[Rachit is a student at National Law School of India University.]
Initial coin offerings (ICOs) first emerged in 2017, as a revolutionary form of raising capital for startups, providing an alternative to conventional methods of raising capital like equity fundraising, venture capital or initial public offerings (IPOs). However, there has been a glaring absence of a uniform regulatory mechanism for ICOs particularly, with different responses from different jurisdictions.
This article argues that there is a need for expansion of regulation to cover ICOs in the interest of democratizing fundraising and preventing financial scams, advocating for an increased role of SEBI in setting standards for ICO. In doing so, it advocates that the “regulatory sandbox” approach that has been in use by RBI for fintech innovation, be applied to regulate ICOs. This article first provides an overview of ICOs and its advantages. It then provides a broad understanding of regulatory sandbox approach used for blockchain technology used in Europe and then shows how it can be applied in India.
What are ICOs?
ICOs work through the sale of virtual tokens issued by the company seeking financing (issuer) for fiat money or cryptocurrencies. While equity fundraising or IPOs give the investors a share in the company, an ICO only provides the investors with some special benefits, discounts or early access to the services of the issuer company or may also give the investors a right to vote. As opposed to other methods of fundraising, ICOs do not have regulated stock exchanges. Rather, they are marketed directly to clients and are undertaken by way of smart contracts between the investor and the issuer, without any intermediaries.
The only disclosure requirement for ICOs is that of a whitepaper, usually published on the company’s website or on social media. This document typically contains information about the issuer and its business, the available tokens, and the investments planned. Although some white papers are quite comprehensive, their level of detail cannot be compared with a prospectus required under securities regulation. The first offer for sale of tokens is usually made to a select group of investors, the secondary trade takes place on the crypto exchanges like Poloniex, where anyone can invest. While the initial price for an ICO is set arbitrarily, it is finally determined by supply and demand forces of the market and the market valuation of the issuing company.
One of the main advantages of an ICO is that it does not require a sale in ownership. The token only provides an early access to the services or some kind of financial returns in the future without offering any equity. It is also difficult to manipulate prices in a crypto market considering tis decentralized and anonymous nature. It is easier to raise more money though ICOs considering its global nature. Incentivizing users to buy the tokens can help in later rounds of crowdfunding as well a broadening the userbase.
The Indian Position
The main problem with Indian law concerning cryptocurrency is that there is no body of law regulating any transactions involving it. The only regulatory response we had was one of a complete ban on crypto transactions made by a notification issued by RBI, which was subsequently struck down by the Supreme Court in 2021. There are reports of SEBI considering regulation of crypto considering the vast economic potential of cryptocurrency in financing domestic and international business and trade. Until then, regulatory bodies have been trying to ICOs within the existing definition of “other marketable securities” under Section 2(h) of Securities Contracts (Regulation) Act 1956. The reason for the same is that crypto security tokens are easily tradable.
However, this conclusion goes against other types of securities mentioned in Section 2(h). crypto tokens are significantly different from traditional securities. Firstly, not all ICOs offer security tokens, some also offer utility or payment tokens. Secondly, these tokens are held digitally and have vastly different transactions from traditional securities. These digital assets are directly issued by the issuer company instead of intermediaries like banks or governmental institutions. They are based on peer-to-peer transactions and are carried out directly between the parties. All these make the safeguards for securities redundant in the domain of ICOs. There are also concerns of investor protections and governance issues that emerge in this unregulated domain.
Regulatory Sandbox Approach
Both SEBI and RBI have adopted the regulatory framework approach for testing fintech innovations, setting relaxed guidelines for these entities. However, both agencies have explicitly excluded crypto based fintech from being registered in the regulatory sandbox. However, European regulatory sandbox relating to blockchain based technologies have provided relaxed guidelines for entities to test their products and services in this regulated environment. This article argues that there is a need to follow the European approach.
The European Blockchain Regulatory Sandbox starts with a small cohort of entities and aims to foment dialogue and cooperation between national and EU regulators with companies and remove legal uncertainties for blockchain based projects. At the individual use level, it provides legal certainty regarding innovative solutions and help companies navigate the relevant legal framework and successfully deploy their projects in accordance with those rules. At a broader level, it summarizes all the individual experiences into a general report, highlighting key issues found in the current regulation.
However, this approach has strict disclosure guidelines, including a validated proof of blockchain application and details of the company. The same would be screened by experts and would be closely monitored by regulatory agencies. They are not exempt from the existing regulations and laws but can be provided some legal leniency. A regulatory sandbox does not set the law concerning fintech innovation, rather it provides the scope, context and prompts for national deliberation and stakeholder consultation on for creating the legal framework governing these innovations. ICOs are one such example of innovations in need for a regulatory sandbox.
Suggestions for the Indian Approach
Since there is hope that regulation of crypto assets might emerge in the future, its important that SEBI or RBI decide to create a regulatory sandbox for ICOs. There is a need to ensure a principle-based sandbox, as opposed to a rule-based one. These principles are upholding market integrity, stability and supervision. A principle-based system allows more freedom for self-regulation and lesser interference from the regulators.
This can start with a small cohort of 20, just like the European version. The regulator must demand detailed disclosures from the participants of the sandbox to not only ensure that it complies with the existing norms and is not a fraudulent entity, but also would help in deciding the disclosure requirements to be applied generally. Since this is a regulated space, the primary market for ICO would be regulated and monitored without external interference. However, relaxation can be provided in the secondary market where the early investors can trade in the tokens. While it is difficult to keep records of the transactions in the anonymous blockchain space, the accounts of the transactions can be submitted to the regulator.
There are also concerns relating to data privacy and problems during insolvency as to how these tokens would be treated. These are more complex questions that require policy responses from all stakeholders and the same can be a subject for testing in the sandbox. There is a need to create a strong and secure infrastructure for ICO trading. Issues related to data privacy should initially be left to the entities themselves who can provide their data protection framework, and if the same complies with the existing norms, can be allowed to work. Same goes for insolvency proceedings as to how the investors would be repaid in the case of insolvency and the same must comply with the IBC.
Conclusion
This article has provided suggestions for creating a regulatory sandbox for ICOs monitored and regulated by SEBI. Considering how ICOs are extremely important fintech innovations in what they offer to new companies, it is important that they are given space to develop in a regulated environment that protected investors and is beneficial to the companies. In the absence of any existing legal framework, and the threats of an unregulated ICO market show that there is a need for reform. In doing so, the policy framework required for regulation can emerge only from a regulatory sandbox where private entities can self-regulate. SEBI must help in the development and refinement of this fintech innovation and ensure that innovations in fundraising continue to prosper.
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