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Initial Coin Offerings: Risks, Legality and Issues of ICO’s

Cryptocurrencies and the blockchain ledger are changing the way companies and people transact globally. Bitcoin was the first successful implementation of a blockchain, which is a digital database that is optimized for recording financial transactions and transferring value securely over the Internet. Thanks to the rise of cryptocurrencies like Bitcoin, alternative funding and “offering” sources for products and services have arisen, including Initial Coin Offerings. An Initial Coin Offering (ICO), which is a network token pre-sale, is the newest way for startups, developers, and early adopters to get funded through cryptographic “tokens” in exchange for money for goods and services on their platform. Companies may also acquire these tokens to simply stash away as an investment. The companies that utilize ICOs are typically early-stage and far from generating significant revenue.[1]

Most ICOs raise money for their operations through Bitcoin or other cryptocurrencies such as Ethereum, DAO, and Mastercoin (now known as Omni). The jargon used in this field is still very loose, as these tokens can also be referred to as app-coins, cryptocurrencies, or just ‘coins’.[1] Coins can be easily traded, though they do not confer ownership rights unlike shares. That is, ICOs to not imply the sale of securities–yet. Through May 2017, companies have already raised $180 million in ICOs, compared to $101 million all of last year, according to Smith + Crown, a blockchain research, data and consulting group.[2]

Legalities of performing an ICO

While a public security sale would be required to have paperwork in order to be official and legitimate, no paperwork is necessary for acquiring an ICO. The lack of regulatory oversight concerns some market experts and financial technology lawyers, which raises questions about the legality of the tokens.[3] A company which uses tokens as its own currency allows its customers to have complete control over their funds, with no intermediaries such as banks involved, and with encryption features protecting against hacks.

Due to the strikingly similar qualities between ICOs and securities, some market participants say that selling tokens can fall under the jurisdiction of the Securities and Exchange Commission (SEC) and thus be illegal. According to Peter Van Valkenburgh, director of research at the cryptocurrency advisory group Coin Center in Washington, it is important to determine whether the token has a useful application, other than for investment, when deciding whether a coin sale is legal.[4] When purchasing the token while the price is increasing, you are also purchasing the token for its utility. The SEC has the power to investigate ICOs on its own, but until there are red flags about significant money being lost by any investor, it seems to be taking a hands-off approach.

Process of SEC and FINRA Regulation

Though the SEC remains distant from any ICO investigation, it is said to be taking a hard look at the increased use of such offerings, especially with the growth of ICOs surging in recent months. The overall value of the coin market is estimated at over $91 billion, which is more than the market cap of Goldman Sachs. The frenzied activity has fueled a record-breaking rise in the price of Bitcoin, which hit an all-time high of $3,102.15 last week, according to the CoinDesk Bitcoin Price Index (BPI).[5]

In June 2017, the SEC looked into the proposal of ICOs and did not find the proposal to be consistent with the Securities Exchange Act. Ajit Tripathi of PWC says “the decision shows that the commission recognizes the benefits of the ICO marketplace but remains concerned by the lack of oversight and transparency from the exchanges on which the coins are traded.” However, there has been no announcement about whether the government will regulate these sales because of how this business operates without a central authority.[4]

The process of SEC regulation begins with the Howey Test, which is a method of determining if a transaction is an investment contract. If it is, then those transactions fall under the descriptions of the Securities Act of 1933 and Securities Exchange Act of 1934.[5] Then, ICOs will be considered as securities, and be subject to disclosure and registration requirements.

Market Liquidity

Liquidity in the market for ICOs has been limited, and ICOs have mostly been small. Before 2017, most ICOs were measured in thousands of dollars, and an ICO raising single digit millions of dollars was considered large. In April 2017, the Gnosis ICO raised $12.5 million in 10 minutes and the token tripled in value, from $30 to $90, giving the company a $1 billion valuation. Gnosis is a startup company that uses blockchain technology to build algorithms to create accurate predictions, such as the U.S. election. As of June 6, 2017, ICOs have raised more than $200 million, about double what ICOs raised in all of 2016.[6]

Unlike equity, a token has a price immediately upon its sale and the price can fluctuate at any time in a global market that operates 24/7. Tokens have a very volatile value and thus many ICO investors choose to buy and sell tokens within minutes rather than years.

Disadvantages of ICOs

Despite the increasing value of ICOs, the regulatory uncertainty and lack of disclosure create downsides for offerors. With potential looming U.S. securities regulations, companies attempt to instead register in foreign jurisdictions, most commonly Singapore and Switzerland.[7] However, disclosure in ICOs generally have been limited whether in the U.S. or elsewhere.

The rapid rise in ICO investments and publicity, especially in 2016-17, shows some typical characteristics of a bubble and draws comparisons to the 1999-2000 dotcom bubble. ICOs do not typically exist in financial industry business practices or in security laws and regulations. The number of ICO assets chasing investments are increasing despite the challenge to determine the actual value.

With rising interest in blockchain technology development, the number of blockchain startup companies seeking token funding in the early stages of development have increased as well. Bitcoin and other digital currencies rose in market value over the past year; the market price of Bitcoin increased from below $450 on January 1, 2016 to over $2,400 by June 1, 2017. The market price of Ether, the cryptocurrency of the DAO, rose in market price from 95 cents to $220 in the same timeframe.[8] With these rising values, the dollar-denominated value held in these digital currencies have been greatly inflated and may possibly be bubbles themselves.

As a result of these trends, ICOs have placed high valuations on some startup companies that do not match the economic value of the startup, which is typical in a bubble. For example, Robert Kim of Bloomberg BNA highlights three ICOs – Gnosis, Aragon, and Basic Attention Token – that raised over $10 million in a single day for companies with questionable value propositions.[8]

Fraud is a large part of the ICO market, as there are instances of inaccurate information and false promises, leaving customers unconfident following some ICOs. The lack of disclosure and reliable information continues to be an issue, with offerings being posted on unsupervised online forums and proving to be unreliable. There has been at least one instance of a digital currency exchange being taken off the market due to an issuer being accused of fraud.[9]

Cybersecurity is becoming an integral part of business across all industries, regardless of ICO or not. Cybersecurity has become a concern for ICOs, notably the loss of approximately $40 million worth of digital currency for the DAO,[8] a decentralized venture capital firm build atop the ethereum network, as a result of security weakness. ICOs may have avoided the exploitations of their security concerns when they were small, but cyber criminals are now exposing the ICO reliance on technology. ICOs that are large enough must now maintain a high level of security and auditing, which will ultimately drive up costs.

Regulatory risk is likely the largest concern for ICOs. Though the SEC or other regulators have not taken action against ICOs, there has been scrutiny by regulators across the world is likely to continue as ICOs continue to grow. The SEC and FINRA may decide to focus on ICOs in the future if the upward trend continues and digital currencies such as Bitcoin, which has already received warnings, become a significant part of the market for investments.[9] Regulatory and enforcement action may occur soon for companies issuing, exchanging, or investing in ICOs.

The great amount of reward in an ICO comes with a great amount of risk. The investor is not guaranteed to get their money back or even make a profit. In an ICO, there is a considerable amount of trust that the project will be completed; if the project is not completed, there will be a loss of the money that is invested.

What is the demand? Is it just hype?

All in all, it appears the demand for ICO and cryptocurrencies is increasing despite the risks. The ICO market had $168 million in crowdfunding resulting in market capitalization of $4.5 billion – 2000% increase in less than three years. The demand is likely driven by the returns, as 45% of ICOs were showing returns of over 500%. Perhaps the biggest draw-in for consumers is the time during which an ICO accepts funds from backers, as the allotted funds were received within hours or even minutes. The 40 ICOs that were surveyed in these results more than doubled in the weeks since. If properly executed, ICOs present a large opportunity to distribute and allocate capital.[10]

Sources

  1. Lawrence Lundy, Jamie Burke & Aron van Ammers, All You Need to Know About Initial Coin Offerings The Blockchain (2016), http://www.the-blockchain.com/docs/Initial_Coin_Offerings_Outlier_Ventures_Research.pdf (last visited Jun 15, 2017).
  2. Ari Levy, Here comes the ICO, a wild new way for cryptocurrency start-ups to raise money CNBC (2017), http://www.cnbc.com/2017/05/25/bitcoin-ico-cryptocurrency-start-up-civic-raising-money-initial-coin-offering.html (last visited Jun 15, 2017).
  3. Balaji S. Srinivasan, Thoughts on Tokens Medium (2017), https://medium.com/@balajis/thoughts-on-tokens-436109aabcbe (last visited Jun 15, 2017).
  4. Henry Engler, “Initial coin offerings” present dangers to investors, new challenge for U.S. regulators Reuters (2017), https://www.reuters.com/article/bc-finreg-bitcoin-ico-idUSKBN1942HF (last visited Jun 15, 2017).
  5. David Zeiler, Why Initial Coin Offerings (ICOs) Raise Millions of Dollars in Seconds Wall Street Examiner (2017), http://wallstreetexaminer.com/2017/06/initial-coin-offerings-icos-raise-millions-dollars-seconds/ (last visited Jun 15, 2017).
  6. Gertrude Chavez-Dreyfuss, Forget IPOs: Initial Coin Offerings Take Off PressReader (2016), https://www.pressreader.com/lebanon/the-daily-star-lebanon/20161220/281608125082816 (last visited Jun 15, 2017).
  7. Moe Adham, Backing A New Digital Currency: Initial Coin Offerings Forbes (2017), https://www.forbes.com/sites/forbesfinancecouncil/2017/05/23/backing-a-new-digital-currency-initial-coin-offerings/#63f5fa8e1d90 (last visited Jun 15, 2017).
  8. Robert Kim, Initial Coin Offerings: A Growing Method For Blockchain Startup Financing Bloomberg BNA (2017), https://www.bna.com/initial-coin-offerings-n73014453179/ (last visited Jun 15, 2017).
  9. Amy Wan, Why Your Initial Coin Offering Is Probably Regulated by Securities Law Crowdfund Insider (2017), https://www.crowdfundinsider.com/2017/03/96598-initial-coin-offering-probably-regulated-securities-law/ (last visited Jun 15, 2017).
  10. Tim Lea, Venture Capital 3.0: the initial coin offering explained Forbes (2017), https://www.forbes.com/sites/forbesfinancecouncil/2017/05/23/backing-a-new-digital-currency-initial-coin-offerings/#63f5fa8e1d90 (last visited Jun 15, 2017).

Curran Aiyer contributed to this article.

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Nate Nead
Nate Nead is a licensed investment banker and Principal at Deal Capital Partners, LLC which includes InvestmentBank.com and Crowdfund.co. Nate works works with middle-market corporate clients looking to acquire, sell, divest or raise growth capital from qualified buyers and institutional investors. He is the chief evangelist of the company's growing digital investment banking platform. Reliance Worldwide Investments, LLC a member of FINRA and SIPC and registered with the SEC and MSRB. Nate resides in Seattle, Washington.