Initial coin offerings (ICOs) – also called token sales or crowdsales – are an unergulated, fast, high-risk, and commonly Ethereum-based crowdfunding mechanism for early-stage digital asset ventures. In ICOs, funds are raised by offering investors cryptocurrency tokens which act as a kind of voucher that may be traded for some resource or special feature of the venture in the future (e.g. storage space, datasets, etc.), in exchange for legal tender or other cryptocurrencies. ICOs might also sell investors royalties or a right of ownership to the project instead of cryptocurrency.
ICOs are commonly compared to IPOs. However, there is a crucial distinction: in ICOs, investors purchase a piece of the ecosystem of a venture’s future technology project or platform, whereas in IPOs, investors buy shares (i.e., they take a piece of equity) in the owership of an operating company, becoming owners of part of the company’s cashflow and profits. Even so, some ICO campaigns do design their tokens to represent ownership in the company, effectivley turning their tokens into securities, which are subject to state regulations (read more in section 3.2 “Comparison with IPOs and securities” below).
Through ICOs, early-stage ventures effectively bypass the regulatory oversight of securities commissions and markets, and void the need for venture capitalists. Because they are not currently regulated, the ICO market is a territory rife with scams.
Ripple Labs may have been the first company to raise funds for an early-stage project (the Ripple platform) through a cryptocurrency token sale (the XRP), in 2013. However, Mastercion is often quoted as being the first to have called their token sale an ICO. In July 2013 Mastercoin raised 5,000 BTC, valued at around $500,000 at the time. Coins like Mastercoin and Litecoin were created by forking the Bitcoin source code and adding original features.)
In 2014, Vitalik Buterin created a new blockchain, with its own Turing-complete programming language (Solidity), called Ethereum. Ethereum was desgined to make the creation of blockchain apps with associated cryptocurrencies easier for anyone, without a need to bootstrap a blockchain network themselves,) thanks to the ERC20 protocol standard. Buterin described it as “decentralised mining network and software development platform rolled into one”. The Ethereum blockchain’s tokens are called Ether. Ethereum is the quintessencial example of a sucessful ICO project. The smart contracts platform’s’s ICO raised $18 million in Bitcoins ($0.40 per Ether). At the time of its initial campaign in mid 2014, Ethereum became the second most crowd-funded project in the history of the Internet.
In early 2016 an ICO was held by The DAO. The DAO was an open source, automated (run solely on code, no human intervetion besides backers), digital organization and venture capital fund, seeking to provide a decentralized business model for organizing both commercial and non-profit enterprises. At the time it set the record for the largest crowdfunding campaign in history, for approximately $150 million. The DAO was run by smart contracts set up on the Ethereum blockchain.
In June 2016, hackers exploited a vulnerability in The DAO code to siphon off 3.6 million ether to a subsidiary account. On 20 July 2016 01:20:40 PM +UTC at Block 1920000, the Ethereum community decided to hard-fork the Ethereum blockchain to restore virtually all funds to the original contract. This was controversial, and led to a fork in Ethereum, where the original unforked blockchain was maintained as Ethereum Classic, thus breaking Ethereum into two separate active blockchains, each with its own cryptocurrency. The DAO was delisted from trading on major exchanges such as Poloniex and Kraken in late 2016.
ICOs first became mainstream practice after the Canada-based messaging app developer Kik launched its ICO in September 2017, summoning over 10,000 investors and raising 168,732 ETH (around $47.5 million at the time, with ETH selling at $282), plus $50 million raised in a pre-sale for institutional investors. In connection with this ICO, an unidentified third party executed a phishing scam by circulating a fake URL for the offering through social media.
The concept of airdrops appeared in August 2017 when the company Omise airdropped their “OMG” tokens to every wallet that held more than 0.1 ETH. Rather than doing a public sale of tokens, some ventures just give tokens away for free to promote them. The airdrop trend began to pick up speed in early 2018.
Accoring to Icodata.io, there had been 400 ICOs during the first three months of 2018, with a total raised of $3,063,681,886. According to Coindesk.com, by February 19th 2018, the all-time cummulative funding of ICOs was at $8.84 billion.
How ICOs are implemented
A venture looking to hold an ICO to fund a their tech project should ideally already have a solid sketch of an original platform that satisfies some need in the crypto community, and understand if and why their platform needs its own token. Additionally, the venture should be clear on how the token will be offered and what currency (be it fiat or crypto) will be accepted in exchange. Regarding legal issues, ventures can benefit from having a lawyer on board who understands KYC and AML laws, and who can check how the tokens will be defined and (possibly) regulated under different jurisdictions. Ventures can chose to base their operations in jurisdictions that are more amicable to their business plans.
A project’s technological proposition starts out explained in a Position paper, which after being circulated in a community and tweaked according to feedback can be developed into a more in-depth whitepaper. A serious white paper specifies architectures, scripts, user flow, market strategy, a value proposition, and details about the team involved in making the projects work. It is also a good idea to include token distribution terms, and a description of funds use.
On this topic, blockchain developer Collin Thompson says “The more sophisticated crypto/blockchain companies will offer a Yellow paper, or a second “technical” white paper, that will take much of the first two papers and actually present in scientific detail the technology and the innovations that they have created, or propose to create. In many cases the technology is tested and/or peer reviewed.”
After a period of sharing the whitepaper on Reddit, Telegram, Slack, Bitcointalk, Quora, or other social channels (ads are also a possibility, although Facebook and Snapchat have banned ICO ads), ventures will first create an original token. If they do it on Ethereum, they must follow the standard guidelines of ERC-20, so the tokens will be usable on currency exchanges and in cryptocurrency wallets with minimum implementation hassle.
Token creation and release
Most ICOs are based on the Ethereum blockchain, an open-source distributed computing platform featuring smart contract functionality created specifically to make it easier for developers to create blockchain based apps and cryptocurrencies instrinsic to their ecosystem (see “History of ICOs above”). Ethereum’s programming language, Solidity, and the protocol standard ERC-20, enable and standardize the creation of these apps and coins.) Smart contracts are the program that will control the token sales. They act as escrow, holding the tokens and releasing them to individual public addresses upon receipt of payment. Another popular platform for token creation is Waves. Still, other ventures prefer to create their own blockchains from scratch.
Ventures will create tokens, which are then either airdropped or offered for sale during a specified time period. During this period, backers that are effectively convinced of the project’s future success will purchase the tokens, either to use in the venture’s platform once the project takes off, or to hold them in the hopes that the tokens become more valuable with time and can be traded on exchanges for a profit.
Motivated by the delays experienced in waiting for tokens to be listed on exchanges, some ventures opt for holding a pre-ICO. This is a way of giving investors access to tokens before the official crowdsale begins. Pre-ICOs usually offer the tokens at a lower price than will be offered in the official ICO. Pre-ICOs are also a recurrent method amongst ventures that do not yet have a tight circle of investors, as a means to get the word out before the real sale. In this latter case, pre-ICOs are even riskier for backers than regular ICOs.
In the context of ICOs, bounty programs consist of ventures offering tokens to backers in exchange for their completion of some tasks, such as marketing, bug reporting or bettering the cryptocurrency framework.
ICOs are under the scrutiny of governments around the world, both because the tokens issued have been compared to securities, whose trade is subject to strict regulations, and because many ICO campaigns have turned out to be fraudulent.
Risk and fraud
ICOs are considered a high-risk investment because they are typically run by tech or cryptocurrency ventures that are at an initiation stage. It is often the case that these start-ups do not even have operational code or a running network yet. Ventures will offer potential investors a whitepaper and landing page that describes the goal of the project, the amount of capital needed, and how the tokens being offered will work. Often case ICOs are reported to present whitepapers that lack any real depth, or that have little to do with the actual project. Some even report on ICOs that hire whitepaper writers to embellish fake whitepapers.
Investors are frequently warned about fraudulent ICO campaigns, which abound thanks to the abscence of regulation under most jurisdictions. Newcomers (“newbies”) to the crypto world are advised to beware of ICOs whose numbers do not seem to add up and whose whitepapers lack technical depth and make grandiose promises while providing no explanation as to how the venture will deliver on them. Potential backers must bear in mind that ICOs offer no guarantees of project implementation, that the initial price of tokens is fixed only according to the project team’s whim, and that there exist no regulations that prescribe, nor authority that can enforce, a quality standard on ICO whitepapers.
Peter Van Valkenburgh, research director for the blockchain advocacy Coin Center, warns “(m)any token sales are outright securities fraud that differ little from a typical pyramid or Ponzi scheme”.
Comparison with IPOs and securities
The tokens issued in ICO campaigns fall into a legal gray area, with proponents arguing they do not constitute securities and detractors contesting that they do. The question of whether ICO tokens are securities is important because the sales and purchases of securities are strictly regulated by states’ securities commissions. If ICOs became regulated, their whole purpose would be voided.
Securities are defined and regulted slightly differently under different jurisdictions (see table below), but in a general sense, they are intangible tradable financial assets that derive value from a contractual claim. They are described by the Encyclopedia Brittanica as “written evidence of ownership conferring the right to receive property not currently in possession of the holder.” Bonds and stock are common examples of securities; while bonds represent debt, stocks represent equity. Backers that invest in IPOs, for example, are buying stock in a company, and this action is regulated according to the jurisdiction under which the IPO is held.
ICO tokens are sometimes described as ‘representing a share’ in the venture that issues them. Although ICO tokens are – at least in theory – not meant to represent stock or ownership in an operating company, it is possible that an ICO might purposefully design their tokens as securities. To escape the definition of security, tokens must be designed to be a piece of the venture’s technology ecosystem, a utility token that gives the owner access to a specific protocol or network – they must not be designed to represent ownership in the venture.
International regulation and bans
On July 25th 2017, after an investigation on DAO tokens, the United States Securities and Exchange Comission (SEC) announced that ICO tokens would be regulated as securities, and stated that offer and sale of such securities should be registered, or be subject to criminal punishment. On the official website, SEC states “offers and sales of digital assets by “virtual” organizations are subject to the requirements of the federal securities laws. (…) Whether a particular investment transaction involves the offer or sale of a security – regardless of the terminology or technology used – will depend on the facts and circumstances, including the economic realities of the transaction.” This means that, in the U.S., whether or not ICO tokens being sold count as securities will depend on each ICOs specific case.
In September 2017, after the success of the Kik ICO, the Chinese Central Bank became the first to officially ban ICOs, with the Korean central bank following closely behind. In January 2018, Facebook banned ads pertaining cryptocurrency, binary options and initial coin offerings.. In March 2018, Twitter banned ads pertaining to promotion of cryptocurrency and initial coin offerings.
A week before the 2018 G20 summit in Argentina, International Monetary Fund Managing Director Christine Lagarde stated that, while the technology behind cryptocurrencies offered exciting advancements that could empower people in low-income countries who lack traditional bank accounts, there was a “peril that comes along with the promise”, namely in the form of a potential new vehicle for money laundering and the financing of terrorism. https://www.nytimes.com/reuters/2018/03/13/technology/13reuters-g20-imf-cryptocurrencies.html
In a letter to central bankers and finance minister, the head of the Financial Stability Board (FSB), Mark Carney, claimed that the FSB’s initial assessment was that crypto-assets do not pose risks to global financial stability and there is no need for global rules, despite Japan’s earlier calls for global regulation.
After the G20 2018 summit, the finance ministers and central banks of the group issued the document “Communiqué Finance Ministers & Central Bank Governors 19-20 March 2018”, in which they committed to implementing the FATF standards “as they apply to crypto-assets, looking forwards to the FAFT review of those standards” and called on the FAFT to “advance global implementation”. The FAFT, or Financial Action Task Force, is a Paris-based intergovernmental organization that designs and promotes policies and standards to combat financial crime. The document acknowledges cryptocurrencies’ potential for “efficiency and inclusiveness” but also the issues it raises concerning “consumer and investor protection, market integrity, tax evasion, money laundering and terrorist financing.” Furthermore, the document’s authors “call(ed) on international standard-setting bodies (SSBs) to continue theoir monitoring of crypto-assets and their risks, according to their mandates, and asses multilateral responss as needed.”
Jurisdictions and ICOs
Jurisdiction can refer either to the authority (of a court, for example) to interpret and apply the law, or as the territory within which said authority may be exercised. ICOs will be treated differently under different territories’ jurisdictions. Some jurisdictions (Singapore being a prime example) have created guidelines (or a “Sandbox”) to help ventures figure out whether their ICO is legal, and to provide guidance and monitoring during the regulatory process. Ventures are advised to follow these guidelines to avoid legal trouble.
Many ventures have preffered to set up their ICOs in Switzerland, which is a Civil law jurisdiction with a variety of different types of vehicles available for to tech start-ups. Liechtenstein and Mauritius are also popular jurisdictions.
|Australia||Australian Securities and Investments Commission (ASIC) issued guidance in September 2017 stating that the legality of an ICO depends upon its detailed circumstances. According to an August 2017 government statement, a new bill is to “close a regulatory gap by bringing digital currency exchange providers under the remit of AUSTRAC; strengthen AUSTRAC’s investigation and enforcement powers; increase police and customs officers’ search and seizure powers at the border; and provide regulatory relief to industry through the deregulation of low-risk industry sectors.”|
|Canada||Though Canada is working on regulating ICOs, the jurisdiction is overall quite friendly towards crypto-assets, with The Royal Bank of Canada even considering in putting credit scores on a blockchain as of March 2018|
|China||On September 4, 2017 seven Chinese financial regulators officially banned all ICOs within the People’s Republic of China, demanding that the proceeds from all past ICOs be refunded to investors or face being severely punished according to the law. This action by Chinese regulators resulted in large sell-offs for most cryptocurrencies. A week later, however, a Chinese financial official stated on Chinese national television that the ban on ICOs is only temporary until ICO regulatory policies are in place.|
|France||As of October 2017, the Autorité des marchés financiers (AMF) was working on regulations governing the use of blockchain technology in capital raising transactions.|
|Hong Kong||The Securities and Futures Commission released a statement in September 2017 explaining that tokens may constitute securities for purposes of the Securities and Futures Ordinance, in which case dealing in such tokens would be a regulated activity under Hong Kong law.|
|Isle of Man||Working on regulating ICOs.|
|New Zealand||In October 2017, the Financial Markets Authority (FMA) released guidelines on the current regulatory environment in regards to ICOs.|
|Gibraltar||In October 2017, the Government of Gibraltar published regulation establishing a framework for regulated DLT (Distributed Ledger Technology) companies to become effective on January 1, 2018. This regulation encompasses ICOs and subjects them to financial controls and standards.|
|Republic of Korea||The Korean Financial Services Commission banned ICOs in September 2017 and promised stern penalties for violations.|
|Switzerland||Although Switzerland was previously viewed as a friendly jurisdiction to coin offerings, the Swiss Financial Market Supervisory Authority announced an investigation of an unspecified number of coin offerings in September 2017, and would examine whether these offerings were in compliance with Swiss regulations.|
|United Arab Emirates||The Abu Dhabi Global Market issued official guidance on ICOs in October 2017.|
|United Kingdom||Britain’s FCA has issued a public warning regarding ICOs, stating that only experienced investors should participate in them so long as they are “confident in the quality of the initial coin offering project.”|
|United States||In July 2017 the U.S. Securities and Exchange Commission (SEC) indicated that it could have the authority to apply federal securities law to ICOs. The SEC did not state that all blockchain tokens (ICOs) would necessarily be considered securities, but that determination would be made on a case-by-case basis.|
ICOs and cryptocurrency market volatility
Coins produced for an ICO are normally traded on smaller exchanges like Etherdelta, because there is usually such a low volume of them. Consequently, they have a potential to quickly increase orders of magnitude in value (compared to coins with larger markey caps). A large buy order can completely clear through the sell orders, and the price oscillate violently between high and low extremes.
Some users speculate that the recent surge in ICOs is affecting the price of ETH, since many backers are buyin in order to contribute to these ICOs. The sudden demand may be making the price of ETH rise, while the subsequent release of ETH back into the market by the ICOs’ venture is having the opposite effect, lowering the price again.