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The Year 2009 saw the emergence of the sensational bitcoin, a form of cryptocurrency, through a white paper published by an anonymous source known as Satoshi Nakomoto. Bitcoin is based on the blockchain technology.
Blockchain can be defined as a digital ledger to record and pass on information. Based on the peer to peer network, it operates on an open source network, depending on a community of users to verify every new transaction. This prevents concentration of the control over data in the hands of a single entity. Based on the foundation of cryptography, it is resistant to modification which makes blockchain a more efficient and reliable method of storing data.
The ethereum blockchain has expanded the horizons of what a blockchain can do. Bitcoin as a traditional blockchain system focused on virtual currency exchange meanwhile, ethereum blockchain focuses on how the blockchain technology can be used to execute pre-designed programmes and hence came ‘smart contracts, which are basically self-executing contracts based on the fulfillment of pre-requisites as are expected of parties. Smart Contracts take away any third party interference in validating a contract as blockchain is resistant to alteration. This made the application of blockchain technology much simpler.
Finance service firms have been the first to adopt the blockchain technology.
One of the most popular applications of this technology is in the field of capital formation.
Initial coin offering (‘ICO’), also known as token launch or token generation is when a company is creating a new product with an associated utility, and wants to build an ecosystem of stakeholders upfront who will benefit from purchasing the product early. This token sale enables the company to further develop their product with an established user base, and the company can use some of the proceeds to build the product.
In a simple language, it gives a start-up company the opportunity of selling its shares and raising capital based on the product/service and its value in the future, without the regulations of a regulatory institution.
The popularity of ICOs can be attributed to their timing.
After the financial crisis, banks became a lot more cautious when it came to giving loans to businessman while securities regulations overburdened the businessman with unnecessary costs and compliances which eventually restricted innovation and also wasted a lot of time. The small scale businessmen and entrepreneurs had the worst of this market situation. In other words, the financial crisis coupled with the newly issued banking regulation created the perfect stage for the emergence of the phenomenon of ICOs.
ICOs provided a stark contrast to the status quo. ICOs allow startups to fund raise bypassing both banking and non-banking entities, e.g. VCs, as well as their services. This even allows the issuers to take investment from the small investors who are otherwise barred from investing through the traditional methods, thus, unlocking an unprecedented level of liquidity. All in all, ICOs enabled the democratization of the fund raising market by the inclusion of small investors.
Furthermore, ICOs give the issuers the liberty to decide what type of token they want to issue, i.e., a payment, utility and asset token. All these tokens serve a different purpose.
The payment token can be used by the holder to make payment for goods and service subject to the acceptance of the token in the market. The utility token provides advantages to the holder of the services provided by the issuer’s developed product, in other words, they reflect the purchase of a future good or service provided by the issuer. The asset tokens give the holder a share, in accordance with his investment, in the actual earnings of the company.
It can be observed that sale of tokens, to raise capital, does not necessarily involve giving equity or other rights in the company. This gives the issuer the advantage of creating a pre-existing ecosystem of supply and demand with an already established base of prospective issuers without the having to sacrifice equity/ in the company. This in turn gives a lot of creative freedom to the issuers, who otherwise, would be restrained; having to seek investors’ approval every time they make a little detour from the original plan.
Another advantage of ICOs is that it provides access to a worldwide pool of investors through the multiple global cryptocurrency exchanges across the world, providing access to trading with significant liquidity which is possible only because of the universal nature of blockchain.
After an evaluation of the advantages that ICOs offer, the obvious question that comes up is, why has it not become a mainstream capital raising approach yet? The answer to this question lies in the dynamic nature of ICO. Unlike the shares of other companies, the investors cannot really know the tangible value of their assets as it is predominantly based on speculation. The second biggest drawback is the high failure rate. Any new project comes with a risk of failure depending upon various factors such as a lack of reception in the market, problems with execution, conflict between the developers etc. Despite having created a considerable consumer base beforehand, ICOs are still fraught with these risks. Another factor contributing to this end is the volatility of cryptocurrencies in which the investment is made. This volatility affects the funds available for the project and any low harms the project development dearly. It also provides ample room for issuer opportunism, in the absence of any binding regulation. The issuers are at liberty to misappropriate the funds of the investor without any liability as there are no regulations, which makes it a double-edged sword.
Another issue with ICOs is that due to the absence of proper regulations, it can be used for money laundering or for other illegal purposes.
Nevertheless, the advantages of ICOs, however, over-weigh the disadvantages. What is required is a regulatory code for ICOs which does stifle the creative freedom provided by ICOs while securing investor interest at the same time.
At present there is does not exist a uniform set of rules for the regulation of ICOs. The reasons for the same are threefold.
Firstly, the lack of comprehensive understanding of crypto assets and the blockchain technology creates apprehension in the minds of regulators (of uncertainty),
Secondly, the determination of the nature of tokens issued in the ICO becomes a challenge, thirdly, the universal nature of ICO,i.e., the absence of a centralized database makes the determination of jurisdiction difficult.
After an analysis of regulatory framework regarding ICOs across various jurisdictions, the approaches can be categorized into the following three categories-
Given the uncertainty and high percentage of fraudulent ICOs, jurisdictions like China and South Korea have banned entirety to prevent its ill effects on their economy.
While this approach protects the investor’s interest effectively, it deprives the start ups of a viable fund raising mechanism.
This approach is an extremist one and may also lead to loss of potential benefits ICO’s may provide, What can be done instead is to impose partial bans to protect the most vulnerable sections of the society without affecting the prerogative of the investor to invest.
(ii) Regulation by the securities law
The definition of securities in some jurisdictions, like USA, is broad enough to accommodate new instruments like tokens. In such jurisdictions, tokens issued are governed by the securities law of that country. Although this approach provides adequate protection to the investors, it has certain shortcomings.
Firstly, as mentioned earlier, not all tokens can serve as investments to get returns on, thus, they do not qualify as security. This approach leaves the holders of non-security tokens out of the ambit of protection.
Secondly, despite the protection of securities law, token holders do not have the same position as shareholders as they are not subject to corporate law. For instance, there cannot be forced take overs which is a remedy available to the regulators in case of companies regulated by corporate laws.
Furthermore, in countries like India, with a narrow definition of securities, tokens cannot fit within the ambit of security. Therefore, this approach cannot be applied in these jurisdictions.
(iii) Token Registration
Mexico exercises complete ex ante control on the issue of tokens. This approach requires the issuers to get the issue registered and authorized by the regulators. This ensures the trustworthiness of the ICO, thus, protecting both the investors and the economy.
France uses the same approach except that the issuers are given the discretion to choose between a regulated and unregulated ICO. If the issuers opt for an unregulated ICO they need to expressly inform the investors of the same.
The only shortcoming with this approach is the added costs and man force required for proper execution.
The potential of ICOs in encouraging entrepreneurship is undoubtedly unlimited. It can revolutionize the start up culture in India.
But RBI’s notification prohibiting all the entities regulated by it from transacting in crypto currencies has made the country’s position on ICO ambiguous.
While the release of draft norms for a regulatory sandbox for fintech technology products by the RBI revives hopes of India embracing new technologies, the current stand of the country is causing significant loss to the country. The fintech companies in India.
For instance, Drivezy, a Mumbai based car rental, which raised $5 million from its first security based ICO registered its parent company in USA to offer the ICO because of the ambiguity of laws relating to crypto in India.
Given the difficulties in involved with the application of Indian Securities Law to ICO, the regulatory framework most suited to the Indian context would be a combination of partial ban and token registration.
While the partial ban will protect the most vulnerable sections, like pensioners etc, token registration will ensure the launch of only legitimate ICOs.
ICO is still an evolving phenomenon and any attempt to crystallize the laws surrounding it will stifle the innovation and deprive the capital market of the benefits this phenomenon may bring to it. What is required is a regulatory framework which clearly outlines the responsibilities of the investment scheme issuers to ensure investor protection without suffocating innovation by burdening them with unnecessary compliance.
ABOUT THE AUTHOR(S)
Ritika Srivastava is currently a third year student at Dr Ram Manohar Lohiya National Law University. Her areas of interests include Constitutional Law, Competition Law and Arbitration Law.
Ishan Saxena is currently a third year student at Dr Ram Manohar Lohiya National Law University. His areas of interests include Constitutional Law, International Law and Public Policy issues.
In Content Picture Credit : Innovecs