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Understanding what’s going on with controversial “initial coin offerings”
You’ve heard the hype about initial coin offerings (ICOs).
You think there could be opportunity to win big with this new vehicle. You think it might also be a scam. Even your office crypto-nerd hasn’t figured them out.
But it is clear that whatever part of the financial value chain you are a part of, ICOs will be relevant to you sooner than you think.
The building block(chain)s
There are many articles and YouTube videos that do a good job of explaining what exactly Bitcoin and the blockchain are and the mechanics behind them. You can go down a rabbit hole for an entire Sunday afternoon if you like. If you’re new to the topic, I like this quick overview by The Guardian.
Bitcoin (and by extension, blockchain technology) has been around since 2008 and has gained traction as a global, unregulated currency that can simply be used as a store of value, as well as to purchase goods on e-commerce websites like Reddit, Expedia, Overstock, OkCupid, Subway, and Foodler. (Bitcoin is trading at $6,843.90 as of the moment of writing this post; and Ethereum at $335.50)
Some benefits of Bitcoin and other currencies based on distributed ledgers (the concept behind blockchain tech) include: cheaper global transactions; low risk of money laundering; and growing market demand.
The major risks that are often cited about cryptocurrency are that it is very volatile; prone to scammers and hackers; and could be a bubble.
When I spent a summer working at the U.S. Treasury Department a little more than a year ago, a senior regulator told me that he had no intention of writing public policy on Bitcoin because he didn’t expect the blockchain to become a major form of currency anytime soon.
Anatomy of an ICO
Since that conversation, start-ups in the blockchain space have been creating digital tokens or currencies and selling them to the public to raise capital. Similar to crowdfunding and IPOs (initial public offerings), ICOs or crowdsales raise funds for a project or enterprise through the issuance of virtual tokens in exchange for crypto or fiat currency. The goal of buyers is to make a return on the higher value of the tokens upon project completion or to use the tokens to access a product or platform—possibly both.
ICOs typically involve three steps:
1. Project plan. A company creates a project plan in the form of a white paper, which includes a summary of the project, fundraising threshold and cap, timeline, and breakdown of uses of capital raised. Typically, the project is a discrete digital-currency-oriented project under a larger parent company.
2. Marketing the ICO. Then, the company begins its digital campaign to get project enthusiasts and supporters to buy virtual tokens with fiat or virtual currency through a digital wallet. These campaigns can simply be listed on sites like CoinDesk and ICO Countdown, or entire PR campaigns with press releases and celebrity endorsements to generate buzz.
Boxer Floyd Mayweather gained notoriety promoting the Stox ICO on Instagram in July. Recently, the Securities and Exchange Commission began cracking down on unlawful ICO promotion by celebrities.
3. Token issuance. Finally, if the minimum funds required by the company are raised, the company issues the token sale, and gets to work on the project through automatically executing “smart contracts.” Smart contracts can be thought of as highly restrictive and sophisticated “if/then” statements—they’re not actually enforceable by law. Indeed, they are meant to be self-executing.
Backers can also trade tokens on secondary markets. Alternatively, if not enough tokens are sold, the funds are returned to investors.
Initial Coin Offerings take off
This summer, ICOs skyrocketed in popularity. According to CoinDesk’s ICO Tracker, the ICO trend began in 2014 with slow but steady growth in both volume and amount of money raised. In 2016, the ill-fated DAO ICO raised over $150 million worth of tokens, which kicked off a much higher rate of ICO issuances.
Most recently, we have seen a summer of six-fold ICO growth, with the three biggest ICOs ever issued launched since June 2017. (Filecoin at $262 million in September, Tezos at $232 million in July, and Bancor at $153 million in June. These deals are not without controversy, the Tezos raise, for example, spawning a class-action securities lawsuit earlier this month.) The cumulative U.S. dollars raised through ICOs now totals over $3.3 trillion.
ICOs have become so popular that companies like TokenHub and ICO Box are now providing turnkey solutions for issuing ICOs in as little as two weeks.
Regulators get involved
Along with a wild number of ICOs this summer, we saw a number of regulators cracking down on them.
In the U.S., the SEC ruled in July that the DAO ICO referenced earlier was actually a security sale, but it did not take any enforcement action. The commission also issued a bulletin to investors on ICOs. The Commodity Futures Trading Commission determined that it will classify cryptographic assets as commodities.
Additionally, in late September the SEC filed charges for fraud against two ICOs, marketed as “REcoin” and “DRC” that did not actually have any underlying blockchain.
In addition, the SEC has said that it may use a 70-year-old methodology, the “Howey Test” to determine whether ICOs are issuing securities tokens (regulated as securities) or utility tokens (unregulated…for now).
Regulators also say that other laws around commodities, broker-dealer relationships, taxation, currency transmission, and know-your-customer and anti-money-laundering rules may also apply to ICOs. They are not specific about these applications, but warn those interested in participating in token sales that the government cannot help in cases of ICO hacking and contract enforcement.
Meanwhile, China and South Korea have banned ICOs, and Japan is considering doing the same. Places like Singapore, Abu Dhabi, Germany, Russia, Switzerland, and Lithuania, are conducting investigations and issuing guidance on ICOs, all with different principles on how they will regulate token sales.
So who’s got it right?
Deciding whether ICOs are good or evil is indeed a conundrum. Various public figures have weighed in. Blackrock CEO Larry Fink is a “big believer” in cryptocurrency. JPMorgan Chase CEO Jamie Dimonthinks cryptocurrency is a “fraud” and “novelty” but thinks that the blockchain will persist. Wikipedia CEO Jimmy Wales thinks that ICOs are an “absolute scam.” Meanwhile, according to one report, UNICEF is considering issuing its own ICO to raise money for its humanitarian efforts across the globe.
Perhaps we don’t have to decide good and evil in such extreme terms. As entrepreneurs are looking at ICOs as a vehicle to raise capital in a constantly changing regulatory landscape these ICO issuers must self-regulate, at least for the time-being.
At the recent StartEngine ICO 2.0 Summit, the first regulated ICO conference, ICO companies spoke about using robust KYC and “geofencing” processes to eliminate anyone trying to participate in their token sales from banned jurisdictions. They talked about employing lawyers from many different regions to make sure they are complying with local laws. They even talked about which government regulators are best suited to crack down on complaints against bad ICO behavior.
In the last year, we have seen a “Cambrian explosion” of ICOs. The chips are still falling, but in the meantime, entrepreneurs, regulators, banks, fintech companies, economists, game theorists, and historians need to come together to better understand the risks and opportunities of ICOs. A “regulated ICO” is inevitable and may actually result in a more vibrant, accessible, and healthy ICO marketplace.
Originally published at Banking Exchange Blogs, courtesy Banking Exchange