Thorsten Koeppl is a professor in the Department of Economics at Queen’s University and a scholar in Financial Services and Monetary Policy at the C.D. Howe Institute. Jeremy Kronick is an associate director of research at the C.D. Howe Institute
The momentum around initial coin offerings (ICOs) continues to build. Since 2016, when less than US$100-million in ICOs was issued, more than $20-billion in capital has been raised. By the end of 2017, ICO funding originating in Canada totalled $175-million, good for eighth worldwide.
Naturally, skepticism of such a bonanza abounds. This is perhaps especially true when we talk about cryptocurrencies that, in and of themselves, have no value and seem ripe for fraud. However, despite these valid concerns, in a recent C.D. Howe Institute commentary, we argue that ICOs do indeed fill a market gap, under limited circumstances. What is critical for regulators and investors is determining these circumstances.
ICOs are a form of crowdfunding where many investors – mostly with fairly small stakes – combine to fund a project. In an ICO, an entrepreneur raises funds from many investors in the form of government-backed currencies, such as the Canadian or U.S. dollar, or from common cryptocurrencies, most commonly bitcoin and ether. In return, investors receive new tokens or coins. Typically, these coins are themselves cryptocurrencies stored on either a new or existing blockchain as a smart contract.
There is a certain leap of faith that investors take that the entrepreneur will make good on his or her business plan and carry out the project to their satisfaction. While incentives exist for entrepreneurs to succeed (for example, through the value of the retained coins), there is always potential for fraud. That is where the need for regulation to protect consumers arises and, hence, a balance needs to be struck between the innovative ideas of the new business, and the costs of disclosure and other regulations.
The Canadian Securities Administrators approach to regulating ICOs has to this point been focused on determining whether an ICO implies the issuance of securities. In principle, this is a reasonable course given the CSA’s mandate, and the incentive of potential ICO issuers to circumvent securities regulation. Our analysis does nothing to change the view that most ICOs indeed issue securities according to the CSA’s definition. And, of course, as soon as ICOs are deemed an issuance of securities, full securities regulation should kick in.
However, the requirements of securities regulation are fairly onerous for startups, and many provinces have introduced regulatory relief. Additionally, the CSA has also recognized that even seeking regulatory relief can be a cumbersome process, especially for fintech businesses that operate in a fast-paced world where innovation often means live experimentation. It, therefore, has introduced the CSA Regulatory Sandbox as an umbrella for expedited, more flexible application of exemptions.
The question then becomes how to determine whether a particular ICO should get regulatory relief, and what form the relief should take. Determining the right answer, however, requires a reorientation of how to think about regulation when ICOs are recognized as a new form of financing. This calls for a new, activity-based approach to regulating ICOs, as has happened with other forms of financing in the past, such as crowdfunding.
In our view, for an ICO to qualify for regulatory relief, through the Sandbox or otherwise, the business venture needs to develop a decentralized platform, usually based on blockchain technology, where a coin gives digital access to the platform and serves as a means of payment for users that engage in decentralized, person-to-person (P2P) exchange in order to create and transfer value between them. Crucially, it also must be the case that a sufficient amount of coins are retained by the issuer so that incentives exist, in the form of future increases to the coin’s value, for the issuer to invest in the proper development of the platform.
The very successful ethereum is a perfect example of an ICO issuance that would pass our test. Exchanging bitcoin for ether provides investors with a set of membership coins, which they can then use to transact in smart contracts over a decentralized blockchain-based platform. The coins initially paid for the development and management of the decentralized platform, which also provides incentive for issuers to retain some coins themselves.
There is value in bringing together economic, regulatory and legal aspects to develop a specific framework for the regulation of ICOs in Canada. This can ensure an environment that reaps the benefits of the ongoing blockchain revolution for the Canadian economy without exposing investors unnecessarily to fraud.