The popularity of the digital currencies (also: “cryptocurrencies”) is on the rise. More and more people become interested in investment via digital currencies due to their rising prices in the last several months. However, such investments don’t come without risk, which in this case might be quite serious, warns the Netherlands Authority for the Financial Markets (the “AFM”).
Digital currency
There are currently over 1,000 various types of digital currencies of which Bitcoin is undoubtedly the biggest and most well-known. But what is a digital currency? A digital currency is a currency unit, like a US dollar or an euro. There are no coins or banknotes available. It is a digital representation of value, which is not issued, guaranteed or monitored by a recognized financial institution and which can be used for effectuating payments within specific virtual platforms. Transactions in digital currencies require no intermediaries such as banks and therefore, no bank fees or transaction fees apply. The transactions are instantaneous, cross-border and digital currencies also offer anonymity to their users. Basically, a digital currency is no more than a computercode, stored in a digital log, in which the users of the currency jointly register who transfers the currency to whom, all on the basis of mathematical formulas that are not eligible for fiddling (as alledged).
Regulatory framework
In the Netherlands, trade in digital currencies does not fall within the ambit of the supervision by the AFM or the Netherlands Central Bank (“DNB”). There are no rules that regulate the issue and trade of digital currencies. Therefore, the investors in ICO’s do not enjoy any investor protection which is guaranteed by the national financial laws and regulations.
Initial Coin Offerings
A relatively new method, in which the digital currencies are used, is the Initial Coin Offerings (“ICO’s”).
The ICO’s are used by businesses, often startups, as a means to raise capital for development by issuing custom built digital currencies. The ICO’s are used as an alternative to capital-raising through banks or on regulated financial markets. Much like with a regular crowdfunding campaign, the company initiating an ICO will describe its project, its financing needs and the way the investors will receive the return on their investment. Investors purchase the new digital currency, or “tokens”, which represent the right to receive goods or services, a stake of the startup or company or a part of the expected return. The tokens can be bought and sold with regular currencies such as euro or US dollars or (more often) with digital currencies, such as Bitcoin or Ethereum. ICO’s offer cross-border investments and these investments fall outside of the scope of the supervision of the financial market authorities.
The AFM warns investors
The AFM issued a general warning on the investments in digital currencies as well as a specific warning on the risks of investments in ICO’s.
As stated above, digital currencies fall outside the scope of supervision of the AFM and DNB. The fluctuations in price of the digital currencies show certain similarities to the price developments of a financial bubble: as the popularity of the (digital) coin increases, so does its price, which may quickly collapse in case of even a small negative event. The AFM also warns about other risk factors, such as price volatility and significant price swings, which may reach hundreds percent in a single day, as well as vulnerability of the digital wallets for hackers. Due to limited trade, digital currencies are also vulnerable to price manipulation.
In its new warning, the AFM warns investors on the risks around the ICO’s. According to the AFM, the ICO’s, due to their anonymous and cross-border character, create ideal circumstances for various types of fraud and manipulation. The overstated return projections and the lack of specialist knowledge among private investors make it very difficult to estimate the real value of the revenue model offered by the ICO. The lack of transparency regarding the project may lead to emerging of “pyramid” structures and other types of fraudulent projects. Without the investor protection, ICO’s pose a strong risk that the investors will lose their entire investment. The AFM therefore advises investors to avoid investing through ICO’s, especially when it comes to not freely available or borrowed funds.
Exit scam?
Recently, also in the Netherlands, there has been an ICO offering in respect of which investors never received any information from the issuer after they paid for their investment. A company called “Confido” pitched itself as a blockchain-based app that allowed for smart contracts that acted as an escrow between buyers and sellers during transactions. Investors brought USD 374,000 into the ICO which is now seen most likely to be an exit scam (although the person in question, through the service of his lawyer, claims differently).
Case law on bitcoin
Very recently, on 16 November 2017, the Amsterdam (district) court ruled in summary proceedings between ING Bank and a bitcoin broker, that ING rightfully terminated its banking relationship with the bitcoin broker. The bitcoin broker, in the course of its business, accepted cash funds from investors. At first, the Amsterdam court concluded that transactions in bitcoins are high-risk transactions and points out the warnings DNB (DNB earlier warned banks and payment service providers on integrity risks they run as they are not aware of the identity of the buyers and sellers of bitcoins). On the basis of the Netherlands Act on the financial supervision and the Netherlands Money Laundering and Terrorist Financing (Prevention) Act, ING is obliged to tighten up its investigation as to the source of the funds that are entrusted to it. In that light, ING requested the bitcoin broker not to accept cash funds anymore and to perform know-your-customer investigations. In the absence of the bitcoin broker satisfying ING’s lawful requests, the Amsterdam court rules that the bitcoin broker abused ING’s trust and therefore, ING had a legitimate interest in terminating its banking relationship with the bitcoin broker.
