EU supervisor warns about risks of ICOs and calls for regulatory compliance

By Giovanni Campi and Ignasi Guardans

Following the rapidly increasing use of Initial Coin Offerings (ICOs), the European Securities and Markets Authority (ESMA) issued two statements to warn investors on ICOs’ risks and to encourage companies involved in ICOs to comply with the relevant European legislation.

ESMA defines an ICO as “an innovative way of raising money from the public, using coins or tokens”. In an ICO, businesses issue tokens and sell them in exchange for traditional, or more often, virtual currencies like Bitcoin or Ether. The tokens are created and disseminated using distributed ledger or blockchain technology (DLT).

Following a similar warning by the U.S. Securities and Exchange Commission (SEC), ESMA alerts investors that ICOs might fall out of the EU regulatory framework and may be used for illicit purposes, including money laundering and fraud. Describing ICOs as extremely risky and speculative instruments, ESMA warns about the possibility of a total loss of invested capital and inability to redeem the tokens, as well as the lack of exit options. Companies raising funds through ICOs inform investors about their projects in the form of a white paper. According to ESMA, white papers tend to be misleading and emphasize the potential benefits, without sufficiently explaining the risks involved. Moreover, ESMA cautions that the underlying blockchain technology might be subject to hacking or malfunction.

In the second statement, ESMA stresses that firms using ICOs have to comply with the EU regulatory framework. More specifically, where tokens qualify as financial instruments and/or transferable securities, firms are likely to be conducting a regulated activity. ESMA thus calls for compliance with EU Directives on Prospectus, Markets in Financial Instruments (MiFID), Alternative Investment Fund Managers (AIFMD) and Anti-Money Laundering (AML). ESMA also underlines that the list of applicable legislation is not exhaustive and further obligations might apply at a national level.

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