SO…. Are you thinking about jumping on this ICO train?
I am an entrepreneur with a background in engineering focused on UX. I started my career at VMware, back when the company was only a fraction of the size it is today. I do not have a deep interest in coding on a daily bases but event in my early days at VMware, I had a chance to touch a bit of the code. I have a strong IT background, that’s why VMware infrastructure interested me a lot. I hated my 400 Level CS classes because I thought understanding sort cost was a waste of time as solutions to old problems are boring to me. I never really cared about game theory, economics, and I had huge reservations on sales and marketing as a hard skill. I am an artist, engineering is my medium, products are my masterpieces. This all changed with the advent and rise of crypto currency, blockchain technology, and Ethereum’s smart contract technology. At the core, this hype transformed everything I was disinterested in learning about and excited the insomniac in me. Why? Because money. What I am saying is. This is a 3 week expert opinion on what you need to be aware of when moving on an ICO.
I have spent the last 3 weeks catching up to the technical and economical details of crypto currency. I have studied about 50 companies who have successfully, in their own scope, raised a successful ICO. Dumb ones like KarmaCoin, which wrote a paragraph and raised half a million on an ICO that barely trades at a volume of 5 coins a day after ICO… lol — a real pump and dump coin… Compelling and complex ones that are claiming to be true utility coins, like EOS (operating system for distributed Apps, or DApps)… To GNO, which is the most successful but least technically complex utility coin that claims to be an utility coin but really looks like a pump and dump disguised betting platform to me.
This week, I have barely slept, reading about the current and future ecosystem around ICOs and what it will take for anyone to execute a successful ICO. I want to list out some topics that you must understand before moving forward with an ICO if you are going to execute one. This is just my opinion, I am too lazy to list our references so you should do your own research after reading this.
Also, mad credit to my old friend, a thought leader of crypto currency at Google. He really was really my sounding board and devils advocate as I sifted my thoughts out.
Utility Coin vs App Coin vs Securities Tokens
The biggest statement you should walk away with is this: it is a big deal whether your coin is considered an utility coin or app coin vs security token. Utility coins and app coins are basically the same thing in the governments view. They serve a purpose higher than speculative trading. App Coin/DApp Coin/Utility coins are coins that have an integral part in what I call the technical business model.
You can also look at utility coins as gift cards, Dave and Buster chips or Chucky Cheese chips. There is a value to them, however the value does not fluctuate much compared to the outside economy. Everything that is not used in this manor will be considered an unregulated security. A security is like stock. Basically, anything you can speculate on.
Technical Business model of coins
DApps and decentralized software are actually quite expensive, do to the cost to build it, maintain a community, securing the codebase, and marketing the platform. Compute processing is also expensive compared to centralized Apps. Therefor, we can say there is a cost associated with each action. For example if we made a DApp for email, each time we sent an email, there will be a cost to it. This cost could be also transferred at the same time, using an AppCoin. Making these coin/tokens an utility coin.
A Traded Token is a Traded Token
The problem with Utility Coin and App Coin is that they are still being traded for market gain. Which is the very definition of a security. A lot of these companies explicitly say that these coins are not for speculative trade, they have no value outside the utility, etc. Really, this could be interpreted as just trying to cover their ass legally. If any government that wants to “protect” it’s people from price gouging, racketeering, money laundering, and pump and dump ponzi schemes… you know, real wolf of wall street stuff. They will come down hard on all crypto currencies that are actively trading.
DAPP/ APP COIN Value
So is there value in DApps, blockchain, open ledgers, and smart contracts. One play for an ICO is to align with the DApp ecosystem. Another play is to build some kind of core crypto technology as the bases of your ICO.
Although, there are a few technical problems with DApps.
- They are slow. like 10000000x slower than centralized apps. This is because of how each transaction of information is taken care of. Don’t get me wrong, there are ways to increase the speed of DApps. IOTA coin, promises that through a new approach to replace blockchain they call tangle. It improves on the blockchain the same way merge sort O(n log n) improves on linear sort O(n).
- There are incredible security issues. It is very easy to hack a DApp. You need to understand how to implement crazy complex security protocols and probably invent new ones to keep your ecosystem from malice attack. If you raise any substantial ICO and launch your coin you are going to be a crazy target. Remember IOTA from the point above? MIT found vulnerabilities earlier this month. Are they able to to deal with it? Well yes, they are the 8th largest crypto currency with a $1.9B market cap. So make sure your ICO raises enough money to take on security challenges.
Don’t get me wrong, DApp and App coins are good for a few things
- Automation of a trusted 3rd party witness. When the world adopts this as trusted contract verification over notarized paper, it will drive the cost down and speed the execution time of these contracts.
- Distribution of computing responsibilities and control over the coin. Yay! democracy! Let’s all have equal voting rights.
Are there use case for this? Yes. of course.
STOCKX vs NASDAQ vs Coinbase
So there is this company, StockX which claims to be the “stock exchange for goods”. This proliferates the adoption and observation of data based trading. All the marketing material around this company screams security trading. Why wouldn’t they be regulated?
The SEC probably doesn’t care much about STOCKX, even though its blatantly a trading floor as the volume is not big enough and the gains and losses are not great enough for true speculative trading beyond the tight community of sneaker heads.
The SEC’s real goal is to protect the public consumer from toxic trading environments. To me, their regulation backbone seems more moralistic instead of capitalistic. I know… In an open market morality is meaningless. But in SEC case, regulation is demanded by the population, which in this case, wants fair practices. If enough people lose, they will complain, regulation will materialize. In contrast to StockX, in the crypto game, there will be a lot of losers.
NEW TECHNOLOGY AND CRIME
Is all new technology bad? Why does crypto currency, blockchain, and ICOs seem like a criminals playground. Well, there is an argument that if you are playing in the black market or if you are doing gray area things, than you are playing a very high risk game. If you are playing a high risk game you need every advantage you need, therefor, you will adopt the latest technology. This argument claims that all new technology will be first adopted by those who need it the most. When the internet was first created, criminals were the first to adopt it — IRC channels were the backbone for black market communication, when cellphones were first invented it was the drug dealers who carried them, pagers, etc. shoes? wheel? Lol. Some old economist proved this, I forgot his name.
I am just saying that these new technologies have more uses than crime.
GRAY AREA AND POLICY CHANGE
Another argument for cutting edge technology is that they create policy change. If the population wants it enough, legalization of gray area or activities that are perceived or treated as criminal activity will be legalized. Without diving into game theory, there will be governments who embrace ICO and some governments who will regulate it as security trading. It depends on the state of the government and community controlling it.
You can think of all the historical economic crashes and the policy change made after after the population was burned as creating harsher regulations for the safety of the population as a whole. In contrast, you can see a lift on regulations as the community accepts that the regulation is confining positive growth. We saw this recently with UBER, AirBNB, Marijuana, etc.
The question for you is, is your ICO going to impact the population in a positive way so that it will lift regulations off of you? Are you going to be able to run fast enough and raise enough money to fight through all the conversation around policy change?
An important test to understand if your ICO is considered a security or not is the Howey Test. If you pass the Howey test, than you fail SEC regulations.
The “Howey Test” is a test created by the Supreme Court for determining whether certain transactions qualify as “investment contracts.” If so, then under the Securities Act of 1933 and the Securities Exchange Act of 1934, those transactions are considered securities and therefore subject to certain disclosure and registration requirements.
UNDERSTAND THE DEFINITION OF YOUR TOKEN
Can your tokens can be used in your business like an arcade?
If so, it may not be considered a security as the value of the token will not change to the value of the service you receive. However, the token could be used to skirt gambling laws if the token is used to win prizes and those prizes can then be bought for their market value. So understand if you are breaking other laws instead of security laws. This is a famous use case from Japan's underground gambling rings that made the government legalize gambling (a node to gray area policy change).
Is the token mainly bought for gambling on the price of the token going up or down?
If the token is mainly or maybe even slightly bought on market speculation in hopes of monetary gain, it is considered a security.
Is having tokens core to your business model?
If the token is used as a fundraising mechanism, it is not a central part of your business model. A token must be an utility or have a fixed value or else it would pass the Howey test and be considered a security. You will need to prove that this token has fixed value. Perhaps withholding trading for a year or limiting the market fluctuation rate. Which makes the ICO very unappealing. Good luck raising that ICO when you self regulate.3
ICO AS FUNDRASING
If you can answer any of these questions with yes, then you are using your ICO as a fundraising mechanism, therefor your token is considered a security.
Are you using the token in place of an IPO?
Are you using the token in place of venture funding or angel funding?
Are you using the token instead of issuing equity in your company instead?
Are you using the token because crowdfunding your idea legal?
FIXED OR DYNAMIC TOKENS
Here are some fun definitions so you sound smart talking about regulated token economy.
Fixed token — If you issue tokens that are not tradable and always offer the same service, then they stay fixed in value relative to their service.
Dynamic token — If the main utility of these tokens is for speculative trading and hence a holder of the token holds the tokens in anticipation that the value relative to your service will go up due to speculation in secondary markets.
Fixed tokens are not considered securities and therefor may not be regulate by the SEC. Dynamic tokens are for sure considered a security will pass the Howey test, meaning that your token is considered a security.
HIGH COST OF CENTRALIZED VS DECENTRALIZED
It’s much easier to manage ledgers with a centralized source like 100000000X easier and you don’t have to worry about decentralized hacks etc.
If you did a centralized clearing of bearer assets, it can clear so much faster, it does not need proof of work across all nodes to come to a consensus. It is by definition more efficient.
Version control is a pain. Period. For the first time the public is exposed to forks and hard forks in code. If the public needs to understand development details like this, imagine how much planning it takes to execute a fork, or hard fork.
BLOCKCHAIN AS INNOVATIVE TECHNOLOGY
If you had a centralized software packet similar to ERC-20, then you do not need a blockchain. There is no new innovation here beyond what could already be done today. The difference is centralized vs decentralized.
You can do centralized clearing of tokens already providing centralized security. The reason this hasn’t been done is because:
- An exchange requires KYC/AML (anti money laundering process)
- People don’t see the possibility of getting rich fast.
- There is no incentive for the current players to build clearing house as it doesn’t effect their underlying business model.
REASON FOR ICO AND PATH TO ICO SUCCESS
- For now, crypto allows digital regulatory arbitrage — it allows you to skirt regulation and avoid KYC/AML and have your token be traded, raising funds.
- If you somehow do get 1 correct, then you must prove that your token as used by people is more for its service than as a speculative trade.
- If you cannot, then you must only offer your token to accredited investors or provide proper financial filings/regulatory disclosures quarterly.
ICO AS A WAY TO AVOID REGULATION
Crypto for the first time allows digital regulatory arbitrage. It allows you to bypass regulations which will soon be enforced. This enforcement can be be retroactively be enforced too.
ICOs are basically a way for you to skirt regulation and get massive funding from naive retail investors that have hopes of getting rich fast and not really care about the utility of the service. It becomes a ponzi scam that ultimately hurts the economy. It’s a game of hot potato, last person holding the coin loses. Which is why the SEC is already throwing warning shots and why China has banned ICOs as they re-evaluate their policy around security trading, and why you can’t IPO unless you have quarterly filings or you can’t get venture funding unless its from an accredited investor.
You might think, I will just ICO in a country that is ICO friendly. The problem comes if you are planning to do business in the US or any other country that is regulating ICOs and token exchanges. For the US, if your token goes into the hands of a US customer, you are under US jurisdiction, thus your token must only be listed in exchanges that do not serve US customers or not be listed at all.
There are ways around this.m through proxy channels. However, only the most skilled traders will understand this paradigm. Making it more likely to be viewed as a ponzi scam. Which might not have a negative impact on your ICO as skilled traders can pump and dump your coin, unless you are the last entity holding the coin. Then you care a lot. Also, this basically takes away any utility value of your coin.
REGISTERING AS A SECURITY
OK so you might be thinking, just register as as security and run your ICO. By doing that, you are essentially going to IPO as a fundraising mechanism.
- First, It’s going to cost a lot. It requires an entire audit of your company pre-ICO/IPO and quarterly auditing and reporting. If you have a small cap company. It still may run your company anywhere from $200,000 a year to $500,000 a year. Medium cap companies and any help from a notable firm is north of a $1,000,000. I read a good rule of thumb is 1% of your raise will be accounting and reporting costs. I mean there are instances where 60% of a traditional crowdsourced fund raise was used to cover regulation fees so it could be worst.
- Your company operation has to be transparent, listed, and public. Making it hard to make agile business maneuvers, and you might have to deal with voting rights. Regardless of how you cut it, some control of your company will be lost at the demand of the market.
The good news:
- The good is that ICOs are still hot right now and will be for 2–5 years as this new technology takes root at a global scale. Having a coin that is SEC compliant will be, in the short term, a huge market advantage. As being compliant coddles the fear of the SEC marking your operation illegal and forcing the return of funds from an ICO to the investor, negating the ICO.
DECENTRALIZED COMMUNITY VS REGULATION & USER DEMAND
A common argument for decentralized open ledger is that it gives power back to the community. The counter to this statement is that we are already in a regulated community. The current “centralized” community can use regulation to change their circumstances. Community pulling funds and fighting the machine, the centralized government and the centralized bank power seems like just a nice wish. There is however, no incentive from an over all business play to decentralize. Regulation via user demand makes more sense as a market mover. Of course, we can all understand disruption of power and shift of power. The argument that this blockchain based shortcut to decentralization is not powerful enough to disrupt the current players in the industry that you are going into.
PROVING UTILIY vs SPECULATION
This statement is the real test for the value of the utility token.
One way to prove your token is used more for utility than speculation without setting a fixed value peg to your service is don’t allow trading of any tokens until a year after your service is out so people would buy your tokens now and can’t trade for a year.
This doesn’t seem attractive, but it is the only legitimate proof that your token is not a security.
TRANSPARENCY OF YOUR COMPANY, DEV CYCLE, ROADMAP
The volatility of the market creates the need to have very clear and open communication with the community that is holding your coin. Because they are speculating on the worth of your coin, any misstep, slip in communication will fall under heavy scrutiny. You must come up with a concrete execution plan for your technology stack and community adoption then follow it with precession.
I am no advisor, nor do I claim to know the inner workings of security trading. But if you are going to hold an ICO, I recommend a few things to make sure you last through the storm of regulation and market critique.
- Your token must have an utility application.
- Your company must be very open, hit development deadlines on time, have a clear roadmap, or be harshly judged by the public after your initial ICO.
- You must have a very strong security team. This is going to be a large part of your operational cost.
- You should be working on critical DApp features. You could have a commercial use case, but the technology you are building must be core technology to be considered as a true innovation that needs a decentralized token exchange.
SO… SHOULD YOU MOVE TOWARDS AN ICO?
My opinion on executing an ICO is neutral. Cryptocurrency and the technology behind it is a very exciting space and decentralized technology seems to have some interesting implications. Will this disrupt, from a technological level, many industries? Probably not. Does the current ICO ecosystem disrupt security trading and funding models? For now… a little… but not in China anymore lol. In the US, you are for sure going to get a call from the SEC, so you better have your ducks in a row.
The train is leaving the station, don’t be the last one onboard.
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