Coin Talk

Regulating Cryptocurrency and Initial Coin Offerings: The Nigerian Perspective – Part 2

Tuesday, September 22, 2020 / 02:00PM /
Aelex Partners / Header Image Credit: Aelex Partners

Introduction

This
is the second part to the article on Regulating Cryptocurrency and Initial
Offerings: The Nigerian Perspective, (read part one here).
In part two, we explore Initial Coin Offerings (ICOs), how it is used to raise
funds, the Nigerian legal framework on ICOs, and the pros and cons of ICOs.

A New Way of
Raising Capital

The
rapid increase in the value of cryptocurrency and the possibility of high gains
within a short time frame has seen a number of companies deciding to use the
technology driving cryptocurrency to raise funds.

Companies
have started seriously considering ICOs as a viable tool to raise capital as opposed
to Initial Public Offerings (“IPOs”). This is because ICOs are not subject to
as much regulatory oversight as IPOs considering the definition of tokens fall
outside the scope of regulated investment instruments in most jurisdictions,
thus simplifying the offering process. In addition, companies get to protect
their shareholding against dilution as the assets on offer during are ICO are
tokens and not shares in the company.

In
2017, it was posited by financial experts that there was an ICO Bubble¹, (a situation where the price of coins
far exceeded their fundamental value due to their connection to ICOs) This was
supported by the fact that in 2017 alone, USD1,362,588,431 was raised from the
top ten ICOs² globally.
Though the bubble may have burst in 2019 due to ICOs not being able to meet
their targets and the prevalence of fraudulent ICOs, they are still being used
by companies to raise capital³
and the promise of rapid, large investment returns makes it more appealing to
investors.

IPO vs ICO

There
is still a debate in the financial industry that tokens constitute a share or
security of the company; therefore it is similar to an IPO because ownership is
being sold through the use of the tokens instead of shares. This assertion has
its flaws because fundamental differences exist between an IPO and an ICO which
will be highlighted below.

IPO	ICO
The company sells part of its ownership through shares for additional capital.	The company has a unique technology or a project they need to raise funds for.
The capital gained is used to grow the company and help in operations.	The tokens are usually sold to gain stakeholders who will become users of the product or will be in the product ecosystem (blockchain native to the token).
The owners of the shares will usually gain dividends and reap the benefits of the company’s growth.	The owners of a token gain product value as they are able to do various things with the token acquired from an ICO. They can sell their tokens for a higher price, exchange it for other tokens or coins, or use the product that the token was created for.⁴
IPOs are heavily regulated and are typically subject to regulatory oversight and requirements.	ICOs are hardly regulated and the level of entry is low. A company following the right steps can easily set up an ICO.
An IPO involves a lot of money as the company seeking to raise capital would have to invest in brokers, roadshows to discuss the benefits of their IPO to potential investors, issuing houses and even Underwriters.	An ICO does not involve spending large amounts of money since everyone on the internet can easily access the ICO and purchase the tokens and there are minimal third-party expenses required to ensure the success of the ICO.

The
characteristics of an ICO and the freedom it affords companies looking to raise
capital has aided the increasing popularity of token sales and in recent times,
ICOs have been categorized and broken down for potential investors to
understand the intricacies of the process.

The Token Sale

An
ICO or a Token Sale is the process of raising capital through the sale of
tokens to the public for a limited period in exchange for cryptocurrency⁵. Instead of receiving shares like a
typical IPO, investors receive tokens and pay in cryptocurrency (or cash in
some instances). The tokens received represent the participation of the
investors in the project the ICO was created to raise capital for.

So, Investors in a Token Sale are usually
called participants because ICOs are a form of Crowdfunding; however the
company will be receiving cryptocurrency rather than cash.⁶ This can be compared to equity-based
crowdfunding where the public donates cash in exchange for shares in the
company⁷.

Types of Token Sales

There
are two major types of ICOs the Private ICO and the Public ICO. In a Private
ICO, a limited number of investors, typically financial institutions and high
net-worth individuals, participate in the process. The company can choose to
set a minimum investment amount⁸.

A
Public ICO on the other hand, is open to the general public, with no limits on
who may participate, subject to any regulatory considerations in the relevant
jurisdiction⁹.

However,
Private ICOs are becoming a more preferred option compared to public offerings as
regulators are now looking at ways to regulate Public ICOs in order to protect
the investing public.

Characteristics of a Token Sale

In
order to mitigate the risk investors associate with ICOs, companies have had to
be strategic in structuring ICOs and four characteristics have emerged as the
foundation for any Token Sale Model.

A cap on the amount of
money that will be raised from the ICO;
An appropriate time frame
for the period the ICO will run in order to gain the attention of buyers.
The time frame must not be too long so investors can see actual results
and for the specified project to move to the next phase;
Public information on the
number of tokens that are in circulation, the amount that is going to be
sold and the amount currently being held by all stakeholders in the
ecosystem of the token; and
The value of the token
must be clear and unambiguous¹⁰.

The
structure of an ICO and the benefits a token offers determines the type of
investors it attracts. The utility the token offers is also one of the factors
that will determine whether an investor will use the token he acquired or trade
it off in return for another token with a different utility or cash.

The Types of Investors in a Token Sale

There
are two types of participants in a Token Sale – Stakeholders and Speculators.
Stakeholders are buyers who acquire a token to be able to use it for the true
utility it was created for. In the first article, we talked about the Brave
browser and how it is using its Basic Attention Token (BAT) to create value by
rewarding people who advertise on its browser with the token when a user views
their ad which does not have an ad tracker or is transparent¹¹. If the Brave browser was to have an
ICO, they would most likely sell their BAT and a Stakeholder buyer would
acquire it to use in securing an advert space on the browser because the BAT
can be used in the Brave ecosystem to gain products or services¹².

Speculators
are investors who do not wish to use the utility that a token offers. They
participated in the Token Sale with the hope of making a return on the token
when its value rises, either by selling to Stakeholders or other Speculators.

ICOs
require an understanding of a combination of finance, technology and the
regulatory requirements that may hinder the process in the jurisdiction the
issuing entity resides in. Therefore, the steps highlighted below in order to
be successful will entail an understanding of the subject matter
aforementioned.

Kickstarting a Token Sale

Because
the mechanism for an ICO is fairly simple, it has a low barrier of entry and in
most jurisdictions, it can be started without jumping through regulatory hoops.
There are typically four stages in kickstarting an ICO:

Stage
One:

This
includes the preliminary stage where the company or the token issuing entity
identifies their potential investors and the project they want to fund.

After
identifying its potential investors and its underlying project, the token
issuing entity will issue a White Paper (similar to a Prospectus for an IPO)
that provides details of the underlying project and details of the tokens that
will be issued in exchange for cryptocurrency¹³.

The
White Paper is made publicly available, usually through the issuing entity’s
website. The White Paper will include the mechanism for payment of
cryptocurrency to the issuing entity’s account. t is now common practice for
payments to be made into an escrow account, to foster investor confidence in
the validity of the ICO¹⁴.

Stage
Two:

The
tokens are created. The tokens will be the representations of an asset or a
utility on the blockchain native to the token and are tradeable for other
tokens or coins¹⁵. The
issuing entity does not need to create new tokens, instead they can build on
existing blockchains such as Ethereum which allows the creation of tokens on
its blockchain.

Stage
Three:

The
issuing entity will usually run a promotion campaign to attract potential
investors. These campaigns are usually executed online to achieve the widest
investor reach. It should be noted that a lot of online platforms such as
Facebook and Google ban the advertising of ICOs¹⁶;
therefore, it is recommended that the campaign run on the issuing entities
website or on cryptocurrency exchanges.

Stage
Four:

After
the creation of the tokens, the tokens are issued and the token purchasers or
investors will pay for the tokens, usually in cryptocurrency. Issuing entities
can request for fiat currency if they wish, but common practice is the use of
coins to buy tokens.

Once
the purchasers have paid for the token, they can use their tokens in the
project ecosystem as a utility for the product or trade the token on a
Cryptocurrency exchange, subject to any lock-in period prohibiting the exchange
or sale of the token -this will be stated in the White Paper.

Cryptocurrency
is financially risky as we highlighted in our first article, so in order to
assuage the fears of investors, the management team of the issuing entity
usually take tokens themselves to prove to potential investors that the ICO is
relatively safe.

Below
is a process flowchart highlighting the stages of a typical ICO:

¹⁷PWC, Switzerland

The Nigerian Legal Framework on ICOs

As
defined in our first article, a token is an asset built on top of an existing
blockchain, which has the ability to replicate such functionality or assets¹⁸. We also explained how securities are
financial assets and provided the definition of securities according to the
Nigerian Regulatory Framework for securities¹⁹.

The
regulatory framework for securities being offered to the public or to private
individuals in exchange for cash comprises of the following rules and
regulations:

The
Investment and Securities Act 2007 (“ISA”); and
The
Rules and Regulations of the Security and Exchange Commission 2013 (“SEC
Rules”).

Article
279(1)(c) of the SEC Rules provide that all securities subject to registration
by the Securities and Exchange Commission (“SEC”) may be offered through the
following methods:

offer for subscription;
offer for sale;
rights issue;
bonus issue;
debt-equity conversion;
private placement by public companies and other entities; and
offer by introduction;
debenture/loan stock;
State and Local government bonds
Sukuk

The
SEC Rules also provide that an entity may offer or transfer its securities
electronically: provided that where an investor elects to have a certificate,
such certificate shall be issued by the issuer²⁰.

The
aforementioned principles of the SEC Rules seem to give a legal foundation for
potential ICOs in Nigeria but sadly, coins and tokens do not fall under the
scope of securities set out in the ISA and therefore, cannot be registered as
securities that can be offered to the public or to private entities in exchange
for capital in Nigeria. Also, the SEC is yet to classify what coins or tokens
are in Nigeria, hence, ICOs are unregulated in Nigeria.

This
position may soon change as the Proposed Rules on Crowdfunding by SEC²¹ seem to permit equity crowdfunding
and ICOs are an offshoot of it. The proposed rules provide that an entity may
issue other investment instruments approved by the Commission (including simple
contracts) without registering the securities or investment instruments with
the SEC. Tokens being offered in ICOs are investment contracts that are built
on blockchains and are easily programmable to provide any type of utility the
issuing entity programmes the smart contract to perform. This position has not
been affirmed by the SEC but it is hoped that ICOs can take advantage of the
proposed provisions of the Proposed Rules.

Also,
the National Blockchain Strategy released by the Federal Ministry of
Communications and Digital Economy, while admitting that there is no regulatory
or legal framework for cryptocurrency in Nigeria, believes that there is a
promising future for blockchain in Nigeria due to the adoption of blockchain by
various Nigerian start-ups for numerous purposes. The Blockchain Strategy lists
out the various regulations that the Federal Government has released to create
an enabling environment for cryptocurrency in Nigeria²². It goes further to explain how the Federal
Government wants to use cryptocurrency and blockchain technology as one of the
paths towards a digital economy and one of the strategic objectives is the
creation of investment opportunities through blockchain.

According
to the Blockchain Strategy, “Blockchain
has the potential to completely transform traditional models in several sectors
both private and public. By promoting blockchain adoption and providing an
enabling environment, new business models will spring up to open opportunities
for businesses that will drive investments in a market such as Nigeria.”

This
seems to be a nod to ICOs and the government’s consideration of it to diversify
the Nigerian Economy and the methods of investment in Nigeria.

Furthermore,
the Final Report of the Fintech Roadmap Committee of the Nigerian Capital
Market by the SEC, lists out recommendations that the Capital Market Community
will take into consideration regarding ICOs:

SEC should be responsible for the regulation of Virtual Financial
Assets (VFAs) Exchanges and develop a framework around it.
For the regulation of crowdfunding, interest-based crowdfunding
should be regulated by the Central Bank of Nigeria (CBN) while equity-based
crowdfunding should be regulated by the SEC (ICO, STO or IPOs).
SEC should issue guidelines and standards for White Papers and
ICOs.
Advertising and issuance procedures should be defined without
ambiguity.
SEC should create appropriate licensing regimes for new entrants
into the crowdfunding ecosystem.
SEC should develop a detailed framework for VFA based economy.
SEC should develop a stringent framework for KYC and due diligence
which will apply regardless of the legal status of an ICO or token.
SEC should have clear taxonomies of tokens based on their nature,
characteristics and economic realities as their determining factors.
The taxonomy of traditional securities should remain intact, and
serve as useful, instructive and illustrative guide for the taxonomization of
the new cryptocurrency capital market investment products and services.
The global best practices in order to give a taxonomy to
cryptocurrency assets especially jurisdictions like Malta should be followed by
SEC. The Malta Guide broadly taxonomises tokens as;

Payment token
Asset token
Utility token

ICOs – Risky Business or Not?

Though
the advantages of an ICO were mentioned earlier in this article, they need to
be highlighted again to understand why ICOs are being strongly considered by
companies as a way to raise capital.

Lack of Regulatory Oversight: Most ICOs lack regulatory
oversight, hence it is an interesting opportunity for founders or entities to
adopt it as a method to raise capital. Bypassing the regulatory oversight that
comes with IPOs is a major boost to the appeal of ICOs to issuing entities and
even investors.

Substantial Gain Quickly: Since ICOs have a target and
an estimated time to achieve the target which is usually short²³, investors usually gather their funds
to invest heavily in ICOs due to the potential returns that are projected. Most
times the returns projected is higher than returns on fixed or floating assets
such as bonds or shares respectively. The recent furore for and discussion
around the novelty and profitability of ICOs has whetted the risk appetite of
certain investors hoping to make a huge return on their investments, which
means that the issuing entity also sees a quick inflow of capital.

Anyone can Invest: Due to the nature and
accessibility of ICOs which are typically offered online, issuing entities are
not limited to investors within their geographical area, and do not incur costs
that are typically seen with the traditional methods of raising capital. Anyone
can invest in an ICO and the pool of potential investors is essentially every
user of the World Wide Web. The use of cryptocurrency also means that the
issuing entity does not need to worry with the currency in which to dominate
the offer and thus, bypasses any foreign exchange concerns.

So,
with all the advantages mentioned above, why are ICOs still considered risky
business? Well in 2017 alone, 80% of ICOs were identified as scams by Statis
group, an ICO advisory firm²⁴.
To put in context, US$11.9 billion of investor money fell to scams in 2017 and
three fake ICOs alone consumed US$1.31 billion²⁵.

Also,
the lack of regulatory oversight means most ICOs end up “going dead”²⁶ and investors cannot recoup their money
due to the lack of a mechanism or a reporting procedure to reclaim their funds.

In
addition, investors and issuing entities are faced with the risk of digital
currency theft as cryptocurrency wallets – where the coins or tokens stored –
are hackable. A study²⁷ from
CipherTrace, a cryptocurrency intelligence firm based in Silicon Valley
provided an overview of the major cryptocurrency thefts, scams, and fraud
worldwide in 2019. The study showed that criminals and fraudsters netted
approximately US$4.26 billion for the first six months of 2019 and US$1.7
billion for the entire 2018 according to the study.

Although
exchanges, wallets, and other cryptocurrency custody services are strengthening
their defenses, hackers continue to innovate and outpace even the current state
of the art in cybersecurity, the CipherTrace study notes²⁸.

Conclusion

ICOs
are not popular in Nigeria and are hardly used to raise capital by entities in
this part of the world. Also, given the fact that coins and tokens are not
classified in Nigeria, the absence of classification makes Nigeria a very harsh
terrain for an ICO to be conducted, but that may soon change.

In
January 2018, SureRemit a Nigerian non-cash remittance start-up raised $7
million through an ICO²⁹.
ICOs may become the rave for Nigerian tech companies who do not want to jump
through the regulatory loopholes of the SEC for raising capital and registering
securities.

The
drive of the Federal Government and SEC is also duly noted as the government
and its apex capital market regulatory body looks into the future to tap the
benefits of cryptocurrency and all the technology that comes with its use.

This article is part
of the series titled THE CHANGING OF FINANCE IN NIGERIA highlighting the
various modern financial developments in Nigeria. Other articles in the series
may be accessed here.

Footnotes

1. The
Financial Times, “ICO regulation inconsistent as cryptocurrency bubble fears
grow” https://www.ft.com/content/32315636-cb01-11e7-ab18-7a9fb7d6163e
accessed 5 August 2020.

2.
PWC, “Introduction to Token Sales (ICO) Best Practices” https://www.pwccn.com/en/financial-services/publications/introduction-to-token-sales-ico-best-practices.pdf accessed 5 August 2020.

3.
There
are still ICOs occurring according to various ICO Calendars such as ICODROPS. https://icodrops.com/

4. Deloitte, “Initial Coin Offering a new Paradigm” https://www2.deloitte.com/ru/en/pages/financial-services/articles/initial-coin-offering-a-new-paradigm.html.
accessed 6 August 2020

5.
PWC, “Introduction to Token Sales (ICO) Best Practices” https://www.pwccn.com/en/financial-services/publications/introduction-to-token-sales-ico-best-practices.pdf accessed 5 August 2020.

6. ACCA, “ICOs: real deal or token gesture? Exploring Initial Coin Offerings” https://www.accaglobal.com/content/dam/ACCA_Global/professional-insights/Initial-coin-offerings/pi-initial-coin-offerings.pdf accessed 6 August 2020.

7. Oyeyosola
Diya, “The Changing Face of Finance in Nigeria : Crowdfunding” https://www.aelex.com/wp-content/uploads/2020/03/THE-CHANGING-FACE-OF-FINANCE-IN-NIGERIA-CROWDFUNDING1.pdf accessed 6 August 2020.

8.
Corporate
Finance Institute, “Initial Coin Offering (ICO) An initial public offering that
uses cryptocurrencies” https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/initial-coin-offering-ico/ accessed 6 August 2020.

9.
Corporate
Finance Institute, “Initial Coin Offering (ICO) An initial public offering that
uses cryptocurrencies”

https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/initial-coin-offering-ico/ accessed 6 August 2020.

10.Deloitte, “Initial Coin Offering a new Paradigm” https://www2.deloitte.com/ru/en/pages/financial-services/articles/initial-coin-offering-a-new-paradigm.html accessed 6 August 2020

11.
Oluwapelumi
C. Omoniyi, ” Regulating Cryptocurrency and Initial Coin Offerings: the
Nigerian Perspective” https://www.aelex.com/regulating-cryptocurrency-and-initial-coin-offerings-the-nigerian-perspective/ accessed 6 August 2020.

12.Deloitte, “Initial Coin Offering a new Paradigm” https://www2.deloitte.com/ru/en/pages/financial-services/articles/initial-coin-offering-a-new-paradigm.html
accessed 6 August 2020

13.ACCA, “ICOs: real deal or token gesture? Exploring Initial Coin Offerings” https://www.accaglobal.com/content/dam/ACCA_Global/professional-insights/Initial-coin-offerings/pi-initial-coin-offerings.pdf accessed 6 August 2020.

14.ACCA, “ICOs: real deal or token gesture? Exploring Initial Coin Offerings” https://www.accaglobal.com/content/dam/ACCA_Global/professional-insights/Initial-coin-offerings/pi-initial-coin-offerings.pdf accessed 6 August 2020.

15. Corporate
Finance Institute, “Initial Coin Offering (ICO) An initial public offering that
uses cryptocurrencies” https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/initial-coin-offering-ico/ accessed 6 August 2020.

16.
Corporate
Finance Institute, “Initial Coin Offering (ICO) An initial public offering that
uses cryptocurrencies” https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/initial-coin-offering-ico/ accessed 17 August 2020.

17. PWC, “ICO Regulation & Compliance Legal Frameworks and regulation for ICOs” https://www.pwc.ch/en/industry-sectors/financial-services/fs-regulations/ico.html accessed 6 August 2020.

18.
Oluwapelumi
C. Omoniyi, “regulating Cryptocurrency and Initial Coin Offerings : the
Nigerian Perspective” https://www.aelex.com/regulating-cryptocurrency-and-initial-coin-offerings-the-nigerian-perspective/ accessed 6 August 2020

19.
The
Investment and Securities Act 2007 in Section 315 defines ‘security’ to mean:

debentures, stocks or bonds issued or
proposed to be issued by a government;

debentures, stocks, shares, bonds or notes
issued or proposed to be issued by a body corporate;

right or option in respect of any such
debentures, stocks, shares, bonds or notes; or

commodities futures, contracts, options and
other derivatives,

The definition
of securities in the ISA included those securities which may be transferred by
means of any electronic mode approved by the Securities and Exchange Commission
(SEC) and which may be deposited, kept or stored with any licensed depository
or custodian company as provided under the ISA

20.
Article
345 of the Rules and Regulations of the Security and Exchange Commission 2013
(SEC Rules).

21.
SEC
Nigeria, “Exposure of Proposed new Rules to the Rules and Regulations of the
Commission” https://sec.gov.ng/wp-content/uploads/2020/03/SEC-NG-Crowdfunding-Rules-for-Exposure-March-2020.pdf
accessed 9 August 2020.

22.
National
Digital Economy Strategy and Policy 2020-2030, National IT Policy 2012,
E-Government Master Plan, Nigeria Cloud Policy 2019, National Broadband Plan 2020-2025 and the Nigeria Data
Protection Regulation 2019

23.
The
longer the ICO period, the less appealing it looks to investors.

24.
“Sherwin Dowlat, “Cryptoasset Market Coverage Initiation: Network Creation July
11, 2018” https://research.bloomberg.com/pub/res/d28giW28tf6G7T_Wr77aU0gDgFQ accessed
10 August 2020.

Ana Alexandre, “New Study Says 80 Percent
of ICOs Conducted in 2017 Were Scams”

https://cointelegraph.com/news/new-study-says-80-percent-of-icos-conducted-in-2017-were-scams accessed 10 August 2020.

25.
Pincoin
($660 million), Arisebank ($600 million), and Savedroid ($50 million).

26.
TechCrunch released a
report based on data from Coinopsy and DeadCoins, which found that more than a
thousand crypto projects were “already dead” as of June 30, 2018.

Helen Partz,
“Over 1000 Crypto Projects Are Considered ‘Dead’ Now”https://cointelegraph.com/news/techcrunch-over-1000-crypto-projects-are-considered-dead-now accessed 10 August 2020.

27.Cipher
Trace, “Q2 2019
Cryptocurrency Anti-Money Laundering Report” https://ciphertrace.com/q2-2019-cryptocurrency-anti-money-laundering-report/ accessed 10 August 2020.

Jeb Su,
“Hackers Stole Over $4 Billion From Crypto Crimes In 2019 So Far, Up From $1.7
Billion In All Of 2018” https://www.forbes.com/sites/jeanbaptiste/2019/08/15/hackers-stole-over-4-billion-from-crypto-crimes-in-2019-so-far-up-from-1-7-billion-in-all-of-2018/#229fc9a655f5 accessed 10 August 2020.

28.Cipher
Trace, “Q2 2019 Cryptocurrency Anti-Money
Laundering Report” https://ciphertrace.com/q2-2019-cryptocurrency-anti-money-laundering-report/ accessed 10 August 2020.

29. Victor Ekwealor, “3 things you need to know
about ICOs in the Nigerian context” https://techpoint.africa/2018/02/14/ico-nigeria/ accessed 10 August 2020.