of the SFA and that the ICO in question falls under one of the ‘regulated activities’ under Part IV of the SFA. For that purpose, the court would have to examine on a case-by-case basis whether the digital token is a capital markets products under the SFA (section 2(1) SFA).187 In order to proceed with their claim, the claimants will need to make a case that the marketing and Gaviria v. Dynamic Ledger Solutions, Inc., Case No. 6:17-cv-1959-ORL-40-KRS (in the Middle District of Florida). 186  A similar lawsuit was filed in 2018 against Ripple claiming that Ripple sold unregistered securities. See Ryan Coffey v. Ripple Labs Inc., Case No. CGC-18-566271 (filed San Francisco County Superior Court) Available at: https://static1.squarespace.com/ static/5938711a9de4bb74f63b4059/t/5aebc4112b6a28e0ef4a0381/1525400594617/ Coffey+v+Ripple+Labs+Complaint.pdf. 187  Under section 2(1) of the SFA, “capital market products” means any securities, futures contracts, contracts or arrangements for the purposes of foreign exchange trading, contracts or arrangements for the purposes of leveraged foreign exchange trading, and such other products as MAS may prescribe as capital markets products. In this context, the MAS will examine if the token has characteristics akin to a share, debenture of a unit in a collective investment scheme.

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issuance of digital tokens constitutes an offer of securities that is subject to the same regulatory regime under Part XIII of the SFA as a traditional offer of securities. If so, an ICO issuer in Singapore may only make an offer of digital tokens which constitute securities or units in a collective investment scheme, if the offer complies with the requirements under Part XIII of the SFA. The ICO issuer would need to prepare a prospectus to be issued in connection with the offer and the prospectus would need to be registered with the MAS as outlined respectively in sections 240 and 296 of the SFA. A contravention of the SFA requirements attracts statutory civil and criminal remedies. The claimant may either under section 325 of the SFA apply to court to make certain orders based on a breach of the SFA, or may attempt to rely on a breach of statutory duty under section 234 the SFA to bring a civil claim and seek a civil penalty under section 232. As in the Tezos case, the investors may bring an action under the SFA for omissions and false and misleading statements made by the ICO issuer under section 253 and 254 of the SFA. However, token holders seeking compensation may encounter a difficulty in relying on these provisions, since the whitepaper does not constitute a prospectus. Therefore, if we follow a strict reading of the SFA, it is open to question whether a claimant could allege false or misleading statements and recover his financial loss. If ICO issuers are involved in insider trading or other market misconduct, the investors may rely on Section IV of the SFA. Again, the first hurdle is to establish that the ICO token issuance falls under the purview of the SFA. Under section 219 of the SFA, insider trading is a strict liability offence. Other prohibited market conduct including false trading and market manipulation may be relied upon to target those offenders that disseminate false or misleading information or fraudulently induce investors to deal in securities.188

Part D: Token Characterization

In view of the uncertainty in pursuing a claim in contract law, an aggrieved investor is likely to assert the application of the regulatory framework governing securities. The focus of Part D is on digital token’s characterization as a security under securities law. Upon closer look, it becomes obvious that characterizing tokens as securities is not a straight-forward exercise due to the inherent dual natural of tokens that encompasses both its utility and investment element. The present paper argues that what we are witnessing is a rise of a new digital asset class that struggles to fit into the traditional conceptions of securities law. 188  Sections 197 to 201 of the SFA.

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Nevertheless, market participants need guidance in ascertaining whether their token amounts to a security. Characterization of tokens is crucial not merely for the purposes of bringing an action, but primarily as part of a self-regulating model for ICO issuers who plan to conduct ICOs and are concerned with the status of their tokens as potential securities. At a regulatory level, delineating tokens that have a pure utility purpose and security-like tokens is crucial in light of mounting pressure on regulators worldwide to assert a more pro-active approach towards ICO regulation. Subjecting digital tokens to a securities regime and its draconian obligations, which do not sit comfortably with the ICO funding model, without a prior assessment of the tokens’ nature would defeat the democratizing function of the ICO funding model and potentially hamper the development of blockchain technologies. Instead, what we need is a clear understanding of the technology behind the digital tokens and an unequivocal, yet flexible framework to ascertaining when a token passes the security threshold. For that purpose, Part D concludes with a framework for token characterization, which draws parallels the current securities regulation in Singapore. Jurisdictions will differ in their legal definition of securities, which are either codified in statutory provisions or based on case law – as the present section makes clear, what amounts to a ‘collective investment scheme’ in Singapore, as opposed to an ‘investment contract’ in U.S. may differ and therefore a single universal framework is not advisable. i Digital Token Taxonomy Digital Tokens Before we can develop a framework for token characterization, it is necessary to address token definition and classification in order to consistently and accurately assess the nature of digital tokens. Equally, a taxonomy of tokens will clarify the relevant authority of governmental agencies vis-à-vis the digital token. When it comes to digital tokens, what we are interested to know is (i) how to classify them and (ii) how to define them. Unfortunately, there is no consensus to these questions, with market participants, outsiders, media and even regulators using different definitions and classifications.189 One approach is to devise a taxonomy based on the technical and functional aspects of tokens; another is to view tokens as a ‘fiction’ employed by users to interact

189  The present paper cautions against adopting a rigid taxonomy – the space is fast-evolving and what we can qualify as a digital token today may not be the case in near future. The general consensus in the crypto-community is the landscape of today’s digital tokens is merely a glimpse of what is to come.

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with the network being created.190 The confusion is not surprising given the staggering number of tokens issued daily and the technical confusion on how they function. At first glance, a token issued in an ICO may resemble a crossover between a commodity and currency. Upon closer look, the digital token ecosystem reveals that each issued token will have different characteristics and assigned functions. A common characteristic of tokens is that they are a digital representation of a value that is tradable on secondary markets, and in William Mougayar’s words, tokens are created by a start-up company to ‘selfgovern its business model, and empower its users to interact with its products, while facilitating the distribution and sharing of rewards and benefits to all of its stakeholders’.191 The ICO issuers create tokens not merely to raise finance, but as a means of accessing the product/service being developed – in other words, a token adds financial value and simultaneously adds functionality to the network. From a technical perspective, a token is a programmable unit functioning on a blockchain, issued with the help of smart contracts’ logic, as devised by the ICO issuers. Once the tokens are issued, they are cryptographically secured and they represent the token holder’s right to participate in or engage with the project’s ecosystem. The ICO issuer is the sole creator of the token being issued and will design the token characteristics and functions depending on the business model the team intends to pursue. The token functionality and issuance, including the amount of tokens issued, their tradability and function within the ecosystem will depend on the product/service being offered and will be customized in order to create network effects for its use. Token Taxonomy Tokens differ in their functions and represent a variety of assets, which take a variety of forms. In basic terms, a token is a digital representation of a value that is tradable on secondary markets and functions as a token-holder’s right to receive or benefit from the ICO issuer’s future product or service. Token taxonomy will depend on the functional categorization adopted. There is no right or wrong answer to establishing a token taxonomy, given the myriad of tokens issued and the number of diverse verticals under which they may fall. 190  Pierre Entremont, ‘ICOs: You’re scammy and you know it’ (Token Economy, 6 October 2017) Available at: accessed 20 March 2018. 191   William Mougayar, ‘Tokenomics  –  A Business Guide to Token Usage, Utility and Value’ (Medium, 10 June 2017) Available at: accessed 11 February 2018.

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Currently, the ICO market does not have a standardized token classification and commentators differ in their terminology.192 Tokens can have one or several properties. Mostly, they serve to accord a range of rights, including (i) the right to access the platform, the right to future profits (ii) the right to influence the development of the product/service or to exercise voting rights, (ii) the right to use the token to pay usage fees, (iii) the right to membership in the network developed. They may also function as a currency, ie a medium of exchange, store of value and a unit of account. Digital tokens can be categorized depending on their function. The differences in classification are often based on which token dimension is used as a yardstick to differentiate between the myriad of tokens; including: technical layer, underlying value, utility or even legal status. In the U.S. context, Rohr and Wright distinguish between protocol and application tokens, whereby application tokens can be divided into investment and utility tokens.193 In the EU context, Hacker and Thomale distinguish between currency tokens, utility tokens and investment tokens.194 While Rohr and Wright take an operational approach to token taxonomy by distinguishing between tokens based on which layer (protocol or application layer) they operate on, Hacker and Thomale take a functional approach, which focuses on the main function of the token. Similarly, the Swiss Financial Market Supervisory Authority FINMA uses a functional approach and categorises tokens into three types (allowing for hybrids): payment tokens synonymous with cryptocurrencies, utility tokens that provide access to the application and asset tokens which represent assets such as participations in real physical underlyings, companies, or earnings streams,

192  For token classification, see: Saman Adhami, Giancarlo Giudici, and Stefano Martinazzi, ‘Why Do Businesses Go Crypto? An Empirical Analysis of Initial Coin Offerings’ (October 20, 2017) Available at: accessed 11 February 2018, Jonathan Rohr and Aaron Wright, ‘Blockchain-Based Token Sales, Initial Coin Offerings, and the Democratization of Public Capital Markets’ (October 4, 2017) Cardozo Legal Studies Research Paper No. 527; University of Tennessee Legal Studies Research Paper No. 338. Available at: accessed 8 February 2018, 23. 193  Jonathan Rohr and Aaron Wright, ‘Blockchain-Based Token Sales, Initial Coin Offerings, and the Democratization of Public Capital Markets’ (October 4, 2017) Cardozo Legal Studies Research Paper No. 527; University of Tennessee Legal Studies Research Paper No. 338. Available at: accessed 16 March 2018. 194  Philipp Hacker and Chris Thomale, ‘Crypto-Securities Regulation: ICOs, Token Sales and Cryptocurrencies under EU Financial Law’ (November 22, 2017) Available at: accessed 12 March 2018, 12.

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or an entitlement to dividends or interest payments.195 An interesting taxonomical approach to conceptualizing tokens was proposed by a Swiss law firm MME, which put forward a framework treating tokens as a form of a ‘digitallydefined property’, referring to tokens as Blockchain Crypto Property (BCP).196 MME adopts a civil law-based conceptualization of tokens by treating tokens as units that contain elements of a property rights in a digital form and are registered on a blockchain. This taxonomy is in contrast to Burniske and Tatar’s approach that comes from an investor-angle.197 Burniske and Tatar broadly classify digital tokens, or as they refer to them ‘cryptoassets’ into: cryptocurrencies, cryptocommodities and cryptotokens.198 Cryptocurrencies as currencies within the traditional understanding fulfil three purposes – to serve as a means of exchange, store of value and unit of account. Cryptocommodities provision raw digital resources (computer power, storage). Cryptotokens function to orchestrate products and services (most commonly operating within applications built on blockchains such as the Ethereum).199 The present paper will for the sake of clarity adopt a two-fold taxonomy. At a fundamental level, similar to Rohr and Wright, tokens can be divided into protocol tokens and application tokens, depending on the layer they operate on. On a secondary level, we can distinguish between cryptocurrencies, utility tokens, investment tokens, equity tokens and security tokens. The rationale behind the two-fold distinction is to make a technical distinction as to the layer at which the tokens operate and their function. The functional sub-groups have been identified as the most common kind of tokens issued and in no way are determinative or exclusive. After all, given the multi-functionality of tokens, strict groups are merely indicative of the token’s main function. Protocol tokens function on protocols – blockchain technology made of a set of cryptoeconomics rules and consensus. Blockchain protocols will have their native protocol tokens, which function to facilitate transactions on the 195   F INMA, ‘FINMA publishes ICO guidelines’ (Press release, 16 February 2018) Available at: accessed 19 February 2018. 196   M ME, ‘Conceptual Framework for Legal and Risk Assessment of Crypto Tokens’ (MME, 1st May 2018) Available at: accessed 2nd May 2018. 197  Chris Burniske and Jack Tatar, Cryptoassets: The Innovative Investor’s Guide to Bitcoin and Beyond (McGraw-Hill, 2018). 198  Chris Burniske and Jack Tatar, Cryptoassets: The Innovative Investor’s Guide to Bitcoin and Beyond (McGraw-Hill, 2018) 32. 199  Chris Burniske and Jack Tatar, Cryptoassets: The Innovative Investor’s Guide to Bitcoin and Beyond (McGraw-Hill, 2018).

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protocol.200 They act as a financial incentive to reward users for ensuring the integrity of the network and simultaneously facilitating transactions as the protocol’s de facto ‘currency’. Well-known examples of protocol tokens include Bitcoin, Lisk, EOS, Ethereum or Tezos (in development). Ether, Ethereum’s protocol token is used to execute programs on Ethereum’s network and power smart contracts, enabling the creation of decentralized applications (DApps). In turn, application tokens function on top of the blockchain protocol and are created by the ICO issuer deploying a smart contract program.201 The Ethereum protocol allows for the execution of ‘smart contracts’ (computer code, which controls the transfer of assets on the blockchain) to settle transactions and has become the building block of the majority of ICOs. Instead of each ICO project developing its own decentralized platform with its own codebase, the developers can build their DApps on top of the Ethereum platform, as Ethereum is not application-specific, and instead can execute any arbitrary code. Ethereum allows an ICO issuer to create its own application token, which is a representation of a value. Application tokens tend to be native to the application being developed with more specific functions within the particular product/service ecosystem. At a functional level, we can distinguish between cryptocurrencies, utility tokens, investment tokens, equity tokens and security tokens. Cryptocurrencies function as a means of payment and may/may not exhibit the other characteristics of money – store of value and unit of account. Cryptocurrencies are often referred to as a sub-group of digital currencies built on a decentralized peer-to-peer network, which utilize cryptography to secure payments and execute transactions (examples include Bitcoin, Bitcoin Cash, Litecoin, Monero). A utility token functions to allow its users access to the protocol or application (examples include Storj, Filecoin, Golem, BAT). A buyer invests in a utility token with a belief that there is a value in the issuer’s product. For example, following the product-development, a utility token may be used by the investor to access the start-ups product or to actively use it as a medium of exchange. For instance, a start-up offering a decentralized storage network, which uses available storage space on computers among the network participants will allow token holders to spend the purchased tokens for storing or receiving 200  As previously mentioned in Part A, blockchain protocol is a form of a consensus mechanism, which governs how information is added to the block and in what manner do the nodes reach consensus. 201  Jonathan Rohr and Aaron Wright, ‘Blockchain-Based Token Sales, Initial Coin Offerings, and the Democratization of Public Capital Markets’ (October 4, 2017) Cardozo Legal Studies Research Paper No. 527; University of Tennessee Legal Studies Research Paper No. 338. Available at: accessed 16 March 2018, 12–14.

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data. Despite being tradable on a secondary market, utility tokens are integral to the functioning of the ICO project and are not designed as investments. The purpose of the prospectus regime is not applicable for utility tokens, as the information asymmetries between what the investor and ICO issuer know are functional and not financial. Theoretically, a utility token would not be considered a security by the regulators, as the token holder does not invest in the token with the objective of deriving a monetary value. Instead, a utility token is a digital representation of token holder’s right to benefit or participate in the ICO product/service being developed. The token provides an access to the product/service in the same manner as a purchase of a ticket for an amusement ride or a purchase of gym membership. However, this is not to say that the utility token does not acquire a monetary value upon issuance. To the contrary, utility tokens are tradable on secondary markets and their value is tied to the perceived or actual value and to the utility of the product being developed. Tradability may invite suspicion that utility token resembles a security, yet what we are concerned with here is the utility element and whether the utility objective was intended by the token purchaser and the ICO issuer. An example of a utility token is GNO, the native utility token of Gnosis, a prediction market platform that enables information sharing and rewards participants who successfully predict event outcomes.202 Similarly, Electrify a Singapore-based decentralized marketplace, uses utility tokens for consumers to purchase electricity.203 In contrast to utility tokens, investment tokens give economic rights to their holders (amount to investment contracts or securities).204 The most common economic rights are a share of future profits generated by the project or another form of a cash flow deriving from the token. De facto, an ICO issuer will issue a token as a utility token. However, its inherent characteristics and the rights it confers, may convert a utility token into a security-like structure. Since tokens can serve a number of utilities, their multifaceted nature makes it difficult for investors and regulators to categorise them. What complicates the distinction further is the fact that all utility tokens can be traded on secondary markets and sold for profit. Some may argue that even with the purchase of utility tokens, an investor could have an expectation of profit despite the primary design of a token to confer a pure utility. 202  Gnosis, https://gnosis.pm/. 203  Electrify, https://electrify.asia/#home. 204  Jonathan Rohr and Aaron Wright, ‘Blockchain-Based Token Sales, Initial Coin Offerings, and the Democratization of Public Capital Markets’ (October 4, 2017) Cardozo Legal Studies Research Paper No. 527; University of Tennessee Legal Studies Research Paper No. 338. Available at: accessed 16 March 2018, 14.

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What is problematic is ascertaining when a utility token becomes an investment token. How can we with legal certainty distinguish between a utility token and an investment token, bearing in mind that the latter displays characteristics of a financial instrument and arguably should fall under the existing securities law? At the heart of this debate is the elusive nature of blockchain technology and tokenization. In an ICO, the issuer is offering a product or service, which is not a financial instrument, but the process of tokenizing the product/service and the means by which tokens are offered and latter traded, makes the token exhibit characteristics of a security. From the point of view that tokens have an inherently dual-nature whereby a utility token is converted into a security-like structure simply by virtue of being tradable, it becomes impossible to make a distinction between the two. Another common group of tokens are equity tokens that represent ownership of an asset, such as a debt owned by a company or company stock. While not as common, they are expected to become relevant in project finance. In 2016, Lykke Corp issued equity on their own exchange.205 Security tokens, not to be confused with tokens which amount to securities for the purposes of securities regulation, are tokens which tokenize assets. They are commonly referred to as asset-backed tokens, in form of tokenized real estate or tokenized commodities, representing a fractional ownership claim on a tangible asset.206 The tokenization of an asset is said to allow the ownership of the asset to be shared between multiple investors and unlock higher liquidity. Digital Tokens – US and EU Approach The relevant authorities overseeing the crypto-markets in the United States include the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC) and the 50 state regulators.207 The SEC has cautioned on the ICO-related investor risks and has established a Cyber Unit within the U.S. SEC, which targets cyber-related misconduct.208 The SEC 205  Lykke, https://www.lykke.com/company/news/lykke_corp_completes_public_offering. 206   Stephen McKeon, ‘Liquidity is about market depth, not magic’ (Hackernoon, 21 August 2017) Available at: accessed 17 March 2018. 207  Financial regulation in the United States operate on a federal and state level. In Commodity Futures Trading Commission v. McDonnell, 287 F. Supp. 3d 213 (E.D.N.Y. 2018), the judge has concluded that fraudulent ICOs can be subject to enforcement proceedings brought up by the SEC, the Department of Justice, the Treasury Department’s Financial Enforcement Network (FinCEN), the IRS and others, all depending on the factual circumstances and the function of the digital tokens in question. 208   U.S. Securities and Exchange Commission, ‘SEC Announces Enforcement Initiatives to Combat Cyber-Based Threats and Protect Retail Investors’ (US Securities and Exchange

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is notable for its proactive approach in ICO regulation, having issued numerous cease and desist orders to ICO issuers and it continues to scrutinize any improper offerings without a registration or exemption under the securities laws. The applicability of the federal securities laws will depend on the classification of digital tokens as securities and the relevant test to determine the scope is the Howey test (Securities and Exchange Commission v. W. J. Howey Co., 328 U.S. 293 (1946)). If an ICO is not considered to be a security offering, the tokens will be treated as commodities and under the purview of the CFTC. SEC’s treatment of digital tokens as securities was elaborated on in the ‘DAO report’.209 The SEC’s Chairman Jay Clayton has expressed the view that most digital tokens are securities for the purposes of the securities laws.210 The SEC is set to make a determination with respect to digital tokens in light of the Howey test in the upcoming lawsuit against Kik, where the SEC is suing Canada-based messaging app Kik over its USD$100 million ICO, which it claims was conducted without registration.211 SEC’s position towards digital tokens has been partially clarified in the published Framework for Investment Contract Analysis of Digital assets which offers the latest guidance for ICOs by the SEC and the applicability of securities regulations.212 Together with the Framework, the SEC issued a no-action letter setting a bar for what does not constitute an investment contract. In summary, the Framework reinstates that securities laws continue to apply to token sales as expected (and predicted). What is new is that this position was finally put into writing following many calls from the crypto-community to clarify the treatment of token sales. Commission, 25 September 2017) Available at: accessed 22 February 2018. 209   U.S. Securities and Exchange Commission, ‘SEC Issues Investigative Report Concluding DAO Tokens, a Digital Asset, Were Securities’ (US Securities and Exchange Commission, 25 July 2017) Available at: accessed on 25 February 2018. For a detailed critical legal analysis see Jonathan Rohr and Aaron Wright, ‘Blockchain-Based Token Sales, Initial Coin Offerings, and the Democratization of Public Capital Markets’ (October 4, 2017) Cardozo Legal Studies Research Paper No. 527; University of Tennessee Legal Studies Research Paper No. 338. Available at: accessed 16 March 2018. 210   U.S. Securities and Exchange Commission Chairman Jay Clayton, ‘Statement on Cryptocurrencies and Initial Coin Offerings’ (US Securities and Exchange Commission, 11 December 2017) Available at: accessed 20 February 2018. 211   U.S. Securities and Exchange Commission v Kik Interactive Inc Case no. 19-cv-5244. 212   U.S. Securities and Exchange Commission, ‘Framework for “Investment Contract” Analysis of Digital Assets’, Available at: https://www.sec.gov/corpfin/frameworkinvestment-contract-analysis-digital-assets.

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The Securities Act 1933 only applies when the transaction concerns a security, which is defined widely in order to accommodate for increasingly innovative financial arrangements.213 Whether a digital token will be subject to securities laws will be a matter of assessing whether the token sale is a de facto investment contract, which under the Howey test is a matter of substance, not form. Under the Howey test, a token is a security if: (i) there has been an investment of money, (ii) in a common enterprise, (iii) with the reasonable expectation of profits, and (iv) resulting from the managerial efforts of others. Unless an ICO uses a helicopter drop of tokens, the investment of money prong is satisfied, as token investors offer consideration for the tokens. The investment in a common enterprise refers to the extent to which there is sufficient commonality with other investors whose financial interest in the undertaking is identical. As Rohr and Wright point out, the U.S. district courts have developed different approaches to this prong and determining which version of the commonality is sufficient will be open to question.214 The third prong refers to the profit expectation at the time of token purchase, whereby courts will make a distinction between a consumptive and investment objective.215 In the case of utility tokens, the differentiation between a utility and an investment element is difficult to make, since the exercise would involve analysis of the subjective mind of the token holder. If the case arises, we can speculate based on the U.S. SEC’s DAO Report that the courts will examine the ICO-related documentation and communication during the marketing stage and whether profit expectation has been mentioned.216 Lastly, the profits obtained from the investment must .

213   U.S. Code § 77b(a)(1): (1) The term “security” means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, votingtrust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing. 214  Jonathan Rohr and Aaron Wright, ‘Blockchain-Based Token Sales, Initial Coin Offerings, and the Democratization of Public Capital Markets’ (October 4, 2017) Cardozo Legal Studies Research Paper No. 527; University of Tennessee Legal Studies Research Paper No. 338. Available at: accessed 16 March 2018, 48. 215  United Housing Foundation, Inc. v. Forman 421 U.S. 837 (1975). 216   U.S. Securities and Exchange Commission, ‘SEC Issues Investigative Report Concluding DAO Tokens, a Digital Asset, Were Securities’ (US Securities and Exchange Commission,

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result from the efforts of others. Under this prong, the courts will ask whether the efforts of the ICO issuer were entrepreneurial or managerial and the degree to which the efforts were necessary in order to generate profit. Despite the instructive test and the case law, Howey is an old test that cannot possibly accommodate the dual nature of the tokens.217 The application of prongs can only be done in hindsight, which is not a satisfactory solution for ICO issuers hoping to operate under legal certainty. Likewise, the prongs may point in different directions, especially in cases where the primary objective is the investment element, but neither the ICO issuers nor third parties have in practice contributed to the profit generation. Indeed, the fluid nature of tokens has been addressed by the William Hinman, the U.S. SEC’s Director of the Division of Corporate Finance.218 Hinman elaborated on his view that in the initial phases of deployment, tokens are more likely to be characterized as securities under the Howey test, but gradually may attain attributes sufficient enough to eliminate this designation. Hinman substantiated his position upon the Howey test, making a distinction between a network that relies on the efforts of a third party and a sufficiently decentralized network which is self-sustaining in its existence.219

25 July 2017) Available at: accessed on 25 February 2018. 217  Jonathan Rohr and Aaron Wright, ‘Blockchain-Based Token Sales, Initial Coin Offerings, and the Democratization of Public Capital Markets’ (October 4, 2017) Cardozo Legal Studies Research Paper No. 527; University of Tennessee Legal Studies Research Paper No. 338. Available at: accessed 16 March 2018, 41. 218   U.S. Securities and Exchange Commission, ‘Digital Asset Transactions: When Howey Met Gary (Plastic)’ (Speech, 14 June 2018) Available at: accessed 28 June 2018. 219  In this context, a presence of a person or coordinated group in developing the network for the token use is a key factor. To determine whether a third party indeed drives the expectation of a return, Hinman lists a number of illustrative (non-exhaustive) factors: (i) Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value? (ii) Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset? (iii) Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?

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To illustrate the hybrid nature of tokens, there is the example of Munchee and its MUN token, which was subject to the U.S. SEC scrutiny. Munchee was a restaurant review application, which sought to raise funding by issuing MUN tokens. Its whitepaper offered a legal disclaimer and an explanation as to why its token did not constitute a security in the USA, merely conferring a utility value (token would be used within the Munchee ecosystem and not to fund its operation).220 However, in its analysis, the SEC halted Munchee’s offering of tokens, arguing that its tokens were securities pursuant to the Howey case.221 The crucial investment elements identified by the SEC, were (i) the purchaser’s reasonable expectation of profits based on Munchee’s promise to build an ‘ecosystem’ that would create demand for the tokens and (ii) the marketing of tokens via social media promising investors a ‘return’. In a landmark case U.S. v Zaslavskiy, the federal court has ruled that indeed in specific circumstances, ICO issuance will be subject to the provisions of U.S. securities laws.222 As part of the EU FinTech Action Plan, the EU recognizes the opportunities related to crypto-assets.223 ICOs are permitted in the EU, subject to future regulation. The EU is taking a wait-and-see approach, where it is continuously assessing risks and opportunities and whether the existing regulatory

(iv) Are purchasers “investing,” that is seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network? (v) Does application of the Securities Act protections make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset? (vi) Do persons or entities other than the promoter exercise governance rights or meaningful influence?  See U.S. Securities and Exchange Commission, ‘Digital Asset Transactions: When Howey Met Gary (Plastic)’ (Speech, 14 June 2018) Available at: accessed 28 June 2018. 220  Munchee, ‘Munchee Token: A decentralized Blockchain based food review/rating social media platform’ (Whitepaper, 14 November 2017) Available at: accessed 18 February 2018, 2–3. 221   U.S. Securities and Exchange Commission, ‘In the Matter of MUNCHEE INC., Respondent’ (Administrative Proceedings File No. 3-18304, 11 December 2017) Available at: accessed 10 February 2018. 222   U.S. v. Zaslavskiy, No. 1:17-cr-00647, slip op., 2018 WL 4346339 (E.D.N.Y. Sept. 11, 2018). 223  European Commission, ‘FinTech Action plan: For a more competitive and innovative European financial sector’ (Report COM (2018) 109/2, 2018) Available at: accessed 15 March 2018.

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frameworks suitably address the new funding model.224 ICOs are subject to AML/KYC requirements and they must comply with various regulatory frameworks, in particular, the: Prospectus Directive, Market Abuse Regulation, Markets in Financial Instruments Directive, Alternative Investment Fund Manager Directive and 4th Anti-Money Laundering Directive.225 The EU is in the process of assessing the need to regulate cryptocurrencies and will implement new legislation seeking to address the anonymity of the financial technology by implementing rules for cryptocurrency exchanges, platforms and wallet providers.226 As of 2018, digital tokens will fall under the scrutiny of securities regulation depending on the legal characterization of tokens.227 Under art 2(1) of the Prospectus Directive, the regulated instrument must fall within the definition of a security.228 Determining whether a token constitutes a security is by comparatively analysing the elements of transferable securities with token characteristics. The general criteria for a security broadly include: transferability, standardization, negotiability and functional comparability.229 ii Digital Tokens and Securities Law in Singapore Digital Tokens – Singapore Instead of imposing an outright ban or legislating, Singapore considers ICOs to fall within its existing regulatory framework. MAS continues to actively monitor ICOs within its jurisdiction while recognizing the potential future value of the ICO funding model and blockchain. MAS’ position on digital tokens and 224  European Commission, ‘Remarks by Vice-President Dombrovskis at the Roundtable on Cryptocurrencies’ (Speech, 28 February 2018) Available at: accessed 26 February 2018. 225   E SMA, ‘ESMA alerts firms involved in Initial Coin Offerings (ICOs) to the need to meet relevant regulatory requirements’ (ESMA Statement, 13 November 2017) Available at: accessed 10 February 2018. 226  European Parliament, ‘Anti-money laundering: MEPs vote to shed light on the true owners of companies’ (Press Release, 20 April 2018) Available at: accessed 21 April 2018. 227  For a detailed analysis see Philipp Hacker and Chris Thomale, ‘Crypto-Securities Regulation: ICOs, Token Sales and Cryptocurrencies under EU Financial Law’ (November 22, 2017). Available at: accessed 5 March 2018. 228  Directive 2003/71/EC of the European Parliament and of the Council of 4 November 2003 on the prospectus to be published when securities are offered to the public or admitted to trading and amending Directive 2001/34/EC (Text with EEA relevance). 229  Philipp Hacker and Chris Thomale, ‘Crypto-Securities Regulation: ICOs, Token Sales and Cryptocurrencies under EU Financial Law’ (November 22, 2017). Available at: accessed 5 March 2018.

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their characterization is consistent with the present paper’s token taxonomy. A Guide to Digital Token Offerings (hereafter ‘DTO Guide’) published by MAS is instructive in setting up the basis for token definition and the treatment of digital tokens in Singapore.230 MAS consistently refers to tokens as ‘digital tokens’ and defines them as ‘a cryptographically-secured representation of a tokenholder’s rights to receive a benefit or to perform specified functions’, which may also represent ‘ownership or a security interest over an issuer’s assets or property’.231 This definition rightly characterizes tokens as intangible, electronic representations, which are cryptographically-secured. MAS recognizes in the DTO Guide that with the advent of ICOs, the function of digital tokens has moved beyond cryptocurrencies and two new sub-groups have arisen, utility tokens and investment tokens that may amount to capital market products. The focus of this section is on a third group – digital tokens that are treated as de facto capital market products by virtue of representing ownership or a security interest over an issuer’s assets or property. Such tokens may be considered as equal to an offer of shares or units in a collective investment scheme under the SFA. Digital tokens may also represent a debt owed by an issuer and a debenture under the SFA. In contrast to the U.S. position which takes a substantive approach based on prior case law, the definition of a security in Singapore refers to the statute-based common law conceptions of debentures, shares and collective investment schemes. Characterizing Tokens as Securities The DTO Guide does not offer a detailed guidance on the application of the definition of ‘securities’ under the SFA to digital tokens. MAS stopped short of considering which specific token characteristics are indicative of the token being considered a security. The managing director of the MAS, Ravi Menon, stated that ‘what makes a security a security is basically a promise; a promise to share in the economic interest of your enterprise’.232 Digital tokens are analysed on a case-by-case basis to determine whether they fall within the 230   M AS, ‘A Guide to Digital Token Offerings’ (News and Publications, 14 Novem­ ber 2017) Available at: accessed 10 February 2018. 231  Monetary Authority of Singapore, ‘MAS clarifies regulatory position on the offer of digital tokens in Singapore’ (Press release, 1 August 2017) Available at: accessed 10 February 2018. 232  Laura Noonan, ‘Singapore keen on initial coin offerings’ (Financial Times, 15 November 2017) Available at: accessed 10 February 2018.

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definition of the SFA, either as a share, a debenture or a unit in a collective investment scheme (DTO Guide para 2.3). This conscious decision gives flexibility to MAS and addresses the inherently complex nature of tokens. MAS will look at the substance of a token and examine the token structure, utility/investment elements and any rights attached to it (DTO Guide para 2.2). The following section attempts to fill this gap by outlining under what circumstances a token would be considered a share, a debenture or a unit in a CIS. This is a speculative exercise, as given their novel structure, digital tokens are merely comparable in effect to securities. Nevertheless, the emphasis is on the comparability of tokens to securities instead of their form. (i) Share In general terms, a share is a legal chose in action or a collection of rights relating to a company.233 Under section 2(1) SFA read with subsection 4(1) of the Companies Act (Cap 50, 2006 Rev ed) share means a share in the share capital of a corporation and includes stock except where a distinction between stocks and shares is expressed or implied.234 In simple terms, a share is a right of participation in the company on the terms of the articles of association.235 Therefore, the rights and obligations attached to a share will depend on the company’s constitutional documents. By default, the ownership of shares in a company confers on the shareholder two rights: ‘first, while the company is a going concern, the right of participation on the terms of the memorandum and articles of association; secondly, if and when the company is wound up, the right to participate in the assets of the company remaining after all the debts of the company have been paid’.236 The right to vote remains the most fundamental characteristic of a share.237 Other common rights of shareholders may include; the entitlement to a pro-rata share of any dividends that are declared and paid, a power to appoint and remove the directors of the company or a 233  Lan Luh Luh, ‘Sale of Securities’ in Michael Hwang and Yeo Tiong Min (ed) Law Relating To Specific Contracts in Singapore (Sweet & Maxwell Asia, 2008) at 11.2.1 see also Per Andrews Ang JC in Pacrim Investments Pte Ltd v Tan Mui Keow Claire [2005] 1 SLR 141 (High Court, Singapore) at 149. 234  Farwell J in Borland’s trustee v Steel Brothers & Co Ltd [1901] 1 Ch 279 at [228]: a share is the interest of a shareholder in the company measured by a sum of the money, for the purpose of liability in the first place and of interest in the second, but also consisting of a series of mutual covenants entered into by all shareholders. 235  Prudential Assurance Co Ltd v Newman Industries Ltd (no. 2) (1939) 61 CLR 457 at [503]. 236  Walter Woon on Company law, para 11.5. 237  Hans Tjio et al., Principles and Practice of Securities Regulations in Singapore (3rd ed) (LexisNexis, 2017) at 3.14.

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pro-rata share of any assets remaining upon a winding up after the creditors of the company have been paid. The DTO Guide states that a digital token may constitute a share under the meaning of the SFA (DTO Guide para 2.3.1), where the token ‘confers or represents ownership interest in a corporation, represents liability of the token holder in the corporation, and represents mutual covenants with other token holders in the corporation inter se’. In other words, if the rights attached to the token are comparable in effect to the rights commonly attached to a share, then the token would be likely to fall within the definition of a share. The rights attached to the token could include voting rights or a right to profit. For equity tokens, which tokenize equity ownership, the case is more straightforward. However, for tokens which display only one characteristic of a share, it is questionable which element would be determinative. Unlike in an IPO where the purchaser receives an ownership share in a company, in an ICO the tokens do not represent a share in the ICO issuer’s company, unless they are equity tokens. If we follow the line of argument that a right to vote is the most fundamental characteristic of a share, then the purchased token would need to confer some form of a membership right. A strict reading of what is a membership right suggests the need for a separate entity from the identity of token holders, in which the token holders would have a stake. In reality, the token confers a right to use the future product/service, and not a right vis-à-vis the ICO issuing company. A non-literal reading would suggest a shareholder-like position in the future project from an economic perspective. At first glance, such reading may stretch the definition of a share under section 2(1) of the SFA beyond its limits. However, if the ICO issuer is a decentralized autonomous organization (comparable to a DAO), the token holders do not hold any equity ownership, but instead have voting powers to influence the investment decisions that the DAO smart contract makes. Comparable to a membership, the token holders are members in a blockchain-based investment vehicle. In that case, instead of attempting to fit a token with voting or similar membership-like rights into the definition of a share, the token may be closer in resemblance to a unit in a CIS. (ii) Debenture For the purposes of the prospectus requirements under the SFA, a debenture is “any debenture stock, bond, note and any other debt securities issued by a corporation or any other entity, whether constituting a charge or not, on the assets of the issuer”, with some specified exceptions (section 2(1) of the SFA). Case law has acknowledged that a debenture is a document which either

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creates a debt or acknowledges it.238 Under section 239 of the SFA, a debenture includes debenture stock, bonds, notes and any other debt securities issued by a corporation or any other entity, whether or not constituting a charge on the assets of the issuer.239 In practice, usage and custom would determine whether an instrument is considered a debenture and whether it is traded/tradable.240 In the ICO context, the main question is whether a token can create any form of debt owed by the ICO issuer. The answer is that the creation of such debt is not common in ICOs, as given the ICO’s funding model, the ICO issuer will refrain from fund raising that attaches a liability to the issuing company. As a result, it is unlikely that an ICO will fall under the debentures framework of the SFA. (iii) A Unit in a Collective Investment Scheme (CIS) Under section 2(1) of the SFA, a “unit”, in relation to a collective investment scheme, means a right or interest in a collective investment scheme (whether or not constituted as an entity), and includes an option to acquire any such right or interest in the collective investment scheme. Under section 2(1) of the SFA, a “collective investment scheme” is an arrangement in respect of any property bearing all of the following characteristics: the participants do not have day-to-day control over the management, irrespective of whether they have a right to be consulted or not; the scheme is managed as whole by or on behalf of a manager; the monetary contributions of participants are pooled; and the purpose of the scheme is to enable the participants to share profits in a pecuniary form. The structure of a CIS can be in the form of a trust or a corporation, and courts will take an inclusive approach to characterizing an entity as a CIS.241 Offers of digital tokens which constitute units in a CIS are subject to the same regulatory regime under Part XIII of the SFA, as units in a CIS made through traditional means.242 If we follow the statutory definition of a CIS, there are a number of elements that we can extrapolate from to apply to ICOs. 238  L evy v Abercorris Slate and Slab Co (1887) 37 Ch D 260, also see Bensa Sdn Bhd v Malayan Banking Bhd [1993] 1 MLJ 119 (High Court, Malaysia). 239  Subject to exclusions under section 239 of the SFA. 240  Hans Tjio et al., Principles and Practice of Securities Regulations in Singapore (3rd ed) (LexisNexis, 2017) at 3.15. 241  The category of CIS is not closed off and is subject to judicial determination. In Financial Services Authority v Fadley [2006] 2 BCLC 616, the court held a betting service that collected money from public to place bets on horse races was a CIS. 242  Where an offer is made in relation to units in a CIS, the CIS is subject to sections 286 and 287 of the SFA and to Part II of the Securities and Futures (Offers of Investments)

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– The first issue is to assess whether the ICO investors have day-to-day control over the management of the funds collected in the ICO. This factor will depend on whether the token holder is an active participant in the management of funds. In practice, ICOs do not afford token holders with rights to participate in the management of the ICO parent company or any other managerial roles as to the development of the product/service. Nevertheless, this will depend on the facts. – Second, the ICO fund need to be managed as whole by or on behalf of a manager. In the context of ICOs, whitepapers will normally outline how the ICO proceeds will be distributed and managed by the ICO team. Unless, the ICO was conducted for a DAO or an entity where the managerial efforts are entirely on behalf of token holders, the securities regulation will not apply, as there is no investment risk or information asymmetry that would need to be regulated. If the ICO proceeds are managed exclusively by the ICO team, the arrangement will resemble a CIS. A common example is when an ICO project is de facto imitating the business model of a venture capital fund by using the collected ICO proceeds to invest in projects and in turn offer the token holders a share in the returns provided by the projects. – Third, the monetary or crypto-contributions by investors have to be pooled. This requirement is easily satisfied, as the ICO proceeds are pooled in one bucket. – Fourth, the purpose of the ICO has to enable the participants to share profits in a pecuniary form. These four requirements are conjunctive in nature.243 Therefore, in order to characterize a fund that holds ICO proceeds as a CIS, all four requirements will need to be satisfied. Hong Kong has a comparable CIS regime to Singapore, and under Schedule 1 of the Securities and Futures Ordinance (SFO), a CIS has four relevant elements: – it must involve an arrangement in respect of property; – participants do not have day-to-day control over the management of the property even if they have the right to be consulted or to give directions about the management of the property; – the property is managed as a whole by or on behalf of the person operating the arrangements, and/or the contributions of the participants and the profits or income from which payments are made to them are pooled; and (Collective Investment Schemes) Regulations 2005, the Code on Collective Investment Schemes (“Code on CIS”) and the Practitioner’s Guide to the CIS Regime under the SFA. 243  Hans Tjio et al., Principles and Practice of Securities Regulations in Singapore (3rd ed) (LexisNexis, 2017) at 3.16.

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– the purpose of the arrangement is for participants to participate in or receive profits, income or other returns from the acquisition or management of the property. Under the regulated CIS regime, Hong Kong’s SFC has halted the Black Cell Technology ICO, as the ICO proceeds were to be used to fund the development of a mobile application and holders of the tokens would be eligible to redeem equity shares of Black Cell.244 The SFC considered the arrangement, advertised to Hong Kong’s public to be a CIS in violation of securities law.245 iii Issues in Classifying Tokens A detailed analysis reveals that tokens, when categorized against their functionality, represent a variety of assets which take a variety of forms. As outlined above in Part D, investment tokens are more likely to qualify as securities than utility tokens, bearing in mind that there is a fine line between investment and utility tokens.246 Prima facie, an ICO issuer will issue a token characterized as a utility token. However, because of the substance over form approach, its inherent characteristics and the rights it confers, may mean it is de facto a security. The changing nature of tokens over their development life-cycle gives them a uniquely fluid nature. What remains to be answered is how do we regulate an instrument which changes over time and at which point can we with sufficient certainty establish that the change has occurred. For example, once the ICO project reaches the proof of concept stage, does a seemingly security-like token become a utility token? Among ICO market participants, 244   S FC, ‘SFC’s regulatory action halts ICO to Hong Kong public’ (News & Announcements, 19 March 2018) Available at: accessed 21 March 2018. 245  Under section 103 of the SFO, it is an offence for a person to issue, or to have in his possession for the purposes of issue, whether in Hong Kong or elsewhere, an advertisement, invitation or document which is to his knowledge is or contains an invitation to the public to, among other things, acquire an interest in or participate in, or offer to acquire an interest in a CIS. Equally, under section 114 of the SFO, it is an offence for a person to carry on a business in a regulated activity or hold himself out as carrying such a business in a regulated activity unless the person is licensed or authorized by the SFC. 246  A buyer invests in a utility token with a belief that there is a value in the issuer’s product. For example, following the product-development, a utility token may be used by the investor to access the start-up’s product or to actively use it. A start-up offering a decentralized storage network, which uses available storage space on computers among the network participants will allow token holders to spend the purchased tokens for storing or receiving data. Despite being tradable on a secondary market, utility tokens are integral to the functioning of the ICO project and are not designed as investments. In contrast, investment tokens assign economic rights to their holders. There is a strong investment component in investment tokens.

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the argument goes that once a token becomes functional and may be used by its user in the project’s ecosystem, the investment component is no longer a dominant one and the entire enterprise has a functional utility. A watered down version of this argument would focus on the value of the token and argue that once the value is determined by the token’s commercial use, then the token cannot be a security. It presupposes that once the product/service become functional that the tokens’ price will not be determined by the market. This is not entirely true, as the tokens will continue to be traded on secondary markets. More fundamentally, this argument does not address the fact that we are dealing here with an instrument, which at its inception can be characterized as a security, but overtime it adopts features of a commodity. The issue of a token being a security-cum-consumption product was voiced during a hearing of the U.S. Subcommittee on Capital Markets, Securities and Investment, were Chris Brummer aptly pointed out that the Howey case itself involved citrus groves that could have theoretically yielded oranges to investors, comparably to the future utility of digital tokens.247 Since tokens can serve a number of functions, their multifaceted nature makes it difficult for both investors and regulators to categorise them. What complicates the distinction further is the fact that all utility tokens can be traded on secondary markets and sold for profit. Some may argue that even with the purchase of utility tokens, an investor could have an expectation of profit despite the primary design of a token to confer a pure utility function. From a commercial perspective, it is only rational that an investor who is essentially investing into the future idea of a project and potentially, into a technology that may never reach development stage, should not be afforded some form of a financial return. On the other hand, we need to be in position where we can distinguish between tokens in order to subject them to the purview of securities law. The Janus-faced nature of digital tokens is evident in Ether, Ethereum’s protocol token used to pay for smart contract execution on the Ethereum network. Clearly, Ether serves a functional purpose in being the native currency of the Ethereum network. However, investors may purchase Ether solely for the purpose of speculating on its value, without ever intending to use it. How, then, can we with certainty distinguish between a utility token and a security-like token, bearing in mind that the latter displays characteristics of a financial instrument and is more likely to fall under existing regulation? 247   Subcommittee on Capital Markets, Securities and Investment, ‘Examining Cryptocurrencies and ICO Markets’ (Memorandum, 9 March 2018) Available at: accessed 11 March 2018.

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Unless clearly stated that the token is an investment token, and the ICO issuer complies with the offer requirements, it may be misconstrued to categorize and label tokens as either utility or investment tokens at the outset. Instead, a more nuanced substantive approach is to focus on the investment and utility features of the token, as indeed it is difficult for investors to decipher the fine line between what constitutes a utility and an investment token. Investment-like aspects may include status as a share of profits, ownership interest in the ICO company, an instrument allowing the token holder to convert into equity, as opposed to functional aspects which may include; a right to vote on the business direction of the project, a right to participate in the project’s network or a right to contribute to the network. The difficulty is in establishing when security-like characteristics surpass the threshold that would trigger regulation. One popular argument suggests that the threshold could be determined according to the financial risk accompanied with the purchase of the investment token. There are two issues with this argument. Firstly, the token itself is not determinative of the level of investment risk, instead, it is the prospects of successful development of the product/service which is key to its risk, as well as the external risks outlined in Part B. There are also no derivatives and government bonds in the ICO ecosystem, which ties to the second issue that there is always investment risk present in digital tokens – regardless of whether the investment or utility component dominates. In other words, financial risk is inherent in the tokens and its level depends on the external factors (market risk, product development, management governance, fraud), not internal aspects of the token. Therefore, the level of investment risk should not be a determinant of whether the securities regulation applies. Tradability on Secondary Markets and No Product Argument A more hard-line approach is to consider all tokens that are tradable on secondary markets as securities, regardless of whether the primary design was intended to be a functional utility. Non-transferable tokens would not be considered securities. What remains to be answered is how this position would approach tokens that are subject to a hold-up period and may be traded only upon product development. Again, the changing nature of tokens during their life-cycle complicates any attempt to identify a threshold against which one could discern utility tokens from securities. The second hard-line conceptualization argues that if the token is issued at a time when there is no existing product/service, it is by default a security. The reasoning is that if the ICO issues a token that has no functional utility, but objectively only has a speculative value which hinges on the future success of the network, then the token must be a security. If the only value stems from the tokens’ immediate liquidity

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upon issuance, then it is nothing more than an inducement to invest based on the speculative value. These two positions are not nuanced as to the dual nature of the token, and instead take an objective assessment of tokens. Utility tokens, which objectively can be construed as digital goods with no investment element, have the potential to become regulated securities by virtue of tokenization. Tokenization of digital goods or tangible assets imbues tokens with security-like characteristics. Objective Assessment Due to the complex economic realities, to make a finding of an investment element, the courts will have to carry out a factual inquiry and assess the facts leading up to the ICO issue. First approach is to carry out an objective assessment of the facts, as was done in the Howey case and later on in SEC’s analysis of Munchee’s ICO. The presence of a profit component in promotional materials and communications prior to the ICO is an indication that the investors would have reasonably expected to gain a profit from the ICO. In the EU context, Hacker and Thomale likewise argue that the focus should be on the objectively judged evidence, and suggest that tokens should only be characterized as securities if the expectation of profits from the efforts of the issuer is a significant motive.248 The issue with objectively determining the investors’ and ICO issuer’s motives is that there are cases where there is no evidence of a profit inducement by the ICO issuer, but the investors are either acting upon a pure investment motive or on the positive market sentiments of other crypto traders. Deliberately excluding any mention of profits during the marketing stage or solicit investors with an expectation of a profit need not be problematic. Hacker and Thomale suggest that if the ICO issuer knows or should have known that there was a profit expectation, then ‘the investment component should also be considered sufficient to trigger prospectus regulation’.249 A reasonable investor standard would ask whether, based on objective facts, a reasonable investor would know or should have known that there would have been an investment aspect to the token purchase. Such determination would be based on the substance not the form of the marketing phase. This approach goes only to determine the presence of an investment aspect to the token at 248  Philipp Hacker and Chris Thomale, ‘Crypto-Securities Regulation: ICOs, Token Sales and Cryptocurrencies under EU Financial Law’ (November 22, 2017). Available at: accessed 5 March 2018, 34. 249  Philipp Hacker and Chris Thomale, ‘Crypto-Securities Regulation: ICOs, Token Sales and Cryptocurrencies under EU Financial Law’ (November 22, 2017). Available at: accessed 5 March 2018, 35.

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the time of issuance. The following section (v) attempts to elaborate on this standard by presenting a framework for token characterization. iv A Framework for Token Characterization As illustrated in section Part D (ii) above, in Singapore, the statutory definition of a security is broad and given the recent nature of the ICO phenomenon, it may be premature to define when a token is a security. In light of this, the following framework serves to illustrate how tokens compare to securities with their sui generis nature. Token assessment is a question of fact and this paper takes the view that, as the facts will often show, it is difficult to attempt to fit tokens into old conceptions as to what constitutes a security. A comparative approach is instructive but cannot be determinative. The following framework is primarily intended for ICO issuers and investors as a tool to assess the legal status of the token, and to assess whether their conduct amounts to a regulated activity, as it would be determined under the SFA in Singapore. It is intended to guide the self-assessment, but ultimately it is the views of the MAS and the Singapore courts that will determine the token’s legal status. The scope of this framework is applicable to ICOs conducted in Singapore or ICOs targeting Singapore’s residents. Framework Outline Step 1 Crypto-Asset The first step is to determine whether the token in question is indeed a cryptoasset. To establish this, we need to consider whether the underlying technology is based on a distributed ledger technology (DLT). A working definition of DLT describes the technology as a digital database or ledger, which is: (a) distributed, shared and replicated (distributed peer-to-peer network) (b) decentralized in nature (c) permissioned or permissionless or hybrids; (d) public or private or hybrids; (e) protected with cryptography or equivalent forms of encryption.250 If the token in question is based on a technology that fulfils the descriptive requirements of the DLT definition, the next step is to assess whether the asset in question is a digital token. MAS refers to tokens as ‘digital tokens’ and defines 250   M AS does not have a working definition of a DLT. The definitional attributes have been based on the current blockchain Project Ubin in Singapore, see Deloitte and MAS, ‘The future is here. Project Ubin: SGD on Distributed Ledger’ (Report, 2017) Available at: accessed 20 April 2018.

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them as ‘a cryptographically-secured representation of a token-holder’s rights to receive a benefit or to perform specified functions’, which may also represent ‘ownership or a security interest over an issuer’s assets or property’.251 Based on this definition, the token will have to fulfil the following requirements: (a) cryptographically secured (b) digital representation (c) offers a functional utility in exchange for a financial consideration (d) performs specific functions within the intended DLT ecosystem. Step 2 Token or Cryptocurrency Once we have established that the said technology is based on a distributed ledger and the asset in question has the characteristics of a digital token, the second step is to assess whether the digital token functions either as: (a) a native asset to the product/service being developed, or (b) a means of payment This step is necessary to distinguish between a cryptocurrency, a protocol token or an application token. Nevertheless, the technical distinctions between the tokens should not be determinative of whether a token is a security, as for the purposes of establishing the purview of the SFA, the distinction between a protocol and application token is not necessary. Step 3 Token Within the Legal Definition of a Unit in a CIS The third step is to assess whether the digital token qualifies as a security under the SFA. For example, if the digital token has characteristics resembling a unit in a CIS, the characterization will be guided by the statutory definition of a CIS under the SFA. There are a number of elements that we can extrapolate from under section 2(1) of the SFA.252 These elements are conjunctive and 251   M AS, ‘MAS clarifies regulatory position on the offer of digital tokens in Singapore’ (Press release, 1 August 2017) Available at: accessed 10 February 2018. The definition makes an assumption that all digital tokens are ‘secured’ and presents a possibly misleading notion that ‘cryptographic’ and ‘secured’ are necessarily interlinked. 252  Under section 2(1) of the SFA, a “collective investment scheme” is an arrangement in respect of any property bearing all of the following characteristics; the participants do not have day-to-day control over the management (regardless whether they have a right to be consulted or not), the scheme is managed as whole by or on behalf of a manager, the monetary contributions of participants are pooled and the purpose of the scheme is to enable the participants to share profits in a pecuniary form. The structure of a CIS can be

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the token will amount to a unit in a CIS, if the arrangement has the following characteristics: (a) the participants do not have day to day control over the management of the property AND (b) the property is managed as a whole by, or on behalf of, a manager (c) the contributions of the participants AND (d) the profits or income from which payments are to be made to them are pooled. Step 4 If Not CIS, Is It a Debenture or a Share? Unlike a unit in a CIS, a share or a debenture does not have a statutory definition under the SFA and needs to be considered within the wider notion of company and financial law. The assessment in this case comes with unavoidable legal uncertainty, as the assessment is based on a set of elements which will or will not indicate that the ICO in question has engaged in a regulated activity. The first set of elements relate to the ICO issuance structure: (a) financial consideration (b) timing of the sale (c) marketing of the sale (d) timing of token distribution (e) target audience (f) intention of the seller and buyer. The second set of elements considers token characteristics: (a) Functional and utility aspects (b) Voting (c) Profit Element 1 Financial Considerations The most fundamental inquiry is to ask whether the tokens were acquired in exchange for some form of consideration. This will commonly be in the form of cryptocurrency or fiat currency. This is of importance as a token that was purchased in exchange for financial consideration will be a form of money investment. Alternatively, the ICO issuer may choose to give away tokens for free, in which case the tokens are not purchased for value and do not involve an investment of money. Some tokens are distributed via mining, whereby the in form of a trust or a corporation and courts will take a wide approach to characterizing an entity as a CIS.

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users earn tokens. In case of mining, it is open to question whether the mining process is a form of money investment. On one hand, it requires algorithmicsolving capabilities on part of the miners, but the computing power that goes to solving the algorithmic puzzle also requires substantial amount of costly computational energy. Element 2 Timing of the Sale and Functionality The timing of the ICO vis-à-vis the product functionality may be indicative of the speculative aspect being dominant. If the token sale is at a point where the product/service is at an ideational stage or the code has not been developed, the investors are entirely relying on the aspirational promise made by the ICO issuers and not on tangible evidence. The more lacking the evidence to enable an investor to make an informed decision, the more likely that the speculative element is dominating over the utility element. Investors seeking to purchase tokens which are fully functional will be in a better position to make an assessment based on available financial data on the token’s performance. Nonetheless, this factor should not be determinative, as the decision to invest may be entirely divorced from the functionality of the product/service and be simultaneously motivated by other considerations such as philanthropy and ideology. Element 3 Marketing of the Sale Marketing of the token sale is a crucial element. This consideration has been of importance in U.S., where the SEC has looked closely, for example in the Munchee ICO at the marketing stage prior to the ICO, scrutinizing whether the marketing and general solicitation of the tokens, be it in the form of public pronouncements, social media or the whitepaper, would have lead a reasonable investor to believe that the token purchase will generate future monetary returns. The regulators will watch out for terms such as ‘returns’, ‘profits’ or ‘dividends’. The absence of profit-inducement may also be indicative, as ICO issuers will be advised to promote their tokens without emphasizing the investment element and instead focus on functionality and use cases. In circumstances when any investment language is missing, the inquiry should focus on the substance, rather than form. Element 4 Timing of Token Distribution The timing of the tokens’ distribution to the investor is relevant to the argument that only a functional product/service can have a utility value in the investor’s eyes and not be motivated by investment considerations. Timing is a valid consideration, but should not be given undue weight in the token’s

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characterization. After all, the rationale behind the ICO funding model is to offer a funding mechanism for early-stage start-ups. Expecting ICO issuers to deliver tokens only once the product/service is functional would remove the tokens’ liquidity premium upon issuance and dissuade investors. Element 5 Target Audience The question that a regulator or court will ask is whether the tokens have been offered to retail or institutional investors. The distinction may play a role in jurisdictions that have a securities regime that has a mandated investor or consumer protection. If the tokens are offered to a selected group of investors, the investment risk may be mitigated by their experience. Element 6 Intention of the Seller and Buyer As previously suggested, the intention of the ICO issuer and investor will be a crucial consideration. The present paper suggests the use of a reasonable investor standard and asks whether based on objective facts, a reasonable investor would have known or should have known that there would be a profitinducement aspect to the token purchase. Such determination should be based on the substance of the circumstances. This standard goes only as far as to determine the presence of an investment aspect to the token at the time of issuance. Functional and Utility Aspects The second set of factors focuses on token characterization and takes into account token features that may indicate a comparability with securities under the SFA. The focus is on objective indicators and the assessment should, again, put substance over form, especially in cases where the ICO issuer is silent on the investment element of the token, despite the wider ICO market being induced by profit or speculation. An important distinction needs to be made at this point between what the parties’ motivations and the token’s function. An ICO investor may have consumptive, investment or speculative motivations in purchasing the tokens. The consumptive value of the token refers to its underlying function and the market demand for this function among users. The higher the number of users, the value of the token increases. Investment value is driven by the investor’s prediction on the increase in value in the future. In the ICO market today, the speculative value tends to be a primary motivation given that most of the tokens have not matured enough for their speculative value to be equal to their utility value. An objectively determined consumptive motivation would not be a factor contributing to the finding of a security. However, investment and

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speculative motivations may be so. It will be interesting to see how courts will grapple with finding a speculative/investment motivation on part of the purchaser. De facto, every token that is tradable will become a speculative instrument. Where and how the regulators will draw a line will depend not only on considering other token characteristics, but more importantly on the level of scrutiny they will be willing to subject the tokens to. When considering the functional aspects of a token, the focus is on the role of the token vis-à-vis the application or protocol and its necessity for the functioning of the product/service. It is important to ask whether the product/service would function without the token and whether the token’s role is to solve a technical problem. With functionality, also come rights and entitlements for users. The clearer the participation rights through the medium of the token, the more likely that the token is necessary for the functioning of the product/ service. The following rights and entitlements are less likely to constitute securities: (a) Use of tokens as a means to pay for platform service/product (b) Right to access the platform via the token (c) Token necessary for the settlement of transactions (d) Right to develop the ecosystem or mine tokens The following rights and entitlements are more likely to constitute securities: (a) Tokens explicitly structured as securities253 (b) Financial advice offered by the ICO issuer on the offer of tokens (c) Right to dividends (d) Right to a share of the start-up’s profits (e) Corporate governance rights (any other right that resembles traditional equity rights) (f) Ownership or equity interest in the foundation or CLG (g) Investor has a status of a creditor or lender (h) Right to repayment of token purchase price or payment of interest (i) Transferability of the token (a disputable element) (j) A claim in bankruptcy (k) Token has no function in the product/service developed, purchased merely with an expectation of profit Voting The right to vote has been intentionally left out from the list of rights and entitlements, as voting may arguably find itself in both categories and may 253  Equity tokens or security tokens will certainly be considered as securities. Other tokens which give traditional equity or debt-related rights will also amount to securities.

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therefore point to two different conclusions. Objectively, a right to vote on the strategic development of the product/service, or a right to vote on the distribution of funds may de facto be considered as an equity shareholder’s right to vote. On that reading, a token has comparable properties to a share. However, a right to vote on the development of the product or on the access to the funds, especially if it requires a collective approval of token holders, may rightly be viewed by many crypto-enthusiasts as outside of the regulatory framework. The argument is that if the investors have active ownership and decision-making powers in realizing the future value of the project, then there cannot be an information asymmetry. A similar argument is used under the Howey test, where the managerial efforts of the ICO developers are necessary in finding a security. If the value realized is due to the efforts of the investors, it cannot be said that the investors made a passive investment. Whether this distinction will hold in Singapore will likely depend on the facts. Profit Regardless of whether the investors are promised financial returns on their investments, it is not unusual that the token holders, by virtue of using the product/services, may be incentivized or rewarded for doing so. In that case, the token holders are rewarded for their own efforts, instead for making a passive investment. It is important to make the distinction between profit obtained as a result of an active or passive investment. The difficulty is in establishing when a passive effort become an active effort on part of the investor, and whether the active investor condition precludes the efforts of ICO developers entirely. To further complicate matters, the expectation of control and factual control may differ. A similar point was made by Rohr and Wright in the U.S. DAO context, they concluded that a court will look at the expectation of control as stated at the outset when the investment was made and not how it came to be exercised.254 Whether this approach is the correct one is questionable, as surely the actual practice after the ICO should carry equal weight. The profits generated as a result of investors’ active engagement after the ICO would rationally preclude the imposition of securities law on the tokens, thus the importance of differentiating between a passive and active engagement in profit generation. An additional set of factors that the regulators and courts may take into account will include: 254  Jonathan Rohr and Aaron Wright, ‘Blockchain-Based Token Sales, Initial Coin Offerings, and the Democratization of Public Capital Markets’ (October 4, 2017) Cardozo Legal Studies Research Paper No. 527; University of Tennessee Legal Studies Research Paper No. 338 Available at: accessed 5 March 2018, 64.

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(a) Effort to list the tokens on secondary markets (b) Token transfer restrictions and hold-up periods (c) Internal management processes (to battle market manipulation or insider trading) (d) Legal advise (e) Communication with regulators prior to the ICO (f) Sale format and amount of tokens retained by the developers

Part E: Regulation and Challenges

Whether regulators should indeed regulate ICOs, and what form the regulation should take, is a question that cannot be answered without first asking: why do we regulate and what means of regulation are the most suitable in view of the picture of ICOs drawn in this paper. i Why Regulate Securities? What Is Regulation Regulation in an abstract sense is systemic and coercive in its nature. It is a form of governmental intervention in the private domain, which by implementing binding legal rules creates a framework that shapes the conduct of regulated entities.255 Put differently, regulation introduces standards to modify the behaviour of market participants and is backed by a sanctions regime.256 Securities markets serve a number of functions: (i) bring together investors and companies looking to allocate funds, (ii) investors who wish to sell and make their asset liquid and (iii) offer a variety of financial products that investors can choose as a means of risk management. In securities markets, regulation focuses on information asymmetries, fraud, market manipulation, insider dealing and market transparency. Regulators will prioritize which objectives a particular regulation is intended to address. In that manner, regulation is principlebased. The IOSCO principles of securities regulation are based on three main objectives: protecting investors, ensuring that markets are fair, efficient and 255  Barak Orbach – ‘What is Regulation’ (2012) 30 Yale Journal on Regulation Online 1 and Martin Cave and Robert Baldwin, Understanding Regulation: Theory, Strategy, and Practice (Oxford University Press, 2011). 256  More on financial regulation, see Mads Andenas and Iris H-Y Chiu, The Foundations and Future of Financial Regulation (Oxford: Routledge 2014) at chapter 2 and Jan Dalhuisen, Dalhuisen on International Commercial, Financial and Trade Law (Oxford: Hart Publishing 2004, 2nd ed) at chapter 6 and Martin Cave and Robert Baldwin, Understanding Regulation (Oxford University Press 2012) at chapter 1.

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transparent, and reducing systemic risk.257 With regard to investor protection, the market may fall short of providing an environment of trust and transparency. Regulation’s objective is not to interfere in market dynamics, but instead to fill the gaps where there is a perceived market failure.258 For example, information asymmetry is inherent to securities markets between investors and companies. Disclosure-based regimes achieve a higher-quality of disclosure of relevant information for the investor to make an informed decision. This links to the second objective of market efficiency. If the price of goods in markets is reflected in the information available to investors, the markets will be efficient and transparent (assuming that investors are all rational).259 Managing systemic risk has become increasingly relevant after the Global Financial Crisis and is linked to the promotion of financial stability and the assessment of how securities regulation may monitor and mitigate systemic risk.260 Why Regulate the Securities Markets More fundamentally, regulating securities markets generates growth. If investors can rely on a solid disclosure regime and legal protection, this generates trust and confidence in the markets. Iris Chiu describes securities as ‘credence goods’ as their quality is difficult to ascertain independently. This inherent characteristic is argued to warrant regulation which facilitates efficient price formation and optimizes the market conditions for securities transferability.261 One of the measures of market efficiency is that a security price accurately reflects the underlying economic value, and creates allocative efficiency as

257   I OSCO, ‘Objectives and Principles of Securities Regulation’ (IOSCO, May 2017) Available at: accessed 10 March 2018. 258  See John C Coffee, ‘Market Failure and the Economic Case for a Mandatory Disclosure System’ (1984) 70 Virginia Law Rev 717 and Alan Schwartz and Louis L Wilde, ‘Intervening in Markets on the Basis of Imperfect Information: A Legal and Economic Analysis’ (1979) 127 University of Pennsylvania Law Review 630. 259  Eugene Fama, ‘Efficient Capital Markets: A Review of Theory and Empirical Work’ (1970) 25 Journal of Finance 383, Art Durnev, Merritt Fox, Randall Morck, and Bernard Yeung, ‘Law, Share Price Accuracy, and Economic Performance: The New Evidence’ (2003) 102 Michigan Law Review 331–386. On investor behavioural economics: Donald Langevoort, ‘Taming the Animal Spirits of the Stock Markets: A Behavioral Approach to Securities Regulation’ (2002) 97 Northwestern University Law Rev 135, Joshua D Wright, ‘Behavioral Law and Economics: Its Origins, Fatal Flaws, and Implications for Liberty’ (2012) 106 Northwestern University Law Review 1. 260  Steven Schwarz, ‘Systemic Risk’ (2008) 97 Georgetown Law Journal 193. 261  Iris HY Chiu, Regulatory Convergence in EU Securities Regulation (Wolters Kluwer, 2008) 26.

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investors (again assuming their decision-making processes are rational) will allocate their capital to productive uses.262 In other words, securities regulation ensures that investors feel confident in investing and the target companies are able to grow. Bernard Black in his seminal article acutely summarizes the magic of securities markets: A strong public securities market, especially a public stock market, can facilitate economic growth. But creating strong public securities markets is hard. That securities markets exist at all is magical, in a way. Investors pay enormous amounts of money to strangers for completely intangible rights, whose value depends entirely on the quality of the information that investors receive and on the sellers’ honesty.263 Black’s observation illustrates why securities regulations are based on a disclosure regime. The theory behind the disclosure regime is built upon the Efficient Capital Markets Hypothesis that demonstrates a relationship between information and price, whereby asset prices reflect all the available information.264 The rationale for the prospectus regime is based on the Efficient Market Hypothesis, which itself is a direct application of rational choice theory to market behavior.265 George Akerlof illustrated the impact of information asymmetry on the state of a market.266 Akerlof showed how without verified 262  The criticism of the presumed rationality of investors is outside the scope of the present paper. Prospect theory, bounded rationality, behaviouralism or herding expose the limitations of disclosure regulation. The criticisms do not diminish the value of disclosure as a regulatory tool, but it becomes meaningful if subjected to empirical studies. 263  Bernard S Black, ‘The Legal and Institutional Preconditions for Strong Securities Markets’ (2001) UCLA Law Review, Vol. 48, 781–855. 264  Eugene Fama, ‘Efficient Capital Markets: A Review of Theory and Empirical Work’ (1970) 25 Journal of Finance 383. More on rationale for disclosure regime as a foundation for well-functioning capital markets see John C Coffee, “Market Failure and the Economic Case for a Mandatory Disclosure System” (1984) 70 Virginia Law Review 717, Iris HY Chiu, “Examining the Justifications for Mandatory Ongoing Disclosure in Securities Regulation” (2005) 26(3) Company Lawyer 67, Niamh Moloney, How to Protect Investors (Cambridge University Press, 2010), Rafael La Porta, Florencio Lopez-de-Silanes, Andrei Shleifer and Robert Vishny, ‘Law and Finance’ (1998) Journal of Political Economy 106 (6), 1113–1155 and Hans Christensen, Luzi Hail, and Christian Leuz, ‘Capital-Market Effects of Securities Regulation: Prior Conditions, Implementation, and Enforcement’ (2016) Review of Financial Studies 29 (11), 2885–2924. 265  Fama, Eugene, ‘Efficient Capital Markets: A Review of Theory and Empirical Work’ (1970) 25 Journal of Finance 383. 266  George A Akerlof, ‘The Market for “Lemons”: Quality Uncertainty and the Market Mechanism’ (August 1970) 84 The Quarterly Journal of Economics No. 3.

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and accurate disclosure, the market will discount both the good and bad stock. Mandatory disclosures ensure comparability of data, and transparent markets deter abuse.267 After all, as Louis Brandeis put it, ‘sunlight is said to be the best of disinfectants’.268 Under mandatory disclosure, an issuer of securities must disclose all relevant (price sensitive) information upon its decision to go public, when a company carries out a seasoned equity offering, when it issues bonds to the public on a periodic basis and/or on a continuous or ad hoc basis. Disclosure and Regulation in the ICO Context The documents related to the ICO offering are not under the disclosure regime’s burden to disclose accurate and verifiable information, but instead the ICO issuers are free to make public any information they deem appropriate. The ICO issuers are absolved from the costs of complying with the disclosure rules. Objectively, compared to IPOs, this makes the information in whitepapers next to useless for gaining accurate insight into the true state of the project. Disclosure requirements give legitimacy to the market, make information on ICOs comparable and discourage bad actors from entering the market. Lack of regulation is detrimental to legitimate ICO issuers, as investors are unable to objectively distinguish between bad and good ICOs. Building on the efficient market hypothesis came a wave of behaviouralist who exposed the limits of not only disclosure as the foundation of investor protection, but the regulation of capital markets alike. Modern regulators continue to use models in which investors are assumed to be rational decisionmakers. This implies that when presented with a detailed prospectus, an investor will make an optimal resource allocation and base his decision in line with utility maximization, provided that the prospectus offers sufficient information. Behavioural finance offers a different perspective. Barberis and Thaler note that the benefit of the rational actor framework in which the prospectus regime is wrapped is ‘appealingly simple’.269 What it does not account 267  The wider availability of market information will result in better pricing of securities and prevent misallocation of resources. Mandatory disclosure rules ensure issuer commitment to consistent disclosure of high-quality information and create a common format for the compilation and release of financial and other corporate information by securities issuers in order to enable investors to draw meaningful comparisons between firms of the same sector. 268  Louis Brandeis, ‘Other People’s Money’ Available at: accessed 10 March 2018. 269   Nicholas Barberis and Richard Thaler, ‘A survey of behavioral finance’ in George M Constantinides, M Harris & Rene M Stulz (ed.), Handbook of the Economics of Finance (2003) 1055.

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for is that investors are subject to behavioural biases, which would make the prospectus regime framework much harder to adjust to generalized investor needs. Therefore, the causation that the more information you give, the more accurate the pricing of the security will be, since the investor will make a rational decision follows the efficient market hypothesis, but the behaviouralists will disagree. Instead, investors are prone to numerous cognitive biases among which belong overconfidence and over-optimism, as they overestimate their ability to accurately process information. More specifically in the context of the prospectus regime, investors are prone to frame dependence and loss aversion. Kahneman and Tversky, who looked at prices and volatility in the market, demonstrated that not only choice can be manipulated through framing of information, but moreover, when faced with a set of data, investors are prone to loss aversion instead of utility maximization.270 Such investor behaviour is even more evident when faced with an informational overload presented in the prospectuses. As Parades writes, investor behavioural biases such as putting emphasis on headline information or failing to process an overload of information is due to investors not being able to use the prospectus information rationally. Such behaviour is predicated on the human’s ‘limited cognitive abilities to store, process and interpret information’.271 This bounded rationality has been demonstrated by Herbert Simon to make actors behave not perfectly rational.272 An example of how the presumption of a rational investor failed to protect investors despite the prospectus regime in place can be seen in the financial crisis of 2008. The oft-stated argument is that investors were not adequately informed of the risks regarding structured securities. However, opposite is true. As Avgouleas argues, the financial crisis ‘exposed the limits of disclosure’, since most of the risks were fully disclosed, but the investors failed to understand them due to complexity of these financial products and other behavioural biases, such as an overconfidence in the market or herding.273 Indeed, behavioural finance may provide a lens to analyse how behavioural heuristics influence the way investors in crypto-markets behave the way they do. If we focus on the rationality of investors in crypto-markets what we can identify is a common group of behavioural biases which can be commonly 270  Amos Tversky and Daniel Kahneman, ‘Judgment under Uncertainty: Heuristics and Biases’ (1974) Science, New Series, Vol. 185 1124–1131. 271  Troy Paredes, ‘Blinded by the Light: Information Overload and its Consequences for Securities Regulation’ (2003) 81 Washington University Law Quarterly 417, 435. 272  Parades, ibid. 273  Emilios Avgouleas, ‘The Global Financial Crisis and the Disclosure Paradigm in European Financial Regulation: The Case for Reform’ (2009) 6(4) European Company and Financial Law Review, 1.

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found in traditional financial markets. These biases are cognitive and are fuelled by irrationality, heuristics and emotions. Due to their digital form, the information on crypto-markets and ICOs comes from all sorts of virtual avenues causing an overload of data. Distinguishing what is relevant and what is not becomes more difficult as Herbert Simon made the case for investors suffering from inherent bounded rationality, the wealth of information together with the relatively novel and developing methods of financially assessing digital tokens creates a poverty of attention.274 As a consequence, investors and traders are more likely to affirm their decisions in social proof and herding. In other words, they will look at what the majority is doing and mimic their actions as a guide for their own.275 The complexity, novelty and difficulty in analysing and discerning verifiable crypto data increases the importance of market sentiment as a factor for decision making and feeds into the so-called ‘Fear, Uncertainty, Doubt’ (FUD) cycle and the Fear of Missing Out (FOMO) cycles. A FOMO cycle drives up the interest in the market and the demand skyrockets, which is often followed by a FUD cycle. Both are a consequence of market sentiment, whereby crypto-crowds attempt to manipulate the markets through emotion and sentiment. It should be evident in light of the above discussion that instead of treating investors as rational and applying the disclosure regime, alternative forms of regulation should be explored to best cater to the particularities of the crypto-markets and the behaviour of its participants. Difficulties In Regulating ICOs A seemingly straightforward advantage of imposing the disclosure regime to ICOs is met with a difficulty of designing a securities regime that both protects the investors and facilitates the disruptive innovation at the same time.276 The regulators are faced with the so-called ‘regulatory trilemma, whereby regulators seeking to provide clear rules, ensure market integrity and simultaneously

274  Herbert A Simon, Models of Bounded Rationality: Empirically Grounded Economic Reason (vol. 3) (MIT Press, 1997). 275  See Satish Kumar and Nisha Goyal, ‘Behavioural biases in investment decision making – a systematic literature review’ (2015) Qualitative Research in Financial Markets 7 (1) 88–108 and David Hirshleifer, and Siew Hong Teoh, ‘Herd behaviour and cascading in capital markets: A review and synthesis’ (2003) European Financial Management 9 (1): 25–66. 276  Mark Fenwick and Wulf Kaal and Erik Vermeulen, ‘Regulation Tomorrow: What Happens When Technology is Faster than the Law?’ (September 4, 2016). Lex Research Topics in Corporate Law & Economics Working Paper No. 2016-8; U of St. Thomas (Minnesota) Legal Studies Research Paper No. 16-23; TILEC Discussion Paper No. 2016-024. Available at: accessed 19 March 2018.

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encourage financial innovation can only achieve two of these goals at best.277 The regulatory trilemma is further complicated by the ongoing developments in blockchain technologies. As previously argued, blockchain itself has an inbuilt regulatory function and if we allow regulators to assess how this property could interact with traditional forms of regulation, the ICO market may be in a better position to self-correct. Prima facie, the ICO funding model allows for efficient capital formation targeting start-up companies, and creates an economy for each stage of the project’s development. Even though a funding model based on blockchain technology may not currently be the adequate model for all companies, it holds a promise of disrupting capital markets more broadly, including: capital formation, market liquidity and intermediaries. The age-old issues of information asymmetry, lack of liquidity and market makers, insider trading and market abuse in the capital markets can be dealt with by using blockchain technology. Cryptoeconomics that underpin the blockchain technology will address what economists have been trying to solve through theories, and regulators through legislation. Whether it is blockchain used as part of a funding model or a ledger, it is the art of cryptoeconomics that can address the vices of capital markets. While one might argue that a symbiotic relationship between blockchain technology and regulatory tools is the ideal model for drawing up a regulatory framework, letting the ICO market self-correct invites the question of moral hazard, i.e. if we absolve ICOs from the disclosure regime, investors will require some form of legal redress for misrepresentation, fraud or market manipulation alongside with letting the ICO market to self-regulate. Allowing ICO issuers to rely on an endless list of caveat emptors with no legal redress for the investors is not a satisfactory position, but neither is imposing traditional securities regulation. Indeed, regulators are in position of picking between lesser evils.

277  ‘If regulators prioritize market safety and clear rulemaking, they necessarily must do so through broad prohibitions, likely inhibiting financial innovation. Alternatively, if regulators wish to encourage innovation and provide rules clarity, they must do so in ways that ultimately provide simple, low intensity regulatory frameworks, increasing risks to market integrity. Finally, if regulators look to promote innovation and market integrity, they will have to do so through a complex matrix of rules and exemptions, heightening the difficulties of compliance, international coordination and enforcement.’ Chris Brummer and Yesha Yadav, ‘Fintech and the Innovation Trilemma’ (17 October 2017) Vanderbilt Law Research Paper No. 17-46 Available at: accessed 19 February 2018, 6.

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ii Regulatory Approaches to ICOs The following section looks at the available approaches to the regulation of ICOs and argues that self-regulation with a light-touch involvement may be the optimal solution to regulating ICOs in the current state of the market. Besides self-regulation, regulators may impose an outright ban on ICO-related activities, regulate under the traditional securities law or take a wait-and-see approach. As it stands, we are at the very early stages of understanding how to approach the regulatory trilemma, and what effects ICOs may have on capital markets. What is important is that in the meantime we protect the most vulnerable – retail investors. Keeping with the spirit of ICOs as a financial innovation, the present paper proposes self-regulation by ICO issuers to be a suitable regulatory approach, while limiting the role of regulators to policing the market of crypto-intermediaries, accompanied with the use of light-touch regulatory tools and an establishment of soft laws such as good practices and standardization of disclosure. Outright Ban on ICOs The first regulatory and the least frequent approach is to impose an outright ban on ICO-related activity. As of 2018, only two countries – South Korea and China have imposed such bans. South Korea imposed a ban on all forms of cryptocurrency fundraising. China’s central bank has declared ICOs illegal on the grounds that ICOs appeared to be a financial scam and pyramid scheme. Moreover, foreign ICOs targeting the Chinese market are also banned and the Chinese companies which have previously conducted an ICO were instructed to refund their investors.278 There is no evidence to suggest that an outright ban on ICOs, irrespective of whether tokens amount to securities, is beneficial. To the contrary, a ban is counterproductive and will hinder advancements in blockchain technology. Rationale for Applying Securities Law to ICOs The arguments for regulating ICOs are many-fold: (i) ICOs circumvent regulation. The ICO funding model is nothing more than a back-door to accessing less sophisticated retail investors on a mass scale while escaping the purview of securities regulation.

278  Ministry of Industry and Information Technology of the People’s Republic of China, ‘Seven Sectors Announcement on Preventing the Risk of Issuance of Coinage Offerings’ (Statement, 4 September 2017) Available at: accessed 10 February 2018.

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(ii) Useless tokens with no value. ICOs sell investors a token with no underlying value, only a future promise of a product/service. (iii) No investor protection. The popularity of the ICO funding model in raising capital and the network effects upon which it functions means that increasingly more investors are exposed to ICO-related risks and require more paternalistic regulation. ICOs thrive on information asymmetry coupled with unfair marketing practices. Mandatory disclosure would offer more accurate information on which investors could base their decision on, and ICO issuers would be less likely to get away with misrepresentations. (iv) Legal certainty. Regulation carries legal certainty. ICOs thrive in a legallygrey area and take advantage of regulatory arbitrage, which can only lead to a race to the bottom. (v) A financial bubble in the making. Not legislating or imposing securities laws on ICOs, while letting the market self-correct, is not a satisfactory position. The market will self-correct, but through a hard crash with many investors losing out on their investments. (vi) Best practices do not work. Best practices and other soft law tools are not backed by sanctions, and ICO issuers are free to ditch the best practices and save both money and time at the expense of reputation. (vii) Institutional investors. There is room for arguing that the current wide wild-west of cryptocurrencies discourages institutional investors. By alleviating regulatory uncertainty, institutional investors with their best practices and standardization will flock to ICOs and give the sector needed legitimacy. Securities Law Ill-Equipped for ICOs There are a number of justifications to support the paper’s position that despite the objectively beneficial effects of imposing securities law, such imposition is not advisable. 1. The arguments for regulating ICOs and treating digital tokens as securities, do not take into account the rationale behind the ICO funding model. The truth is that the current securities framework was not designed with the new class of crypto-assets in mind. As outlined in Part D, the dual nature of tokens as both an investment medium and a utility medium means that over their lifetime, tokens can change in function. As emphasized, at the heart of this debate is the elusive nature of blockchain technology and tokenization. In an ICO, the issuer is offering a product or service, which is not a financial instrument. However, it is the process of tokenizing the product/service, and the offering of tokens, which makes

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the token exhibit characteristics of a security due to the fact that tokens can increase in value and the economic purpose of holding a token is an investment, with an expectation of deriving an income or capital gain. Worldwide, there is no consensus on which tokens constitutes a security, and if we cannot clearly establish that a token is one, and we attempt to fit tokens into the regulation’s straight-jacket, we will be left with an equal amount of legal uncertainty as at the outset. Indeed, if one looks at the suggested framework for token characterization in Part D, it is a list of characteristics and attributes which carry unequal weights and may often point to different directions. This paper submits that if we cannot arrive at a clear-cut characterization of tokens with sufficient legal certainty, imposing traditional securities frameworks on digital tokens would be a mistake that will prove to be unsatisfactory. Similarly, Burniske and Tatar argue: ‘How can a regulator possibly hope to put a cryptoasset in a category that is centuries old, when these assets are redefining themselves and breaking their own boundaries every couple of years, if not every couple of months? They can’t…. especially when it is the first digital native asset class the world has seen.’279 Secondly, the disclosure requirements are not suitable for the ICO funding model, but instead were drafted for mature companies going public. ICO issuers are unsuitable targets to be considered by investment bankers and underwriters as viable IPO targets. Start-ups without a developed product, no cash flow, only ideas will be disadvantaged by the disclosure regime geared towards established companies. The disclosure regime requires the disclosure of all facts that would materially influence the investor’s decision. An ICO issuer, with a mere idea and a plan how to execute it, is not in a position to disclose the sort of information that the regulatory framework expects. In practice, the business model after carrying out an ICO may change and so can the product/service offered. Expecting ICO issuers to continuously disclose any relevant change would be too erroneous, and result in high legal fees. Neither is the standard process for carrying out an IPO suitable to the ICO model – the traditional model of complying with a costly prospectus regime, hiring an army of investment bankers, underwriters, consultants and lawyers to ensure that the marketing and offering of securities is carried out in a compliant manner, is not an option for ICO issuers.

279  Chris Burniske and Jack Tatar, Cryptoassets: The Innovative Investor’s Guide to Bitcoin and Beyond (McGraw-Hill, 2018) 108.

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Neither is the exemption regime suitable for ICO issuer’s purposes. For example, in Singapore, the token issuance may be exempt from the prospectus regime, if the offer is covered by Part XIII Subdivision 4 of the SFA. Exemptions are be granted in following circumstances: (i) An offer made with no consideration (section 272 of the SFA). This exemption would be suitable for those ICOs that do not issue tokens for a consideration, but instead issue tokens through so-called ‘airdrop’ whereby ICO issuers give away their tokens for free. (ii) Small personal offers where the total amount raised from such offers within any 12-month period does not exceed 5 million SGD or such other amounts as may be prescribed by the MAS; (section 272A of the SFA)280 This exemption is not suitable for all ICOs and will be only available to those ICOs that cap their token offerings under 5 million SGD. (iii) An offer to no more than 50 persons within any period of 12 months and under certain conditions; (section 272B of the SFA).281 This exemption is unsuitable for ICOs, since the offer is only available to 50 persons. The ICO funding model relies on network effects and it is highly unlikely that an ICO will ever only develop a product with such a small pool of users. (iv) An offer to qualifying persons like employees of the corporation or its related corporations under the specified conditions; (section 273 of the SFA). Again, offering tokens only to the ICO companies’ employees defeats the purpose of an ICO and will not be a likely exemption. (v) An offer to institutional investors; (section 274 of the SFA).282 In theory, this exemption could be applicable to a pre-ICO sale. Nevertheless, in the crypto-community, pre-ICO sales remain controversial as they go against the ideology of decentralization.

280  A small offer must be a personal offer that satisfies section 272A(3) and 302B(3) respectively. A personal offer is one that is made to a pre-identified person, which includes offers made to persons who have previous professional or other connection with the offeror. As the word “personal” suggests, each personal offer must be made personally by the offeror, or by a person acting on its behalf, to the pre-identified person, and may only be accepted by the pre-identified person to whom the offer was made. See Guidelines on Personal Offers made pursuant to the Exemption for Small Offers for further details. 281  Sections 272B and 302C of the SFA. 282  See section 4A(1)(c) of the SFA for the definition of “institutional investor” and regulation 2 of the Securities and Futures (Prescribed Specific Classes of Investors) Regulations 2005.

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(vi) An offer to defined categories of persons, such as accredited investors, or an offer made to a person is at a consideration of not less than 200,000 SGD for each transaction (section 275 of the SFA).283 Again, as for point (v), in practical terms, this exemption would be applicable to pre-ICO sales only.

Wait-and-See Approach The most common approach among regulators around the world is a wait-andsee approach accompanied with regulatory warnings on the risks associated with investing in ICOs. Silence on part of regulators can be viewed in three ways: tacit approval, lack of understanding or a deliberate but neutral stance. If construed as a form of intentional ambiguity, the tacit approval would have the effect of keeping the ICO issuers on their feet and make them tread carefully.284 To what extent is this the case is not verifiable given the lack of empirical data. Argument for a Paradigm Shift Blockchain technology and the ICO funding model based on blockchain technology are disrupting capital markets to the core. It is a matter of opinion whether one sees this trend as either a new ICO market developing alongside (in competition or not) with the capital markets, or as attempting to carve out a functional space within the capital markets. Burniske and Tatar argue that as an emerging asset class, digital tokens ‘will be uncorrelated with the broader capital markets because there is not much overlap between the early adopters of the asset and the broader market investors’.285 What is clear is that regulators have predominantly approached the crypto-related activities through the legacy lens of the securities regime. It is only human that we attempt to apply age-old securities law concepts and theories to new financial instruments that have comparable properties. The irony of it lies in the fact that the rise of the ICO funding model is a direct result of the aging principles associated with the disclosure regime and market asymmetry.

283  S ection 4A(1)(a) of the SFA for the definition of “accredited investor” and regulation 3 of the Securities and Futures (Prescribed Specific Classes of Investors) Regulations 2005. 284  Ryan Clements, ‘Assessing the Evolution of Cryptocurrency: Demand Factors, Latent Value and Regulatory Developments’ (February 3, 2018) Forthcoming, Volume 8, Michigan Business & Entrepreneurial Law Review, Available at: accessed 20 March 2018, 19. 285  Chris Burniske and Jack Tatar, Cryptoassets: The Innovative Investor’s Guide to Bitcoin and Beyond (McGraw-Hill, 2018) 132.

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Indeed, the new generation of young ICO developers has recognized that the strict and erroneous rules of the securities regime whether it is in Singapore, the U.S. or the European Union are at odds with their vision for a decentralized future and entrepreneurship based on ideas. Securities regulation is a form of a centralized intervention by regulators with an interest to protect investors in markets that cannot police themselves in face of information asymmetry, fraud and market manipulation. Following the DOTCOM bubble, it has become evident that there is a steady decline in public trust in the stock market. The IPO drought is a mark of it, especially for tech companies struggling to raise funds in the markets. Following the DOTCOM bubble, tech IPOs have been in a steady decline and the bar for an IPO is much higher.286 For tech companies, it takes years before they reach a sufficient development stage for a liquidity opportunity to materialize. Most often, they are small to mid-sized companies, which are too small to be considered by investment bankers and underwriters as viable IPO targets. Start-ups without a developed product and no cash flow, only ideas, have the odds stacked against them, but with developments in blockchain and crowdfunding, the ICO funding model has emerged as the viable funding mechanism. If one looks at the ICO model objectively without any knowledge of how ICOs have operated in practice, what we see is a democratizing funding model going against the rigid edifice of the traditional model of complying with a costly prospectus regime, hiring an army of investment bankers, underwriters, consultants and lawyers to ensure that the marketing and offering of securities is carried out in a compliant manner, is no longer the only way to gain access to capital. Nevertheless, ICOs should not be seen as a back-door to carrying out an IPO or securing VC funding. Indeed as a society we conceptualized what ICOs offer and instead threw them into the same pit as capital markets, where its participants brought out the worst of it. The blockchain technology underpinning ICOs is a fundamentally different manner of raising funds and places cryptoeconomics at the forefront.287 In other words, cryptoeconomics is about designing an economic structure powered by economic incentives and cryptography in an adversarial ecosystem.288 The Byzantine Generals Problem resembles today’s capital markets – how do we coordinate economic activity in an ecosystem where information is 286  Benedict Evans, ‘Andreessen Horowitz: US Tech Funding’ (Report, June 2015) Available at: accessed 20 March 2018. 287  See Part A. 288  BlockchainHub, ‘Cryptoeconomics’ (BlockchainHub) Available at: accessed 22 March 2018.

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incomplete, the communication between participants is imperfect and some participants are opportunistic in exploiting it. Securities regulation responds precisely to this scenario. While we sought to address these issues through regulating institutions, markets and individuals constitutionally, computer scientists found a way algorithmically to achieve a Byzantine fault tolerance (BFT) by treating the problem as an incentive problem. In line with this paradigm shift, Sinclair et al. refer to blockchain technologies as ‘institutional technology’, whereby it offers a new way of coordinating economic activity and is in itself a new form of an economic institution. The institutional aspects of capital markets can be imbued within the blockchain technology.289 Markets are essentially a bundle of billions of relational contracts and blockchain now presents a new alternative to coordinating economic activity of these bundles. It is essential that before we endeavour to regulate ICOs that we explore how cryptoeconomics and regulation can interact to avoid replicating the structural deficiencies inherent in today’s capital markets. With ICOs, we are at ground zero of pursuing regulatory attempts based on any theoretical findings. Our primal instinct is to apply age-old concepts of market dynamics. Instead, the focus should be on identifying risks and using regulation to fill in the gaps where the ICO market fails to self-police. The principled-approach of investor or consumer protection as pursued respectively in Singapore and the EU should not be applied as a straight-jacket to ICOs. Blockchain is challenging the principle of a centralized regulator and paternalistic regulation of market participants. Essentially, the regulator is being supplanted by technology, which can serve the role of a trusted third party that prevents information asymmetry as well as a policing mechanism. Self-Regulation via Code and Supervision of Secondary Markets The following sections argue that exploring how a symbiotic interplay between soft law regulatory tools and blockchain technology as a form of regulation is the way forward in order to foster a healthy ICO market. The present paper suggests four ingredients to a self-regulatory approach: (i) light-touch regulation, (ii) self-regulation by market participants, (iii) use of blockchain technology as a self-policing tool and (iv) regulation of secondary markets. Self-regulation is a form of a self-policing framework that entails policing and standard-setting by industry’s participants, rather than by public institutions. The four-fold approach is suggested as self-regulation is better achievable if carried out with the support of the government and an effective deployment of blockchain 289  Davidson Sinclair, De Filippi Primavera and Potts Jason, ‘Blockchains and the Economic Institutions of Capitalism’ (2018) 14 Journal of Institutional Economics 639.

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technology. This is particularly the case in the technology sector where market participants have better technical expertise and the industry is exhibiting a fast growth and change. (i) Light-Touch Regulation The regulator should adopt a light-touch approach towards regulating ICOs, encouraging the entry of ICO issuers. For the purposes of risk assessment, empirical studies will need to be undertaken in order to ascertain when the financial services/product offered pose a substantial risk that would warrant regulation. The light-touch approach allows the market to function without overarching interference, but if it starts to show signs of failure and an inability to self-correct, the regulator will step in. Indeed, soft norms are preferable – adopting hard-fast rules will influence the behaviour of market participants who in turn may opt for regulatory arbitrage, whereas soft norms are preferable as a mode of incentivizing compliance and adopting a principle-based approach. For that purpose, market regulation via self-regulation and code is preferable to asset regulation. In 2017–2018, the majority of regulatory attention has been on the regulation of digital tokens and their legal characterization. Iris Chiu makes a strong argument that market regulation should reflect the reality of the participants’ behaviour in the crypto-markets and makes a strong case for investor protection in relation to the secondary markets instead of focusing on asset regulation.290 (ii) Self-Regulation by Market Participants291 Market-driven initiatives are abundant and calls for accountability and self-policing are increasingly vocal. The case for self-regulation by market participants can be put as follows: (a)  Decentralization ethos and digital contracting narrative. Blockchain technology’s supporters have created a movement with decentralization at its heart. Regulation by a central entity is at odds with this movement, which has an inert desire to achieve consensus on standards and a preference to self-regulate. Self-regulation via code is in line with the former narrative used to rationalize the ICO funding model. It is all too easy in the midst of scams and undelivered promises to forget the narrative initially offered by the ICO 290  Iris HY Chiu, ‘Decoupling Tokens From Trading: Reaching Beyond Investment Regulation for Regulatory Policy in Initial Coin Offerings’ (April 4, 2018) International Business Law Journal/ Revue de Droit des Affaires Internationales Forthcoming, Available at SSRN: accessed 29 June 2018. 291  Martin Cave and Robert Baldwin, Understanding Regulation: Theory, Strategy, and Practice (Oxford University Press, 2011) 138–164 on self-regulation generally.

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issuers to justify their operation in an unregulated space. The initial promise of ICOs was to digitize, automate and enforce financial contracting via code and offer a fund-raising mechanism that protects investors’ rights. Prima facie, the fundraising process is carried out via code (smart contracts), which are deterministic and automate the relationship between the ICO issuer and investor, disabling the potential for abuse, conflict of interest or fraud. The ideational concept of smart contracts was introduced by Nick Szabo who defined them as ‘a set of promises, specified in digital form, including protocols within which the parties perform on these promises’.292 In other words, we can design smart contracts for a specific functionality for the purpose of collecting funds and distributing tokens. Consequently, in theory, smart contracts can substitute the traditional legal frameworks and embed consumer protection and securities regulation, while eliminating the need for financial intermediaries such as credit rating agencies, brokers or investment banks. However, as Part B demonstrates, currently the ICO funding model has failed to deliver these promises, which in turn brought about numerous investor risks. As Cohney et al. demonstrate, the underlying code effectuating the token sale has failed to deliver not only the ideational expectations, but even the whitepaper promises.293 If indeed we are to argue for self-regulation, it is absolutely imperative that the underlying code delivers the promises made and offers sufficient investor protection. If that is not the case, we cannot justify ICOs operating in a legally-grey area and it becomes clear that the regulatory arbitrage accusation is warranted. (b)  Code of Conduct and Best practices. Before we witness a regulatory hard-hand clamp down on all ICO issuers, irrespective of the utility of their project, this is an ideal time for ICO market participants to establish best practices based on accountability and transparency. By emulating the practices of securities regimes and imposing similar standards for disclosure and marketing may lead to an acceptance by regulators. Best practices would not only improve the

292  Nick Szabo, ‘Smart Contracts: Building Blocks for Digital Markets’ (1996) Available at: accessed 9 August 2018. 293  Shaanan Cohney, David A Hoffman, Jeremy Sklaroff and David Wishnick, ‘Coin-Operated Capitalism’ (July 17, 2018) Columbia Law Review (Forthcoming) Available at: accessed 10 October 2018.

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image of the industry, but more importantly impose reputational costs on those who refuse to follow them. In Switzerland, the Crypto Valley Association (CVA) has launched its own Code of Conduct, whereby its members are to conduct their business according to the Code, which places legal and moral standards on token sales.294 Similarly in Hong Kong, the FinTech Association of Hong Kong has published the Best Practices for Token Sales.295 Blockchain start-up Coinbase, in collaboration with CoinCenter, Consensys and Union Square Ventures published a 27-page framework that offers investors a decision matrix and sets out best practices for ICOs.296 (c)  Nascent and developing technology. With ICOs, we are still at ground zero. While securities regulation took a hundred years to materialize and develop, we have seen increased ICO activity only since late 2016. (d)  The multidimensional nature of tokens. As previously argued, the current securities framework was not designed with the new class of crypto-assets in mind. The dual nature of tokens as both an investment medium and a utility medium means that over their lifetime, tokens can change in their nature. Securities law was designed to regulate one-dimensional instruments that can be characterized at the outset. Letting the proliferation of tokens settle down and leaving it to the market participants to determine which dimensions to use as a yardstick for classifying tokens, is preferable. (e)  Cross-border nature of ICOs. For the first time in history, the assets in question are entirely digital and native to the Internet. ICOs are border agnostic in contrast to securities law which is jurisdictionspecific. Imposing harsh regulatory compliance on ICOs can only result in jurisdictional arbitrage. It is no secret that following the Chinese ban on ICOs, there has been increasing activity in Singapore. Despite the ban, it is not feasible for a regulator to oversee all ICOs, especially since they are in a digital form. Additionally, investors in jurisdictions where a ban has been imposed on ICOs are still able to overcome the firewalls imposed on crypto-related websites.

294  Crypto Valley Association, ‘Mission and Policy Framework’ (CVA, 8 January 2018) Available at: accessed 19 February 2018. 295  Fintech Association of Hong Kong, ‘Best practices for Token Sales’ (December 2017) Available at: accessed 19 February 2018. 296  Coinbase, ‘A Securities Law Framework for Blockchain Tokens’ (Coinbase) Available at: accessed 10 April 2018.

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(f)  Cooperation. MAS has been open to cooperation with the industry, which mirrors the stance taken by other regulators.297 Similarly, the New York Attorney General’s Office launched a Virtual Markets Integrity Initiative and sent letters crypto-trading platforms requesting disclosures on their operations.298 (g)  Gatekeepers and market research. On a par with equity research, new ICO market research entities are being established with a focus on ICOs, including Coincenter, Ark Invest or Smith + Crown among others.299 (h)  Governance initiatives. Numerous non-governmental initiatives have been created to encourage dialogue between market participants, and come up with compliance and best practices for ICOs. In Singapore, ACCESS – Singapore Cryptocurrency and Blockchain Industry Association has been active in establishing regulatory clarity and encouraging best practices.300 The ICO Governance Foundation is cooperating with regulators to create methods and standards for ICO regulation, and has initiated a voluntary registration form for ICOs.301 Project Transparency has launched an initiative whereby the member voluntarily binds her/himself to disclosure requirements.302 The Waves Platform, together with Deloitte, has created a self-regulatory body for ICOs to establish ICO disclosure protocols.303 The establishment of self-regulatory bodies, with ICO issuers as members, is encouraged. Such bodies can provide legal aid to ICOs, cyber-security processes, request periodic compliance statements or blacklist violators. 297  Ravi Menon, ‘Crypto Tokens: The Good, The Bad, and The Ugly’ (Speech at Money 20/20, 15 March 2018) Available at: accessed 17 March 2018. 298  The New York Attorney General’s Office, ‘Virtual Markets Integrity Initiative Questionnaire’ Available at: accessed 13 May 2018. 299  Coincenter https://coincenter.org/, ARK Invest https://ark-invest.com/, Smith + Crown https://www.smithandcrown.com/. 300   ACCESS, https://www.access-sg.org/blog/. 301   I CO Governance Foundation, https://icogovernance.org/. 302  Project Transparency, http://projecttransparency.org/. 303  Deloitte, ‘Waves Platform, with the support of leading market players, is founding a new self-regulatory body to set standards for ICOs’ (Deloitte, 11 December 2017) Available at: accessed 10 March 2018.

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(iii) Blockchain (and Smart Contracts) as a Regulatory Tool It is desirable, instead of relying entirely on the ICO market to selfregulate, that the regulators explore how blockchain technology itself can be used to regulate different aspects of the market and its participants. Blockchain technology has the potential to inject the market with investor protection by integrating this aspect into its underlying code.304 Instead of looking to regulators to correct market failure, computer science has the potential to imbue the market with integrity, transparency and trust.305 These elements would be enforced on the protocol level. As Primavera de Filippi and Aaron Wright elucidate, instead of relying on traditional laws and hierarchies to order the crypto-market, we will increasingly rely more on lex cryptograhica to organize economic activity.306 In other words, the rule of code will see the administration of law by code.307 In theory, smart contract design together with blockchain technologies have the capacity to substitute the traditional legal governance and deliver investor protection. Within the near future, we will be able to integrate the following processes into the blockchain technology that the code will be able to execute: (a)  Lock-up periods preventing token holders from dumping their tokens immediately after the token issuance (b)  Know-your-customer processes whereby the technology will be able to verify the identity of token purchasers (c) Blockchain arbitration through the use of smart contracts binding the parties in case of a claim arising308 (d) Escrow systems to lock in the raised ICO funds and allow issuance based on pre-determined conditions. If the conditions (e.g.

304  Randolph Robinson, ‘The New Digital Wild West: Regulating the Explosion of Initial Coin Offerings’ (1 September 2017) U Denver Legal Studies Research Paper No. 18-01 Available at: accessed 10 April 2018, 55–56. 305   See Nick Szabo, ‘Money, Blockchains, and Social Scalability’, UNENUMERATED (Unenumerated Blog, 9 February 2017) Available at: accessed 18 March 2018. 306  Primavera De Filippi & Aaron Wright, Blockchain and the law: the rule of code (Harvard University Press, 2018) 6–7. 307  This idea was initially explored by Lawrence Lessig who makes an argument that cyberspace is a place where code dominates and is simultaneously a form of law. See Lawrence Lessig, Code 2.0 (Basic Books, 2006). 308  See Datarella, https://datarella.com/.

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development milestones) are not met, the funds would be returned to investors309 (e) A pooled risk guarantee fund as a form of insurance for the token holders in case of insolvency or fraud that would automatically award the token holders with damages (f) Other cryptographic methods to control the management of funds raised (g) Consensus-based strategic management (h) Prediction market on a blockchain on the valuation of tokens (i) Consensus-based vetting of ICO projects (j) Smart contract templates to implement pre-determined standards (iv) Regulation of the Secondary Market If investor protection can be achieved via code, ensuring adequate consumer protection in cases of mis-description, misrepresentation or failure of consideration, the focus of regulators should be on secondary markets. The rationale is simple – if token investors know they cannot rely on the code to deliver the promises made in the whitepaper or they face a heightened risk related to a missing product/service, the bare minimum protection should be afforded to them in secondary markets, in particular on crypto-exchanges. This argument is supported by Chiu who also suggests that primary markets (ICOs) should be governed by consumer protection, while a higher level of protection should be afforded to investors on secondary markets, as token purchasers rely on secondary markets as a form of risk management.310 Indeed, the present paper agrees that the current state of secondary markets, in particular cryptoexchanges is worrisome and is in a dire need of imposing standards that mitigate principal-agent problems, misconduct, conflict of interests and ensure overall health and functioning of marketplaces. The office of the New York State Attorney General produced the Virtual Markets Integrity Report, in which it identified a number of mal-practices within cryptoexchanges, including; exchanges engaging in several lines of business creating a potential for a conflict of interests, operating on their own accounts, inadequate prevention on insider trading, varying market implementation of standards combatting abusive trading activity, lacking 309  See ESC Lock, https://www.esc-lock.com/ or Ventureum, https://ventureum.io/. 310  For an elaborate justification on the regulation of secondary markets, see Iris HY Chiu, Iris, ‘Decoupling Tokens From Trading: Reaching Beyond Investment Regulation for Regulatory Policy in Initial Coin Offerings’ (April 4, 2018) International Business Law Journal/ Revue de Droit des Affaires Internationales (Forthcoming) Available at SSRN: accessed 29 June 2018.

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monitoring of bots or automated algorithmic trading and a limited protection of customer funds.311 To address the current mal-practices and achieve consistency, one approach is to regulate crypto-exchanges under traditional frameworks for market operators and focus on principal-agent problems by imposing regulation targeting fair dealing, dispute resolution mechanisms, conflict of interest or management of business. Alternatively, some regulators, most prominently including Japan and New York have chosen a licensing regime. The New York ‘Bitlicense’ targets ‘virtual currency exchange services’ to require a license.312 Similarly, Japan has amended its Payment Services Act in order to offer a licensing framework for cryptoexchanges.313 Regardless of which of the two approaches is chosen, the regulation of crypto-exchanges should touch upon the following issues: (a) Legal definition of what constitutes an intermediary in the cryptomarkets (b) Risk management and control systems for the purposes of assessing risks related to AML/CFT (c) Appointment of a compliance officer (d) Management and storage of records for auditing purposes (e) Customer due diligence framework (f) Standards for combatting abusive trading activity, monitoring of bots or automated algorithmic trading (g) Dispute resolution that is transparent and fair (h) Internal management of conflict of interests (i) Proper handling of customer orders (j) Robust custody of assets. iii Recommendations – a Way Forward In view of the suggested self-regulatory approach to ICOs, the following section makes a number of general recommendations that regulators across jurisdictions may consider if they wish to cultivate an ICO-friendly environment: 1. The Sandbox. Despite the sandbox being the epitome of light-touch regulation, the application requirements for the FinTech sandbox may not 311  Office of the New York State Attorney General, ‘Virtual Markets Integrity Report’ (18 September 2018) Available at: accessed 20 September 2018. 312   Available at: https://www.dfs.ny.gov/legal/regulations/adoptions/dfsp200t.pdf under ‘Part 200, Virtual Currencies’. 313  Financial Services Authority of Japan, ‘Virtual Currency Exchange Agency Registration List’ April 20, 2018, Available at: https://www.fsa.go.jp/menkyo/menkyoj/kasoutuka.pdf.

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be suitable for ICOs. For that reason, the adequacy of the sandbox in the ICO context should be reconsidered, with public guidance for ICO issuers on how to apply for entry to the sandbox. Global sandbox. The U.K.’s Financial Conduct Authority (FCA) has spearheaded a global sandbox projected under the Global Financial Innovation Network (GFIN).314 The initiative with 12 regulators and related organizations has invited other actors to participate in regulatory cooperation and advance the proposal for a global sandbox. A global sandbox would indeed enable greater cooperation between regulators, establish a regulatory convergence, reduce the overall effort it takes for innovative projects to reach international markets and prevent regulatory arbitrage in the manner that regulators set up their respective sandboxes. Cooperation and actor-engagement. It is recommended that clear communication channels be established by regulators that are publicly available for prospective ICO issuers and crypto-intermediaries seeking questions on compliance. Commonly, start-ups complain about the cultural gaps and friction in understanding and trying to comply with the regulator’s vocabulary. Conversely, regulators are aware that regulation is always ex post and therefore what regulators really need is knowing where the crypto community is heading and what its future goals are. An active cooperation and dialogue between regulators and market participants will have the positive side-effect of providing invaluable input on the blockchain technology and in turn, give the ICO issuers the regulatory certainty of not unexpectedly falling within a definition of a securities offering. On a greater scale, such engagement could take a form of hackathons or pitches. Framework for best practices and code of conduct. The role of regulators could evolve to offer vetting of technology and testing of the ICO code as a form of technical due diligence. For example, they could act as standard-approvers, whereby a commission would give a stamp of approval to those prospective ICO issuers that would bind themselves to using a smart contract template with predetermined standards. The standard-setting framework may be carried out in cooperation with existing standard-setting bodies including the International Organization for Standardization (ISO) or the IOSCO.

314   Financial Conduct Authority, ‘Global Financial Innovation Network’ (Consultation Paper, 7th August 2018) Available at: accessed 10th August 2018.

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Registry of ICOs. As it stands, there are very few government-approved registries of ICOs (apart from Thailand and Malta). Instead, ICOs are documented on various websites, often with incomplete or non-verified information. It would benefit investors, the regulator and ICO issuers, to have such a registry in order to provide independently verifiable information on ICOs. The public registry would include a list of recognized and supervised ICOs, crypto-exchanges and financial advisors. Simultaneously, the registry would be a gateway for investors to identify blacklisted offenders. A blacklist of entities dealing with digital tokens that are known to be entangled in fraudulent schemes has been established in France.315 An alternative approach is to create a registry of ICOs for the purposes of code vetting in order to ensure that investors can rely on the whitepaper representations to be mirroring the code behind the token issuance. The auditing of ICOs should be carried out in cooperation with engineers and developers, with a particular focus on code that embeds consumer protection rights, dispute resolution clauses or asset distribution. Further guidance on token characterization. In view of the concerns voiced in Part D, detailed guidance on token characterization would be beneficial. Official guidance on token characterization should include a detailed analysis with case studies on which factors can be used to differentiate between an utility and an investment token. Establish a Cyber Unit. In Singapore, MAS has set up a Financial Technology & Innovation Group and a FinTech office, with the aim of forming regulatory policies, facilitating the use of technology and developing a vibrant FinTech ecosystem, respectively. Alternatively, regulators could consider setting up a ‘cyber unit’ akin to the one set up by the U.S. Securities and Exchange Commission. Such an initiative would send a signal to the market that regulators are serious about regulating ICOs under securities regulation where appropriate, yet at the same is cautious not to excessively pursue issuers so as to kill the market. Bankability. An initiative either on part of the regulator or by an association of banks would be welcome to create a working group to help both blockchain companies and investors to open bank accounts. As current financial market regulations on AML and CFT are not tailored

315   A MF, ‘The Autorité des marchés financiers (AMF) is warning the public against several companies proposing atypical investments without being authorized to do so’ (News Releases, 2018) Available at: accessed 8 August 2018.

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to blockchain-based entities or crypto investors, legal clarity on part of banks and setting of high standards would be welcome. 9. Market research. For the purpose of designing a customized regulatory framework, the regulators need to engage with verifiable market data on the number of ICOs carried out within their jurisdiction. Special attention needs to be paid to the funding raised, investor profile and whether the parent company behind the ICO issuers intends to develop the blockchain solution within the same jurisdiction. A number of ICOs within a jurisdiction should not be correlated with the number of blockchain projects to be developed, as ICO issuers will often set up a corporate structure whereby the ICO issuer is not within the same jurisdiction. 10. International regulatory regime. Regulators worldwide should strive to encourage the establishment of an inter-governmental initiative to align the interests of regulators in face of the border-agnostic ICOs and regulatory arbitrage. The efforts should go beyond the IOSCO Consultation Network on ICOs.316 Conclusion Future Trends There are a number of trends that can be expect in the ICO market, as market participants learn from their mistakes, regulators become more tech-savvy and more investors get the green light to invest: a. ICO sale format: Changes to the ICO sale format can be expected, with a more customized approach. The Gnosis’ reverse Dutch auction ICO revealed how a carefully planned ICO format can help issuers achieve specific economic goals. From the business strategy perspective, more creative models of raising funds can be expected and structured fundraising rounds will become common practice. Together with lock-up periods, ICO issuers will pay closer attention to the economics of token valuation and the demand/supply side. b. KYC and AML compliance: Compliance with KYC and AML standards increasingly resonates among upcoming ICO issuers and is a sign of a strong internal compliance regime both for investors and regulators.

316   I OSCO, ‘IOSCO Board Communication on Concerns Related to Initial Coin Offerings (ICOs)’ (Media Release IOSCP/MR/01/2018, 18 January 2018) Available at: accessed 18 March 2018, 1.

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From speculation to utility: As ICO projects mature and self-regulation among ICO participants takes place, we will see a push towards utility generation. On a spectrum of speculation to utility, the move will signal a maturing of the ICO ecosystem. Most visibly, this will impact the token valuation which will no longer be purely speculative, but will reflect on the utility value of the ICO project. Regulatory clarity: As more media attention is given to ICOs and there is a steady increase in ICOs worldwide, more governments will begin to explore how to effectively engage with DLTs and regulate crypto-related activities. Regulatory clarity sends the right signal to the ICO market participants seeking certainty and rule of law. Equity and security tokens: Whether it is tokenized equity granting investors shareholder rights, or security tokens representing tokenized assets, the trend of tokenization of assets and ownership will continue with the possibility of a new crypto-asset class solidifying. Institutional investors: So far, the main investors in ICOs have been retail investors. The trend is likely to see more institutional investors. As ICOs become more standardized, self-regulation sets best practices higher, along with KYC and AML compliance, ICOs will see increased interest from institutional investors. The latter has a different set of expectations, with an emphasis on corporate governance, segregation of funds, audit and compliance. Convergence between the ICO market and venture capital: Since 2017, more engagement between the venture capital funds and ICO issuers has been taking place. As the two cohabit a space for raising early-stage tech start-ups, more convergence between the two models may be expected. ICO issuers may even go as far as emulating the venture capital funding model therefore allowing investors to invest at their preferred level of risk.

Concluding Remarks Digital tokens are progressing on a path to become a recognized new asset class that will not only help to build new economies and fuel growth, but will become part of every investors’ diversified portfolio. Indeed, ICOs serve a crucial means of providing funding for the crypto community, instead of being labelled as obfuscating the actual nature of the tokens offered as investments. Aside from funding technological innovation, ICOs have disrupted our conceptions of traditional asset classes. It is therefore not surprising that ICOs have caught regulators worldwide off-guard by defying the traditional regulatory definitions. Just as the success of Uber or Airbnb, which operated on a

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regulatory parameter, while seeking forgiveness later, so are ICOs digital phenomena that operate cross-jurisdictionally and take advantage of frictions in capital markets. As of June 2019, there is little international convergence on the regulation of ICOs – instead, governments prefer to regulate aspects of the fundraising process by targeting data protection or anti-money laundering requirements. Akin to prior financial products, the regulators grapple with the same set of issues including: a rapidly developing market of digital assets, potential for fraud, market manipulation and an ICO business model that is always at danger of falling victim to its own mismanaged cryptoeconomics. Smart regulation of ICOs holds the promise of encouraging an innovative ecosystem where blockchain-based companies can rely on the support of a technology-savvy regulator. It is essential that before we endeavour to regulate ICOs that we explore how cryptoeconomics and regulation can interact to avoid replicating the structural deficiencies inherent in today’s capital markets. Similarly, Jesse Powell, CEO of Kraken a crypto exchange, makes the case for self-regulation: [w]e have greater transparency, fewer middle men, instant settlement, irreversible transfers, individual custody, atomic swaps, programmatically enforceable contracts, single assets traded on hundreds of exchanges. Because we have all these things, we have less systemic risk and many advantages over traditional markets. Assumptions we make about how traditional markets work don’t apply to crypto markets and therefore we need to try to remember why we imposed a specific requirement in the first place, before we unnecessarily impose it on the crypto markets.317 Indeed, if we are to follow up on the ideational project put forward by ICOs as a funding model executed via code, the only two alternatives are either traditional regulation or self-regulation. Any oft-stated proclamations on ‘finding the right balance’ obfuscates the origins of the crypto-community. If the underlying code is to be a guarantee of investor protection, we need to ensure that the future of the ICO model is based on legal contracting that is embedded in the code, instead of being used opportunistically for fraudulent purposes. The current state of ICOs indicates that the ideological case advancing this technological capacity does not match reality. Nevertheless, ICOs present an invaluable opportunity for us to assess how regulation and technology can 317  Jesse Powell, ‘Kraken’s Position on Regulation’ (Kraken Blog, 22 April 2018) Available at: accessed 10 May 2018.

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FMA, see Fintech section: https://www.fma.gv.at/en/cross-sectoral-topics/fintech/ fintech-navigator/. FSA, ‘Initial Coin Offerings (ICOs): User and business operator warning about the risks of ICOs’ (FSA, 27 October 2017) Available at: accessed 12 February 2018. FSA, ‘Financial Supervisory Authority warning: cryptocurrencies and ICOs (Initial Coin Offering) are high-risk investments’ (FSA, 22 November 2017) Available at: accessed 12 February 2018. FSC, ‘The Executive Yuan approved the draft “Financial Technology Innovative Experimentation Act”’ (FSC, 6 July 2017) Available. FSMA, ‘Initial Coin Offerings’ (Communication FSMA_2017_20, 13th November 2017) Available at: accessed 10 March 2018. Government of Bermuda, ‘Initial Coin Offerings in Bermuda’ (Government of Bermuda, 19 March 2018) Available at: accessed 19 March 2018. Government of Bermuda, ‘Initial Coin Offering Regulations’ (Newsroom, 13 July 2018) Available at: accessed 25 July 2018. HM Government of Gibraltar, ‘Token Regulation’ (Whitepaper, 2018) Available at: accessed 20 March 2018. IOSCO, ‘IOSCO Board Communication on Concerns Related to Initial Coin Offerings (ICOs)’ (Media Release IOSCP/MR/01/2018, 18 January 2018) Available at: accessed 18 March 2018. IRAS, ‘Income Tax Treatment of Virtual Currencies’ (IRAS) Available at: accessed 17 March 2018. Izabella Kaminska, ‘ Time to re-evaluate blockchain hype’ (FTAphaville, 3 August 2016) Available at: accessed 27 February 2018. Jan Lorenz, Heiko Rauhut, Frank Schweitzer and Dirk Helbing, ‘How social influence can undermine the wisdom of crowd effect’ (2011) Proceedings of the National Academy of Sciences May 2011 Available at: accessed 11 February 2018. Jason Goldberg, ‘Insider Reflections on the ICO Bubble, Part II: What it takes to ICO’ (Hackernoon, 23 December 2017) Available at: accessed 5 March 2018. Jason Goldberg, ‘Insider Reflections on the ICO Bubble Part III: 2018 is when crypto begins to move from speculation to utility’ (Hackernoon, 30 December 2017) Available at: accessed 30 March 2018. Jesse Powell, ‘Kraken’s Position on Regulation’ (Kraken Blog, 22 April 2018) Available at: accessed 10 May 2018. Joel Monegro, ‘Fat Protocols’ (Union Square Ventures Blog, 8 August 2016) Available at: accessed 1 April 2018. John Biggs, ‘Exit scammers run off with $660 million in ICO earnings’ (TechCrunch, 13 April 2018) Available at: accessed 18 April 2018. John Pfeffer, ‘An (Institutional) Investor’s Take on Cryptoassets’ (Medium, 30 December 2017) Available at: accessed 27 April 2018. John Russell, ‘Kik raises nearly $100M in highest profile ICO to date’ (TechCrunch, 27 September 2017) Available at: accessed 10 February 2018. Jon Russell, ‘Telegram has raised an initial $850M for its billion-dollar ICO’ (TechCrunch, 16 February 2018) Available at: accessed 20 February 2018. Josh Stark, ‘Making Sense of “Cryptoeconomics”’ (Hackernoon, 17 November 2017) Available at: accessed 16 March 2018. Juan Batiz-Benet, Marco Santori and Jesse Clayburgh, ‘The SAFT Project: Toward a Compliant Token Sale Framework’ (SAFT Project, 2 October 2017) Available at:

accessed 10 March 2018. Julia Leung, ‘New Technologies and Asset Management: A time of great promise and great peril? Hong Kong Investment Funds Association Luncheon’ (SFC Speech, 13 April 2018) Available at: accessed 16 April 2018. Justin Scheck and Shane Shifflett, ‘How Dirty Money Disappears Into the Black Hole of Cryptocurrency’ (Wall Street Journal, 28 September 2018) Available at: accessed 28 September 2018.

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Kadhim Shubber, ‘Crypto-bailouts for struggling startups’ (Financial Times, 30 August 2017) Available at: accessed 11 February 2018). Kim Yoo-Chul, ‘Korea to allow ICOs with new regulations’ The Korea Times (March 2018) Available at: accessed 24 March 2018. KNF, ‘Statement by Narodowy Bank Polski (NBP) and the Polish Financial Supervision Authority (KNF) on “virtual currencies”’ (News, 7 July 2017) Available at: accessed 19 February 2018. Komsan Tortermvasana, ‘Experts throw weight behind SEC to handle digital assets’ Bangkok Post (Bangkok, 9 March 2018) Available at: accessed 12 March 2018. LAToken, ICO trends (Report, 2017) Available at: accessed 3 February 2018. Laura Noonan, ‘Singapore keen on initial coin offerings’ (Financial Times, 15 November 2017) Available at: accessed 10 February 2018. Lior Yaffe, ‘The Token Duality Problems’ (Medium, 21 January 2018) Available at: accessed 30 March 2018. Loi Luu et al., ‘Making Smart Contracts Smarter’ (24–28 October 2016) CCS ’16 Proceedings of the 2016 ACM SIGSAC Conference on Computer and Communications Security, 254–269, 255. Luka Müller, Stephan D Meyer, Christine Gschwend and Peter Henschel, ‘Conceptual Framework for Legal & Risk Assessment of Blockchain Crypto Property (BCP)’ (MME, 2017) Available at: accessed 26 March 2018. Mark Carney, ‘The Future of Money’ (Speech to the inaugural Scottish Economics Conference, 2 March 2018) Available at: accessed 5 March 2018. MFSA, ‘Discussion paper on initial coin offerings, virtual currencies and related service providers’ (MFSA REF: 08-2017, 30 November 2017). MFSA, ‘Consultation paper on the financial instrument test’ (MFSA REF: 04-2018, 13 April 2018). Mike Sall, ‘Valuing Cryptoassets from the Ground Up’ (Medium, 24 April 2018) Available at: accessed 26 April 2018.

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MINFIN, ‘Draft federal law “On digital financial assets”’ (MINFIN, 25 January 2018) Available at: accessed 10 February 2018. Ministry of Industry and Information Technology of the People’s Republic of China, ‘Seven Sectors Announcement on Preventing the Risk of Issuance of Coinage Offerings’ (Statement, 4 September 2017) Available at: accessed 10 February 2018. Monetary Authority of Singapore, ‘A Guide to Digital Token Offerings’ (News and Publications, 14 November 2017) Available at: accessed 10 February 2018. Monetary Authority of Singapore, ‘MAS clarifies regulatory position on the offer of digital tokens in Singapore’ (Press release, 1 August 2017) Available at: accessed 10 February 2018. Munchee, ‘Munchee Token: A decentralized Blockchain based food review/rating social media platform’ (Whitepaper, 14 November 2017) Available at: accessed 18 February 2018. NBU, ‘Comment of the Deputy Chairman of the National Bank of Ukraine Oleg Churia on the status of Bitcoin in Ukraine’ (NBU, 11 August 2017) Available at: accessed 25 March 2018. NBS, ‘Národná banka Slovenska’s warning to the public on Bitcoin’ (NBS, 26 November 2013) Available at: accessed 18 March 2018. Neil Jerome Morales, ‘Philippines to allow cryptocurrency operators in economic zone’ (Reuters, 25 April 2018) Available at: accessed 10 May 2018. Nick Szabo, ‘Smart Contracts: Building Blocks for Digital Markets’ (1996) Available at: accessed 9 August 2018. Nick Szabo, ‘Money, Blockchains, and Social Scalability’, UNENUMERATED (Unenumerated Blog, 9 February 2017) Available at: accessed 18 March 2018.

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Olga Kharif, ‘Only One in 10 Tokens Is In Use Following Initial Coin Offerings’ (Bloomberg, 23 October 2017) Available at: accessed 11 March 2018. Olga Kharif, ‘Hedge Funds Flip ICOs, Leaving Other Investors Holding the Bag’ (Bloomberg, 3 October 2017) Available at: accessed 16 February 2018. Paul Vigna, ‘Tezos Raised $232 Million in a Hot Coin Offering, Then a Fight Broke Out’ (The Wall Street Journal, 19 October 2017) Available at: accessed 7 February 2018. Pavel Kravchenko, ‘Is the ICO market currently a Ponzi?’ (Medium, 16th September 2017) Available at: accessed 18 March 2018. Pierre Entremont, ‘ICOs: You’re scammy and you know it’ (Token Economy, 6 October 2017) Available at: accessed 20 March 2018. President of the Republic of Belarus, Decree No. 8 ‘On the Development of the Digital Economy’, Available at: accessed 28 March 2018. Ravi Menon, ‘Crypto Tokens: The Good, The Bad, and The Ugly’ (Speech at Money 20/20, 15 March 2018) Available at: accessed 17 March 2018. Reserve Bank of India, ‘Statement on Developmental and Regulatory Policies’ (Press release, 5 April 2018) Available at: accessed 7 April 2018. Reuben Bramanathan, ‘The perfect token sale structure’ (GDAX, 19 May 2017) Available at: accessed 18 March 2018. Reuters, ‘Mexican authorities warn cryptocurrency offerings could be a crime’ Reuters (14 December 2017) Available at: accessed 21 February 2018. Reuters, ‘Ukrainian ministry carries out first blockchain transactions’ (Reuters, 7 September 2017) Available at: accessed 21 February 2018.

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Robert M Metcalfe, ‘It’s All In Your Head’ (Forbes, 20 April 2007) Available at:

accessed 21 March 2018. SARB, ‘Media Statement’ (SAB, 13 February 2018) Available at: accessed 15 February 2018. Satis Group, ‘Cryptoasset Market Coverage Initiation: Network Creation’ (11 July 2018) Available at: accessed 18 July 2018. SBV, ‘Information related to the use of virtual currency’ (SBV, 30 October 2017) Available at: accessed 23 February 2018. SCA, ‘SCA issues circular warning investors against digital, token-based fundraising activities’ (SCA, 4 February 2018) Available at: accessed 10 March 2018. SEC, Emergency Decree on Digital Asset Business B.E. 2561 (2018) (Digital Assets Decree), Available at: https://www.sec.or.th/th/Pages/News/Detail_News. aspx?tg=NEWS&lg=th&news_no=73&news_yy=2561. SEC, ‘SEC Thailand’s Viewpoint on ICO’ (SEC, 14 September 2017) Available at: accessed 18 February 2018. Securities and Exchange Commission Philippines, ‘Rules on Initial Coin Offerings (ICO)’ (SEC Memorandum Circular, 2 August 2018) Available at: accessed 10 September 2018. SCM, ‘Media Statement on Initial Coin Offerings’ (Kuala Lumpur, 5 January 2018) Available at: accessed 15 February 2018. SCM, ‘Cautionary Statement on Initial Coin Offerings’ (Kuala Lumpur, 19 January 2018) Available at: accessed 16 February 2018. SFC, ‘SFC’s regulatory action halts ICO to Hong Kong public’ (News & Announcements, 19 March 2018) Available at: accessed 21 March 2018. SFC, ‘Statement on initial coin offerings’ (SFC, 5 September 2017) Available at: accessed 11 February 2018.

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Stan Higgins, ‘ICOs Welcome: Isle of Man to Unveil Friendly Framework for Token Sales’ Coindesk (6 September 2017) Available at: accessed 13 February 2018. State Bank of Pakistan, ‘Prohibition of Dealing in Virtual Currencies/Tokens’ (BPRD Circular No. 03 of 2018) Available at: accessed 11 April 2018. Stephen McKeon, ‘Liquidity is about market depth, not magic’ (Hackernoon, 21 August 2017) Available at: accessed 17 March 2018. Steve Tweedie, ‘Messaging app Kik just raised $50 million to become the newest member of tech’s billion-dollar unicorn club’ (Business Insider US, 18 August 2015) Available at: accessed 15 March 2018. StreamSpace, ‘The Wisdom and Herd Behaviors of Crowds’ (Medium, 30 January 2018) Available at: accessed 7 February 2018. Subcommittee on Capital Markets, Securities and Investment, ‘Examining Cryptocurrencies and ICO Markets’ (Memorandum, 9 March 2018) Available at:

accessed 11 March 2018. Tanzeel Akhtar, ‘Israel Securities Authority to Form Committee to Oversee and Regulate ICOs’ Nasdaq (1 September 2017) Available at: accessed 19 February 2018. TenX, ‘Reflecting on a highly successful TenX tokensale’ (TenX Blog, 26 June 2017) Available at: accessed 7 February 2018. The Economist, ‘The market in Initial Coin Offerings risks becoming a bubble’ (The Economist, 27 April 2017) Available at: accessed 13 February 2018. The Jakarta Post, ‘Cryptocurrencies decided as future trading commodity’ (The Jakarta Post, 4 June 2018) Available at: accessed 10 June 2018. The New York Attorney General’s Office, ‘Virtual Markets Integrity Initiative Questionnaire’ Available at: accessed 13 May 2018.

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Appendix 1: Glossary of Terms

Altcoins a popular term which refers to all the other cryptocurrencies apart from Bitcoin – Ethereum, Litecoin, Monero or Bitcoin Cash AML Anti-Money Laundering Bit a sub-unit of a bitcoin. One bitcoin has a million bits Bitcoin with a capitalized B, it stands for the technology, the community, the protocol and software of Bitcoin bitcoin describes the unit of currency (XBT or BTC – abbreviations of bitcoin) of Bitcoin BFT Byzantine fault tolerance

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Blockchain with a capitalized B, a universal public ledger of all bitcoin transactions to date blockchain describes one type of distributed ledger technology Crowdfunding an umbrella notion used to describe a financial model whereby a start-up raises external financing via Internet from individuals contributing often small amounts, which can either be as a form of donation or in exchange for a future product or service Cryptography a branch of mathematics and computer science that gave birth to cryptocurrencies Crypto-exchange a secondary market or platform for converting cryptocurrencies into fiat currency or trading listed cryptocurrencies Crypto-markets a term used loosely to describe the ecosystem comprising of digital tokens, ICOs, secondary markets and its participants DApps applications running on top of the Ethereum protocol Digital token (or ‘token’) refers to a medium exchange used in a blockchain ecosystem or to fund a project DLT a distributed ledger technology ERC20 a token, which is a standardized code that functions to issue, distribute and control the assets deployed during an ICO FinTech  technology-enabled business model innovations in the financial sector FOMO fear or missing out on the next ICO sale or digital token price movements Fork Forking is a technical term that describes the process of a blockchain splitting into two branches. Forking occurs as a result of significant changes or ‘divergences’ to a blockchain FTIG FinTech & Innovation Group set up within MAS FUD abbreviation for fear, uncertainty, and doubt in the crypto community ICO Initial Coin Offering, also referred to as Digital Token Offering (DTO) by MAS IRAS Inland Revenue Authority of Singapore ITAP International Technology Advisory Panel KYC Know Your Customer MAS Monetary Authority of Singapore Mining the process of computer hardware running complex mathematical calculations that confirm transactions and enhance the security of the Bitcoin network. Miners are those who manage this hardware

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Pre-token sale also referred to as a ‘pre-sale’ is private and will most often involve accredited investors Private keys secret alphanumeric password or number used to send and spend cryptocurrencies Public keys the alphanumeric address that receives the coins SAFT simple agreement for future tokens Smart contracts computer code, which controls the transfer of assets on the blockchain Token or a digital token, a digital representation of a value that is distributed in an ICO Whitepaper a comprehensive report that details the problem and solution an ICO project hopes to solve



Appendix 2: Regulation of ICOs across Jurisdictions318

The majority of countries listed take a technology-neutral approach towards financial regulation, with a focus on activities rather than specific technologies. The following table provides an overview of the general attitude of regulators towards ICOs and the crypto-markets. These approaches are subject to ongoing developments, whereby regulators are continuously assessing whether specific licensing regimes, regulatory guidelines or regulation should be pursued. Country

Regulatory responsea

Commentsb

Argentina

The Argentine Securities and Exchanges Commission allowed – no existing regulation has stated in its communique that ICOs are in principle not subject to securities regulations, but may be applicable subject to the authority’s purview depending on the ICO’s structure.c

318  There is a great deal of diversity in the way regulators approach ICOs. This overview is not meant to be exhaustive and the reader is encouraged to keep up-to-date with the ongoing regulatory developments in each jurisdiction. For a detailed list of regulators’ official statements and guidance, see the IOSCO publications https://www.iosco.org/ publications/?subsection=ico-statements.

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Country

Regulatory responsea

Commentsb

Australia

allowed – within the existing regulatory framework

Austria

allowed – within the existing regulatory framework allowed – within a new regulatory framework allowed – within the existing regulatory framework allowed – within a new regulatory framework

Depending on their legal characterization, some ICOs are regulated under the Australian consumer protection or if found to be financial products, digital tokens will fall under the Corporations Act.d The Australian Securities & Investments Commission (ASIC) requires ICOs that involve combined investment to adhere to the Corporations Act, to keep track of those shares, to issue a disclosure document and to acquire a financial services license if the ICO issuer also offers financial advice to its customers. In 2018, the ASIC has been increasingly concerned with overseas ICOs offering tokens to their citizens and has taken a proactive approach to investigating and targeting fraudulent ICOs and related unlicensed activities.e Follows the EU regulatory stance. The Austrian Financial Market Authority (FMA) maintains a welcoming approach towards new technologies, but remains wary of the ICO-related risks.f Belarus is one of the first countries to legalize cryptorelated activities, including exchange services, ICOs, mining and the use of smart contracts.g Follows the EU regulatory stance. The Belgian Financial Services and Markets Authority (FSMA) is aligned with the EU ESMA’s approach to ICOs and has issued alert on investor risks.h Bermuda is an ICO-friendly jurisdiction, encouraging ICO issuers hoping to use the jurisdiction’s favourable incorporating regime. Bermuda is planning to propose a bill, designating ICOs as ‘restricted business activities’. The ICO issuers will be required to obtain a consent from the minister of finance in order to operate legally in Bermuda. The application process will require a disclosure of information on the ICO and related investment risks.327 The Bermuda Monetary Authority (BMA)

Belarus

Belgium

Bermuda

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Country

Brazil

British Virgin Islands

Canada

Cayman Islands

Regulatory responsea

Commentsb

remains risk-averse. The BMA closely monitors ICOs and currently, these forms of investment vehicles are not subject to prudential regulation, which among other things requires regulated entities to hold sufficient capital and have adequate risk controls in place.j In 2018, the government enacted the Limited Liability Company (Initial Coin Offering) Amendment Act of 2018, which treats ICOs as ‘a restricted business activity’ which will require the prior consent of the Minister of Finance, who will be supported by a FinTech Advisory Committee in the review process. allowed – within The Securities and Exchange Commission of Brazil (SEC) will consider digital tokens under the securities regulathe existing tion when deemed applicable and the securities offered regulatory in an ICO cannot be traded on a crypto exchange.k framework In the British Virgin Islands (BVI), no legislation specific no official to ICOs has been enacted. Instead, the existing BVI laws information apply to ICO issuers. BVI is taking a wait-and-see apavailable proach, while the AML and KYC compliance rules apply. BVI Financial Services Commission (FSC) has not issued any ICO or blockchain-specific rules or guidance. Canada is an ICO-friendly jurisdiction and is keen on supallowedl – porting developments in cryptocurrencies and ICOs. The within the existing regulatory Canadian Securities Administrators (CSA) offers consulting services for ICO issuers and a Regulatory Sandbox.m framework The CSA considers the securities regulation to be applicable to ICOs on a case-by-case basis. The nature of the digital token will be judged depending on substance, rather than form. The CSA applies a four-factor test akin to the U.S. Howey test to determine whether the digital token needs be registered as a security.n The Cayman Islands Monetary Authority (CIMA) has not no official made any public statements or issued a guidance about information its approach. available

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(cont.)

Country

Regulatory responsea

Commentsb

China

banned – prohibition on ICOs

Estonia

allowed – within the existing regulatory framework

European Union

allowed – within the existing regulatory framework

China’s central bank has declared ICOs illegal on the grounds that ICOs appeared to be financial scams and pyramid schemes. Moreover, foreign ICOs targeting the Chinese market are also banned and the Chinese companies which have previously conducted an ICO were required to refund their investors.o Follows the EU regulatory stance. The Estonian Financial Supervisory Authority (EFSA) is of opinion that the digital tokens, depending on their structure, may be considered securities according to the definition set forth in the current Securities Market Act (SMA) as well as in the Law of Obligations Act (LOA). The assessment is on a case-by-case basis.p As part of the EU FinTech Action Plan, the EU recognizes the opportunities related to digital tokens.q ICOs are allowed in EU, but subject to future regulation. The EU is taking a wait-and-see approach, where it is continuously assessing risks and opportunities and whether the existing regulatory framework suitably covers the new funding model.r ICOs are prima facie allowed, but subject to AML/KYC requirements and the compliance with various regulatory frameworks, in particular: Prospectus Directive, markets in Financial Instruments Directive, Alternative Investment Fund Manager Directive and The 4th Anti-Money Laundering Directive.s The EU is in the process of assessing the need to regulate cryptocurrencies and will implement new legislation seeking to address the anonymity of the financial technology by implementing rules for cryptocurrency exchanges, platforms and wallet providers.t In the meantime, the European Securities and Markets Authority has issued separate warnings to investors and firms involved in ICOs respectively.u EU has been diligently working on formulating its position and has established the Blockchain

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(cont.)

Country

Finland

France

Germany

Gibraltar

Regulatory responsea

allowed – within the existing regulatory framework allowed – within the existing regulatory framework

Commentsb

Observatory and Forum that analysed the member states’ regulatory approaches and helped to formulate EU’s position by seeking convergence.v Follows the EU regulatory stance. The Finnish Financial Supervisory Authority (FSA) has published a warning on cryptocurrencies and ICOs.w

Follows the EU regulatory stance. The French Financial Market Authority (AMF) is currently looking to formalize its regulatory framework for ICOs.x The proposal aims to achieve a balance between the development of the ICO funding model and the protection of investors. allowed – within Follows the EU regulatory stance. The German Federal Financial Supervisory Authority has issued warnings the existing on ICO-related risks.y Based on the specific formularegulatory tion of the contract for each ICO, BaFin decides on a framework case-by-case basis whether the offeror is required to obtain authorisation pursuant to the German Banking Act (Kreditwesengesetz – KWG), Investment Code (Kapitalanlagegesetzbuch – KAGB), Payment Services Supervision Act (Zahlungsdiensteaufsichtsgesetz – ZAG) or Insurance Supervision Act (Versicherungsaufsichtsgesetz – VAG) and whether they must fulfil prospectus requirements. Germany has no specific regulation for ICOs per se and conducts a caseby-case analysis of tokens to establish the applicable law.z allowed – within a Gibraltar is an ICO-friendly jurisdiction. In its bid to become an attractive jurisdiction for ICOs, the Gibraltar new (future) Services Commission (GFSC) developed a licensing regulatory framework for companies planning to conduct an ICO. framework Under the DLT Regulatory Framework, firms in Gibraltar that use DLT to store or transmit value will need to apply for a license as a DLT provider. With regards to the issuance of digital tokens, the GFSC has issued a whitepaper,

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Country

Regulatory responsea

Hong Kong

allowed – within the existing regulatory framework

India

allowed – within a new (future) regulatory framework

Indonesia

no official information available

Commentsb

whereby the regulator will authorise and supervise secondary token market operators and will establish “a public register of such operators.”aa The Securities and Futures Commission (SFC) reiterated a number of times about the potential risks of investing in digital tokens, and stressing that such tokens may constitute “securities” regulated under the Securities and Futures Ordinance (“SFO”). Moreover, the ICO issuers involved in the crypto-related activities that target Hong-Kong citizens have to obtain licenses and register with the SFC regardless of their location.ab SFC has been actively monitoring the ICO market in view of its securities regulation and has been proactive in intervening against ICOs offering digital tokens that fall under the SFO or advertising ICOs which resembled a collective investment scheme without a registration.ac Julia Leung, deputy head of the SFC has acknowledged on behalf of the SFC the innovative potential of blockchain, but has voiced scepticism about ICOs, pointing out that many of the ICOs are fraudulent, escaping the scrutiny of securities regulators.ad The Reserve Bank of India and the Securities and Exchange Board of India are taking a wait-and-see approach to ICOs, with potential future regulation to come. The issue at stake is whether the ICOs will be regulated under the existing legal framework or whether amendments will be required.ae No official statements have been issued on the respective agencies’ websites. With regards to cryptocurrencies, Reserve Bank of India barred all regulated financial institutions from engaging in crypto transactions.af Bank Indonesia does not recognize cryptocurrencies as a legal medium of exchange and has a taken a riskaverse approach.ag Nevertheless, the Indonesian Trade Ministry’s Futures Exchange Supervisory Board has recognized cryptocurrency as a commodity, making it

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(cont.)

Country

Regulatory responsea

Isle of Man

allowed – within a new (future) regulatory framework

Israel

allowed – within the existing regulatory framework allowed – within the existing regulatory framework

Japan

Commentsb

tradable on stock exchange.ah No official statement has been given on the legality of ICOs. With its liberal financial regulation, Isle of Man is a welcoming jurisdiction for ICOs. The prospective ICO issuers will need to register under the Designated Businesses (Registration and Oversight) Act 2015 and comply with the Anti-Money Laundering and Countering the Financing of Terrorism legislation under the Financial Services Authority oversight. A future regulatory framework can be expected, whereby the digital tokens will have a legal status with an aim to promote ICOs.ai Israel has a favourable position towards ICOs, with an objective to position itself as a ‘start-up nation’. Currently, Israel is in the process of reviewing the suitability and applicability of securities regulations to ICOs.aj Japan is one of the leaders in the volume of cryptocurrency trading. The Financial Services Agency of Japan (FSA) remains risk-averse and has published warnings on ICO-related investments. Cryptocurrencies are recognized as a legal form of payment. With regards to the regulation of digital tokens – if a digital token issued in an ICO falls under the virtual currency provisions of the Payment Services Act, then the ICO issuer providing digital currency exchange services must be registered. Also, if the digital token has characteristics equivalent to an investment, the ICO issuer is subject to the Financial Instruments and Exchange Act.ak Crypto-exchanges and broker-dealer services are under a licensing regime that is subject to a series of requirements, including a corporate governance system, segregated client assets, sound security, AML/KYC requirements and external audit. In April 2018, The Tama University and the Center for Rule-making Strategies (government-funded research group) has produced a proposal for regulating the ICO funding model.al

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Country

Regulatory responsea

Commentsb

Lichtenstein

allowed – within the existing regulatory framework

Lithuania

allowed – within the existing regulatory framework

Malaysia

allowed – within the existing regulatory framework

Lichtenstein is an ICO-friendly jurisdiction The Financial Market Authority (FMA) published a fact sheet on ICOs where it states that its treatment of digital tokens is based on a case-by-case basis, depending on whether the digital token in question is a financial instrument. If found to constitute financial instruments, the ICO issuers will be subject to licensing requirements.am Bank of Lithuania has given guidance on which national laws are applicable to the ICO issuers, depending on the characteristics off the funding model and the function of the digital token. The approach is on case-by-case basis and the relevant legislation may include securities regulation, crowdfunding or collective investment schemes. AML and KYC compliance is emphasized.an In June 2018, Lithuania’s Ministry of Finance has also issued guidelines on ICOs, setting out a framework for ICOs and identifying which elements establish the purview of relevant regulatory frameworks.ao The Securities Commission Malaysia (SCM) has taken a risk-averse position towards ICOs, with an emphasis on investor risk and price volatility on secondary markets.ap The digital tokens may be caught under the national regulatory frameworks. ICO issuers should be mindful that the launching of an ICO, the offering of digital tokens in exchange for digital currency or any form of payment and incidental activities may trigger regulatory requirements under securities laws. In addition, no person is permitted to carry out any regulated activities such as fundraising, fund management and dealing in capital market products without obtaining necessary approval or authorisation from the SCM.aq SCM together with Bank Negara Malaysia are working together to develop a regulatory guideline on ICOs and cryptocurrencies. Bank Negara Malaysia has taken a proactive approach in enforcing the country’s securities laws by targeting ICO issuers and ICO advertising.

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Country

Regulatory responsea

Commentsb

Malta

allowed – within a new regulatory framework

Malta is an ICO-friendly jurisdiction. Malta Financial Services Authority (MFSA) has given guidance on cryptocurrencies and ICOs, reiterating that the above fall within the existing financial services legislation depending on the nature of the token in question. If outside the scope of the legislation, there is no regulatory framework to achieve investor protection. Malta is often referred to as a ‘blockchain island’ and its size plays to its advantage in offering a more flexible way of legislating. The MFSA has submitted a proposal to achieve the objectives of financial regulation, whereby certain cryptocurrencies and activities pertaining to them would be licenced and regulated under a new legislative framework to be drafted by the MFSA and adopted by the Maltese Parliament under the Malta ‘Virtual Currencies Act’.ar The legislation’s aim is to ensure investor protection and financial soundness with regards to collective investment schemes that invest in virtual currencies. In April 2018, MFSA has released a consultation paper for the Financial Instrument Test, which would be part of the Virtual Financial Asset Act.as In July 2018, Malta has passed 3 pieces of legislation relating to the regulation of blockchain and digital assets. The Virtual Financial Assets Act (VFAA) sets out a framework for the regulation of ICOs. VFAA proposes a Financial Instruments Test which is used to ascertain whether the digital token being sold is a financial instrument under the scope of MiFID. The VFAA also requires that the ICO issuer submits a whitepaper which clearly outlines the project details (article 4). Malta Digital Innovation Authority Act (MDIA) creates a new authority – Malta Digital Innovation Authority (MDIA) which will function as a one-stop-shop in streamlining the process and overseeing the certification of blockchain projects and digital assets. Thirdly, the Innovative Technological Arrangement and Services Act (ITAS) handles the registration of Technology Service

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Country

Regulatory responsea

Mexico

allowed – no existing regulation applicable

Pakistan

banned – prohibition on ICOs allowed – within the existing regulatory framework

Philippines

Poland

allowed – within the existing regulatory framework

Commentsb

Providers and the certification of technology arrangements, in particular – software and other forms of architectures that will be used for the development and delivery of DLTs. Mexico’s National Banking and Securities Commission together with the Mexican Central Bank has issued a warning on cryptocurrencies and ICOs, but has not issued a direct ban on ICOs or any specific regulatory guidelines. The general position is cautious and possibly open to future developments.at The State Bank of Pakistan has prohibited the dealing in virtual currencies and digital tokens in Pakistan.au The Philippines’ Securities and Exchange Commission (SEC) has adopted a risk-averse approach.av Based on circumstances and the facts of the issuance, ICOs are subjected to the national securities regulation.aw The current approach may be subject to future legislation. The SEC has taken an active approach in targeting fraudulent cryptocurrency activities with a focus on consumer protection.ax The SEC has issued a notice on its future plan to regulate ICOs. Market participants were invited to submit their feedback on the proposed guidelines for ICOs.ay Philippines has assigned a designated economic area the Cagayan Special Economic Zone as a zone for blockchain and virtual currencies.az Follows the EU regulatory stance. No official statement on the legality of ICOs. The Polish Financial Supervision Authority (Komisja Nadzoru Finansowego, KNF) and the National bank of Poland (Narodowy Bank Polski (NBP)) issued a statement in relation to cryptocurrencies, warning market participants that dealing with cryptocurrencies is considered is a high-risk activity.ba No statement has been issued as to the legal treatment of ICOs.

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Country

Regulatory responsea

Russia

Under the supervision of the Central Bank of Russian Federation, ICOs are allowed, but the authority remains risk-averse. Russia’s Ministry of Finance (RFM) plans to introduce a federal law, which will include limitations as to the maximum amount an ICO can raise or an investment limit for unqualified investors. ICO issuers in Russia will have to disclose various information in order to comply with the proposed regulation, including the name of the token issuer, the project’s website and network provider, as well as permanent operating bodies of the organizer. Moreover, the ICO issue will have to be registered as a legal entity in Russia and hold a bank account with a licensed financial institution.bb No official statement or guidance as to the legality of no official ICOs. Slovakia is most likely to follow the EU’s regulatory information stance. With regards to cryptocurrencies, the National available Bank Slovakia (NBS) does not recognize cryptocurrencies as a legal tender and the activities related to it are not supervised by NBS.bc No existing information as to the legality of ICOs in allowed – no existing regulation Slovenia. Nevertheless, the government is supportive of blockchain technology and has established the applicable Blockchain Think Tank to align market participants’ interests with the government.bd allowed – within Follows the EU regulatory stance.be The National Securities Market Commission (CNMV) together with the existing Banco de Espana has issued an official statement regulatory reiterating that the ICO market is a non-regulated space, framework whereby individuals who purchase tokens do not benefit from the safeguards and guarantees associated with regulated financial products.bf It has been reported that Spain is considering legislation to attract blockchain firms by means of tax rebates.bg No information on the application of securities regulation is currently available.

Slovakia

Slovenia

Spain

allowed – within a new (future) regulatory framework

Commentsb

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Country

Regulatory responsea

Commentsb

South Africa

no official information available

South Korea

banned – prohibition on ICOs (subject to future permission)

Sweden

allowed – within the existing regulatory framework allowed – within the existing regulatory framework

The governmental agencies are yet to provide a public statement on ICOs. The South African Reserve Bank (SARB) established a Financial Technology (FinTech) Programme, to assess the emergence of FinTech and to consider its regulatory implications.bh Currently, there is a prohibition on ICOs by the Financial Services Commission (FSC), which has been explained in terms of investor protection and as a violation of the capital market law.bi This prohibition is subject to future changes, as South Korea plans to lift the ban with new regulations in late 2018.bj Follows the EU regulatory stance. The Swedish regulatory Authority finansinspektionen (FI) characterized digital tokens issued in ICOs as potential investment products.bk

Switzerland

Taiwan

Switzerland is supportive of the ICOs and has established the foundation of Crypto Valley Association, which is an independent body with a governmental support. Its objective is to establish a crypto-friendly ecosystem. The Swiss Financial Market Supervisory Authority (FINMA) issued an ICO guideline that clearly establishes how the jurisdiction will treat digital tokens and how it intends to apply the existing financial legislation. FINMA also issued market guidance, whereby depending on the ICO and digital token structure, relevant supervisory regulations, collective investment scheme legislation and banking law provisions may be applicable.bl In 2018, FINMA has published further principle-based guidelines on the applicable regulatory framework for ICOs (referred to as Token Generating Events).bm Taiwan is an ICO-friendly jurisdiction. The government allowed – no existing regulation is supportive of the ICOs and cryptocurrencies and is not planning to ban ICO-related activities. This approach applicable is line with the government’s comprehensive support for FinTech under the Financial Technology Innovation Experimentation Act.bn

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Country

Regulatory responsea

Commentsb

Thailand

allowed – within a new (future) regulatory framework

UAE

allowed – within the existing regulatory framework

Thailand’s Securities and Exchange Commission Thailand (SECT) has taken a risk-averse position, highlighting the risk for fraud and scam in the ICO market. Nevertheless, the government is pursuing a balancing approach between protecting investors and supporting innovation.bo SEC’s board of directors is expected to review the ICO regulatory framework. In such manner, Thailand is taking steps to regulate ICOs by expanding on the current guidelines.bp In 2018, Thailand has enacted licensing rules for crypto-exchanges and registration requirements for ICO issuers.bq The purpose of the Digital Asset Decree is to regulate the offerings of digital tokens, trading and the operation of related intermediaries under the SECT’s supervision. ICO issuers seeking to conduct an ICO in Thailand will be required to register on an official ICO portal and pass a screening application, which will be evaluated by the SECT. UAE by default does not regulate ICOs, unless the digital tokens and the ICO-related activities are found to be in substance akin to regulated activities. The Securities and Commodities Authority (SCA) is cautious about potential ICO-related risks. SCA reiterated that it does not recognize, regulate, or supervise any ICO presently and the ICO investments are not offered any legal or regulatory protection. The SCA said that investors involved in ICO investments are doing so at their own risk. It called upon digital token issuers, intermediaries advising on or facilitating digital token offerings, and digital token trading platforms to seek legal and regulatory advice to ensure compliance with all the applicable laws and regulations. The SCA added that it has recently formed a FinTech team assigned with facilitating the implementation of FinTech initiatives and keeping up with the latest FinTech developments.br

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Country

Regulatory responsea

Ukraine

no official information available

United Kingdom

allowed – within the existing regulatory framework

Commentsb

The Abu Dhabi Global Financial Services Regulation Authority (ADGM FSRA) has issued a Guide – Regulation of Initial Coin/Token Offerings and Crypto Assets under the Financial Services and Markets Regulations which sets out the guidelines for ICO issuers and related cryptointermediaries. Guidance is issued under section 15(2) of the Financial Services and Markets Regulations 2015 (“FSMR”). The guide characterized digital tokens and their nature – it identifies three types of digital assets including: non-security tokens, security tokens and crypto assets. Digital assets deemed to be security tokens will be regulated as securities pursuant to the FSMR and digital assets which do not exhibit the characteristics of a security will be deemed to be commodities. FSRA will assess the status of the digital assets on case-by-case basis. The Dubai Financial Services Authority (DFSA) for the Dubai International Financial Centre (DIFC) does not currently regulate digital tokens and places the onus on ICO issuers to establish whether their tokens my fall under regulatory scrutiny as regulated investments.bs No official statement or guidance on the legality of ICOs. The National Bank of Ukraine (NBU) does not recognize bitcoin as a currency nor other cryptocurrency as a form of payment.bt Nevertheless, the government is open towards the use of blockchain technology.bu The UK’ Financial Conduct Authority (FCA) has issued warnings on the ICO-related risks, but acknowledged the opportunities cryptocurrencies bring for start-ups. The FCA requires a case-by-case analysis and cautions ICO issuers that any entity carrying out an ICO should carefully consider if its activities could mean they are arranging, dealing or advising on regulated financial investments.bv

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Country

Regulatory responsea

USA

allowed – within the existing regulatory framework

Vietnam

Commentsb

The Securities and Exchange Commission (SEC) has cautioned on the ICO-related investor risks and has established a Cyber Unit within the SEC, which targets cyber-related misconduct.bw The SEC is notable for its proactive approach in the ICO regulation, having issued numerous cease and desist orders to prospective ICOs and continues to scrutinize any improper offerings without a registration or exemption under the securities laws. The applicability of the federal securities laws will depend on the classification of digital tokens as securities. The relevant test to determine the scope is the Howey test (Securities and Exchange Commission v. W. J. Howey Co., 328 U.S. 293 (1946)). SEC’s treatment of digital tokens as securities was elaborated on in the ‘DAO report’.bx SEC’s Chairman Jay Clayton has expressed a sceptical view that he considers most digital tokens as securities for the purposes of the securities laws.by The online cryptocurrency trading platforms that trade security tokens need to be registered with the SEC and meet the listing standards as required.bz The Financial Crimes Enforcement Network (FinCEN) cautioned on the application of money transmitter rules to ICOs and the KYC/AML requirements and the combatting the financing of terrorism and illicit financing of criminal activity regulations apply both to crypto-exchanges and companies involved in ICOs.ca no official informa- Even though no official statements on the legality and tion available regulation of ICOs have been published, the ban on cryptocurrencies has had a practical knock-on effect on the ICOs. The State Bank of Vietnam (SBV) has prohibited the use of cryptocurrency payments as unlawful means of payment.cb

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Nestarcova Five general regulatory responses are identified; (i) allowed – no existing regulation applicable, (ii) allowed – within the existing regulatory framework, (iii) allowed – within a new regulatory framework, (iv) banned – prohibition on ICOs and (v) no official information available. The state of regulation is not indicative of the ICO activity within the respective countries. The borderless nature of the ICO funding model defeats the expectation that ICO activity would be correlated with the regulatory approaches. It is also interesting to note that the way regulators engage with ICOs varies, whereby the issues regulators chose to address or omit may include; application of securities regulation, regulation of crypto exchanges, compliance with AML and KYC requirements, classification of digital tokens or application of distributed ledger technology. CNV, ‘Ofertas Iniciales de Monedas Virtuales o Tokens’ (Advertencia, December 2017) Available at: accessed 17 March 2018. ASIC, ‘Initial coin offerings’ (ASIC, September 2017) Available at: accessed 14 February 2018. ASIC, ‘18-122MR ASIC takes action on misleading or deceptive conduct in ICOs’ (Media Release, 1 May 2018) Available at: accessed 1 May 2018. FMA, see Fintech section: https://www.fma.gv.at/en/cross-sectoral-topics/fintech/ fintech-navigator/. President of the Republic of Belarus, Decree No. 8 ‘On the Development of the Digital Economy’, Available at: accessed 28 March 2018. FSMA, ‘Initial Coin Offerings’ (Communication FSMA_2017_20, 13th Novem­ber 2017) Available at: accessed 10 March 2018. Government of Bermuda, ‘Initial Coin Offerings in Bermuda’ (Government of Bermuda, 19 March 2018) Available at: accessed 19 March 2018. BMA, ‘Risks of Initial Coin Offerings’ (Press Release, 17 January 2018) Available at: accessed 10 February 2018. Central Bank of Brasil. ‘Communiqué No. 31,379, of 11/16/2017’ (November 2017) Available at: accessed 17 March 2018. Government of Bermuda, ‘Initial Coin Offering Regulations’ (Newsroom, 13 July 2018) Available at: accessed 25 July 2018. CSA Staff Notice 46-307 Cryptocurrency Offerings, (CSA, 2017) Available at: accessed 10 February 2018. Canadian Securities Administrators, ‘Canadian Securities Regulators Outline Securities Law Requirements That May Apply To Cryptocurrency Offerings’ (Canadian Securities

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