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Virtual currencies, coins and tokens as an investment – legal framework and regulation for “ICOs”

Blockchain-based virtual currencies, coins or tokens are no longer an insider tip for IT nerds. We currently have a kind of a gold-rush. These synthetic crypto-units, which are often created in an electronic “mining” process through complex arithmetic calculations, have become a favorite investment object with potential for value appreciation. Even family offices have included BitCoins and Co. into their investment universe. Instead of “IPO’s”, there are now “ICO’s” or Initial Coin Offerings, where digital coins or “token” are issued to the public via crowdfunding.

But what is the legal basis of virtual currencies, coins or tokens and are they a permitted investment? They are no form of money, because they are not a legal tender. Nor do they typically fall under the definition of e-money. The main characteristic of e-money is that it is issued against a payment of cash amount and represents a payment claim against the issuer that is accepted as a means of payment by third parties. Virtual currencies created through a “mining” process have no “issuer” and while third parties may accept them as a form of payment, they can only convert them into cash if they find a buyer.

Other virtual currencies are created in online games, where the gamer can exchange real money into virtual money and is entitled to play with this virtual money, e.g. to buy virtual objects that can be used in the game. In this case the issuer accepts the virtual currency as a counterparty, so that this is no case of e-money, too.

However, if the gamer could redeem the currency and get real money, this issue and redemption of the currency could be a deposit transaction for which the issuer would require a banking license.

Parallels to crowdfunding

Virtual coins or tokens are frequently sold as a crowdfunding project. The collected money will be used to finance a project (e.g. the building of a piece of software). The coins or tokens can be used to buy services from the software manufacturer after the software has been built. These types of coins are not e-money, but simply a prepayment for future services. Evidently, the investor will bear the risk that the project is not completed and that consequently, there will be no services that could be purchased with the tokens.

The creation of virtual currencies could be seen as an illegal violation of the government’s monopoly on the issuance of money, but this is not the case. The issue of virtual currencies is not prohibited. The German regulator takes the view that virtual currencies are “units of account”, which fall under the definition of financial instruments. Holding virtual currencies or the private sale and purchase, also for investment purposes, is not illegal and does not require any governmental authorization.

Likewise, the “mining” of virtual currencies is legal. Nor is it forbidden to accept virtual currencies, coins or tokens as a payment for goods and services. However, professionals dealing in virtual currency must be seen differently. Companies who convert virtual money into real money, who agree to safekeep the coins electronically for a customer or who give investment advice will be seen as an investment firm and need to obtain a license, at least in Germany. The same goes for intermediaries and platform operators who are involved in the raising of money trough ICOs.

Otherwise, there is surprisingly little regulation of virtual currencies If a company wants to create a new type of virtual currency, there is no licensing requirement. Investors can acquire the coins in an ICO. The coins or tokens are typically not considered securities or alternative investments. Therefore, there is typically no requirement to publish a prospectus, at least not in Europe. But there are exceptions: If the coins or token give an entitlement to a profit participation in a certain venture, or an interest payment or a right for repayment of the invested money, they are an alternative investment that will require the preparation of a prospectus. For crowdfunding platforms, Germany has created an exemption for small offerings up to EUR 2.5 million (with per-investor ceilings between EUR 1,000 and EUR 10,000 depending on the net worth and income of investors), provided that the platform operator is regulated.

The need to protect investors.

From an economic point of view, virtual currencies are a means of payment, which it is subject to “currency” fluctuation, which makes them an investment object and an object of speculation. Differently than securities markets, the pricing takes place largely in a non-transparent manner, and that opens the flood gate to price manipulation. For this reason, the US Securities and Exchange Commission recently refused to approve a project for a Bitcoin-based exchange-traded fund.

But there are further reasons to protect investors. The problem of many ICOs is, that they are frequently run or initiated by “tecchies”, who may be able to describe their project in technical, but who have little knowledge of financial and legal requirements. Therefore the legal descriptions of the investment terms in ICOs are typically vague and hard to understand. There may be no bad intent but simply ignorance, but as a result, it is sometimes difficult to understand, what the investment terms are, whether there are any “legal” terms at all or whether all terms are simply embedded in software code that creates a “smart contract”. That makes it very difficult for an investor to enforce his rights. Due to the fact that blockchain-based currencies are booked in a distributed ledger that is stored in multiple copies on computers all over the world, it may even be difficult to decided the conflict of law-question: Which law govers the ownership to and rights associated with a particular virtual currency? Moreover in many cases the initiators of an ICO sit in a country far away from the investor, so it may be difficult to take them to court in case of a dispute.

The rapid growth of ICOs and the lack of regulatory oversight is causing concern and attracts the attention of scammers, fraudsters and even robbers. In the past, there were some spectacular electronica thefts of coins or tokens, the first of which drove one of the biggest BitCoin exchanges into bankruptcy. In another case of the blockchain-based currency “Ether”, had to be separated into two different currencies (“hard fork”) after a so-called digital automated organization (“DAO”) had been deprived of a large part of its virtual currency holding by an unknown hacker. There are apparently technical and also legal obstacles to remedy these types of thefts or to criminally pursue the perpetrator.

Moreover virtual currencies (e.g. “OneCoin”) may in fact be fraudulent Ponzi Schemes, which are organized as multi-level marketing systems. The main purpose of these system is to recruit “sales persons” who need to pay to play and who can recoup their investment by recruiting other sales persons. At the end only the organizers of such a system will reap a benefit. Those systems are void, because they violate public policy and are ultimately a criminal fraud.

Conclusion: How to judge ICOs?

There are also advocates, who support the development of ICOs. One of them reportedly estimates that blockchain projects going through ICOs can raise 25 times the capital compared to traditional venture capital investments. Others believe, that blockchain technology is the future and those, who invest in virtual currency at this early stage will earn incredible returns and describes ICOs as a collaborative system, where no classic negotiation dynamic exists where each side wants to sell high and buy low.

But getting rich quickly way by speculation entails risk. Due to the lack of transparency, the profit potential of ICOs is difficult to evaluate. A number of offers have a “social” crowdfunding background, so they are not primary directed on the generation of a profit. The tokens from such offerings may represent some value but through speculation, the market price may be much higher than should normally be justified by the project funded with the proceeds from the sale of the tokens so that there is a high risk that the price will crash at one time.

As long as there is no regulation that meaningfully protects investors, anyone who is interested in investing in ICOs should try to understand the project or company that will be funded, identify the persons behind the project and the actual “rights” afforded by the virtual coins: do they represent a right to share in the profits of the project, can they be redeemed into money or services or goods. Even with this precaution in mind, investors should be aware that the information provided to them has not been independently verified. And finally, investors should be mindful of the risk that their coins could be “hacked” or stolen with little prospect for effective legal remedies against the perpetrators of such acts.

Manuel Lorenz
Manuel Lorenz is a lawyer in Baker McKenzie's Frankfurt office. He advises banks, securities firms and fund issuers on regulatory matters such as licensing and compliance as well as structuring and registration of products.