This article was written by David Woliner, Head of Financial Regulation at Porat & Co Law Firm.
One cannot but agree that cryptocurrencies are not trends any more but a phenomenon. Out of this phenomenon have emerged several practices and trends, and some of them can be classified as phenomena in their own right. One of these practices is the constantly growing practice of initial coin offerings (ICOs).
The cryptocurrency ecosystem now contains over 800 issued cryptocurrencies, and the number keeps growing. ICOs basically offer the possibility of raising huge amounts of capital rapidly, through a rather straightforward process. We have seen ICOs raising millions of dollars in funds within minutes. Along with the growing success of ICOs came the rise in investor complaints regarding ICOs, mostly related to lack of transparency by the issuers and misunderstanding of the product by investors, and in some cases even issuers raising huge amounts of money just to run away with it.
Evaluating whether ICOs fall under Securities laws is more of a policy question rather than a pure juridical question
Unsurprisingly, the increasing numbers of ICOs, the magnitude of the funds raised and the growing number of complaints, attracted the attention of major regulators who switched their passive stand to this ecosystem into a more active approach.
Regulators take action
On August 30, the Israeli Securities Authority (ISA) issued a statement on the establishment of a committee tasked with evaluating whether ICOs fall under Israeli securities laws. The ISA’s statement is in line with reactions by regulators in the US , UK , Hong Kong , Singapore and recently China regarding ICOs.
Evaluating whether ICOs fall under securities laws is more of a policy question than a pure juridical question. There is no doubt that an ICO is a model to raise funds. That alone does not justify the application of securities regulation. The process of raising funds through venture capital funds and angel investors is an example of a model to raise funds which was left out of the regulatory scope. Crowdfunding is an example of a model to raise funds where securities regulations may apply only in specific circumstances and if certain thresholds are crossed, and even then the regulatory implications are relatively light. In both cases the applicability of securities laws on these models was based on policy decisions and not on mere legal interpretation and reasoning.
Is Bitcoin a Security?
Therefore, the primary question regarding ICOs will not be whether crypto currencies can be defined as ‘security’ or as a ‘financial instrument’ or any other product under the ISA’s supervision, but rather whether cryptocurrencies should be regulated. We believe that given the fact that ICOs are intended primarily to retail investors, there is a good chance that the ISA will answer this question positively.
Assuming the ISA decides to regulate ICOs, the first question will be that of supervision and enforcement in a blockchain / distributed ledger environment and the challenges it encases. We expect the regulatory response to ICOs to include any or all of the following:
- The issuance of warnings to investors about the risks involved in trading cryptocurrencies;
- The application of transparency principles on the offering documents of the ICO, by stating all mandatory information which must be included in offering documents;
- Limitation as to the amount of funds to be invested by each investor;
- Requirement to conduct suitability and appropriateness tests on potential investors;
- Requirement to hold the funds raised in the ICO in bank account in Israel;
- Imposing a minimum capital requirement to be held in a bank account in Israel;
- Publication of websites / ICOs which reportedly do not meet the above mentioned requirements (blacklist);
- Exchange of information with fellow regulators in matters of supervision and enforcement.
ISA must communicate with the local industry
The aforementioned requirements can be applied to ICOs regardless of the highly sophisticated technological environment of blockchain following a process of research and self-teaching by ISA staff, which will involve meeting with industry experts and correspondence with fellow regulators.
Much like the attitude towards venture capital and crowdfunding, it is important that the ISA keep in mind that a burdensome regulatory framework may severely impair the cryptocurrency ecosystem, which has revolutionary potential. Therefore, a cautious approach is required.