Initial Coin Offerings (ICOs) are a relatively new fundraising method for startups and blockchain-based projects. ICOs have some similarities with IPOs, with the difference that the coins that are released and issued as a part of an ICO also can be useful for a software service/product.
A few ICOs, like Alias, Stratis, and Ark, have yielded returns for investors. At the same time, conducting an ICO involves considering the legal part of things to ensure compliance with all types of regulations and protect both investors and project owners. In this blog post, we will explore the legal subtleties of ICOs in Germany, highlighting major regulations and best practices that businesses should consider before launching an ICO campaign.
Why Germany? Well, it is one of the biggest financial markets in the European Union, and it would have been interesting to check out how these innovations are regulated in such a well-developed environment.
But first, let’s elaborate on what ICO is and why it has to be regulated
An ICO is the sale of units (tokens) of a virtual currency. It is in a very early phase of its existence (less than a decade old) and development.
Typically, these tokens are exchanged for Bitcoin (BTC) or Ether (ETH) rather than conventional currencies (nor dollars, nor euros). Proceeds go to the project developers and are intended to ensure the financial sustainability of the further development of the cryptocurrency on offer. According to Decrypt, investors poured $22 billion into initial coin offerings during Bitcoin’s 2017/18 run, with an absolute leader EOS.
The volume of funds EOS raised during its year-long initial coin offering (ICO), totaled $4.2 billion, surpassing the combined total of the three largest venture funding rounds in 2018. So it is an effective way of fundraising, but how does it work?
It all begins with the project concept: the project owner outlines the purpose, goals, and tech aspects of the entire operation. Then they create a whitepaper to present the details about the project (team description, tech stack, token economics, use cases, and the roadmap.
The whitepaper is a key document for potential investors. After that token creation and sale happen. Interested individuals can participate by purchasing tokens using established cryptocurrencies. Smart contracts, powered by blockchain technology, are employed to automate and secure the token issuance and distribution process.
Once the ICO is successfully concluded, project owners seek to have their tokens listed on reputable cryptocurrency exchanges, enabling liquidity and potential trading. Noe, it’s time to check out how ICOs are regulated in Germany and other European markets.
First Tries to Regulate ICO in Germany
In 2016, when Initial Coin Offerings (ICOs) were first introduced, financial markets, scholars, and entrepreneurs were impressed and eager to utilize by the opportunities and challenges the technology offered.
Legalities for ICOs in the EU
Directive 2014/65/EU on Markets in Financial Instruments categorizes investment tokens, including hybrid tokens that possess certain investment functions, as “transferable securities.”It is crucial to emphasize that the national financial markets regulators of the European Union member state retain the authority for market supervision and law enforcement.
One of the responsibilities of the European Securities and Markets Authority (ESMA) is to promote supervisory convergence and ensure consistent application of market rules. Nevertheless, the actual regulation at the forefront is still conducted by individual national agencies. Consequently, there is a lack of unified communication among financial market supervisors in the EU.
European Union (ESMA)
The ESMA published information about the regulation of token sales in November 2017.
Nevertheless, the statement is somehow vague, as it suggests that if the coins or tokens meet the criteria of being financial instruments, it is probable that the firms engaged in initial coin offerings would be involved in regulated investment activities.EU regulations that could potentially apply to ICOs include prospectus regulation, regulations regarding financial intermediaries, fund management regulations, and anti-money laundering regulations. However, specific guidance on which tokens qualify as “financial instruments” was not provided. Therefore, in Germany, it is regulated additionally.
The German BaFin issued guidance in February 2018. It went into more detail than similar acts in the UK, for instance, all tokens needed to be assessed on a case-by-case basis, which means that the BaFin avoided far-reaching statements about the classification of tokens.
Furthermore, crypto exchanges were designated as multilateral trading facilities, indicating that they would need authorization from national regulators. Let’s dive deeper into the legal framework of German ICOs
Legal Framework for ICOs in Germany
What is a “token” speaking legally?
In Germany, tokens issued through ICOs are typically classified as financial instruments, securities, or utility tokens. The classification determines the applicable legal framework and regulatory requirements.
Germany’s Federal Financial Supervisory Authority (“BaFin”) in the aforementioned advisory letter distinguishes the following categories of tokens:
Payment tokens (function as mediums of payment and can be traded and exchanged for both traditional and virtual currencies on the platforms dedicated to trading)
Equity tokens grant ownership rights or a share in the issuer’s future revenues)
Utility tokens (used for the purchase of services that the fundraiser develops)
Many tokens combine the elements of each category, being payments and equity payment tokens at the same time.
If tokens are classified as utility tokens, they won’t fall under the scope of securities regulations. BaFin is responsible for supervising financial markets and enforcing compliance with relevant laws. German Central Bank (Deutsche Bundesbank) also oversees ICOs.
Security Token Offerings
If tokens offered in an ICO qualify as securities, the issuer must comply with existing securities laws in Germany, including obtaining a prospectus approval from BaFin.
ICOs are also entitled to correspond to anti-money laundering and know your customer’s requirements. That includes verifying the identities of inventors, for instance. No money laundering and terrorism financing should be involved.
ICOs also have tax implications in Germany. Businesses must understand the tax obligations associated with token sales and comply with applicable tax laws in Germany. Profits from cryptocurrencies for physical entities are taxed at the personal income tax rate.
Best Practices for ICOs in Germany
Now we know the general framework of regulations for German ICOs, we can make a checklist of best practices that could be held.
- Comply to regulations
- Follow documentation requirements
- Protect investors interests
- Define the purpose and functions of tokens
- Conduct smart contract audits
- Work on token wallet security
- Establish communication between the community and investors
- Collaborate with reliable service providers in the business
- Make sure you track updates of regulations to follow
Comply to regulations
This step is quite self-explanatory. One has to conduct a thorough legal analysis to determine the classification of tokens and then follow the regulatory requirements. It is advisable for ICO issuers to get some legal advice to ensure compliance with securities laws, AML/KYC rules, and tax obligations.
Follow documentation requirements
While conducting a Security Token Offerings, prepare a whitepaper that provides comprehensive and accurate information about the project, team, technology, risks, and financials. The documentation must meet BaFin’s requirements and be submitted for approval before the ICO launch. It should also provide transparency to the investors.
Protect investors interests
Implement measures to protect investors’ interests. Such as offering clear and transparent documentation, ensuring accurate and up-to-date information disclosure, and providing a mechanism for dispute resolution. Take all the possible measures to protect investor funds.
Define the purpose and functions of tokens
Define the purpose, functionality, and limitations of the tokens issued during the ICO. Ensure the token economy aligns with the business model you’re conducting.
Conduct smart contract audits
Conduct a comprehensive security audit of the smart contracts to identify and mitigate potential vulnerabilities.
Work on token wallet security
Emphasize the importance of securing token wallets and educate investors on best practices for storing and protecting their tokens.Encourage the use of hardware wallets and multi-factor authentication methods.
Establish communication between the community and investors
Maintain open and regular communication with the community and investors. Provide timely updates on every step of the project’s progress, at least the most important milestones, and any significant developments. Address concerns and inquiries promptly.
Collaborate with reliable service providers in the business
Collaborate with reputable partners and service providers experienced in the blockchain and cryptocurrency industry. Engage with regulatory authorities (BaFin) to seek guidance and ensure compliance.
Make sure you track updates of regulations to follow
Stay up to date with evolving regulations and adapt the ICO strategy accordingly. Continuously monitor legal developments, seek legal advice, and implement necessary changes to maintain compliance.
Initial Coin Offerings in Germany present both opportunities and challenges for businesses and investors. It is crucial to grasp the concept of legalities surrounding ICOs to ensure compliance and mitigate risks for all involved parties.
As we dived deeper into key legal considerations and best practices, we came to the conclusion that engaging with reputable blockchain service providers can significantly enhance the success and security of an ICO.
In other words, expertise in developing blockchain-based applications is a must, or very desirable throughout the entire ICO process. That’s why we’re happy to propose our services in developing blockchain-based applications
Elinext can help you with anything: from concept design to smart contract development, to post-ICO support. Contact us to get qualified help in launching ICO according to all the regulatory compliance and industry best practices.