Initial coin offerings (ICOs) have hit the headlines for a variety of different reasons in the past year. Here is what you need to know about them.
A company with no working platform or viable product raised US$185m from investors in just five days earlier this year. Block.one did so by launching an initial coin offering (ICO). This is a new fundraising tool that allows investors to purchase digital assets, known as ‘tokens’, issued by a company using blockchain technology.
Block.one is not the only company to do so. Indeed, according to ICO tracker and marketing platform, Coinschedule, companies have raised US$3.6bn using ICOs this year. This is up from US$96.3m in 2016.
In brief: ICOs
An ICO is a fundraising tool that allows companies to issue digital tokens in exchange for an investor’s (retail or institutional) cash or cryptocurrency. Raising funds through an ICO enables companies, typically start-ups at present, to bypass banks and traditional underwriters of capital raisings, giving them a quick and low-cost way to raise funds.
Unlike an IPO (initial public offering), the typical ICO fundraising method is more akin to the crowdfunding campaigns offered through websites like Kickstarter.
Underpinning ICOs is the blockchain, which serves as the record of legitimacy, verifying transactions between buyers and sellers of the tokens.
Investors in an ICO receive tokens as a proof investment. These grant the holder certain rights/benefits depending on the structure of the ICO. Rocky Mui, Senior Associate at Clifford Chance and an ICO expert, notes that typically there are three structures that companies issuing ICOs use:
Entitlement to income or payment:
This structure gives the holder of a token with entitlements similar to shareholders’ right such as a share of the company’s profits, dividends or distribution of surplus assets. The token may also be used to create a debt owed by the issuer akin to a debenture. This is very similar to a securities-style instrument and can fall under securities regulation in certain jurisdictions.
Tokenisation of assets:
This structure gives the token holder part-ownership of certain underlying assets, such as shares or physical goods. Depending on the assets included in the structure and the actual features of token, these ICOs might also be regulated instruments in certain jurisdictions.
The token could be a simple store of value (like bitcoin and other cryptocurrencies) and/or gives the holder rights to the use of a service, use of goods or access to a platform.
“Right now utility tokens are by far the most popular form of ICO,” says Mui. “This is because they most closely match objectives – because in certain jurisdictions they may not be regulated as securities and avoids the complexity that comes with that.”
Despite the unclear regulatory environment surrounding ICOs, and the fact that many businesses issuing them do not have a discernible product or even operational step up, investors continue to be hungry for investment opportunities.
Mui notes that there are a few reasons for this, including investors being passionate about a product and/or wanting to take advantage of its offerings once it goes live.
For the most part, however, investors may be looking to strike it rich. The tokens can be traded on secondary market exchanges such as Poloniex or Bittrex and the price of a token may rise and fall significantly due to market fluctuations.
According to a report from VC Mangrove Capital, the average return across ICOs in 2017 is 1,320%. Unsurprisingly, with returns such as this, hedge funds and investment banks are beginning to take a much closer look at the market.
“The big risk for investors is that the company they are investing in may never launch a legitimate product, meaning the token can lose all value,” warns Mui. “Investors are also at risk of fraudsters who are issuing ICOs without any legitimate underlying business. Investors should be mindful of what they are investing their cash in.”
The Wolf of Wall Street speaks out against ICOs
Despite the popularity of ICOs, some notable figures have come out with harsh criticism of the latest fundraising craze. Few have been quite as vocal as Jordan Belfort, the convicted securities fraudster known as ‘The Wolf of Wall Street’.
In an interview with the Financial Times, Belfort said that the promoters of ICOs are “perpetuating a massive scam of the highest order on everyone”.
He was quick to add that he did not think that everyone issuing ICOs had bad intentions, although the percentage that has, has the potential to create a disaster.
“It is the biggest scam ever; such a huge, gigantic scam that’s going to blow up in so many people’s faces,” he concluded. “It is far worse than anything I was ever doing.”
The increasing popularity of ICOs and the potential risks that they pose to investors have caught the attention of the regulators. And around the world, they are taking different stances towards ICOs, says Mui.
The most extreme regulatory approach is in markets like China, South Korea and Vietnam, where the regulators have put in place a complete ban on ICOs. In China, the regulators called them a “form of unapproved illegal public financing behaviour”.
On the other hand, some jurisdictions, such as the Isle of Man, the Cayman Islands and Gibraltar have come out in support of ICOs, although it must be noted that both the Isle of Man and Gibraltar have indicated they will launch a regulatory framework surrounding cryptocurrencies in 2018 that will provide greater oversight over ICOs.
Most markets are waiting to see how this space develops. Some, such as Hong Kong and Singapore, have issued warnings to issuers, indicating that, depending on the structure, an ICO might fall under existing securities laws. Investors have also been cautioned about the risks and are encouraged to complete their own due diligence before backing any ICO.
Even with the regulators bearing down on ICOs, Mui does not expect to see the pace of issuance fall in 2018. “I think ICOs will continue to capture people’s attention in the coming years,” he says. “While there will be ups and downs, the technology and concepts are certainly here to stay.”
How it develops will have a lot to do with the actions of regulators. “Some will continue to react positively and others negatively to the product,” he says. “I believe, however, that generally, the move will be positive as they understand how to balance ICOs and consumer protection. As a result, we might even see the bans being lifted in markets such as China and South Korea.”
More broadly speaking though, Mui expects the entire ICO ecosystem to develop positively in the coming years. “ICOs are a nascent fundraising tool and the ecosystem that surrounds them is still evolving, including regulatory framework,” he says. “It is encouraging to see more established market players taking a closer look at this space, in particular on regulated securities-type tokens, because as they enter the ecosystem with additional regulatory clarity, it will give more confidence to all participants in the market.”