Regulation of ICOs - Tricks, Tulips and Treasures

It happens routinely when we open the newspaper: in one day, a bank says cryptocurrencies are dangerous. Shortly thereafter, the same bank announces an investment in virtual currencies. Across the street, a competing bank ponders to operate with bitcoins and different cryptocurrencies in a moment, only to a few days later say that the risks related to such assets are excessive and that the investors should keep their distance. At the same time, from the doctor to the dentist, from the taxi driver to the teacher at the gym, you may have heard people saying that they have invested or are thinking of investing in bitcoins. Your 12-year-old nephew, probably. Your 80-year-old grandmother, possibly.

These apparently unrelated events show a pattern: (i) when we speak of cryptocurrencies, the truth is that no one can in their right mind predict what will happen in 6 months or 6 years; (ii) when the general population starts to euphorically discuss a financial asset, the chances are that this excitement is, in fact, a mania - with all the consequences that accompany it. Precisely because of the accelerated pace of change and its possible impacts, it is worth paying attention to what has been happening with the regulation of these assets in order to have an idea of what is going on.

Clarifying the concepts

Before analyzing the latest developments in the subject, some concepts should be clear. The basic idea is not difficult to understand: cryptocurrencies (such as bitcoin) are a type of digital asset based on cryptography principles that (i) control the issuance of new units and (ii) allow a secure means of exchange between its holders. Its decentralized issuance, independent of central banks, reduces the possibility of interference by external authorities in its operation.

The fact that the asset is digital usually generates an immediate reaction: "But it is not real! It has no intrinsic value!". Well, any currency is an abstraction: in a simplified way, we consider that the US Dollar has value because we trust the institution that issued it - an arm of the United States’ government, a powerful and prosperous nation. Likewise, we think the US Dollar is worth more than the Brazilian Real on a given day because there is a consensus formed about it - not because there is more gold in Fort Knox than in Brazil. The value of the cryptocurrencies comes from a similar abstraction: the collective trust placed on the structure that issued it and in the possibility of perpetuation of that asset. This is one of the reasons why bitcoin moves larger amounts than a newly created cryptocurrency: more people are involved with the business, and other people deduce that if so many people invested money in something, it is because there is intrinsic value there. As we all know, this is not always the case.

That being said, when does a cryptocurrency cease to be an idea of half-dozen idealizers and become available to a large number of people? ICOs (initial coin offerings) are equivalent to the debutante ball of a new digital asset: the moment it is launched into the world and its creators seek to raise funds in exchange for the issuance of units of that digital asset - tokens or coins. Understanding what a virtual coin is can be intuitive, but the tokens go one step further -although they are also a form of digital asset, their complexity can be much greater, since they allow the connection to an underlying physical or digital asset or right, with infinite possibilities.

With all these possibilities and a positive market trend, ICOs in large amounts have been launched, including File Coin (+ US $ 250 million), Bancor (+ US$ 150 million), Status (+ US$ 200 million), Civic (+$ 33 million), Tezos (+ US$ 200 million) and EOS (+ US$ 200 million), which together have raised to more than one billion dollars. Despite the success, lack of regulation and monitoring causes these assets to carry strong uncertainty and volatility or other problems: as an example, the future of Tezos (and the money of its investors) is threatened by a corporate dispute between its organizers.

Separating tulips from treasures

The novelty of the subject and its technical complexity open the door to doubts and speculations of all kinds. Despite all the uncertainty surrounding the theme, we can separate the efforts involving virtual assets in three main lines: (i) pure frauds, in which scammers take advantage of the public commotion with the subject to strike; (ii) real assets, but whose prices are inflated or will not survive the test of time; and (iii) real assets that will actually gain strength and sustain it in the long run, valuing themselves exponentially. Identifying the first type is relatively easy. Separating the second type from the third is literally a million-dollar question.

About frauds: promises of easy wealth, however absurd they seem, invariably attract some people. The emotional appeal of an unmissable proposal - intended for a select few capable of seeing what others do not see - is strong enough to shake the defenses that rationality usually imposes. We like to think that we will find the pot of gold at the end of the rainbow.

This simple mechanism – an offer of wealth + emotional decision - is the basis of frauds and scams from time immemorial. Usual scammers have found a new niche with certain ICOs, using them as a mere instrument to extract money from unwary investors. A recent case in Brazil is illustrative: with the offer of a supposed currency called "kriptacoin" (in fact, a traditional ponzi scheme, in which there was no true ICO), hustlers moved around R$ 250 million and damaged over 40 thousand people.

 The sheriffs arrive in town

Attentive to these risks, regulators from different countries have been taking effective measures to reduce investor exposure. China and South Korea, for example, have issued a ban on any ICOs. The SEC has not banned them altogether, but took a clear stand by initiating an enforcement action against promoters of two ICOs, stating that certain tokens or coins offered through ICOs can be considered securities depending on the context and the conditions of the offer - and are therefore subject to due registration with the regulator.

Following that line and with an eye on the developments in Brazil, on October 11, 2017, the Brazilian Securities Commission ("CVM") issued an official note with its position on the issue. The Brazilian market had been waiting for a formal position on the issue for some time, given the growth in the number of such offers and the releases or rules on the subject issued by regulators from different jurisdictions, as mentioned above.

The CVM establishes that the ICOs can be understood as public offers for raising funds that have as counterpart the issuance of virtual assets - tokens or coins. Such assets may, depending on the economic context of their issuance and the rights conferred on the investors, represent securities, pursuant to article 2, of Law 6,385/76 - and, therefore, be subject to the supervision of the CVM.

The regulator understands that in cases where the assets have the characteristics of securities, both the offers and the issuers are subject to specific regulations and to penalties in the event of non-compliance with the existing rules (so far, no ICO has been registered with the CVM or has had its exemption from registration requested). The CVM also acknowledges that certain ICOs are not subject to its sphere of competence, since they do not constitute public offerings of securities.

At the same time, the note clarifies that securities offered through ICOs cannot be legally traded on specific virtual currency trading platforms (virtual currency exchanges), as such platforms are not authorized by the CVM to facilitate trading environments of securities in Brazilian territory. Such position limits the ability of these exchanges to trade in Brazil virtual assets issued abroad that could be included in the definition of securities for purposes of Brazilian law.

The note also contains warnings to potential investors in ICOs about the risks inherent to such investments, such as: (i) risks of fraud and pyramid schemes, (ii) lack of formal processes to adapt the investor profile to investment risk; (iii) money laundering and foreign exchange evasion, (iv) operational trading risks in an environment not regulated by the CVM; (v) cybernetic risks related to the management and custody of virtual assets (attacks on infrastructure, compromise of access credentials, etc); (vi) volatility risks; (vii) potential absence of liquidity; and (viii) legal and operational challenges in disputes with issuers.

 The CVM recommends potential investors to: (i) verify with the regulator the existence of a registration for the offeror or if the offer has been registered or exempted from registration; and (ii) carefully evaluate the characteristics of such operations, in order to identify signs indicating irregularities - such as high guaranteed returns, pressure to participate in operations immediately, offers and offerors not registered with the CVM, absence of minimum requirements for participation in such operations, among others. We believe it is possible that in the near future the CVM will effectively issue norms on the subject, as more practical situations involving crypto-currencies arise in the Brazilian context and the approach of the international regulators is consolidated.

These actions from the regulators help to inhibit the more problematic offers – the outright frauds. That being said, differentiating bet between assets that are nothing but the product of euphoria and those that will carry value in the long run – separating tulips from pure gold – is up to those who venture down the rabbit hole.

Bruno Ramos de Sousa

Head of the Fintech practice at Veirano Advogados

[email protected]