Home Brokerage Explaining ICOs—the New Investment Craze

Explaining ICOs—the New Investment Craze

by internationalbanker

By Raymond Michaels, International Banker

On August 8, US bank Goldman Sachs reported that the amount raised by cryptocurrency and blockchain start-up companies through early-stage venture-capital funding had been surpassed by that raised by ICOs (initial coin offerings) during the months of June and July. According to Goldman analyst Robert Boroujerdi, “Real dollars are at work here and warrant watching, especially in light of the growing world of ICOs and fundraising that now exceeds internet angel and seed investing”. Indeed, the event is a somewhat momentous occasion for this new investment craze, and reflects just how astronomical its rise has been in 2017.

What is an ICO, or an initial coin offering? It is sometimes referred to by other names such as “token sales” and “token offerings”, but they are all essentially serving the same purpose. ICOs provide a way for a new company—typically a technology start-up that is utilising blockchain technology—to raise money for its ongoing development. In many ways, an ICO is similar to crowdfunding in that financial support for a new project is sourced from the general public. In return, the company issues its own, proprietary digital-currency tokens to those interested backers, who purchase the tokens using existing cryptocurrencies—usually ether and bitcoin, which represent the world’s two biggest cryptocurrency markets at present. As such, instead of attracting customers with venture capital-backed services, as is normally the case for early-stage companies seeking funding, tokens offer disintermediated interaction between the developer and backer and allow capital to flow directly between the respective parties.

The ICO will last for a certain period ranging from a few days to several weeks, during which time a specified portion of the fledgling company’s total supply of cryptocurrency tokens are issued. A difference between a crowdfunding event and an ICO, however, is that while the former mostly relies on donations, those who buy tokens for the latter will invariably receive a return on their investments. Indeed, the overriding incentive for many who participate in ICOs is the opportunity to buy tokens at an affordable price in the hope that the value of each token rises many times over, should the business achieve success. Some companies also offer token-holders specific perks as a reward for participating in the ICO, such as a share of future profits.

However, it should be emphasised that ICOs are not akin to initial public offerings (IPOs). While there are some similarities—for instance, the issuing company in both cases is selling a type of stake to raise funds, while the investor is risking capital to make a profit further down the line—these similarities are easily outweighed by the differences. Much like a Kickstarter project, an ICO is open to the general public, which means that anyone can purchase the project’s tokens; an IPO, in contrast, is normally accessible only to accredited investors who are usually institutional or of high net worth in nature. Unlike IPOs, moreover, there is little regulatory scrutiny over ICOs, nor are they registered with any governmental organisation. That said, this regulatory gap looks set to narrow during the coming months, after recent pronouncements by the US Securities and Exchange Commission (SEC) and the Monetary Authority of Singapore (MAS) that strongly suggest that ICOs will fall under existing securities laws. Furthermore, neither does an ICO constitute the purchase of any equity in the issuing company—tokens are not shares.

After an ICO is completed and the project gets underway, the company’s cryptocurrency token is listed on major exchanges so that it can be accessed by the public and traded against other cryptocurrencies. The value of the token then reflects the market’s assessment of the project’s utility. If the technology works as the company promised investors during the ICO, it is likely to gain popularity, which will be reflected in increasing demand for its token. As the market value of the token increases, therefore, those token-holders who bought in early during the ICO-stage will be able to earn returns should they now decide to sell. In many cases, such returns can be substantial.

The earliest ICO to have taken place is generally accepted as being the offering from Mastercoin, which took place in 2013 and managed to raise more than 5,000 bitcoins in funding. This was then followed by a series of successful ICOs in 2014—in addition to some scams. Ethereum, which is currently the second biggest cryptocurrency market behind bitcoin, also staged an ICO in 2014 between late July and early September, and managed to set a new record at the time for total funds raised from such an event: $18.4 million. While there has been steady growth in the number of ICOs since then, it has not been until 2017 that ICOs have exploded into the mass consciousness. Fundraising records have been broken repeatedly so far during the year, with Swiss-based blockchain company Tezos holding the current title at a whopping $232 million. And given the insatiable appetite investors currently have for ICOs, it seems likely that it won’t be too long before a project manages to generate one billion dollars through a token sale.

Indeed, one need look only at the rate of growth of funding over the last few years to acknowledge the scale and potential of the ICO craze. One of the most popular cryptocurrency websites Coindesk conducted analysis on this very subject between 2014 and July 2017, and found that blockchain start-ups have managed to raise a total of $1.67 billion in ICOs. Of this amount, an astonishing $1.38 billion was raised in 2017 alone, which means that 2017 is experiencing a staggering 600 percent growth rate in ICO funding on an annual basis.

All-time Cumulative ICO Funding (https://www.coindesk.com/1-6-billion-all-time-ico-funding-climbs-as-record-500-million-invested-in-july/)

With July representing the third month in a row in which a new record has been set for total funds raised from ICOs, it would appear that growth will continue accelerating unabated for quite some time.

Clearly part of the growth is down to a snowball effect; with evidence of ICOs raising millions being clear for all to see, they are now inspiring more start-ups to raise funds in a similar manner. What’s more, it may not be too long before ICOs stop being solely limited to new projects; existing companies are also gradually wanting to get in on the action. Social-messenger service Kik is reportedly readying itself to conduct an ICO and introduce its own token, partially as a strategic endeavour to be able to compete with the likes of Facebook and WhatsApp. Should this be successful, it could inspire other companies to follow suit, which would comprehensively boost fundraising numbers in the ICO space.

Part of the uptick in the number of ICOs can also be attributed to the ease with which such events can now be held. Ethereum, in particular, makes running a new project’s ICO on its platform a relatively straightforward process, specifically with the creation of the ERC-20 token, which provides a standard format for new projects to clone their own tokens to be compatible with the ethereum platform. There are now websites that facilitate the creation of tokens for this purpose, which ultimately means that running an ICO on ethereum has become a greatly simplified process.

Given the ease with which ICOs can now be held—and given the evidence of the potentially hundreds of millions of dollars that can be raised from such sales—there is the potential for many scam projects to emerge, however. The absence of clearly defined industry regulation in this regard only exacerbates the dangers for investors. This is perhaps the biggest drawback of ICOs at present, and arguably why they continue to remain divisive among the investment community. As such, some believe greater regulation will help to protect investors from potential scams, whilst also rooting out scam projects before they make it to the ICO stage. That being said, much of the current interest in ICOs and cryptocurrencies in general is down to the innovation of the technology. With blockchain enabling decentralisation, which in turn allows value to be transferred without the need for an authoritative central intermediary, many are wary of regulation having the effect of pushing the industry in the opposite direction, away from innovation and towards a more conventional structure. As such, it would seem a fine line will have to be tread by regulators in order to ensure that both the appropriate investor protections are applied and the innovative spirit of the technology is not suppressed.

Of course, the ICOs themselves can also take the initiative of being in compliance with whatever regulatory requirements are likely to be established in the future. For instance, the recent ICO by the company Filecoin offered just such a proposition by designing an “SEC-compliant” token. Indeed, the ICO ended up raising around $200 million, placing it just behind Tezos on the all-time leader board. The key drawback from the event was that the ICO was open only to accredited investors, which meant that the wider public was prevented from participating. The next logical step, it would appear, would be for ICOs to be both compliant with the rules and provide a way for the masses to be able to take part.

It should also be mentioned that not all ICOs have been unbridled successes. The DAO was one such project that was hosted on the ethereum platform last year. Due to errors in the coding of contracts on the platform, hackers managed to enter and steal millions of dollars. As a result, ethereum developers had to conduct what is known as a “hard fork”, which split the network in two—and why there now exists two separate ethereum markets: Ethereum and Ethereum Classic. Indeed, the problems that emerged from The DAO ICO has informed most of the SEC’s recent rulings on cryptocurrencies and token sales.

The success of ICOs seems to be dependent on a variety of factors. Among the most important, however, is that the company has provided demonstrable evidence that its business model can successfully function in the real world. Invariably, this evidence is provided in the company’s whitepaper, which among several important subjects explains in detail what the company does, how its platform works, the types of real-world problems the company intends to solve, and details of the future supply of its cryptocurrency token. Details concerning the project’s blockchain architecture are also provided, such as the method used by the blockchain network to reach consensus and add new blocks of information to its distributed ledger. As such, investors will often want to see as much detail as possible about the project being provided in the whitepaper, along with rigorous mathematical support of its more technical propositions. Such attention to detail lends the company significant credibility. Indeed, a whitepaper was used in 2008 to announce the first blockchain-based digital currency, bitcoin, to the world.

Other important details that investors are recommended to ideally check before participating in an ICO include the transparency of the team behind the project, whether the project has any notable backers or has formed any notable partnerships, and the general quality of the project’s initial presentation. Indeed, as is the case with investing in any traditional asset, the more information pertaining to the issuer that can be ascertained prior to investing, the better. Indeed, given the lack of regulatory oversight on ICOs at present, as well as the lack of recourse for investors should they be scammed, it is of even more importance for ICO investors to ensure as much due diligence as possible is carried out before deciding to invest in an ICO.

While regulatory issues remain a concern, ICOs nonetheless represent an exciting new frontier, both for companies wishing to raise funds and for investors wishing to provide backing to the innovative world of blockchain and cryptocurrencies. The amounts being raised this year, the growth rate of the overall space, and the largely inclusive nature of the events strongly suggest that ICOs are set to dramatically transform the capital-raising landscape. And the world should start to take note.

 

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