Initial Coin Offerings (ICOs) have come under a lot of scrutiny in recent weeks. From China issuing a ban, to rumblings of class action suits, to dire predictions of forthcoming Draconian regulatory postures, the shine appears to be coming off ICOs. This has followed a sustained period of market exuberance, probably top-ticked by the phase at which celebrities such as GhostfaceKillah, Jamie Foxx and Floyd Mayweather jumped into the mix.
It would be easy to dismiss celebrity enthusiasm as a sure sign of a large bubble about to pop; however, there is a method to the madness and an intriguing, something-new-under-the-sun component to the ICO marketplace that is attracting investors on a global scale. ICO’s are also beginning to attract Wall Street players (picture a hundred hyenas covetously eying the fresh kill of a couple of enterprising cheetahs). A recent Wall Street Journal article reveals that Goldman Sachs is considering trading bitcoin and other cryptocurrencies. The CME and CBOE have recently announced forthcoming trading of bitcoin futures.
Since bitcoin debuted in 2009, the cryptocurrency ecosystem has grown exponentially. Out of this primordial soup, ICO’s have emerged as a sort of next step in an evolutionary path. According to the Token Report, 105 initial coin offerings (ICOs) worth $1.32bn were sold in the last quarter, with more than $956m sold in first half of the year. The year-to-date tally stands at near $3bn, compared with $100m raised in 2016.
There are two sides to the ICO coin: Issuers and investors. On the issuing side, ICO’s generally fall into three categories: ‘utility tokens’, ‘cryptocurrencies’ and what we’ll call ‘proxy equity’ (securities). It’s useful to regard this last category as ‘proxy equity’ (of the non-voting ilk) because the capital that is invested into the new coin issuance is not secured, generally doesn’t bear interest, doesn’t have to be paid back and otherwise acts very much like an IPO for the issuing party (except without all the ensuing rigors and scrutiny of being a public company). Also, generally, coin investors have no Cap Table status of any kind, vis a vis the issuer… which oftentimes isn’t even a company at all, but rather some decentralized automaton that operates according to preordained rules. The SEC recently issued the following language to delineate where a recent ICO fell into the category of ‘Security’ status. (The story of the DAO “tokens” involved represented an approximately $60m loss of investor funds, siphoned off by hackers, as reported by Fortune.)
“The Commission applied existing U.S. federal securities laws to this new paradigm, determining that DAO Tokens were securities. The Commission stressed that those who offer and sell securities in the U.S. are required to comply with federal securities laws, regardless of whether those securities are purchased with virtual currencies or distributed with blockchain technology.”
ICOs that act as proxy equity for issuers are replacing both traditional and more recently available channels to capital, like crowdfunding, that new ideas and young companies have had little choice but to depend on. Venture capitalists have long held the upper hand over entrepreneurs, but the industry is as clubby, craven and hidebound as its more commonly reviled Wall St counterpart… and so is proving to be equally susceptible to the disruptive ramifications of a digital money revolution. If a new company or idea can access a broader, less exigent pool of capital more quickly and cheaply than through any pre-existing set of alternatives – that’s what companies and ideas will do. Of course, some of these companies and ideas will be legitimate and many will be frauds. Hence, the logical incursion of the SEC to provide a measure of consumer protection. Hopefully, the regulators will find the right balance between keeping out the bad guys, while preserving an expanded and invaluable aperture for the efficient funding of young companies and new ideas, i.e. the crown jewel factory of the American economy.
ICO’s that don’t fall into the category of securities underneath the SEC’s purview are either cryptocurrencies, like bitcoin, or utility tokens like Ripple’s (XRP) and Brave Software’s (BAT). The prior category tends to preserve what an industry pundit recently described as ‘moneyness’, while the latter category’s primary purpose is to perform some value conveyance function within the context of the issuer’s business or ecosystem. Irrespective of issuers’ disparate purposes, clearly the current driver of investor interest is speculation. Companies like Ripple and Brave are betting that fundamental demand for their utility tokens will grow with the adoption of their products: respectively, an inter-bank money transfer rail to replace SWIFT in the case of Ripple, and a next-generation web browser that remedies the broken Internet advertising paradigm, while providing a greatly improved user Internet experience, in the case of Brave. As demand for Ripple’s and Brave’s products grows, demand for their utility tokens grows in-step, creating appreciation, or so the theory goes. Cryptocurrencies like bitcoin aren’t tied to these sorts of fundamentals. They tend to rely on one monolithic meta-fundamental: spot supply and demand. There is no way of evaluating whether the price of a bitcoin is too expensive or too cheap based on a multiple of any traditional metric. Instead, ‘moneyness’, i.e. spendability, liquidity, legality, distribution etc., and ‘technical analysis’ (basically, astrology) inform the currency’s evolution, trading patterns and buy/sell decisions.
All cryptocurrencies and utility tokens are created and disseminated using blockchain technology. Many have elected to use Ethereum’s ERC20 standard, others use different blockchains. In order to launch new coins into the virtual currency marketplace, issuing companies and technologists usually engage promoters to market the coins through ICO’s. A small but rapidly growing cottage industry has popped up around this exercise, and today hardly a day goes by without the announcement of a new ICO pre-sale, usually the first step of the ICO process. Because the most likely participants in ICO’s are people who already possess bitcoin or Ether, ICO’s are frequently priced in terms of BTC or ETH, but often, by going through a step or two, the public can participate by purchasing in fiat currency, e.g. USD, EUR, etc.
In some instances, promoters and initial sellers of virtual coins may lead prospective buyers to expect a return on investment. As with any ‘investment opportunity’, particularly one as new and volatile as an ICO market entrant, caveat emptor should prevail. After issuance, cryptocurrencies may be resold to others in a secondary market on exchanges or other platforms, such as Uphold.com. The Financial Times refers to ICOs as “unregulated issuances of crypto coins where investors can raise money in bitcoin or other cryptocurrencies.” Lite regulation allows the ICO market to swiftly innovate and iterate but also leaves unsophisticated investors vulnerable to becoming victims of unscrupulous ICO vendors. Recently, the SEC’s Chairman, Jay Clayton had this to say about the nature of ICO issuances:
“Investors often do not appreciate that ICO insiders and management have access to immediate liquidity, as do larger investors, who may purchase tokens at favorable prices. Trading of tokens on these platforms is susceptible to price manipulation and other fraudulent trading practices.”
So, let’s assume you have successfully participated in an ICO and are in possession of digital currency, what next? Traditional financial platforms, such as banks, are not set up or incentivized to support the full spectrum of digital money, and would certainly prefer their clients steer clear. Most legacy repositories of capital are physical, local, and entirely structured around traditional financial models. Similarly, most purveyors of digital wallets, coins, and payment services cannot meet the breadth of needs of today’s cryptocurrency investor, especially if they want access to a wide array of both crypto and traditional currencies, and are looking for convenience. Which is why leveraging a trusted digital money platform is a smart move for global investors. Crypto-investors who have come into possession of cryptocurrencies via an ICO or other means need instant access to traditional currencies, virtual coins and other investments in real time, and in a safe, secure, transparent environment. But, to avoid DAO-like incidents, best if that platform exercises rigorous screening criteria before making these new issuances available on its platform. ICO’s are at the vanguard of an exciting sea change in the way people interact with their money and investments. Fortunes will be made. There will also be tears.
And, as in all investing, whether it’s virtual or traditional, there are risks. Investors should at all times employ a mindset of robust caveat emptor and thoroughly understand the risks inherent in any contemplated transaction.