ICOs in the EU: How Will the 'Slow Giant' Regulate Tokens?

Jacek Czarnecki is a lawyer specializing in blockchain technology.

In this opinion piece, Czarnecki shines a light on how ICOs might be regulated in the European Union, proposing next steps and potential challenges ahead.

A lot is happening in the initial coin offering (ICO) world.

Spurred by multimillion-dollar sales, the blockchain use case is drawing the interest of funds, investors, lawyers and regulators. But so far, the latter group has largely remained silent on the issue.

That's not to say there's not activity, though.

Much has been said already on how US law might apply to tokens, with the main subject of exploration being securities law.

Perhaps as a result, ICO organizers are now looking for jurisdictions that could provide legal certainty in this field. Some countries, aware of such efforts, are responding, engaging in jurisdictional competition.

Yet, for all the ink on the subject to date, surprisingly, not much has been said about how European Union law deals with tokens and ICOs. With that in mind, let's shed some light on this part of the world and how it might see regulatory approaches emerge.

The legal issues

On the most basic level, the legal problems with tokens and ICOs are the same in both the US and the EU.

Similar to the US, the key problem lies in whether a token is a security. If the answer is "yes," the snowball effect begins, because such an approach triggers application of financial regulations.

Other important issues include anti-money laundering (AML) laws, payment services regulations and, of course, taxes. However, for some reasons these topics are much more complicated under the EU law than under the corresponding US regulations.

There are two main reasons for that.

First, the relevant EU regulatory frameworks are changing. Many laws are new, evolving or under ongoing reconstruction. To name just a few: MiFID II (the cornerstone piece of legislation for investment services), Prospectus Regulation (PR3) and the new Anti‑Money Laundering Directive. A lot is happening as part of the emerging EU’s Capital Markets Union.

Second, the situation in the EU is quite complex. We have the EU level and the member states level, and many laws developed on the former have yet to be implemented on the latter.

This sometimes leads to regulatory inconsistencies across member states, even though – in theory – the laws should be the same. Also, many issues are left to member states' discretion, which can cause differences in their regulatory approaches.

The proper approach

As mentioned, the fundamental question that every ICO organizer should ask is: "Is my token a security?" Unfortunately, under the EU law, the answer is not so straightforward.

MiFID, the EU's cornerstone piece of legislation related to investment services, provides such terms as "transferable securities," which are a type of a broader category of financial instruments.

Transferable securities are those classes of securities which are negotiable on the capital market, with the exception of instruments of payment, such as:

• Shares in companies and other securities equivalent to shares in companies, partnerships or other entities, and depositary receipts in respect of shares
• Bonds or other forms of securitized debt, including depositary receipts in respect of such securities
• Any other securities giving the right to acquire or sell any such transferable securities or giving rise to a cash settlement determined by reference to transferable securities, currencies, interest rates or yields, commodities or other indices or measures.

It is a critical definition, as it is applicable to other regulations as well, such as laws related to prospectus requirements.

The definition is very broad, because basically it defines transferable securities as "those classes of securities which are negotiable on the capital market." Theoretically, none of the securities types mentioned in this definition applies to most tokens.

However, points 1–3 are provided just as prominent examples, and the list is not exhaustive.

One reasonable approach assumes that, as long as a given token does not resemble any of the securities listed in the definition (such as shares, bonds etc.), it is not a security, even though the list is not exhaustive.

This would mean that many tokens should not be considered as securities, whereas some – for example, asset-backed or rights-related tokens (such as equity-like tokens) – are much closer to being qualified as such.

Unfortunately, there is no court judgment or official guidance on the EU level that would serve as an equivalent to the Howey Test in the US.

In practice, this means that all doubts are solved primarily on the member-state level. While it is usually not a problem with regard to standard and well-known types of securities, the case of tokens and ICOs is different.

Notably, many EU states have their own, historically well-developed legal doctrines on securities, which are not necessarily the same as those in other member countries. And as long as a clear framework on the EU level is missing, these local approaches will dominate.

This means that even though ICOs are by nature not only EU-wide, but global, in practice the legal analysis of a particular token crowdsale would be mainly based on the law of just one member state. The EU law would be applicable to the extent that it provides a general definition of "transferable securities," but the lack of more specific interpretative guidance on tokens would have to be mitigated by a member state’s own law and its local interpretation.

In the future this might even lead to diverging approaches (and jurisdictional competition inside the EU).

A well-known example from the past was the case of applying value-added tax (VAT) to the exchange of cryptocurrencies for fiat money, finally solved only after a ruling from the Court of Justice.

One of the main goals of the EU is to take care of the single market, and to avoid such differences among member states. So, there is potentially room for action, taking into account token types, distribution methods, etc.

Regulatory guidance

The European Securities and Markets Authority (ESMA), which is the EU’s securities agency, has not issued any public statement on ICOs yet.

Interestingly, in February 2017, ESMA published a report on distributed ledger technology (DLT). At that time, however, legal discussions with regard to applying securities regulations to token crowdsales were already well underway.

Ultimately, ESMA adopted a specific approach to the topic, which could be illustrated by one sentence from the report:

"In line with current market initiatives in securities markets, the rest of the report deliberately focuses on permissioned DLT."

It thus seems that the ESMA deliberately avoided covering in the report public blockchains, and also tokens and ICOs. As a result, there is no regulatory guidance yet available on the EU level.

Another approach was adopted by the UK’s Financial Conduct Authority (FCA), which in its discussion paper from April 2017 specifically asked about ICOs.

Of course, it cannot be ruled out that ESMA will take a closer look on ICOs in the future. A positive result would mean dispelling some of the doubts and unknowns. On the other hand, one never exactly knows what approach to expect and how restrictive it might be.

Next steps

What follows from the above is that there is very little certainty on whether and how to apply the EU securities law to tokens and ICOs. In practice, the national laws of member states would play much greater role, which is not necessarily an optimal solution from the EU’s perspective.

This uncertainty has triggered some market-led efforts to provide clarity with regard to application of the EU law, including securities regulations, to tokens and ICOs. A prominent example is the European Regulatory Initiative led by blockchain investment platform Neufund, which launched a report called "Tokens As Novel Asset Class," that was supported by many industry participants.

Contrary to smaller jurisdictions with less complex and more flexible decision-making, the EU is a slow giant. Sometimes it takes years before the EU undertakes action, in particular in the field of financial regulation.

In the case of ICOs and tokens, the right and balanced decision is needed sooner rather than later. The market does not need a comprehensive legal solution; just an interpretation defining basic issues would suffice.

I am sure the EU can make it.

EU flag image via Shutterstock