Where the $8 Billion ICO Market Goes From Here
At this point it may be safe to say that anyone with an ear to the ground in the tech industry and their grandmother knows about Bitcoin and the modern gold rush. However, what people might be less familiar with is the world of ICOs.
ICO 101
ICOs, or Initial Coin Offerings, are the sale of unique crypto tokens to the public. These capital raises are relatively new — the first ever ICO was Mastercoin, now known as Omni, in 2013. However, in just a few years, the ICO market exploded in popularity.
In 2017, ICOs raised nearly $6B in cold hard cash. Or rather, in Bitcoin and Ether, the two most popular cryptocurrencies. In the first quarter of 2018, investors handed over another $2B to ICOs.
In return for their money, investors received “utility tokens,” tokens that can be used on a company’s platform in exchange for their services. You can think of these tokens as payment for in-app services and transactions, the means by which the consumer or business interacts with the platform.
What attracts investors?
So why would investors buy these tokens in an ICO and not just purchase them as needed when using the company’s service? Two reasons:
- These tokens are sold at a discount during the ICO, so if an investor is interested in using the platform, it may well be worth their while to buy the tokens ahead of the product launch.
- Secondly, and most importantly, these tokens are traded on exchanges, and with the large degree of price volatility, there is a lot of potential for investors to make (or lose) a lot of money by purchasing and trading these utility tokens.
However, there are problems with the sale of these so-called ‘utility’ tokens, and now the Securities and Exchange Commission of the US government has entered the ring, saying that the vast majority of ICOs to date have been the illegal sale of unregistered securities. What does that mean?
Investor Protection
Let’s talk about context and the worst economic crisis ever faced by the US. After the Great Depression, the US government signed into law the Securities Act to protect everyday Americans from risky investments and hopefully add a greater level of security to their savings. This meant that the general public was excluded from participating in the sale of securities unless a company did an IPO (Initial Public Offering) or if the investor was accredited (meaning they made $200k or more annually for the past two years or have $1M in the bank).
The Securities Act is the reason that venture capital and angel investors are such a big part of the conversation when it comes to companies raising rounds of capital: historically they were some of the only ones who could do it.
However, Obama changed this with the JOBS Act in 2012, which introduced exemptions from registration in the Securities Act if certain conditions were met (i.e limits on capital raises, filing paperwork, etc). This meant companies could now raise capital through the sale of securities (equity, common stock, debt, convertible note) to non-accredited investors. Or, the general public could now buy stock in early-stage startups.
The problems with ICO 1.0
So what does this have to do with ICOs? The majority of ICOs have been selling their tokens to the general public, and that majority were selling securities. You may have guessed the problem already: they weren’t using the aforementioned JOBS Act exemptions.
But why are these tokens securities and not the utilities they’re labeled as? It’s simple. Many of these tokens do not have the utility they claim to because the platform they are intended for isn’t even built yet!
More problematic is the fact that these utility tokens are being traded on exchanges. One of the classic trademarks of a security is whether investors purchase them with the anticipation of turning a profit. If they do, then you guessed it, it’s a security.
Not only does this mean that most ICOs have illegally been selling unregistered securities, but most exchanges have been illegally trading securities too. This leaves investors exposed to bad actors, fraud, and manipulation. It also means that many ICOs were launched that shouldn’t have launched in the first place.
That’s why 46% of ICOs from 2017 have already failed in the first quarter of 2018 alone.
How we fix it and build the ICO 2.0
To be clear, this doesn’t mean the ICO marketplace is being shut down. Not by a long shot. But it does mean that the industry needs cleaning up and regulation to function properly and to grow.
While $8B may not seem like much compared to the $30 trillion US market cap, remember that this growth happened in just a year. Even with its problems, the ICO market isn’t going anywhere. There’s too much potential, and neither companies nor investors are willing to let go.
So where do we go from here? The future of ICOs will look like the development of the western US in the late 1800s. The days of the crypto pioneers are over. The digital frontier will be fenced in and irrigated. Law and order will be introduced. There will be a sheriff.
More specifically, ICOs will have to file their raise with the SEC and use exemptions from registration under the Securities Act, including:
- Regulation CF, in which companies can raise up to $1.07M from the general public in a given year
- Regulation D 506(c), in which companies can raise from accredited investors only, but with no cap limit
- Regulation A+, in which companies can raise up to $50M from the general public in a given year
For ICOs, this means no more instant launching, and for the most part, no more utility token raises. The ICO 2.0 will be an industry dominated by security tokens and the sale of securities. It will require paperwork and planning, but shouldn’t all capital raises work this way? ICOs can no longer build a token in just two hours of coding and make hundreds of millions of dollars when there is not even a functioning business plan in place yet.
On the secondary market, most of the crypto exchanges that trade tokens will be shut down as any exchange trading securities must be registered with the SEC. There are only 20 or so registered exchanges in the US. Competition is steep. Instead, we will see companies become broker-dealers, firms that buy and sell securities to investors as a principal, and then register as an ATS, an alternative trading system, that allows buyers and sellers to trade with each other.
The future will be regulated. Anti-money laundering laws, know-your-customer laws, bad actor checks. There were reasons these were introduced to the financial world, and in the next year we will see these laws and more become requirements for ICOs. The consequences of ignoring them: fines, returning all money to investors in a rescission, and possibly jail time.
Does this mean the process of launching an ICO will be slower and more expensive? Yes, but it also gives the ICO marketplace the chance to grow far beyond its $8B beginnings. Regulation isn’t a bad thing. It is exactly the tough love that ICOs need to be taken seriously by the rest of the world.
