Crucial Information for Investors Part 2: How do regulators actually regulate ICOs in Europe?

How does one actually regulate?

Cracking down on fraudulent activities

At the moment, securities and commodities regulators in Europe are putting most of their manpower into eliminating fraud. They’re looking at what new ICOs are promising investors, they’re looking at the firms’ statements, and they’re judging just how exaggerated or how fishy the projects look.

We spoke to DESICO CEO and co-founder, Laimonas Noreika, to discuss why regulation is needed within the ICO industry.

Statements like ‘205% GUARANTEED annual returns for our early contributors’ or ‘the more friends you recruit, the more funds you will generate for yourself’ will definitely raise red flags, and we support this move to stricter regulations,” said Noreika.

Noreika believes that a crackdown on fraudulent ICOs will help the industry repair its now slightly-tarnished reputation, because official guidelines will re-invigorate investor confidence.

“Given the sheer number of unrealistic promises and misrepresented products, these regulatory efforts are welcomed both by investors and other legitimate ICO firms, whose reputations are harmed by such cases of shameless fraud,” he continued.

Adding definitions

Currently, the majority of different field-related definitions and token names have come not from the top, but from the bottom — from the emerging crypto industry itself, and not their regulators.

As these tokens have not been legally defined before, regulators are stepping in. Some agencies have defined “virtual currencies” as “monetary equivalents” for the purposes of anti-money laundering and money transfers.

Other actors have them defined as market tradeable “digital goods”, so they fall under the “commodities” regulation. The “property” stamp has also been used for taxation purposes.

Nevertheless, when weighing tokens primarily as fund-raising material, they’re most commonly considered as “securities” or “investment contracts”.

These efforts, by all means, are welcomed as they pull ICOs away after the regulatory grey zone they’re currently operating in.

Classifying token assets

Similarly to adding definitions, regulators are also classifying company-issued tokens.

In most jurisdictions, all tokens are separated into utility tokens — the token equivalent of digital exchange-coupon — and security tokens — the equivalent to actual asset-backed investments. If you’re not familiar with the two, discover more here and here.

When using tokens primarily as fund-raising material, they’re most commonly considered as “securities” or “investment contracts”.

The regulations for the two are like night and day. Security tokens are subject to rigorous security regulations, while utility tokens are not touched because they’re not considered investments.

The observed problem is that a number of projects have positioned obvious investment contracts as innocent utility tokens, thus opening a potential loophole of unregulated investments.

Things are made worse, because most tokens are of a dual-nature — not only do they have some consumer utility built into them, they can also can be traded, so they become a hybrid of both security and utility tokens.

Regulators are responsible for deciding which is which on a case-by-case basis, and then approving the validity of ICO. Otherwise, as utility tokens essentially remain unidentified in the regulatory framework, the possibility of running into legal problems down the road of a business’ life is fairly high.

The global test to determine if a token is a security versus a utility is the US-made Howey Test — it is closely observed and followed by the European Union. In testing, they look at how the token is actually being used by investors and whether they anticipate future monetary gains. This is usually the strongest indicator that the token should fall under jurisdiction of securities legislation.

Providing consultation

Some authorities, such as that of Switzerland, provide consultation for ICO startups and guide them through the regulatory process.

This means a firm can present the token offering on paper and receive advice and opinions from the authorities, and not worry about falling under an investigation later, which is a major plus.

In addition, a stamp of approval provides reassurances to the investors, as it signifies the legality of ICO. This trust is then monetized by the firms conducting token sales. In other words, everyone benefits from cooperation with regulators.

Protecting investors’ interests

Finally, regulators go the extra mile just to protect investors. They have good reasons to do so because a regulator’s quality is often gauged by how well it protects the investors and how easily the authorities can be reached in the event of a dispute.

Some countries go to extreme lengths to protect their investors. There’s a history of the US Security Exchange Commission (SEC) extending its jurisdictional reach across borders.

Even if the ICO is conducted in an abroad location with a strong regulatory framework, such as Lithuania, the global regulatory heavyweights — the SEC and the Commodity Futures Trade Commission (CFTC) — may still claim jurisdiction. They may claim a breach in US securities law if a fraudulent ICO sells to some US investors, or if the company conducts any business from within the US. They might even interfere solely because the CEO of the ICO firm is a US citizen.

European law enforcers are a bit more lax, but they also demand adherence to anti-money laundering/know your customer (AML/KYC) practices, and require additional regulatory steps, such as registrations and disclosure statements.

The takeaway

Taking in the Zeitgeist of the regulatory environment for ICOs is a wise idea for anyone wondering into the space. While regulatory regimes seek to better protect investors, it is the responsibility of the investor himself to do his own digging. Extensive research will go a long way if you decide to invest.

Regulations are here to sort out any grievances and conflicts between a company and investors if something should go wrong. It is your obligation to not get yourself into something wrong in the first place.

To discover the first part of the ‘Crucial Information for Investors’ series, click here.