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Friday, 23 February 2018

The Trouble With Categorising Cryptocurrencies As The Basis For Regulating ICOs

Securities regulators are trying to figure out whether and how to regulate Initial Coin Offerings (ICOs). In doing so, they are tending to focus on the economic function and purpose of the 'coins' or 'tokens' offered, to put them in categories that most stakeholders should understand. They are then proposing different regulatory treatments for the process of issuing the coins according to the different categories. The challenge is that tokens - like 'fiat' currencies (and barter goods, for that matter) - generally have multiple uses that are completely independent of the 'issuer' or protocol for issuing them, and which may vary from one 'holder' to the next. Therefore it is suggested that it should not be the economic function or purpose of the token itself that should drive the regulatory treatment, but the activities in which the issuers, holders and potential holders of the tokens are engaged. At any rate, before regulating or threatening the impact of existing regulation, we need to develop a much more comprehensive overview of distributed ledger technology; the role and use of 'tokens', 'coins' and 'cryptocurrencies'; and the participants and their activities. 

In its recent guidelines, the Swiss regulator (FINMA) categorises tokens into three types, although it admits hybrid forms are possible:
  • Payment tokens are synonymous with cryptocurrencies and have no further functions or links to other development projects. Tokens may in some cases only develop the necessary functionality and become accepted as a means of payment over a period of time.
  • Utility tokens are tokens which are intended to provide digital access to an application or service.
  • Asset tokens represent assets such as participations in real physical underlyings, companies, or earnings streams, or an entitlement to dividends or interest payments. In terms of their economic function, the tokens are analogous to equities, bonds or derivatives.
FINMA says the resulting regulatory treatment may be flexible where a hybrid of the above is involved, e.g. anti-money laundering regulation would apply to utility tokens that can also be widely used as a means of payment (or are intended to be used that way in time).

The Malta Financial Services Authority says that these are all forms of "virtual currency" (i.e. digital currencies that are not backed by government - as opposed to e-money, which is the digital version of a country's 'fiat' currency). The Maltese definition of a virtual currency may also be wider, as the Swiss guidelines are only aimed at crypto-currencies - those issued or implemented using cryptographic or "distributed ledger technology".  The other differences seem to be in name only - the Maltese would refer to Swiss "payment tokens" as merely "coins" and prefer the name "securitised tokens" for the Swiss "asset tokens".

The MFSA says this approach to classifying types of “digital currency” reflects the Blockchain Policy Initiative Report of July 2017 (and an European Securities and Markets Authority statement from November 2017). 

But does it?

The crowd-sourced Blockchain Policy Initiative Report does not really give a succinct definition of 'cryptocurrency' and there is no mention of 'payment token' or 'utility token' according to my search of the pdf version. The report is a helpful, but long and discursive, explanation of distributed ledger technology (DLT).  It gives little insight into the uses of such technology beyond financial use-cases - which will likely be the majority in due course (if not already). In any event, with so many ICOs occurring so quickly, it's difficult to see how it could be comprehensive and therefore why it should be particularly reliable. It's even possible that there are initial coin offerings that are not presetned as "ICOs".

Consider "Filecoin", for example. Users can "earn" tokens for making available unused data storage capacity; the tokens become a "currency" for exchange with others; and the result is a means of those with flexible storage needs to manage their data storage costs and capacity. Couldn't this satisfy all three categories outlined above? Should a securities (or payments) regulator be involved in data storage capacity management? Should the transfer or sale of 'coins' representing storage capacity be seen as making a "payment" or "exchange" of "currency"? Consider that certain "carbon credits" or "emission allowances" are regulated securities... but why?

This underscores why we need to develop a much more comprehensive overview of distributed ledger technology; the role and use of 'tokens', 'coins' and 'cryptocurrencies'; and the participants and their activities, before regulating or threatening the impact of existing regulation.