ESMA & BaFin critical on ICOs
Recent statements by ESMA and BaFin stress the high risks associated with ICOs. Investors should be aware of the total loss risk and that investor protection measures might not apply because ICOs often are not subject to existing rules and regulations.
On 15 November 2017, the German supervisory authority (BaFin) issued a warning on initial coin offerings (ICOs). According to BaFin, ICOs are highly speculative investments that often are not subject to applicable regulatory provisions. Investors of ICOs therefore do not benefit from protection provided by regulation. The BaFin position is fully in line with the European Securities and Markets Authority (ESMA) statements of 13 November 2017.
ICO is a new development of venture capital within the space of blockchain technology. There are two basic types of ICOs: i) program code (Smart Contracts) that is recorded on an existing blockchain and ii) creation of various blockchains and virtual currencies. Both types of ICOs generate digital tokens. These tokens are sold in exchange for other virtual currencies or for fiat money in unregulated public offerings (Token Sale).
BaFin highlights the lack of regulation of ICOs. Local securities laws do not apply to them. Therefore, shareholder rights, information rights, rights of control and voting rights are not essential features of an ICO token. The issuer of ICOs has full discretion over the rights and claims attached to the issued token or coin. The documentation - whitepapers, terms and conditions - supporting such a token sale are not subject to any law or regulatory provisions and the supervisory authorities have not reviewed the completeness of their content. Neither does the law require a specific type of enterprise nor the existence of a business operation in order to issue tokens under an ICO.
The risks for investors therefore derive from the lack of regulation of ICOs. The investor should be aware of the possibility of a total loss of their investment, the high fluctuation risk of the tokens and the limited tradability of the tokens on secondary markets, which for themselves are unregulated. In addition, the investor is responsible to keep the private keys safe in order to prevent loss or theft of the acquired tokens.
Because of the high complexity of the underlying technology, only experts are able to review the program code of the smart contracts and thus verify the functionality of the respective token as described in the issuer documentation. In absence of any applicable investor protection measures, the investors are left to only rely on the whitepaper or terms and conditions, which are drafted and can be amended at any time within the full discretion by the issuer of the ICO alone. Because of the pseudonymity of the tokens, the identity of the issuer is not determinable. ICO activities therefore are vulnerable to fraud, money laundering and terrorist financing.
Investors of ICOs should therefore duly investigate the identity, integrity and creditworthiness of the issuer of the ICO. Furthermore, they should check the registered office, legal status, date of foundation, involved persons and capital resources of the ICO issuer. For instance, the registration as a foundation in Switzerland does not per se indicate that the ICO is subject to regulation.
This BaFin announcement follows another BaFin consumer protection warning of the preceding week concerning the identical topic. The BaFin position is fully in line with the ESMA view on ICOs expressed in two recent statements highlighting the risks of investments in ICOs and the existing rules applicable to ICOs.
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