Support for blockchain technologies appears to be at an all time high, from the EU investing over €5m in start-ups to the Finland Central Bank praising Bitcoin’s “revolutionary” ecosystem. Yet, spurred in part by a Chinese crack down on ICOs, new coins could be under threat of regulatory strangulation.
From China to the UK, regulators are issuing warnings against ICOs, urging investors to be cautious. The latest authority to conduct such activity is the UK’s Financial Conduct Authority (FCA), with the view that ICOs constitute “very high-risk, speculative investments.” This move follows in the wake of moves by the US Securities and Exchange Commission, the Monetary Authority of Singapore, the Bank of Russia, the People’s Bank of China and the Securities and Futures Commission of Hong Kong.
ICOs and Regulatory Attention
The main issue, reiterated time and time again, is the lack of governance, the distinct nature of ICOs, in that they have yet to be brought under the control of regulations and law enforcement. Their nature has been likened to stocks and shares, and some commentators have called for their classification as securities. In short, the shortages in governance can cause concern for some investors, from individuals seeking to exploit a system that has no oversight to genuine entrepreneurs who do not know how to run an ICO.
Due to the lack of a system of checks and balances, whether for internal management via an elected board, or external through a regulatory body, ICOs suffer from a lack of oversight that hurts genuine intent. Their analogy to IPOs, as well as standard corporate governance practice, brings further shortages. The lack of equity for token holders, leads to a lack of rights for said investors, whether that be against abuse from the company managers or against other investors (majority vs minority).
Moreover, this extends to a lack of a binding contractual commitment from the managers to safeguard the interests of their investors, including to use best efforts or act dutifully. Whilst standard governance practices may limit a duty of care by directors to the company itself, (for example, the UK Companies Act 2006) the lack of any statutory or common law duty weakens the reliability of the token issuers; aside from extending the intent in their white paper, investors must take them at their word. Additionally, there are no prohibitions on the expenditure of the capital raised.
Compounded by the possibility for unfair token allocation, procedures to dilute allocation and a lack of transparency, the lack of any auditing or reporting structure means that investors have no recourse and are largely at the mercy of coin issuers. This is not to say that ICOs are badly structured or that governance should be issued, which in itself presents issues for stifling innovation through a one-size-fits-all model but is submitted to draw attention to factors investors are faced with when deciding to invest. Tokens themselves offer liquidity as an advantage as compared to traditional stocks since the crypto markets are more transparent and less complex than the inner working of private or public companies. Further, the ease of trading the currencies through exchanges also offers simplicity as compared to a rather complex trading method, as per new investors.
Certainly, while there are no structures in place to govern ICOs, companies looking to use the mechanism to raise capital would benefit from seeking legal advice. Mimicking traditional governance attitudes, while not directly applicable, serves to show genuine intent. A well structured white paper, overseen by legal counsel, definitely offers better insight for investors. Corporate governance norms exist for a good reason; to prevent the abuse by those with more power and knowledge of investors who rely on fiduciary figures for assistance.
China: Code Red
Withal, China’s outright ban of ICOs present the market with a poignant message. Aligned with China’s recent laws governing fund raising and storage of financial capital, cryptocurrencies are also in Beijing’s crosshairs. Resulting from distrust due to their black market usage, an update to Chinese financial law prohibits “token fundraising”. Not only does this extend to upcoming ICOs, but requires completed ICOs to refund tokens, with the law being used to facilitate punishment to individuals who do not comply.
The law, which was effective immediately, further requires that token exchange platforms do not offer exchange services between fiat currency and tokens, including facilitating the trading of tokens for cryptocurrencies. Violating this law has serious ramifications, like empowering the telecommunication department to shut down a website and mobile application, the delisting of applications by the Cyberspace Administration of China or the State Administration for Industry and Commerce discarding business licenses.
Is The Ban a Ceasefire?
The blanket ban initially wiped $35bn in market value, but was the move part of a strategy to take time to reflect on cryptocurrencies? Until China could offer regulatory oversight, deepen its understanding and ensure that the decentralised currencies did not weaken party control, a ban seemed to be the best option. Further, the continued expression of a “bubble” could have caused concern – the rapid growth of China’s economy, especially in tech, is susceptible to wide-ranging damage should a bubble form and subsequently impact growth.
Is such an approach over reacting? Compared to other regulatory jurisdictions, China’s ban on this activity could be perceived as damaging and harsh. Yet, given China’s economic history, particularly in recent times, with the 2015 crash still fresh in one’s memory, an unknown, unregulated financial mechanism that quickly raised capital, with little oversight, is certainly a scary prospect when mixed with a get-rich quick mindset. The July and August ICO capital total was valued at just over $750m. The lack of counter-hype provided the perfect conditions for the market to growth uncontrollably, with the rapid rise of bitcoin to over $4,000 and the onset of ICO-mania, an unchecked continuation could upset the balance and affect more than crypto investors. Combined with the perceived prevalence of ICO scams, the lack of oversight and the decentralised nature of the transactions, China may have established the ban to provide some cooling off time, as opposed to shutting down the market.
There is evidence to suggest that China is not seeking to cause a downfall of crypto or blockchain technology, specifically with China’s central bank outlining a blockchain 5-year plan and the government actively testing such technology, with a keen eye on creating its own crypto. The ban mirrors the approach adopted in the 2015 climate, with a ban on IPOs and those with more than 5% equity in a company being prevented from selling large amounts of shares.
Gradually, the market was then restored to normal operations. The same could be said here, a ban on this activity until such a time as when more is known is a smart play. Perhaps China is waiting to see other reactions from Russia and the US before making a move. China does lead the world in mining capacity for cryptos; such ventures would be lucrative should Beijing be capable of cultivating tech environments to harness talent. China is currently locked in a war with Russia and the US to attract talent in AI, cybersecurity and blockchain; China would not set a permanent ban that would stifle its attempts to catch talent, merely provide itself with some breathing room.
The Difficult Balance in Regulation
Firstly, even if China commits to the ban and never issues trading licences, other jurisdictions could step in to relieve the pressure. This creates competition in the regulatory field – other countries more open to the idea, either regulated or otherwise, would soon fill the gap left by China.
David Moskowitz, co-founder and CEO of blockchain-powered social network Indorse welcomes the ban from China as a stepping stone to protecting both investors and token issuers, hoping that “authorities will recognize the potential of the sector for economic growth and technological development, and enact rules which will allow for the safe and secure future of the industry.”
Once other jurisdictions decide on regulation and conclude that there is a benefit to hosting ICOs, said country could become a haven for ICOs and thus other forms of tech advancements. As a result, a delicate balance in regulating these currencies and the ensuing mechanisms is needed.
Further, it creates difficulties for innovation. It is not merely cryptocurrencies that are affected by these developments, but also the underlying technologies, the proposed ideas and the startups seeking funding all perish if harsh or inadequate regulation is levied against the market. To take blockchain as an example, an outright ban would cause prices to drop due to a lack of utility, leading to a loss of funding for projects aimed at harnessing this technology. Moreover, start-ups and companies alike will avoid those jurisdictions as a result of not feeling welcome. This has ramifications for developing the technology, which has implications for FinTech, the legal industry and medicine, to name a few.
Barry James, the co-founder and CEO of the Crowdfunding Centre, opined that tough regulation which limits the market too much, “risks killing a truly golden goose which could otherwise benefit us all long into the future.”
Regulation is important to protect all parties involved – not just the investors, but the entrepreneurs too. The ethereum ecosystem, which has sprouted several other projects – including Golem – could be under threat from tough regulation, should it interfere with “business as usual”. Criminals would move from currency to currency to finance their operations, but the slower and more sluggish start-ups, relying on expertise and funding in the ecosystem would suffer more. Stunting innovation, slowing growth in technology and causing regression in applications for such technology are all possible effects of poor regulation.
ICOs are not the only method of researching blockchain technology, and thus it has been put in place, in line with Sun Guofeng, director general of the People’s Bank of China’s research institute, the ban “should not prevent relevant financial technology companies, industry bodies and other technology firms from continuing their research into blockchain technology.”
In addition, the dangers of ICOs still present difficulty for investors and some regulation introducing good governance would increase investor confidence and facilitate better growth in the sector. Undoubtedly, the space would benefit from the introduction of governance best practices, borrowing principles from existing corporate norms as well as the introduction of idiosyncratic rules. Moves toward oversight with investors’ interests being considered, with clear and fair disclosure rules would secure the foundation of ICOs. The addition of further rights for investors, balanced against unequivocal rules for companies and managers, would promote the health of the space.
Certainly, some regulatory assistance is welcomed, but whether or not such help would overreach is entirely for the markets to decide.