European Securities and Markets Authority (ESMA) issued two same-day warnings concerning initial coin offerings (ICO) on 13 November after the preceding weekend was witness to dramatic swings in prices and volatility.
One release is geared toward investors and the other is aimed at participating firms.
ESMA Warns ICO Investors
In what might be taken as a response to a rollercoaster weekend for cryptocurrency markets, where bitcoin cash traded places with ethereum, and bitcoin shed billions, ESMA has issued two same-day statements regarding ICOs.
Dated 13 November 2017, ESMA50-157-829 focuses its attention on investors. “If you are considering investing in ICOs or have already done so, be aware of the many risks this may entail,” ESMA begins, “including the total loss of your investment. In particular, be aware that you will have no protection,” they note.
ICOs are indeed largely unregulated in the traditional sense, having gained great traction this year as at least a tail in the price-comet that is bitcoin.
“ESMA has observed a rapid growth,” they write, “and is concerned that investors may not realise the high risks that they are taking.” “ICOs are highly speculative investments,” and “depending on how they are structured, may fall outside of the regulated space, in which case investors do not benefit from the protection,” they reiterate.
The regulatory arm is one of the three European Supervisory Authorities within the European System of Financial Supervisors bureaucracy.
They continue, “ICOs are also vulnerable to fraud or illicit activities, owing to their anonymity and their capacity to raise large amounts of money in a short timeframe.” Risks include the above along with money laundering, losing one’s entire capital, lack of exit options and price volatility, inadequate access to information, and fundamental flaws in early, untested technologies, the body urges.
What are the main risks of investing in ICOs?
ESMA stresses that ICOs are extremely risky and highly speculative investments. Investors should realise that they are exposed to the following risks when investing in ICOs:
Unregulated space, vulnerable to fraud or illicit activities – Depending on how they are structured, ICOs may not be captured by the existing rules and may fall outside of the regulated space. Some ICOs may be used for fraudulent or illicit activities, with several recent ICOs having been identified as frauds, while ESMA cannot exclude that some are being used for money laundering purposes. In the case where an ICO does not fall under the scope of EU laws and regulations, investors cannot benefit from the protection that these laws and regulations provide;
High risk of losing all of the invested capital – The vast majority of ICOs are launched by businesses that are at a very early stage of development. Those businesses have an inherently high risk of failure. Many of the coins or tokens that are being issued have no intrinsic value other than the possibility to use them to access or use a service/product that is to be developed by the issuer. There is no guarantee that the services/products will be successfully developed and, even assuming that the project is successful, any eventual benefit may be extremely low relative to the invested capital;
Lack of exit options and extreme price volatility – Investors may not be able to trade their coins or tokens or to exchange them for traditional currencies, such as the Euro. Not all the coins or tokens are traded on virtual currency exchanges and when they are, like virtual currencies, their price may be extremely volatile. Many of those exchanges are unregulated and vulnerable to market price manipulation and fraudulent activities. Investors may be exposed to the lack of exit options or not be able to redeem their coin or token for a prolonged period; Inadequate information – The information that is made available to investors, e.g. in so-called white papers, is in most cases unaudited, incomplete, unbalanced or even misleading. It typically puts the emphasis on the potential benefits but not the risks. It is technical and not easily comprehensible. Investors may therefore not understand the risks that they are taking and make investments that are not appropriate to their needs;
Flaws in the technology – The distributed ledger or blockchain technology that underpins the coins or tokens is still largely untested. There may be flaws in the code or programs that are used to create, transfer or store the coins or tokens. Investors may not be able to access or control their coins or tokens, or the coins or tokens may be stolen, e.g., in case of a hack. More generally, the technology may not function quickly and securely, e.g. during peaks of activity.
ESMA Warns Participating ICO Firms
ESMA50-157-828 is decidedly more stern in its tone. Issued the same day, it urges firms “to meet relevant regulatory requirements.” In a cat-and-mouse, near Orwellian turn of phrase, they argue, “If their activities constitute a regulated activity, firms have to comply with the relevant legislation and any failure to comply with the applicable rules would constitute a breach.”
This might be very difficult for firms to ascertain, especially when the very same body refers to them as “unregulated.” Keen readers might ask, are such offerings regulated or not?
Some clarification might be had in the following: “where the coins or tokens qualify as
financial instruments it is likely that the firms involved in ICOs conduct regulated investment activities, such as placing, dealing in or advising on financial instruments or managing or marketing collective investment schemes,” the body details. These too seem rather broad and vague.
The memorandum then sets out some basic guidelines for firms. A prospectus is urged among start-ups in the field, containing “necessary information which is material to an investor for making an informed assessment of the facts and that the information shall be presented in an easily analysable and comprehensible form,” ESMA advises.
It continues in this manner, imploring firms to also be transparent in their organizational dealings and structure along with complying with anti-money laundering regulations. “Firms have an obligation to report any suspicious activity and to co-operate with any investigations by relevant public authorities,” they say.