February 2018 Issue
One of the most significant recent developments in the cryptocurrency market has been the rise of the initial coin offering (ICO). ICOs or ‘token sales’ are a form of crowdfunding used to raise funds for development projects and to launch new companies. Participants in an ICO receive digital tokens in exchange for funds, which are usually provided in the form of bitcoins, ether or another form of cryptocurrency. The funds raised are then utilised to support the development of a blockchain project, such as a cloud storage service or a cryptocurrency exchange.
ICOs are, for the most part, unregulated. They are increasingly being used by start-ups as a means of circumventing the regulated capital-raising processes required by venture capitalists and banks. This increased reliance on ICOs is causing concern.
For regulators, such as the Securities and Exchange Commission (SEC) in the US, some important questions surrounding ICOs remain unanswered, chief among which is whether ICOs should be considered securities. In July 2017, the SEC published a report stating that some crypto tokens may fit the definition of securities and would therefore be subject to certain investor disclosure and registration requirements. There are also question marks over ‘utility tokens’ — multidimensional coins which function only partially as a sort of equity in a network.
The lack of protection offered to investors by ICOs is a cause for concern. A number of jurisdictions recently labelled them as scams or vehicles. In September 2017, for example, the People’s Bank of China denounced ICOs as ‘illegal fundraising’ and banned them, which caused the value of Bitcoin and other cryptocurrencies to fall. South Korea has also banned ICOs, with other nations expected to follow suit. Elsewhere, the European Securities and Markets Authority described ICOs as “very risky and highly speculative investments”.
“For ICO issuers, increased scrutiny will eventually require them to meet higher regulatory standards.”
In spite of the criticism, however, more than 200 startups raised more than $3.2bn worldwide through ICOs in 2017, and proceeds from ICOs exceeded $4bn. They outperformed venture capital funding into blockchain startups by more than double, according to CoinDesk. As a result of this growth, regulators are scrutinising ICOs to see if new rules are needed to protect investors.
As with any investment scheme, governments and regulatory agencies demand transparency, and ICOs are no different. In many jurisdictions, existing AML legislation is inadequate for overseeing cryptocurrencies, since it was designed to apply to mainstream financial services providers. As a result, jurisdictions are drafting new guidance to businesses wishing to conduct an ICO.
Regulatory bodies in the UK and elsewhere have reiterated their commitment to exploring the suitability of ICOs. A December statement from the Financial Conduct Authority (FCA) in the UK noted that “the FCA will gather further evidence and conduct a deeper examination of the fast-paced developments” in the ICO space.
In the US, the SEC chairman Jay Clayton said, “A number of concerns have been raised regarding the cryptocurrency and ICO markets, including that, as they are currently operating, there is substantially less investor protection than in our traditional securities markets, with correspondingly greater opportunities for fraud and manipulation.” The SEC has also announced the creation of a new taskforce – the Cyber Unit – that will focus on cyber-related misconduct, including violations involving distributed ledger technology and ICOs. The SEC has already stepped in to stop the ICO of a restaurant review app, after the company failed to register it as a security.
Investors, too, are taking action. One of the most lucrative ICOs of 2017, a $232m offering for a project called Tezos, is now facing four separate suits by investors who allege that the organisers violated US securities laws.
For ICO issuers, increased scrutiny will eventually require them to meet higher regulatory standards, as well as international anti-money laundering (AML) and Know Your Customer (KYC) legislation. While achieving compliance may be challenging, it can also offer listing organisations the opportunity to better integrate themselves with banks and other financial institutions which may be able to offer financial assistance in the future. Furthermore, regulatory bodies will be more willing to embrace the ICO market if existing AML standards are met. Achieving compliance can also help assuage fears over the legitimacy of a company’s operations, as well as improve investor perception and the reputation of the listing.
How the ICO market will develop in the years ahead is hard to determine. Indeed, the ICO bubble could burst at any time. According to Kaspersky Lab, enthusiasm for ICOs will decline in 2018 after a series of launches fail to create the funded products.
While it would be difficult for ICOs to maintain the momentum gathered over the last 12-18 months, they are likely to remain a feature of the financial services market. Given the increased importance placed on FinTech, cryptocurrencies and technology solutions, ICOs will present at least some investment opportunities of tomorrow. Increased regulatory oversight will be the price the ICO market pays for stepping into the limelight.
© Financier Worldwide
BY
Richard Summerfield