AIFMD – ESMA Warns of Risks With ICOs

In mid-November, the European Securities and Markets Authority (ESMA) issued two statements on initial coin offerings (ICOs), one on the risks of ICOs for investors and one on the rules applicable to firms involved in ICOs.

ICOS have become widespread around the globe, including Europe, recently and are growing fast. An ICO, also known as an initial token offering or token sale is an innovative way of raising money from the public to fund a venture, not dissimilar to crowdfunding. A business or individual issues coins for sale and they can then be exchanged for virtual currencies such as Bitcoin, although coins can also be exchanged for fiat currencies. ICOs are most commonly used to raise funds for projects using blockchain or distributed ledger technology.

This year alone, around 200 ICOs have been introduced, raising an estimated US$3.3 billion globally for early-stage ventures. ESMA’s timely warning comes on the back of another period of volatility for Bitcoin, which hit a record high of US$7,511 on 8 November before crashing nearly 30% to US$5,605 just days later, then hitting a new high of US$9,721 on 26 November. Bitcoin is currently worth more than seven times an ounce of gold, traditionally a haven in turbulent times, and ESMA is warning of an investment bubble.

ESMA is concerned that investors may be unaware of the high risks attached to investing in ICOs. The authority is also concerned that firms may not be in compliance with the relevant regulatory legislation when conducting ICO activity.

ICOs are high risk, highly speculative investments and prices of coins can be highly volatile, as seen above. ESMA warns that investors risk losing all of their invested capital as a result, or may find themselves unable to redeem their investment for years. Other risks for investors include ICOs being used as a vehicle for money laundering or fraud. And the watchdog also reminds investors to investigate the structure of an ICO, as many fall outside the scope EU laws and regulations and thus are unprotected.

Firms issuing ICOs that qualify as financial instruments must comply with the relevant legislation, according to ESMA. These regulations include the Alternative Investment Fund Managers Directive (AIFMD), Prospectus Directive, the Markets in Financial Instruments Directive (MiFID) and the Fourth Anti-Money Laundering Directive.

The AIFMD sets out the rules for the authorisation, ongoing operation and transparency of the managers of alternative investment funds (AIFMs) that manage and/or market alternative investment funds (AIFs) in the EU. An ICO scheme could qualify as an AIF, to the extent that it is used to raise capital from a number of investors, with a view to investing it in accordance with a defined investment policy. Firms involved in ICOs may therefore need to comply with AIFMD rules. In particular, AIFMD provides for capital, operational and organisational rules and transparency requirements.

ESMA is emphasising that firms involved in issuing ICOs should give very careful consideration as to whether their activities constitute regulated activities. Any failure to comply with the applicable rules will constitute a breach.