The regulation of cryptocurrencies as investment opportunities is a complex area, both for would-be issuers and prospective investors.
If you, or your organisation, are involved in the establishment of a new cryptocurrency, an understanding of the current framework would be an advantage.
The cryptocurrency landscape
A cryptocurrency is a digital asset that provides a medium of exchange. It uses cryptography to:
- Secure transactions;
- Control the creation of additional units; and
- Verify the transfer of assets between users.
Cryptocurrencies, such as Bitcoin seek to operate independently of a central bank by decentralising control through a blockchain. A blockchain is a public transaction database, functioning as a distributed ledger. Generally, cryptocurrencies gradually decrease production of coins, thereby making the total amount of any given cryptocurrency that will ever be in circulation finite. This mimics precious metals and renders central bank functions such as printing extra money or fractional reserve banking redundant.
Cryptocurrencies are mainly used outside existing banking and governmental institutions and are usually exchanged over the internet. Exact numbers are difficult to ascertain, but recently published data suggests that, as of September 2018, the total market capitalisation of cryptocurrencies exceeded USD 200 billion and record daily trading volumes exceeded USD 500 billion. It’s estimated that there are over 2,000 digital currencies in existence and this number is growing.
So, despite its rapid growth and volatile nature, the cryptocurrency market, with its disruptive effects and decentralised construction, is an attractive proposition for many stakeholders.
Cryptocurrencies are not actual currencies or money in the traditional sense. Units of an issued cryptocurrency may be divided into two categories:
- Coins – these are the pure form of cryptocurrency, issued and operating on their own native blockchain. While the blockchain on which the coin is issued may be capable of giving the coin functionality (and with it a specific utility) the issuer will have given the coins one utility only – to act simply as stores of value; and
- Tokens – a token can represent any assets or utilities that are interchangeable and tradeable, such as from commodities to loyalty points to other cryptocurrencies. They can achieve this by attaching smart contracts to a coin. Smart contracts are computer protocols that automate transactions. They’re self-executing, trackable and irreversible, with the terms of the agreement written into lines of code.
Launching a new cryptocurrency
A new cryptocurrency launch typically involves an initial fundraising process followed by a public sale process by way of initial coin offering (ICO) or token sale.
These steps give the cryptocurrency issuer an opportunity to pursue initial development, offset development costs and fund future projects. They’re also an opportunity to attract a critical mass of interested parties to buy (and subsequently trade) the cryptocurrency.
A diverse pool of holders is the key to creating interest and building a market for any new cryptocurrency. However, before they get to the ICO stage, an issuer may need to do some pre-ICO fundraising activity. Pre-ICO fundraising is used to pay for the final development steps that allow the new offering to operate successfully on a cryptocurrency exchange. Pre-ICO fundraising can also help an issuer assess - and generate - interest in the cryptocurrency before the ICO itself takes place.
Pre-ICO fundraising – who’s protected?
In the pre-ICO fundraising stage, a prospective cryptocurrency issuer will seek funding from backers in order to develop and ultimately launch the product. Pre-ICO fundraising can, therefore, be characterised as reward crowdfunding whereby many direct investments in a project are aggregated, with those contributing promised a form of return on their investment.
If the coin itself is not sold as an investment or security and if the fundraising is not conducted in a way that attracts financial regulation, pre-ICO fundraising within the UK to UK targets will fall outside the remit of the FCA.
This is because the FCA does not regulate reward-based crowdfunding. UK consumer protection rules will apply, however, and these may entitle backers to a full refund on their investment for up to 14 days after delivery, provided the backer is classified as a consumer as defined in the Consumer Rights Act 2015:
"A consumer is an individual acting for purposes which are wholly or mainly outside that individual's trade, business, craft or profession."
Under this definition, a company or a limited liability partnership cannot be a consumer. Indeed, any funder in the pre-ICO phase that is a body corporate will not be considered a consumer and is therefore not entitled to consumer protections.
Furthermore, where an issuer receives more than EUR 10,000 in cash from third parties, anti-money laundering provisions will apply, and where it receives personal information from third parties, data protection provisions will apply. This is true even when no other regulations are in force.
Regulation of cryptocurrencies in the UK
On 19 September 2018, the House of Commons Treasury Committee called for crypto-assets to be regulated by the UK Financial Conduct Authority (FCA) as a matter of urgency. However, as at the date of this article, the FCA does not regulate cryptocurrencies.
However, UK, individuals and firms do need to be authorised and regulated by the FCA if they carry out "regulated activities". Section 19 of the Financial Services and Markets Act 2000 (FSMA) provides that:
"No person may carry on a regulated activity in the United Kingdom, or purport to do so, unless he is an authorised person or an exempt person".
The Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (SI 2001/544) (RAO) sets out what constitute regulated activities under FSMA. The list of investments to which regulated activities may apply is an exhaustive one, however cryptocurrency is not a specified investment on this list. Again, if cryptocurrency itself is not the "investment" opportunity for these purposes, activities relating to it are unlikely to constitute regulated activities and so will fall outside the general prohibition.
Section 21 of FSMA states that:
“A person must not, in the course of business, communicate an invitation or inducement to engage in investment activity" unless an authorised person has signed-off or approved the content and communication.
The “invitation or inducement” here is referred to as financial promotion. To "engage in investment activity" means entering or offering to enter into an agreement that involves a controlled activity or exercising any rights conferred by a controlled investment to acquire, dispose of, underwrite or convert a controlled investment.
The Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (SI 2005/1529) includes an exhaustive list of controlled activities and investments under FSMA. Similarly to regulated activities, cryptocurrency coins are unlikely to fall within any of the controlled investments for these purposes and, accordingly, communications relating to such coins should not constitute financial promotions.
A token, however, could fall within the definition of an investment under English law depending on the nature of the application it is intended for. For example, a token might be considered a forward contract if it entitled the holder to purchase a particular asset at a particular time in the future at a particular price. Equally, a contract for difference (CFD) with a cryptocurrency as the underlying would still be subject to the regulatory oversight of the FCA since the determining factor here is the CFD element of the instrument and not the underlying. Accordingly, the nature of a specific cryptocurrency and any utility it may possess will be key to determining whether it’s subject to the FCA's regulatory oversight.
Cryptocurrencies generally do not currently constitute an investment which would fall under the jurisdiction of the FCA and pre-ICO fundraising should not currently be subject to the oversight or regulation of the FCA. To the extent that funders in the pre-ICO phase are individuals, the provisions of consumer protection rules, anti-money laundering regulations and the data protection regime under English law will apply to such activities. However, if the funders in a pre-ICO phase are companies or other body corporates with their own legal status, consumer protection rules will not apply.