by Dr. Mattia L. Rattaggi, Co-Chair CVA Regulatory and Policy Task Force and Board Member of the SmartOne Foundation.
DISCLAIMER: This post is part of our series of CVA member feedback to the recent FINMA ICO Guidelines. It reflects the private opinion of the author, and does not constitute or represent the official opinion of the CVA. The author adds: “It goes without saying that the below is by no means a legal opinion but just a summary, first opinion and my personal views / assessment only.”
The Swiss financial regulator FINMA issued on 16 February 2018 guidelines for enquiries regarding the regulatory framework for ICOs. The purpose of the guidelines is to specify the information required by FINMA to process enquiries and also to set out the principles on which FINMA will respond to them. FINMA had issued on 29 September 2017 a guidance laying out its position on ICOs and highlighting areas in which ICOs may be covered by existing financial market regulation. I assess the guidelines as good, for many reasons, but I also believe that there is room for improvement in a number of areas.
The work of FINMA deserves praise from many perspectives.
- The guideline comes in response to a sharp increase in the number of ICOs planned or executed in Switzerland and the corresponding increase in the number of enquiries about the applicability of regulation, and aims to enable FINMA to respond quickly and precisely. The guideline is thus an implicit recognition of the ongoing normalization of ICOs – as a financing instrument in its own right – and a support to their professionalization.
- The guidelines confirm the predictability, pragmatic, innovation-friendly, sustainability-oriented and risk-aware nature of the Swiss regulatory approach.
- No u-turn, no surprising change in direction or radical move regarding ICO regulation, but recognition of the innovative potential of blockchain technology, support of the federal government’s blockchain / ICO working group and desire to back the industry with a more efficient handling of requests instead.
- Principle-based / balanced approach as opposed to a straight-jacketed approach, leaving open the door for further refinement – as this innovative financing practice evolves – and ultimate reliance on a case-by-case assessment.
- Firm desire to ensure that the development of ICOs continues to grant highest investors protection, integrity of the financial system, and continuation of investigations into ICOs to ascertain possible breaches of supervisory law, circumventions of regulation, fraudulent intent.
The guideline offers a token classification based on the underlying economic function and assesses applicability of financial regulation against it. The result is: enhanced upfront clarity as to the relevance and applicability of the banking act, the collective investment scheme act, the anti-money laundering act, the stock exchange act, the financial market infrastructure act and even the code of obligations and the draft financial services act.
- Payment tokens (pure means of payment not giving rise to claims on their issuer): when they do not yet exist and the claims are tradeable, AML legislation do not apply and the claims are securities. Payment tokens that exist, are not securities and are subject to AML.
- Utility tokens (conferring digital access rights to an application or service): when they do not yet exist and the claims are tradeable, AML legislation do not apply and the claims are securities. Utility tokens that exist and are not attributed with an investment function, are not securities.
- Asset tokens (tokens having an investment function, a connection with capital markets, being suitable for mass standardized trading, representing a derivative or a debt or equity claim on the issuer, or enabling physical assets to be traded on the blockchain) are securities and are not subject to AML – irrespective from whether they exist or not yet. On a more process-oriented level, the guidance establishes a set of minimum information requirements for ICO enquiries which clarifies the expectations and helps standardizing the preparation of the submissions.
Room for improvement
The good work of FINMA offers room for improvement and perhaps the guidelines would have benefited from a short official consultation period with the community before issuance.
- The large majority of the ICOs (and I expect this category to even increase in comparative significance, as the ICO process normalises) issue tokens on the back of pre-existing protocols or platforms, such as Ethereum. The token may be operative at issuance in a fully-fledged or embryonic blockchain-based platform, or its emission / issuance may finance the development of the blockchain-based platform in which the token will operate. The promoters – like in IPOs – may offer investors to reserve tokens in advance, at bespoke conditions (including discounted price and lock- up periods). These pre-sale agreements are typically bespoke and not tradeable. In these pre-sales the investor receives a claim on future tokens, not a token with which to buy other tokens.
- FINMA states that in the case of pre-financing and pre-sale of an ICO which confer claims to acquire tokens in the future, these claims will also be treated as securities if they are standardized and suitable for mass standardized trading. It calls ‘pre-financing’ the promise of tokens at some point in the future on a blockchain still to be developed, and it calls ‘pre-sale’ when investors receive tokens entitling them to acquire other, different, tokens at a later date. The guideline could have been clearer in relation to the conditions under which the claim on future token and the token itself may be considered a security with reference to the standard ICO model described above.
- According to the guidelines, the issuance of payment tokens tantamount to means of payment subject to AML – provided the tokens can be transferred on a blockchain. Most of the (complex) tokens (i.e., utility and or asset tokens) characterizing the tokenized ecosystem in a standard ICO such as described above have a payment function (within the ecosystem). It is hard to imagine that AML legislation may apply in closed ecosystems, but the text is not conclusive about it. On the other hand, an ICO is a financing instrument where crypto assets or and fiat money changed into crypto- assets flow into an economic venture, alimenting the creation of new tokens which eventually may leave the ecosystem via an exchange. While FINMA subject second market trading to AML legislation, it could have been explicit in addressing the creation phase – given that the financial community should not miss any opportunity to identify, catch and stop funds originating from illicit activities. Fortunately, such checks are becoming an established ICO practice – not least granting protection to the promoter.
- Following the guidelines, a utility token may be considered a securities if it additionally or only has an investment purpose. Now, the mere expectation of the user that the token will gain value should not have an effect on the token qualification as such interpretation would lack a legal basis in Swiss security laws. However, the guidelines lack clarity on this point.
- FINMA writes that securities regulation is intended to ensure that market participants can base their decisions regarding investments on a reliable and defined set of information. This suggests that ICOs based on non-security tokens may mislead market participants and cannot be structured in a way that ensures market participants as if the token was a security – something I disagree with. At the same time, FINMA renews the warning to all investors in ICOs – irrespective from the token classification – about the risks ICOs can pose for investors, suggesting even securities regulation cannot achieve the intended goal.
- A further clarification point is more operational, namely whether the minimum requirements form the basis of a regulatory white paper or an annex to a white paper or something else.
Unless some clarifying interpretations are provided, market participants will have to address FINMA and obtain a ruling. This may partially undermine at least for the time being harvesting the benefits intended with the Guidelines: deal more efficiently with the growing volume of ICOs.