The Government of Gibraltar (GoG) has taken the bold move of being the first authority to publish proposals for specifically regulating certain activity in this new area of crowd financing and has also enacted VA (ICO) laws. This follows the Luxembourg regulator (CSSF) issuing a warning against investments in the space, raising the issue of the absence of consumer protection, and lack of verifiable information and the Swiss Regulators (FINMA) issuing guidance classifying tokens in separate categories, to which certain requirements would apply, and Singapore (MAS) offering guidance around the interpretation issues that are relevant in categorising tokens within the existing financial services regulatory scope. It therefore comes as no surprise that there will be a flurry of legislation in late 2019 and early 20202 with many regulatory authorities placing crypto-related activities high up on their regulatory agenda.
However, the question is how co-ordinated any of this will be on an international basis and developments around the world and interpretation issues around concepts relating to SAFT arrangements, the relevance of functionality (on a jurisdictional test basis) and its implications, the focus on the way that a particular sale takes place, or how it takes place, the disclosure requirements, material information standards that are specific to Blockchain tokens, the general application of associated law, and interpretations around arrangements that may or may not trigger existing regulatory requirements, are all points that indicate a material lack of harmonisation.
Gibraltar, following on from the introduction of the DLT regulations back in January 2019 released proposals on how it intends to regulate activities relating to the issue of tokens and identifies a number of different token utilities/functionalities, openly acknowledging that “most often, tokens do not qualify as securities under Gibraltar or EU legislation”.
Cryptoregulations generally do not aim to directly replicate securities law or prospectus directive requirements as these were written decades before DLT and ICOs arose and are not applicable to the new frameworks and new rules, practices and standards will need to evolve and develop to be specifically relevant to this industry and from draftsmen and lawyers as well as technological specialists that truely understand the area.
The Proposals for Token Regulation include controls on
– the promotion, sale and distribution of tokens;
– operating secondary market platforms trading in tokens; and
– providing investment and ancillary services relating to tokens.
The proposals also highlight supporting “the safe use of tokens as a means of crowd financing” as one of the main objectives behind the introduction of a regulatory framework. This will require
– full, adequate and accurate disclosure of information; and
– adherence with AML/CFT provisions.
The proposal document highlights that disclosure rules setting out the form and nature of disclosures will be published by the GFSC and they are likely to be an updated form of the disclosure regime applicable to listing equities or debt securities on regulated capital markets, with ongoing increases in disclosure requirements as transaction levels increase.
Although FATF outlawed industry self-regulation, Regional blockchain associations such as the Fintech Association of Hong Kong’s document on Best Practices for Token Sales, and private initiatives that include The Brooklyn Project by ConsenSys and the Messari Project have begun working with regional regulators to establish applicable disclosure rules under the proposed regulations; however as self-regulation does not raise the standards through any legally enforceable framework, it will be unacceptable to FATF and regimes such as the one being proposed in Gibraltar will be imposed.
Due diligence on token purchasers (prior to the recent legislative amendments) was driven largely by local banking requirements, which make the implementation of suitable KYC procedures a pre-requisite to opening an account and depositing the fiat conversion of any token sale proceeds, coupled with legitimate concerns as to whether directors and officers of entities involved in conducting token sales (such as exchanges) were properly performing their duties by failing to adopt effective and appropriate measures to safeguard against the receipt of criminal proceeds and tax evaded assets.
In line with previous approaches, Gibraltar does not seek to regulate promoters and issuers of tokens, nor regulate the underlying technology or the tokens themselves but instead regulates:
– authorised sponsors of public token offerings;
– secondary token market operators (i.e. crypto-exchanges); and
– token investment and ancillary service providers.
so that the onus of ensuring compliance with appropriate standards will be on the service providers and token trading platform operators.
Authorised Sponsors, (similar to the Maltese model of virtual asset agents), will be the principal “gatekeepers” responsible for ensuring that token issuers are adhering to regulatory standards and industry best practice and every Gibraltar-based token issuer will be required to appoint an authorised sponsor as a pre-condition to launch (…….again mostly lawyers!) and sponsors will be subject to an authorisation and supervision process by the GFSC and must possess suitable knowledge and experience of the industry to be admitted into the sponsorship regime. A critical component for sponsors to be authorised is to have local presence in Gibraltar, with “mind and management” based in the jurisdiction but operating under their own codes of conduct (why!) setting out what they consider to be best practices relating to token sales and caught within the application for authorisation. The Sponsor regime is comparable to UK regulated public market listings, where Sponsors and Nominated Advisors effectively act as listing agents that guide prospective issuers through the flotation process.
As sponsors will invariably have a vested interest in the success of token sales they advise on, whose best interests will be at the forefront of a sponsor’s actions? and will secondary market traders have access to adequate and accurate disclosures to make informed decisions? The independence and integrity of sponsors together with the management of these inherent conflicts will therefore be critical to the entire process together with the effective policing of sponsors to ensure standards are regularly monitored and maintained.
Secondary Market Operators (i.e. crypto-exchanges) are then the subsidiary “gatekeeper” as they will be using DLT in some way to store / transfer value belonging to others and will consequently be caught by Gibraltar’s existing DLT regulations and there will need to be a dynamic inter-relationship between the different regulatory frameworks (although alas current publications provide little information about how this is to be handled except that secondary market platforms regulation will be needed to the extent not already covered by other regulations).
Gibraltar has also flagged the introduction of further transaction reporting and disclosure requirements as well as extending the application of regulations to cover trading of derivative token products in the future and proposed regulations on market platform provisions under MiFID II and MiFIR which are expected to be “appropriate, proportionate and relevant” but setting out the extensive obligations under MiFID II and MiFIR. Gibraltar is also holding off on references to the Market Abuse Directive or regulations which relate specifically to insider trading and market manipulation all of which are red-hot issues in the crypto-exchange space.
Increased regulatory risk and therefore greater scrutiny is arising for cryptoexchanges due to recent thefts of cryptoassets through security breaches of technology and processes and the shift in in token offerings where issuer are fundraising exclusively through private sale arrangements and limiting participation to accredited/professional investors due to concerns about the regulatory implications of conducting public sales. These issuers then rely on exchanges, who list the tokens, to open up the token market to prospective retail purchasers. The Chinese have imposed outright bans on crypto-exchanges, Japan’s FSA has announced that it will investigate a number of unlicensed token exchanges, the SEC is starting enforcement action and effectively stating that crypto-exchanges must either operate as licensed securities exchanges or regulated ATS and the UK. FCA is investigating a number of exchanges for straying into regulated territory or simply failing to carry out proper AML controls when assets cross borders.
The starting point for crypto-exchanges with regard to token listings usually centres on the security versus utility argument. This is naturally a key aspect for exchanges as it presents the greatest regulatory risk if it is deemed that the exchange is unlawfully offering its users a security trading platform. Individual token offerings therefore will have to be very carefully vetted to ensure their platforms are not being used as a conduit for securities trading or laundering of drug assets, especially via secondary market token trading and things are not make any more secure whilst regulators sit back and allow exchanges to decide which tokens may or may not be listed on their platforms. Clear guidance will be required to give exchanges regulatory comfort in offering their services to the international community .
The final “gatekeepers” will be providers of investment and ancillary services relating to tokens and in particular those offering;
– generic advice (setting out fairly and in a neutral manner the facts relating to token investments and services);
– product-related advice (setting out in a selective and judgemental manner the advantages and disadvantages of a particular token investment and service); and
– personal recommendations (based on the particular needs and circumstances of the individual investor).
This limb of the proposed regulations will (sadly) be proportionately modelled on provisions that currently exist under MiFID 2, with the aim of ensuring that such services are provided fairly, transparently and professionally, ignoring the very real risk that organised fraudsters will more easily target this sector.
Whilst Gib aims to aim to hold such service providers to account through an appropriate licensing regime, little guidance is given on the specific types of advisors involved in a token sale process that will be caught by the proposals (e.g. introducers, marketing professionals, technical developers and smart contract auditors, economic, legal and tax advisors, cybersecurity firms, escrow agents etc.) and also inadequate thought has been given to the extent that Gibraltar-based token issuers will be caught by the regulations if such providers are based abroad or the majority of their services are outsourced to teams based in other countries.