Initial Coin Offerings (ICOs) 78. Many Initial Coin Offerings (ICOS) have failed in their fruition, resulting in financial losses for those...
Initial Coin Offerings (ICOs) 78. Many Initial Coin Offerings (ICOS) have failed in their fruition, resulting in financial losses for those who had initially invested in the ICO. A crowdsourcing website that keeps track of coins that have gone out of existence, www.deadcoins.com, has identified over 900 ICOs that have failed.113 The website lists whether the ICOs failed due to their inadequate business proposals, through a successful hack of the coins or whether they were a fraud or scam to begin with. For example, CraftCoin was designed to be a crypto-asset that would be used as an in-game currency for Minecraft114 users but failed to launch.
115 According to CoinMarketCap, a website tracking the market capitalisation of crypto-assets, the value of CraftCoin in September 2018 was $0.000738 and the market capitalisation, volume traded in the last 24 hours and the circulation supply were unknown.116 Additionally according to ICO Data, a website that lists the funds raised of ICOs, an ICO for a new crypto-asset called Infinitum Coin was launched in January 2018 and ended in April 2018, having raised $0.117 A study of 2,400 ICOs by a research team at Boston College, Massachusetts found that 56 per cent failed within the first four months.118 79. Izabella Kaminska, Editor of the Financial Times Alphaville, told the Committee that would-be investors in ICOs should be cautious: You have to ask: why are these companies going to the ICO markets instead of going to the conventional markets? If your product is good enough to raise money in the markets, you should be able to raise it in the regulated markets, not just go to the ICO issuance.119 80. As discussed earlier, most ICOs are not regulated in the UK, and investors are extremely unlikely to have access to regulatory protections.120 David Geale, Director of Policy at the FCA, explained that: The bulk of this [ICO] activity seems to be in the unregulated space, around things like the utility tokens, where you are buying, for example, future rights to access a theme park or something that does not exist at the moment. Is that the sort of thing we would regulate? It is certainly not the sort of thing we regulate at the moment […]121 81. In its evidence to the Committee, MIT Media Lab argued that “ICOs are essentially a new method of capital raising for a new enterprise [and] they should not be able to avoid relevant securities regulations just by tweaking the form.”122 This view is reflected in the approach taken by the US Securities and Exchange Commission, whose Chairman, Jay Clayton, issued a public statement in December 2017 that: A change in the structure of a securities offering does not change the fundamental point that when a security is being offered, our securities laws must be followed. Said another way, replacing a traditional corporate interest recorded in a central ledger with an enterprise interest recorded through a blockchain entry on a distributed ledger may change the form of the transaction, but it does not change the substance. The Commission applied longstanding securities law principles to demonstrate that a particular token constituted an investment contract and therefore was a security under our federal securities laws. Specifically, we concluded that the token offering represented an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.123 82. In particular, Mr Clayton highlighted that “utility” tokens would generally be treated by the SEC as securities, and regulated accordingly: Certain market professionals have attempted to highlight utility characteristics of their proposed initial coin offerings in an effort to claim that their proposed tokens or coins are not securities. Many of these assertions appear to elevate form over substance. Merely calling a token a ‘utility’ token or structuring it to provide some utility does not prevent the token from being a security. Tokens and offerings that incorporate features and marketing efforts that emphasize the potential for profits based on the entrepreneurial or managerial efforts of others continue to contain the hallmarks of a security under U.S. law.124 83. Mr Geale explained how differences in the law gave rise to the different regulatory approaches to ICOs in the UK and the US: The tests [the SEC] applies are different [from the FCA]. It applies them on the basis of case law, which is more like asking, ‘does it look and feel like an investment, because you are investing for some form of speculative return?’, whereas the definitions of a ‘financial instrument’ are laid down in legislation here. It is different, but if it is a financial instrument that looks like a form of security, or if there is a form of security […] it will be regulated. […] For utilities, where it is not conferring rights to future returns but there might be a future reward of some description, it is outside the perimeter.125 84. On 12 September 2017 the FCA published a consumer warning about the risks of Initial Coin Offerings (ICOs), stating that ICOs are “very high risk, speculative investments”126 and highlighting the absence of regulatory protections.127 The consumer warning went on to highlight the risks faced by consumers from price volatility, potential for fraud and inadequate documentation that are typically associated with ICOs. It cautioned that investors should be “prepared to lose [their] entire stake.”128 85. The FCA’s power to issue consumer warnings extends to products that fall within its remit. Mr Geale conceded that the FCA’s warning on ICOs may “have gone a little bit outside of our remit.”1
86. It is not known how many current or prospective ICO investors have read the FCA’s warning. When asked whether it had been useful, Ms Kaminska stated that “personally, I do not think they have gone far enough, and they have been very late to the game as well. We were all waiting to see action much earlier than it happened.”130 87. The FCA’s stark consumer warning on ICOs is evidence that they present significant risks to investors. But apart from drawing attention to the risks, there is little the FCA can do to protect individuals from being defrauded or losing their money. This is because most ICOs do not promise financial returns, but instead offer future access to a service or utility, meaning they fall outside the regulatory perimeter. 88. While there may be no explicit promise of financial returns, investors in ICOs clearly expect them: they are not buying tokens to gain access to as-yet unbuilt theme parks, or to obtain dental services in years to come, but in the hope of selling them at a profit. The development of ICOs has exposed a regulatory loophole that is being exploited to the detriment of ordinary investors. The Regulated Activities Order should be updated to bring ICOs within the FCA’s perimeter as a matter of urgency, and bring investor protections into line with those in the United States. 89. Crypto assets and ICOs are extremely risky, and the Committee agrees with the FCA that investors should be prepared to lose all their money
Money laundering and terrorist financing 90. Although they will fall within the scope of the Fifth Anti-Money Laundering (AML) Directive and will have to comply with anti-money laundering and counter-terrorist financing rules, crypto-asset exchanges are not included in Anti-Money Laundering (AML) regulations that are currently in force. As the FCA notes: The activities that require firms to comply with anti-money laundering (AML) obligations are set out in the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (MLR). Crypto-asset exchange activities are not included in the MLR, which means that such firms are not currently subject to AML requirements.131 91. It is suspected that crypto-assets and crypto-asset exchanges appeal to money launderers and are being used to facilitate money laundering and terrorist financing. The Solicitors Regulation Authority noted that given the current lack of regulation, “crypto- [assets], and any similar technologies […] facilitate anonymity […].”132 92. When asked about crypto-assets’ role in facilitating money laundering, David Raw, Deputy Director of Banking and Credit at HM Treasury, stated that “the latest risk assessment from the National Crime Agency is that [crypto-assets’] use for money laundering and terrorist financing is currently low. They are seeing cases of it, but it is not widespread.”1
93. In evidence to the Committee’s Economic Crime inquiry, Donald Toon, Prosperity Command at the National Crime Agency, explained that even though there is a growing risk that crypto-assets are facilitating money laundering and terrorist financing, “it is important that we place virtual currencies in the context of the whole money laundering problem.”134 There are “other large-scale areas of the problem.”135 Nevertheless, he stated that “we are not relaxed about this. We see it as a problem.”136 94. Mr Raw, HM Treasury, explained that, although they provide a degree of anonymity, some characteristics of crypto-assets disincentivise criminals and terrorists from using them to launder money: [While crypto-assets are] an anonymous way of paying for illicit activity, there is the fact that you are potentially creating a more transparent record of the transaction, which is potentially auditable. There is a question over whether terrorists would want to use this method. There are other methods available to them, many of which are easier, such as cash couriers.137 95. However, the FCA stated that the role of crypto-assets in money laundering could be more significant than previously assessed: In 2017, the UK’s National Risk Assessment of money laundering and terrorist financing risk (NRA), assessed the risk of crypto-asset use for money laundering to be relatively low. This was because of a lack of evidence of crystallised risk. However, FCA work on this issue using information that postdates the intelligence the NRA relied on shows evidence supporting wider-scale criminal use and we now view the potential harm in this space to be greater than previously assessed.138 96. The Committee received written evidence from Crypto UK arguing that “lack of regulation around the ‘on’ and ‘off’ ramps, where fiat is converted into a cryptocurrency and vice versa, [i.e. crypto-asset exchanges], means that these points are currently vulnerable to criminal activity.”139 97. Obi Nwosu, Chief Executive Officer of Coinfloor, argued that there is an important role for exchanges in mitigating the risk of money laundering: If exchanges put efforts into knowing their customer, track the source and destination of funds on the crypto side as well as the fiat side, have strong policies around monitoring behaviour on the site and have a policy of submitting suspicious activity to the National Crime Agency […] they [would] have very low rates of issues in [money laundering]
98. However, Izabella Kaminska, Editor of the Financial Times Alphaville, argued that the current policies and practices of crypto-asset exchanges are often ineffective: There is a difference between asserting that you are pre-emptively compliant and the reality of that compliance. In my day job as a journalist, I often test a lot of these platforms for exactly that. I have often been privy to situations where I can open accounts without providing the full spectrum of information that is usually needed to fulfil KYC [Know Your Customer] requirements. […] It is very easy to say that you are compliant, but who is testing that compliance?141 99. Mr Raw highlighted to the Committee that the Government is already considering how to apply AML regulation to the crypto-asset landscape. He said the “key thing […] in terms of tackling money laundering and terrorist financing, is […] to bring the exchanges, which is the point at which fiat currency exchanges for cryptocurrencies, into the money laundering directive regulations”.142 100. Mr Raw told the Committee that the next step was for the UK to transpose the European Directive into UK regulation: Transposing the Fifth AML Directive is certainly a matter of urgency.143 […] We will be consulting on how to transpose that over the remainder of this year and the course of next year. The precise timings are still being worked out, but by the end of next year it will be transposed so we will know precisely what that new money laundering framework looks like in relation to crypto assets and exchanges, including who the responsible regulator is. We will know precisely how we are going to deal with it.144 101. The Committee also heard in evidence from David Geale, Director of Policy at the FCA, that the FCA has reminded firms of their own AML responsibilities whilst the Fifth AML Directive is being transposed: In the interim, we have […] written to the chief executives of the banks, asking them to think about the use of crypto assets in terms of whom they are dealing with, the due diligence they do on the customers they have and who those people are dealing with, the jurisdictions they are dealing in, the underlying technology and the governance that is being put around that. There are interim steps that we can take and are taking to remind the banks of their own responsibilities under existing antimoney laundering laws. The new ones will help in terms of what actually comes through the exchanges.145 102. The Committee also heard from Iqbal Gandham, Chair of Crypto UK and Managing Director of eToro, that some crypto-asset exchanges are preparing for the implementation of the Fifth AML Directive, but also require further guidance from the Government and regulators:
[Some exchanges] are also aligning themselves with the Fifth Anti-Money Laundering Directive. [But]we still need clarity from the UK Government to say, ‘these are the checks that we want you to do.’146 103. Owing to their anonymity and absence of regulation, crypto-assets can facilitate the sale and purchase of illicit goods and services, and can be used to launder the proceeds of serious crime and terrorism. 104. The absence of regulation of crypto-asset exchanges—through which individuals convert crypto-assets into conventional currency—is particularly problematic. 105. The adoption of the Fifth Anti-Money Laundering (AML) Directive represents a step forward in this respect. Under the Fifth AML Directive, crypto-asset exchanges will have to comply with anti-money laundering and counter-terrorist financing rules. The Committee urges the Government to treat the transposition of the Directive as a priority, and to expedite the consultation process, which is currently not planned to finish until the end of 2019. If the UK leaves the EU without a transition period in March 2019, the Committee would nonetheless expect the Government to seek to replicate the relevant provisions of the AML Directive in UK law as quickly as possible. 106. The Committee believes that the FCA should be the relevant regulator for supervising anti-money laundering
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