Enhancing consumer and investor protection in Initial Coin Offerings

The emergence of Initial Coin Offerings (ICOs) in recent years has opened up a new, exciting way of financing economic activity.

In a typical ICO, a company or entrepreneur issues cryptocurrencies in the form of "tokens", in exchange for other cryptocurrencies such as Bitcoin or Ethers.

Entrepreneurs can then use the funds received from consumers or investors to finance their businesses.

In a recent study on ICOs from a comparative and interdisciplinary perspective, Assistant Professor Aurelio Gurrea-Martinez from the SMU School of Law argues that more protection mechanisms need to be put in place for the buyers of those tokens that do not meet the prevailing definition of "securities".

In most jurisdictions around the world, including the United States, the United Kingdom, and Singapore, when a token issued meets the definition of "securities" established in the country's securities law - known as a "security token" - the ICO is subject to the same regulatory framework that exists for the issuance of other traditional investment products, such as shares or bonds.

"While the existing regulatory framework for security tokens works reasonably well, the problem comes when the ICO involves the issuance of tokens that are not legally classified as "securities" - that is, when it is a "non-security token".

In those circumstances, the issuance of tokens is subject to neither securities law nor the supervision of the securities regulator," said Asst Prof Gurrea-Martinez.

"My co-author and I propose several measures to protect the buyers of non-security tokens, since these actors are virtually unprotected under current laws. Besides, as the buyers of these tokens are often retail consumers subject to large asymmetries of information and higher risk of opportunism, there is an even stronger case for regulation."

Asst Prof Gurrea-Martinez and his co-author, Nydia Remolina, research associate at the SMU Centre for AI and Data Governance, noted that since many ICOs involve non-security tokens, regulators do not have the opportunity to be aware of their existence nor issuance.

Indeed, in many cases, regulators become aware of these ICOs only when a financial scandal has occurred, by which time, unfortunately, the damage has already been done.

To address this situation, the SMU researchers propose that all ICOs, regardless of the legal nature of the token, should be disclosed to a centralised and public authority in order to reduce the risks of scams.

This would require the entrepreneur to submit a simple, harmonised electronic form providing some basic information about the promoter, the issuance, and the tokens. This will allow authorities to develop a registry of ICOs, making it easier to monitor the entire ICO market, and consequently discourage scammers from launching a fraudulent ICO. "Moreover, as this measure would not imply significant costs to the entrepreneur, it should not harm innovation and firms' access to new funds. Actually, quite the opposite: as it would enhance consumer and investor protection, and therefore confidence, it may facilitate firms' access to finance," explained Asst Prof Gurrea-Martinez.

He also argued that, due to the risks of scams and volatility in the ICO market, commercial banks and pension funds should be prohibited from buying tokens. This is to avoid putting at risk the savings of their customers or jeopardising the stability of the financial system if the ICO fails or turns out to be a scam.

The researchers also called for the applicable law of ICOs to be harmonised across different jurisdictions to provide more certainty to entrepreneurs, consumers and investors involved in an ICO in overseas markets.

This would require regulators to come together to establish some common rules to determine the applicable law governing an ICO.

This could be the place of residence or incorporation of the promoter, or the law could be chosen by the entrepreneur and disclosed to the public agency in charge of receiving information about ICOs.

Finally, as many consumers and investors are not aware of the risks involved in an ICO, Asst Prof Gurrea-Martinez proposed that regulators should invest more resources in education and awareness efforts. If they are unable to do so due to the lack of resources or expertise, they could even consider the possibility of prohibiting the purchase of tokens to retail consumers or investors, he added.

"Our proposals seek to promote entrepreneurship, innovation and firms' access to finance by creating more certainty and confidence in the ICO market, while enhancing consumer and investor protection, market integrity, and the stability of the financial system."

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