Blockchain Startups and Prospectus Regulation
Is the distinction between cryptocurrencies, coins, stablecoins, utility tokens, security-like tokens really so important in order to assess whether prospectus regulation should be applied to utility token offerings? In our paper we argue that it is not, at least when those tokens are excheangable.
In order to reach our conclusion we start by analysing the economics of excheangable utility tokens, the ones that raise more problems from a securities regulation perspective. We observe that utility tokens are the means of payment for services or products that the team wants to create. The team offers these tokens as the cryptocurrency to provide access to the platform and to spend within the relevant eco-system. If the eco-system is large, the utility tokens resemble a currency, because the user can get access to many different types of services that require payments in the system’s tokens. More importantly, since the token is tradable and there is a market exchange rate, users can convert it into Bitcoin, Ether or fiat money. Indeed, different to what usually happens for platform currencies, utility tokens can be exchanged back into cryptocurrencies or fiat money. From this angle, the conceptual difference between a currency token and an excheangable utility token is just the dimension of the crypto environment in which the token is spent. Bitcoin can be used as a means of exchange in any crypto environment, whereas a utility token can be used in the more limited space created by the team, but it can be exchanged on an exchange for bitcoins or others currencies. Therefore the utility token can be conceptualized both as a mini-currency and as an investment in a platform. That is the reason why all tokens are briefly and broadly dubbed ‘cryptocurrencies’. Indeed, they aim at becoming a general currency or a recognized and easily exchangeable market-specific currency. In conclusion, utility tokens combine the customer payment mechanism that makes them similar to currencies, the utility component and the investment one—all in a single instrument. This combination blurs the traditional distinctions between currencies, financial assets and consumption goods.
We then point out the capital market features in cryptocurrency markets and investors. As to markets, we observe the increasing importance of crypto exchanges. The role of those exchanges is not confined to providing liquidity and matching buyers and sellers. Recently some exchanges took up the role of a trusted intermediary and staked their reputation on token offerings. These new token sales are termed initial exchange offerings (IEOs) and have gained in popularity among investors and founders seeking crypto financing. As to crypto investors, we have calculated the semi-annual trading turnover for the top 100 tokens by market capitalization. We have taken the first six months of trading, but have excluded the first week after listing since this period is usually characterized by an abnormal trading volume (similar to the trading of IPO shares following their listing on exchanges). Our calculations indicate that the tokens are traded quite heavily, with the median semi-annual turnover after their creation (either through hardfork, airdrop, ICO or start of mining) equal to 340%. Such volumes can hardly be justified by investors’ sole intention to use them as utility tokens in the relevant platform. These volumes offer a clear indication that all tokens traded on crypto exchanges are seen by their purchasers as investment instruments rather than instruments giving access to the services to be offered on a platform. We also observe that buying and selling cryptoassets entails exposure to financial risks, not just to idiosyncratic risks that concern only the product itself. Exchangeable cryptoassets of whatever nature have at least some of the typical features of capital market products.
We then turn to European securities law, namely to MiFID II and the Prospectus Regulation (PR). We observe that under European law ‘tradable securities’ are issued in classes by for-profit-organizations, are negotiable on the capital market, have an investment component and therefore expose investors to financial risk. Tokens issued in ICOs or IEOs have all these features. They have mixed elements of a means of payment and a security, and can be seen as an investment in a platform. Thus they share all the characteristics of a capital market instrument. We therefore argue that they are subject to prospectus regulation independently from the utility that they offer to contributors. In doing so, we challenge the view that an equivalence test should be applied to assess whether utility tokens share some features of a typical share or bond—a view shared instead by many European authorities. First, we do not believe that the examples contained in Article 4(1)(44) MiFID II are to be read with an ejusdem generis approach, restricting the category of negotiable securities to instruments that at least resemble shares, bonds, or put or sell options on assets or indices and measures. Second, cryptocurrencies can be understood as investment in platforms. This is a new concept, like platform governance. But there are clear similarities with investment in shares. The investor does not get dividends and pro quota liquidation value, but instead receives the increase (decrease) in the value of the token that is related to the increase (decrease) in the value of the platform. Finally, we believe that in any event the key concepts are those of negotiability on capital markets and financial risk involved in the investment component of the asset. When tokens, whatever their nature, are negotiable on capital markets and present an investment component and a financial risk, they are tradable securities in accordance with EU financial markets regulation.
We then turn to the EU exemptions concerning prospectus. We argue that the only significant EU exemption is contained in Article 1(4)(a) PR and concerns offers of securities addressed solely to qualified investors. In the paper, we explain why all the other exemptions are not relevant in an ICO context. Qualified investors are, under Article 2(1)(e) PR, persons or entities that are listed in points (1) to (4) of Section I of Annex II to MiFID II, and persons or entities who are, on request, treated as professional clients in accordance with Section II of that Annex, or are recognised as eligible counterparties in accordance with Article 30 of MiFID II (unless they have entered into an agreement to be treated as non-professional clients). With regard to ICO investors, the most significant class would be persons or entities that, on request, are treated as professional clients. The requirements for being treated as professionals on request are very demanding and require the intervention and the assessment of a financial intermediary. We observe that these criteria are almost impossible to be satisfied by any ICO investor, and if they were satisfied, the intervention of a financial intermediary would be necessary nevertheless, thereby betraying the promise of a new disintermediated financial world.
Since many US ICOs have benefited from capital-raising exemptions, we compare EU exemptions with the US exemption regime. There are multiple exemption regimes in the US, which form a complex and not easy to navigate framework. However, US regulation allows for a broader number of exemptions which include a variety of requirements, investor protection and other conditions. Also, the requirements for a private investor to be qualified as an Accredited Investor under US law are very different from those needed under EU law to be considered as a qualified investor and therefore to participate in a private placement. European rules are much more restrictive and impose the presence of a financial intermediary to act as a gatekeeper, whereas US requirements are based on net assets and income. Accordingly, under US law it is relatively easy for wealthy individuals to act as angels with regard to blockchain startups, whereas in Europe this is almost impossible. We therefore conclude that rethinking securities regulation in the light of the new financial trend offered by ICOs and IEOs requires a reconsideration not only of prospectus regulation but also of MiFID II rules concerning on-request professional investors.
Dmitri Boreiko is Assistant Professor of Corporate Finance at the Free University of Bolzano-Bozen.
Guido Ferrarini is Emeritus Professor of Business Law, University of Genoa, and Chair in Governance of Financial Institutions, Radboud University of Nijmegen.
Paolo Giudici is a Professor of Business Law at the Free University of Bolzano-Bozen.
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