ICO — What’s in a name?
A lot actually.
ICO, as many of you may be aware, stands for Initial Coin Offering. Originally the term “cryptoequity” was embraced by the earliest proponents but it is now generally eschewed by the community due to the legal ramifications surrounding it. But hold your horses, there are more vernacular changes coming your way in the form of — Tokenized Asset Offering, or TAO for short.But before the technical definition take shape behind closed doors, lets use this time to understand what ICO actually is, at a high level.
Trend.
Over the the past five years, an increasing number of cryptocurrency-related projects and endeavors have raised external capital by organizing and partaking in a specific phenomenon euphemistically dubbed as “token crowdsales”. The first of its kind was held by Mastercoin (now, Omni) in July 2013. But the fundraising method was pioneered by Ethereum in 2014. It was little used up to the start of this year but it has been widely taken up in 2017, eclipsing venture capital as a means of raising money for blockchain startups. Over $3.5 billion was raised through ICOs last year. And I think this is small, compared to what is about to come.
Definition.
ICO is method of distributing coins or tokens prior to the launch (and listing on cryptocurrency exchanges) of a cryptocurrency network via a pre-sale or pre-mined or pre-allocation. A certain percentage of the total coin supply is pre-mined or pre-allocated, and handed over to contributors and advisors by the ICO organizers. And if used appropriately, is used to fund the development or reward the developers of the projects. However, there is no universally accepted method or practice by which either occurs. This private arrangement is effectively a pre-pre-sale in that the original tranche of coins or equity is not publicly disclosed or offered to more than a small circle of investors. The investors in the public sale are not provided information around those who participated in the private sale(s). Typically the advisors or organizers of an ICO will pitch their proposed platform or application to potential investors on a road show, often at private meetings held during cryptocurrency events. Pre-sale participants currently involve family offices, small hedge funds and boutique firms. In some cases these organizations act as a type of unregistered underwriter.
A key thing to note is that a lot of these ICOs are funded primarily through transfer of bitcoin or ether to the wallet of the organization doing ICO. This has resulted in the unprecedented demand for both the coins, pushing their market prices to all-time highs. Yet, ICO developers will at some point need to begin liquidating these bitcoins and ether. If the sale of these coins outpaces the demand for them, as in all markets, prices will decline.
Craze.
The craze for ICOs is partly fear of missing out (FOMO), and partly because of the way tax and securities laws surrounding cryptocurrency have been enforced. The truth is there is not much in the name of regulation, except for the Howey’s test in US but the regulatory arms, especially in China and South Korea are clamping down on this billion dollar phenomena. Due to the ability to invest pseudonymously and anonymously, these types of crowdsales attract an element of the population who may not report or who may underreport taxes they may owe. This looks nothing less than a nightmare for a common investor who has zero visibility on virtually any of the activity.
Outcome.
This looks like exactly like you think it does! “Anonymous” investors, including developers and advisors, often “pump” coins on social media by marketing the potential benefits of the coin and then because there is no vesting or even reporting requirements in order to sell, often quickly “dump” their coin holdings based on coordination with other large coin holders. And because many cryptocurrency exchanges lack robust financial controls and surveillance methods (limited KYC, CFT, and AML compliance), it is difficult to hold anyone accountable for “pump and dump” schemes or to identify those who benefited from insider information.
Typical lifecycle.
- Brainstorm on a technology idea or features with friends or a network of friends.
- Bake the idea with a business value proposition so investors might chew on it.
- The marketing sprint begins — find additional like-minded people who are interested in this idea and set about creating an online community on Slack, Twitter, Telegram, or anything that helps kickstart the banter.
- Core group creates a for profit and a non-profit entity.
- Non-profit entity is usually the one launching and managing the ICO, and maintains the website, creates genesis block, safeguards the private keys for developer wallets, etc. This entity provides the necessary regulatory shield (securities) for the profit entity.
- The for-profit entity has some exclusive service agreement (usually) with the non-profit entity and many of the same people are involved in both organizations creating a potential conflict of interest.
- Release white paper(s) which nowadays is nothing more than a marketing gig to create excitement in the market. These papers are seldom reviewed by peers, and often provide bare minimal technical explanations for algorithms or economic and financial explanations for a specific phenomenon.
- Launch a website that provides a superficial facade of legitimacy, along with the ICO launch date.
At this point it is nothing less than a research and development project — and ICO as you may notice is nothing less than a research grant with no strings attached.
Deeper understanding.
With all things said, it is important to note that not all ICOs are a facade or a fraud. Some of these token sales do have bright set of individuals and distributed groups working to create the “next big thing”. And as with any experimental space, there will be blood in the water. Heck that happens even in non-experimental and mature industry ecosystems. But does that mean, the wild-west should continue to flourish without any checks and balances? Absolutely not!
“Whether or not you are regulated by the SEC, you still have fiduciary duties to your investor. If you want this industry to flourish, protection of investors should be at the forefront.” — Valerie Szczepanik, Head of SEC’s distributed ledger group
To create a space for innovation requires progressive steps not just from the regulatory bodies, but also the organizations launching the ICOs. However, currently there are few, if any, ICO-related efforts that have formally created controls to protect or inform investors. And this irrational exuberance is not likely to end anytime soon, pending government interference.
Hence, it’s in best interest of an investor to understand the risk associated with ICOs, and invest with caution and after thorough research.
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