If you haven’t yet fielded any questions from clients about initial coin offerings (ICOs), be prepared. With thousands of ICOs having already launched, investor interest is growing. Given the risks, however, you will want to urge caution when discussing this frothy and unreliable market.
Some people label ICOs as cryptocurrencies, and some call them securities. But what are they really, and how do they work?
ICOs provide launch funding for businesses that run on blockchain technology. Unlike traditional technology startups, such as Airbnb Inc., which makes money as an intermediary by taking a cut from every transaction it processes, blockchain-based systems usually are built to disintermediate by taking the middleman out of the equation and letting people transact directly.
If they’re not acting as middlemen, how do these companies make money? That’s where the ICO comes in.
When people transact with each other through these blockchain-based companies, they use cryptocurrency tokens. Each service creates its own token, which users of the service then use to pay each other.
For example, users of a blockchain-based Airbnb clone (there are several) will use that service’s own tokens to book accommodation directly with each other. Users collecting tokens can then use them to pay others for the same service, or they can cash them in for another service’s tokens, or for fiat currency. To do this, they’ll sell them on cryptocurrency exchanges.
In an ICO, the company’s founders create and sell off tokens to fund the development of the blockchain-based service. Buyers hope that the exchange value of the tokens will increase compared with other tokens or to fiat currency. This will enable them to sell the tokens in the future for a profit.
In some cases, companies may still operate as middlemen, but use an ICO as an easier way to raise funds. In this case, the tokens also may pay their holders a share of a company’s overall profit on an ongoing basis. Either way, an ICO is an end-run around traditional financing methods such as venture capital.
As blockchain technology matures, ICOs are becoming easier to create. Many of them are being launched on the Ethereum blockchain technology platform.
“It’s very easy to whip up a currency, a coin or a token, push it out on the Ethereum platform and you control the distribution and all the different metrics of the project,” says Anthony Di Iorio, founder and CEO of Toronto-based blockchain company Decentral Inc. and one of the founders of Ethereum. “People are using [ICOs] to raise capital to fund ideas and projects. It’s very hot, full of risk, and potentially full of reward.”
The risk is something that has caught regulators’ attention. For several years, ICO organizers deliberately avoided calling the tokens securities to stay out of regulatory scope. More recently, however, that option has disappeared.
The U.S. Securities and Exchange Commission (SEC) issued guidance on ICOs in June 2017, analyzing a collapsed blockchain-based organization called the DAO. The SEC determined that the DAO’s tokens were securities, and therefore fell under existing securities regulations. Since then, at least one U.S.-based company — Munchee Inc — cancelled its ICO offering and reimbursed investors following the SEC’s intervention.
In Canada, the Canadian Securities Administrators (CSA) also outlined rules on ICOs in an August 2017 staff notice that seemed to place many tokens under existing security regulations, but reserved the right to assess each ICO on its own merit. Some ICOs have gained an exemption under the CSA’s sandbox initiative, which lets provincial regulators give fintech companies a temporary pass to encourage startup innovation.
Having explained ICOs to clients, advisors will find themselves fielding the next question: “Should I invest in one?”
The answer should be to tread with care — even more so than with traditional investments — as there’s potential for fraud. Experts point to warning signs, such as companies seeking investment with no product and little information about the management team. Di Iorio has advised on several ICO projects and counsels caution.
“There are so many projects out there,” he warns, “and most of them are predicated on basically a white paper that is just an idea.”
There also are many legitimate projects, but investors may find themselves playing in highly volatile markets. For example, Ethereum launched its own token, called ether, in 2014. From a value of less than US$2 in 2015, it peaked at US$1,410 in mid-January, but then dipped to US$684 in early February.
Many ICOs are akin to unregulated penny stocks. There will doubtless be some gems in the gravel, but finding and exploiting them at just the right time is not for the faint-hearted.
This is the third article in a three-part series on blockchain.