New Kid on the block

Seen Meng Chew
Nirav Gala
June 1, 2018

Initial coin offerings (ICOs) are a fundraising mechanism in which companies issue blockchain-based coins or tokens to investors in return for contributions in popular cryptocurrencies such as bitcoin and ether. The companies use these contributions to develop projects that, in many cases, involve the use of blockchain technology.

These companies publish white papers which provide the relevant details about the projects. Generally, the tokens do not represent an ownership interest in the projects but instead allow investors to access or use the products or utility that are being developed.

Market overview

ICOs have gained tremendous popularity as a fundraising mechanism for start-up firms over the last two years. The strong momentum doesn’t look to be receding anytime soon; more than half of the US$11 billion raised through ICOs to date came in the first quarter of 2018 alone (figure 1).

The type of firms doing ICOs range from infrastructure to art and music, although ICOs from finance, trade and investment-related start-ups account for the largest share, or 31.4% (figure 2).


The largest ICOs have all taken place in 2018, including Russian-developed messaging app Telegram ($1.7 billion), digital gaming chips developer Dragon ($320 million), and China’s cryptocurrency exchange Huobi Token ($300 million).

The popularity of ICOs is partially driven by surging bitcoin prices late last year, which attracted tremendous attention from investors at all levels.

Moreover, the typical online fast and efficient ICO transaction process increases its appeal – some fundraising can be completed within weeks or even days. This stems from the fact that the ICO market is still nascent and lightly regulated, and policymakers are still catching up with its abstract and unconventional structures.

Risks

One of the biggest problems with ICOs compared to traditional fundraising mechanisms like initial public offerings (IPOs) is the adequacy and reliability of information disclosed in white papers.

Unlike IPOs, ICOs have not been vetted by independent professionals such as investment bankers or lawyers. This is further compounded by the lack of standard rules and market practices with regard to the issuance process. There is no set of well-defined standards with respect to what needs to be disclosed and at what level of detail. ICOs also lack all the standard protection mechanisms that are available to IPO investors.

Light regulation coupled with heavy reliance on online marketing mean it is easy for fraudsters and scammers to enter the market and deceive gullible investors. There are several instances of fraud related to ICOs which have been reported from across the globe. The most infamous among them was Bitconnet, a multi-level marketing ICO lending Ponzi scheme which wiped off $2.4 billion in ten days when it collapsed.

Earlier this year, the US Securities and Exchange Commission (SEC) shut down an alleged ICO scam by AriseBank in Texas, which aimed to build the first-ever decentralised banking platform. There were allegations that it made false claims about its agreements with banks that do not exist.

And these are just some of many ICOs where either the underlying projects do not make economic sense, or fail to generate any returns, or worse, result in losses for investors.

Even if the underlying project is legitimate, there is no guarantee that investors’ contributions will be protected from cyber-attacks or hacking. Given the nature of crypto tokens which make it impossible for anyone to recover stolen funds once the private keys are compromised, lax cybersecurity practices have resulted in substantial monetary losses to both ICO issuers and investors.

Crypto analytics firm Chainalysis estimated that 10% of all ICO-marked funds end up in the hands of cyber-criminals.

Another issue is that ICO projects are either high-risk endeavours with unproven business concepts, or initiated by start-ups with a high probability of failure.

Moreover, the volatility of bitcoin and ether prices, which are the two major means of contributions in ICOs, implies that prices of tokens post-ICO could also be very volatile. ICO investors need to be prepared to lose their entire investment.

Opportunities

Despite the risks, ICOs do not seem to be slowing down anytime soon, due to some attractive features.

They help young start-ups to obtain funding and grow quickly without diluting any equity from investors across the globe. They help projects with great ideas to get funded without requiring them to have special connections with, or make endless pitches to, venture capital firms.

Without a consistent track record, these start-ups will have difficulty raising capital through traditional channels or securing bank loans.

For technology firms which have a short turnaround time to remain competitive in the market, ICOs provide a quick and easy way to raise much-needed cash to develop their projects.

From an investor’s standpoint, ICOs open up access to new investment instruments, new business ideas, and a variety of new markets and industries from across the globe.

These new investment opportunities, while highly risky, could potentially offer much higher returns than stocks, bonds and other traditional financial products.

Moreover, many ICOs are priced modestly so that retail investors can invest in small amounts. This is quite different from certain high profile IPOs which are typically snapped up by institutional investors and thus are out of retail investors’ reach.

Another interesting feature of ICOs is that the tokens on sale can be used to access or pay for the underlying firm’s products and services. This serves the dual purpose of fundraising as well as creating a ready customer base for a those products and services.

The success of these products and services will bolster demand for the tokens, thus increasing their value. Also, since the firm’s owners, employees and investors all hold the tokens, everyone has an incentive to help the firm grow and succeed, mitigating agency conflicts and, again, boosting the token values.

Regulatory response

As the ICO market expands and gains popularity among investors, regulators in major countries are keeping a close watch, but have come up with different responses.

In the US, the SEC has taken an extreme view due to rising instances of fraud, and deems all ICOs to be an offering of securities and thus subject to securities laws. It has also issued an investor bulletin on ICOs that warned of their potential risks.

Singapore is more forward-looking and has taken steps to clarify the regulations surrounding ICOs by issuing a guide that details the instances when ICO tokens may be potentially considered as securities and subject to regulatory oversight.

There are countries that have taken a very harsh stance: South Korea and China – two major cryptocurrency trading hubs in Asia – have banned ICOs altogether.

But there are also countries that view ICOs more favourably. Switzerland, for example, intends to become a cryptocurrency hub, with supportive policies that do not compromise the integrity of the financial market.

Meanwhile, Gibraltar is developing a blockchain exchange that aims to be the “world-leading institutional-grade token sale platform and cryptocurrency exchange”.

Given the wide spectrum of regulatory responses and the lack of a consistent approach towards ICOs, it is in an investor’s own interest to do careful due diligence before participating in any ICO.

A simple three-step approach could help to avoid falling for a scam. First, one should read the ICO white paper thoroughly to gain a good understanding of the underlying project to see if it makes any commercial sense. If you don’t understand the project, you are better off staying away from it. Also, if it sounds too good to be true, then chances are it is.

Secondly, don’t just rely on claims made in the white paper – verify them independently. You will be amazed by the amount of information that you can get by doing a simple search on Google.

And finally, initiate an in-person conversation with the project leadership team and other participants to clarify your queries.

The ICO market is likely to expand with the wider adoption of blockchain technology and increasing use of cryptocurrencies. However, the lack of clear regulations and volatile cryptocurrency prices mean ICOs are unlikely to replace IPOs as the main fundraising avenue for traditional firms any time soon.

They do however provide a quick alternative source of financing for young technology firms. And as regulatory checks and balances mature, ICOs are likely to develop further and co-exist alongside IPOs as a fundraising mechanism.          

* Dr. Seen-Meng Chew is head of research and Nirav Gala is tokenisation advisory lead, at FinFabrik.