The acquisition of cryptocurrency coins – also referred to as tokens, depending on their form – as part of so-called "initial coin offerings" (ICOs) may result in substantial risks for investors. This is a highly speculative form of investment that is often not subject to existing capital market regulations. As is the case with most trends, the high level of public interest in ICOs is also attracting fraudsters. This article describes the relevant legal background, explains the risks of ICOs and contains important information for consumers.
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DefinitionInitial coin offerings
Initial coin offerings (ICOs) are a new means of raising capital for the financing of commercial projects. The term stems from that of "initial public offering" (IPO). The apparent similarity of the terms IPO and ICO is at least somewhat misleading as it gives the impression that ICOs are comparable to the issuance of shares – this is not the case from either a technical or legal standpoint.
There are currently two forms of ICOs being performed: the first form is based on the use of smart contracts (program codes) or virtual applications (distributed apps/dApps). These, put simply, are programmed agreements where the program code is stored on an existing blockchain, such as Ethereum. Blockchains are tamper-proof distributed data structures in which transactions are recorded in chronological order and mapped in an understandable and unalterable form without any centralised control. The second form of ICOs is based on the creation of new blockchains or virtual currencies. Both forms of ICOs entail the creation of new digital units (a token generating event). In most cases, the tokens generated are sold to interested investors in an unregulated public bidding process (token sale). Although a legal (fiat) currency is sometimes used, investors usually have to pay the purchase price in a virtual currency, often in advance.
Because stock corporation law does not apply to ICOs, the tokens are not required to carry any membership rights, information rights, control rights or voting rights. The offeror is completely free to decide which rights or entitlements they grant to the investor with the tokens. In most cases, offerors describe their project and the way in which the tokens function in a white paper and sometimes they also publish terms and conditions. In contrast to prospectuses for the issuance of shares, the content of such documentation is neither legally regulated nor checked by a supervisory authority to ensure it is complete.
It is not necessary to have either a particular form of enterprise or any actual business operations in order to conduct an ICO. Individual persons who do not conduct any business operations are technically able to offer tokens, provided they possess the knowledge of programming or commission someone with such knowledge. The costs associated with the issuance of tokens are extremely low in comparison to those of issuing shares.
Risks for consumers
The lack of legal requirements and transparency obligations for ICOs means that consumers might face immense risks. Investors should be conscious of the risk of losses – it is possible that they will lose their investment in its entirety and unrecoverably. Tokens often experience significant price fluctuations. Some offerors claim that their tokens will be tradable on secondary market platforms or raise the prospect of this being the case. Investors should nonetheless bear in mind that they have no entitlement to this and that the secondary market platforms might be unregulated. The investor alone bears the risk of not being able to sell the tokens at all or only being able to sell them at a price that does not meet their expectations. The investor also bears sole responsibility for the safekeeping of the private digital key which is required for any access to their tokens. The loss or theft of this private key is tantamount to losing all of the tokens associated with it.
Typically, ICO projects are still in their very early, in most cases experimental, stages and therefore their performance and business models have never been tested. At the same time, they are usually so complex that extensive technical knowledge is necessary in order to be able to assess them comprehensively.
Furthermore, the structures of ICOs can entail a significant potential for abuse and fraud. Only experts are capable of examining the underlying program code (such as that of the smart contract) in order to assess whether the functionality described in the white paper or terms and conditions is accurate in the case of the tokens concerned. The investor must bear the risk of the offeror providing incorrect information. The code might also contain programming errors and thus be vulnerable to manipulation. The offeror alone determines the content of the white paper, meaning that the documentation is often objectively insufficient, incomprehensible or misleading. Moreover, offerors can change the white paper at any time, both before and during the ICO. In many cases, no relevant legal provisions on consumer protection or investor protection instruments exist and the protection of personal data is not guaranteed. This also means a high level of legal uncertainty for the investor.
There is generally a higher risk of fraud for investors if the ICO offeror cannot be clearly identified or if investments are made in systems that are operated outside of Germany. Should a dispute arise, claims against token offerors domiciled abroad can only be asserted with substantial effort and difficulty, if at all. Because ICOs are potentially vulnerable to fraud and money laundering offences or could be used for such purposes, the risk of investors losing the sums invested is further increased and compounded by the possibility of authorities taking necessary measures against operators or other persons that are involved in such illegal dealings.
At a glanceSpecific risks of ICOs
- Risk of loss: ICOs are a highly risky and speculative form of investment. A total loss of the sum invested is possible.
- Lack of regulation: many ICOs are conducted in an unregulated environment.
- Lack of protection: there are often no relevant consumer protection provisions, no investor protection instruments specific to the capital market and no protection of personal data.
- Insufficient information: rather than a regulated prospectus, investors often receive objectively insufficient, incomprehensible or misleading information in the form of white papers.
- Complexity: extensive, and in particular technical, knowledge is necessary to be able to assess an IPO project comprehensively.
- Projects in early phases: typically, projects to be financed using ICOs are still in their very early, in most cases experimental, stages. Therefore, their performance and business models have never been tested.
- Volatility: substantial price fluctuations are possible. There is often no secondary market. Tokens might also turn out to be completely illiquid.
- Risk of fraud: the structures of ICOs can entail a significant potential for abuse and fraud. The program code might also contain errors that can be exploited by third parties.
What consumers should do
Before consumers decide to invest in an ICO, they should always make sure to verify the identity, reputability and credit standing of the token offeror. Because such offerors are not subject to any transparency requirements, it is left solely up to investors to do this themselves. In particular, investors should inform themselves about the domicile, legal form and capital resources of the offeror as well as the parties participating in it where the offeror provides no such information. If the offeror claims that it is subject to ICO-specific supervision by state bodies, investors should verify this on the website of the relevant supervisory authorities. It should be noted that having a foundation registered in Switzerland is of no significance whatsoever as regards the regulation of ICOs.
Furthermore, investors should always make certain that they have fully understood the benefits and risks of the project or investment. To this end, they should ask the issuer as many questions as necessary and verify the issuer's information from independent sources. Moreover, they should ensure that the characteristics of the project or investment match both their investment needs and their appetite for risk.
BaFin provides further information on blockchain technology and virtual currencies under the menu item Company start-ups and fintech companies on its website. In addition, the websites of many other European supervisory authorities and that of the European Securities and Markets Authority (ESMA) also provide information and warnings about this topic.
Role of BaFin
Based on the specific formulation of the contract for each ICO, BaFin decides on a case-by-case basis whether the offeror is required to obtain authorisation pursuant to the German Banking Act (Kreditwesengesetz – KWG), Investment Code (Kapitalanlagegesetzbuch – KAGB), Payment Services Supervision Act (Zahlungsdiensteaufsichtsgesetz – ZAG) or Insurance Supervision Act (Versicherungsaufsichtsgesetz – VAG) and whether they must fulfil prospectus requirements.
Generally speaking, cryptocurrency tokens constitute financial instruments (units of account) within the meaning of the KWG. Therefore, undertakings and persons that arrange the acquisition of tokens, sell or purchase tokens on a commercial basis, or operate secondary market platforms on which tokens are traded are generally required to obtain authorisation from BaFin in advance.
If BaFin receives information indicating dealings which might be prohibited, it investigates them and, where necessary, intervenes by administrative means. Independently of this, trading without the required authorisation is punishable by law and the law enforcement authorities are responsible for the prosecution of such criminal offences. Therefore, commercial offerors of token sales and operators of brokerage platforms in Germany also face substantial risks.