By gatuyu t.j
The Capital Markets Authority (CMA) has in numerous occasions issued public cautions to warn the public against investing in initial coin offerings (ICO) that have floated by various start-ups, citing the unregulated nature of the offering and the risk of investors losing their money.These cautions comes on a background of continued surge of ICOs as a new model of fundraising, with parallels to initial public offerings (IPO), venture capital, and crowd funding.
ICOs allow Blockchain-based ventures to raise money by creating and selling digital assets usually known as “tokens”. Even though ICOs continue to be a prominent source of fundraising, some have turned out to be speculative ventures without underlying utility, triggering regulatory actions.
New ideas facilitate market efficiency, spurring improvements to services and products and promote market competition. In guiding new innovations, regulations should address and potentially mitigate negative externalities.
In a rapidly changing world of finance, regulators ought to recognise the unique dynamics of emerging technologies and discourage regulatory environment with largely binary outcomes, of either approval or disapproval, which lacks flexibility and often torpedoes innovations.
IPO versus ICO
A company issuing tokens to the public in return for funds is a setting that strongly resembles an IPO used for traditional securities. However, there are visible distinctions. Whereas an ICO leads to the creation of digital tokens on Blockchain, an IPO leads to the distribution of shareholdings to the public, often through underwriters.
Only well-established private companies with profitability record are allowed to carry out IPOs, while ICOs are floated by start-ups on basis of proof of concept outlined in a whitepaper. Lastly, IPOs offer dividends from company profit as a form of return while ICOs offer tokens which have prospects of value increase after a project launch.
The ICOs have been able to gain huge popularity because they have certain merits. First, unlike the IPOs, an ICO enables the compensation of initial developers without giving them more control of the network than other token holders.
For in IPOs, founder shareholders often reserve certain controlling rights in the management of a corporate entity. Second, ICOs permit a venture to finance from future users, similar to the pre-sale of goods or forward contracts, and this provides issuers with an early signal about consumer demand, enabling better informed investments in building.
Further, ICOs tokens have high liquidity, which triggers instances of temporary overvaluation (phenomenon that also exists in IPO markets), leading to huge gains for investors. Lastly, tokens can hasten network effects, which are often central to the marketplaces that ICO issuers seek to build. This is experienced where token price appreciation leads more users to join the platform, even though this may have an offside of facilitating market bubble creation.
Criteria for a security
In exploring the regulatory status of ICOs, interrogation usually centres on whether an ICO meet the definition of a security. The Kenyan Capital Markets Act provides a broad definition of security and includes a phrase“any instruments commonly known as securities.”
There are no clear guidelines in Kenya or court decision that has clarified when an investment contract becomes a security. In other jurisdictions,a criterion popular as the “Howey Test”, which originated from a US Supreme Court decision, is often applied to determine whether an investment scheme qualifies as a security.
The Howey Test postulates that an investment will be deemed to be a security if it meets four conditions. An offering will be a security where an investment of money is made by the purchaser, the investment is part of a common enterprise among numerous investors, the success of the enterprise depends on the efforts of a third-party promoter, and the investor has an expectation of a financial return, such as capital gains.
Applying Howey Test for ICO in Kenya will end with a conclusion they are an offer of securities, hence subjecting the offer to a slew of capital markets regulations, and eventually killing it.
Rules are necessary for proper functioning markets in order ensure market fairness and integrity, protect investors and facilitate systemic stability. However, it is impossible to regulate new innovations like traditional securities.
Many statutes in the financial sector in Kenya date back decades. As a result, the regulatory framework is not optimally suited to address new business models and products that continue to evolve in financial services. This has the potential negative consequence of limiting innovation to the detriment of consumers and small businesses.
If it not for regulatory restraints expended by former CBK governor Njuguna Ndung’u, perhaps M-Pesa similar payment systems may not have been allowed to operate. By the CBK allowing M-Pesa to operate, without unduly alarming the public with public cautions, it fast-tracked the development of this product to the giant it is today.
The mix of technology and its applications to financial services has increased dramatically. It is important for financial regulators to adopt appropriate regulatory approaches without stifling innovations that require time to mature, or create unnecessary barriers to innovation.
Agile regulations and mechanisms such as regulatory sandboxes programs ought to be encouraged, for they facilitate controlled disruption. Further, there need to spearhead proactive amendments of the laws to ensure they keep pace with development in the financial sector.
For every new innovation presents its inherent risks. The regulatory environment should instead be flexible so that firms can experiment without the threat of enforcement actions that would imperil the existence of a firm. Innovating is an iterative process, and regulator feedback can play a helpful role while upholding safeguards and standards.
The regulators should been seen to encourage innovation. They should strive to acquire and understand existing and emerging technologies, to engage with developers and first-movers. Otherwise, the country will lose its repute as a centre of financial innovation. Instead of always issuing warning, CMA should work with innovators and ensure services such as ICO are rolled out successfully. That is the way to foster vibrant financial markets and promote growth through responsible innovation.
The author is the Managing Editor with the Gatuyuriana and a financial markets specialist.