BLOCKCHAIN, DLT & ICOSDirk A. Zetzsche, ADA Chair in Financial Law (inclusive finance), University of Luxembourg

The ICO Gold Rush: It's a Scam, It's a Bubble, It's a Super Challenge for Regulators, Prof. Dirk A. Zetzsche, Prof. Ross P. Buckley, Prof. Douglas W. Arner, Linus Föhr

(https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3072298)

Supported by the Luxembourg National Research Fund Project „A New Law for FinTECHs? – SMART Regulation“, INTER/MOBILITY/16/11406511

„The Distributed Liability of Distributed Ledgers: The Legal Risks of Blockchain“, Illionois Law Review – forthcoming, Prof. Dirk A. Zetzsche, Prof. Ross P. Buckley, Prof. Douglas W. Arner, available at: SSRN: https://ssrn.com/abstract=3018214

A. Blockchain & ICOs

B. Taxonomy of ICOs

C. ICOs: Risk and Policy Considerations

D. Legal Assessment

E. Policy considerations

F. Conclusions

OVERVIEW

Introduction

A.

TOPIC

§ Blockchain & DLT is not only a technical, but also a legal challenge.

§ Legal factors influence strategy of BC/DLT users.

§ Law sets the framework for BC/DLT applications, here: ICOs

Passport, Banking identity today

Taken from OIOSCO, FinTech , PS 4/14

Mechanics of a Blockchain

VARIANTS

Permissioned vs Permissionless Blockchains§ Know your peers? Anonymity? +/-

§ Governance? Hierarchy ó Random

Consensus Model

§ Proof-of-stake

§ Proof-of-work

A BC IS A SOLUTION TO …ü The trust problem when storing data: did anyone manipulate the data stored?

ü The access problem where multiple devices need simultaneous access

ü Permanent storage due to linkage in a block

(-) Turning inaccurate data into accurate data (‚garbage in, garbage out‘)

(-) Governance issues in computer interaction (code renovation etc.)

(-) Data privacy as to data stored on BC (ó data stored in external wallet)

(-) Privileged and confidential data when node participation is permissionless.

(-) Moving into a law-less world. In fact, DLT members may be held liable!

POTENTIAL APPLICATIONS

ü Clearing & Settlementü KYC/AML hub

ü Virtual currencies (Bitcoin)

ü Delivery Chains …

ü Initial Coin Offerings (ICOs)

Taxonomy of ICOs

B.

OUR STUDY INTO ICOS: METHODOLOGY

Creation of global database

§ >450 ICOs globally

§ Source: 4 well-known websites

§ Reviewed: white papers, contractual information

§ Collection of basic parameters (e.g. name of issuer, country of origin,

volume of offering, legal information), volume-related data, funding

objective

§ Distinction between different types of ICO on basis of taxonomy

BASIC TAXONOMY OF ICOS

COIN CHARACTERISTICS

Equity token

§ Cash-flow rights (eg dividend) + participation (eg voting rights etc.)

§ Pooled ó segregated funds

Currency token

§ Backed by value of an underlying currency, characterized by liquidity

(example: 1 token = 1 USD)

Utility token

§ Usage rights to holder (e.g. preferential access, software license etc.)

§ All types of content!

240 million Okoins => USD 1.25 billion; start 25 Jan 2018, 90 days

White paper discloses « Okoin are not securities (US) »

DISTRIBUTION OF ICOS FOR CONSIDERATION (IN %)

48,78

15,52

35,7

Currency Type

Equity Type

Utility

EXAMPLES OF EQUITY TOKENS

Clear cut: Cajutel S.à.r.l. (Guinea Bissau)

§ Token are share certificates: “every token is representing a share in

the company and equal voting right“

Symmetry Fund (Singapore)

§ Each token represents one share in the investment fund, incl. voting

rights and monthly dividend payout

Invacio Ltd. (Hong Kong)

§ “Gifted” Class-C shares in UK holding: Tokens may be traded for

shares --> Right to dividend but no voting rights

EXAMPLES OF CURRENCY TOKENS

Stabilise (United Kingdom)

§ Conversion of FIAT currencies to STB tokens: “Stabilise Platform will

receive deposit logs and create STB token of equal face value to the

FIAT deposit.“

Borderline: Reales (Estonia)

§ Tokens backed by mix of hard assets and virtual currencies (physical

and virtual gold and silver)

THE NUMBERS: DEFINITIONS

ICO Volume

§ Amount the ICO sponsors ask for if maximally subscribed, calculated

at the first day of offering; consideration is often asked for in ETH

(rarely BTC).

Subscription value

§ Amount the participants invested in the ICO, according to publicly

available disclosures (≈50% of all ICOs).

DISTRIBUTION BY ICO VOLUME(1ST DAY OF OFFERING, MILLION USD)

9,47% 12,89%

54,21%

12,63%

4,21%

2,63%2,89% 1,05%

Distribution by ICO volume (in million USD).

0-5 5-10 10-50 50-100 100-150 150-200 200-350 >350

GEOGRAPHICAL BREAKDOWN BY ORIGIN OF ICO

20,84%

0,44%

0,67%

12,20%

2,44%

9,98%

15,74%

5,76%

31,93%

EU/EEA

Middle East

Africa

U.S., Canada

Middle / South America

Rest of Europe

Asia-Pacific

Islands

No info

0,00% 5,00% 10,00% 15,00% 20,00% 25,00% 30,00% 35,00%

Geographical breakdown (by numbers of ICOs)

ICOS BY VOLUME (GLOBAL, 1ST DAY OF OFFERING)

1.697 1.677 1.546 1.493 1.480

1.244

1.029

526 480 461

USA HONG KONG SINGAPORE SWITZERLAND ESTONIA UK AUSTRIA BVI GIBRALTAR RUSSIA

Jurisdictions by Volume [in bio USD]

VOLUME VS. SUBSCRIPTIONS

Data on 451 ICOs§ Total ICO Volume: ≈ USD 19 billion (1st day of offering)

§ Average subscription per ICO: USD 14.24 million

(subsample of 217 ICOs for which subscriptions were disclosed)

Assumption: >1.600 ICOs globally

§ Total ICO Volume: ≈ USD 70 billion (1st day of offering)

§ Total subscriptions: USD 20-25 billion

ICO: Risks and Policy Considerations

C.

INFORMATION ASYMMETRY

Insufficient quality of whitepapers§ ≈18% only technical information

§ >30% grossly inadequate information on initiators

§ ≈25% no description of financial circumstances

CAPITAL MISALLOCATION

Asymmetry of expectations§ Most ICOs achieve some significant funding

(av. 14.24 million USD)

§ Only 1.33% do not reach self-set minimum cap

§ Some ICO Volumes « extra large »

WEAK LEGAL PROTECTION

Lack of accountability of issuer§ 31% do not provide information on applicable law

§ ≈ 50% no background information on sponsors

§ Name of issuer ≠ author of whitepaper in 33.26%

§ Impact of private law liability severely limited

§ Regulatory involvement for investors uncertain

SYSTEMIC RISK

Significant global exposure§ Very large global “market” if 1,600 ICOs globally

§ Estimated subscription value: USD 22 – 25 billion (global)

§ Increasing involvement of institutional investors (>100)

Þ Systemic risk on the rise

« OPEN-ENDED » STRUCTURES ≈ EXCHANGES

Example: Fast Invest (Estonia)§ Volume: USD 336 million

§ Very high volume + buyback commitment

Example: Niobium (Austria)§ Volume: USD 752 million

§ Access to and means of payment for Sao Paolo Virtual Currency

Exchange (BOMESP)

Legal Assessment

D.

GENERAL CONSUMER PROTECTION LAW

Liability in case of breach§ Contractual liability

§ Possibility of Prospectus liability or promotional communication rules

(e.g. FRA)

GENERAL CONSUMER PROTECTION LAW

Determination of applicable law§ Frequently choice of law in token sale agreements

§ BUT: limited by Private International Law in consumer relationships

and often for all entities in tort cases (fraud)

§ Applicability of company law or partnership law?

§ Special provisions of financial law? (e.g. Art. 6 IV Rome I Regulation)

FINANCIAL LAW: EQUITY TOKENS

§ “securities” in some jurisdictions à Registration & prospectus obligation;

U.S. SEC in Munchee Inc.: Assessment of economic realities underlying

transaction required for determining status as security;

Europe: MiFID “other participations equivalent to shares”?

§ Investor portfolio management: Tokens may be financial instruments if

“equivalent to shares” – cash flow + some influence

§ Collective investment: eg Alternative Investment Fund (EU), pooled

investment, CIS etc?

§ Derivative: if coin derives value from “underlying asset” à AUS, US

§ AML/CTF

Policy considerations

E.

OPTION 1: OUTRIGHT BAN

Introduced by China and South Korea

§ On initiative of SEC warning against “pump-and-dump” ICO

Benefits

§ Legal certainty at low regulatory costs

Downsides

§ Overly strict response

§ Overemphasize control of risk

§ Underemphasize importance of innovation

OPTION 2: REGULATORY WARNINGS

Þ About insufficient disclosures, risk of fraud

Benefits

§ Inexpensive

§ Less intrusive than outright ban

§ Potentially measurable effect on consumer

Downsides

§ Warnings may create awareness and promote ICOs by assuring

promoters that financial law does not apply (in certain cases)

OPTION 3: WIDENING SCOPE OF FINANCIAL LAW

Þ Regulate eg usage, currency tokens

Benefits

§ Inclusive: catches most activities of token

Downsides

§ Takes time

§ Intrusive: Would catch all license-based business models

§ Financial regulators not best equipped to combat consumer-fraud

§ Too broad a response viewed systematically

OPTION 4: REDUCING INFORMATION ASYMMETRY

Introduced by eg Russia

§ Minimum formal requirements for whitepapers

§ Best practices

§ Certification of disclosures by initiators (e.g. through auditors)

Benefits

§ Consumer protection

§ Standardization => enhance market forces

Downsides

§ High regulatory costs

§ Discouraging innovation

OPTION 5: ENFORCEMENT THROUGH CONCERTED ACTION

Options

§ Take out some obvious examples (equity tokens, exchanges)

§ Enforce existing rules in cooperation with all agencies (e.g.

ESMA/NCAs, consumer protection, AML/CTF, data protection etc.)

Benefits

§ No additional legislation required

Downsides

§ Enforcement cooperation restricted due to constitutional framework

§ Information & incentive asymmetry among agencies involved

Conclusion & Theses

F.

1) Case for regulatory intervention

§ ICOs no longer too small to care => consumer protection, systemic risk

§ Cost-benefit analysis required to determine best regulatory approach

2) Consider the differences

§ No one-for-all solution possible

§ Application of financial law depends on token type: usage, currency, equity

§ Fraud hard to detect without detailed intervention

3) Supervisory intervention necessary

§ Intervention by cooperation of FSAs and CPAs advisable

§ Financial law enforcement best against Equity Tokens & Exchanges

Thanks!

Prof. Dr. Dirk Zetzsche, LL.M. ADA Chair in Financial Law (Inclusive Finance)Faculty of Law, Economics & FinanceUniversity of LuxembourgMail: Dirk.Zetzsche@uni.lu

The ICO Gold Rush: It's a Scam, It's a Bubble, It's a Super Challenge forRegulators, Dirk A. Zetzsche, Ross P. Buckley, Douglas W. Arner, Linus Föhr (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3072298)