ICOs[1] were initially hailed as a “revolution”[2] and “the next big thing”[3]. The largest ICO to date (Block.one’s EOS) raised $4.2 billion[4]. But figures[5] show that the hype around ICOs has died down again and companies are turning back to classic, more regulated forms of financing. Reasons for this are seen in the high risk for investors due to the lack of regulation, among other things. Now, with MiCA, the EU has created a regulatory framework for crypto assets, the declared aim of which is to promote ICOs and thus achieve an expansion of financing sources for companies. How will ICOs be regulated in the future? And is MiCA an opportunity for the EU to lead the way in crypto regulation and help ICOs become an integral part of the funding landscape?
These are the questions these articles address in a trilogy, just in time for the adoption of MiCA. Today’s first article first defines ICOs and the various token forms and presents their legal situation to date. The second part then presents the future regulation under MiCA, before the third part then gives an outlook on the future development of ICOs after MiCA.
I. Definitions and previous legal situation
- What is an ICO?
Initial Coin Offering (ICO) is a procedure in which previously generated tokens are sold in a public bidding process, in a so-called token sale [6]. The purchase price can usually be paid in cryptocurrencies (e.g. Bitcoin, Ether, etc.) or legal fiat currency (e.g. euros, US dollars)[7]. Depending on the type of token being sold, a distinction is made between “Initial Coin Offering” (ICO) (for currency tokens), “Initial Token Offering” (ITO) (for utility tokens) and “Security Token Offering” (STO) (for security tokens).
ICOs can and are also used for corporate financing. New tokens are created and sold. The company collects the money and the buyer (usually) speculates on an increase in value. Functionally, an ICO has certain similarities to an IPO (Initial Public Offering). However, unlike an IPO, i.e. the issue of shares, a token does not securitise a share in the company (i.e. without the corresponding rights (and obligations) of a shareholder and thus co-owner).
The advantage of the ICO compared to more classic forms of corporate financing is that these have so far been much less strictly regulated and the companies seeking capital have to go through a much less strictly regulated process during the initial sale. The process can also reduce transaction costs due to blockchain technology and replace intermediaries with smart contracts, i.e. self-executing contracts under the law of obligations that are stored on the blockchain as programme code[8]can be replaced [9].
Criticism of ICOs to date is that they result in a high level of information asymmetry between issuers and investors due to the lack of regulation and consequently the lack of a prospectus requirement for ICOs, as well as the reduced incentive for transparency due to the fact that ICOs are only designed for one round of financing[10]. This poses a significant risk for investors, especially consumers.
- Token
Basically, tokens can be divided into three categories: Currency tokens, utility tokens and equity tokens. Due to the different designs of the respective categories and the numerous hybrid forms (so-called hybrid tokens), BaFin has not yet been able to make a generally valid statement on the respective legal nature. It always points out that a regulatory classification must always be made on a case-by-case basis[11].
a) Currency tokens
Currency tokens (also called payment tokens) are probably the best-known form of token. These include Bitcoin (BTC), Ethereum (ETH) or Ripple (XRP), but also the Binance Coin (BNB) issued by the world’s largest crypto exchange, Binance. Currency tokens are also referred to by BaFin as payment tokens and are“designed similarly to Bitcoin; theprovider intendstouse the tokens as an alternative means of payment “[12].
For BaFin, such payment tokens do not constitute securities within the meaning of the WpPG, which is why their ICO is not subject to the obligation to prepare a securities prospect us pursuant to Section 3 WpPG and the associated prospectus liability. Currency tokens also do not constitute investments within the meaning of the subsidiary applicable VermAnlG. Consequently, there is no obligation for the ICO to prepare a prospectus.
However, BaFin qualifies payment tokens as financial instruments under the KWG. Thus, issuers may be subject to authorisation under the KWG. In particular, the obligations of § 24 ff. KWG ALSO APPLY. If the issuer qualifies as a financial services institution according to Section 1 para. 1a No. 6 KWG (crypto custody business), they are also obligated parties according to Section 2 para. 1 No. 2 GwG and must comply with the regulations for the prevention of money laundering and terrorist financing.
b) Utility tokens
In its information letter[13] baFin defines utility tokens as“crypto tokens that allowaccess to certain services or products, similar to a ticket orvoucher”
Voucher“. MiCA itself has a similar definition for crypto-tokens: According to Art. 3 para. 1 No. 5 MiCA, utility tokens are:“a (…) crypto-value that is designed to provide digital access to a good or service, is available via DLT and isonly accepted by the issuer of that token ” . An example of such a token is the FTX Token (FTT) of the now insolvent crypto exchange FTX. FTT allowed customers to enjoy lower trading fees and other benefits on the FTX platform.
These types of tokens currently represent the majority of tokens issued in Germany through an ICO[14].
The BaFin classifies utility tokens in its 2019 advice letter not as securities within the meaning of the WpPG or investments within the meaning of the VermAnlG[15]. This means that when a utility token is issued, there is neither a securities prospectus obligation nor does a sales prospectus have to be prepared.
Such tokens would also not meet the requirements for a financial instrument under the KWG not fulfil[16]which is why, in particular, there is no obligation for the issuer to obtain a licence. Accordingly, in the view of the BaFin, the token does not qualify as a financial services institution pursuant to Section 2 (1) No. 2 AMLA and thus as an obligated party under the AMLA.
c) Security tokens
BaFin defines security tokens as follows:“Holders of such tokens are entitled to membership rights or claims under debt law with pecuniary content thatarecomparable tothose of a holder of shares or a holder of a debt instrument (e.g. claims to dividend-like payments, co-determination, repayment claims, interest).”[17]. This type of token has similarities to a VC investment or asset investment via crowd investment[18].
Such tokens are generally classified by BaFin as securities within the meaning of the Prospectus Ordinance, the WpPG and the WpHG [19]. This also entails a duty to publish a prospectus, including liability. Furthermore, security tokens are financial instruments within the meaning of the KWG[20]. Consequently, according to BaFin, there are also licensing obligations for issuers. If the issuer qualifies as a financial services institution according to Section 1 para. 1a No. 6 KWG (crypto custody business), it is also an obligated party according to Section 2 para. 1 No. 2 GwG and must comply with the regulations for the prevention of money laundering and terrorist financing.
Read more? Click here for Part II of the article.
Footnotes:
[1] ICOs, ITOs and STOs are summarised below under the term “ICO”.
[2] https://www.hiig.de/die-ico-revolution/.
[3] https://brutkasten.com/ico-brandl-talos/.
[4] Weitnauer, VC Handbuch, para. 107, footnote 122; https://financefwd.com/de/blockone-eos-voice/; https://decrypt.co/53950/the-10-biggest-icos-heres-where-the-money-went
[5] see https://cointele graph.com/news/research-ico-market-down-almost-100-from-a-year-ago-raised-40-million-in-q1-2019.
[6] Weitnauer, Handbuch Venture Capital, 7th edition 2022, marginal no.108.
[7] Weitnauer, Handbuch Venture Capital, 7th edition 2022, marginal no.108.
[8] Ernst, Münchener Kommentar, Einleitung Schuldrecht, 9th edition 2022, marginal No. 69; Wendehorst, Münchener Kommentar, 9th edition, section 312, marginal No. 180; Eschenbruch/Gerstberger: Smart Contracts, NZBAz 2018 p. 3.
[9] see LSK 2018, 17808389.
[10] see LSK 2018, 17808389.
[11] see p. 6 of the second BaFin information letter on prospectus and permission requirements in connection with the issuance of so-called crypto-tokens, GZ: WA 51-Wp 7100-2019/0011 and IF 1-AZB 1505-2019/0003.
[12] see p. 6 of the second BaFin information letter on prospectus and permission requirements in connection with the issuance of so-called crypto-tokens, GZ: WA 51-Wp 7100-2019/0011 and IF 1-AZB 1505-2019/0003.
[13] see p. 5 of the second BaFin information letter on prospectus and permission obligations in connection with the issuance of so-called crypto-tokens, GZ: WA 51-Wp 7100-2019/0011 and IF 1-AZB 1505-2019/0003.
[14] see p. 5 of the second BaFin information letter on prospectus and permission obligations in connection with the issuance of so-called crypto-tokens, GZ: WA 51-Wp 7100-2019/0011 and IF 1-AZB 1505-2019/0003.
[15] P. 6 of the second BaFin information letter on prospectus and permission obligations in connection with the issuance of so-called crypto-tokens, GZ: WA 51-Wp 7100-2019/0011 and IF 1-AZB 1505-2019/0003.
[16] see p. 6 of the second BaFin information letter on prospectus and permission requirements in connection with the issuance of so-called crypto-tokens, GZ: WA 51-Wp 7100-2019/0011 and IF 1-AZB 1505-2019/0003.
[17] see p. 6 of the second BaFin information letter on prospectus and permission requirements in connection with the issuance of so-called crypto-tokens, GZ: WA 51-Wp 7100-2019/0011 and IF 1-AZB 1505-2019/0003.
[18] Weitnauer, Handbuch Venture Capital, 7th edition 2022, Part D. Die Gründung, marginal No. 117.
[19] P. 6 of the second BaFin information letter on prospectus and permission obligations in connection with the issue of so-called crypto-tokens, GZ: WA 51-Wp 7100-2019/0011 and IF 1-AZB 1505-2019/0003.
[20] see p. 6 of the second BaFin information letter on prospectus and permission requirements in connection with the issuance of so-called crypto-tokens, GZ: WA 51-Wp 7100-2019/0011 and IF 1-AZB 1505-2019/0003.