Setting the Stage — The Future of ICOs

Initial coin offerings, or ICOs, are a complex subject in the world of cryptocurrencies. The harshest naysayers believe ICOs are the biggest scam since Charles Ponzi invented his infamous Ponzi scheme. On the other hand, cryptocurrency proponents truly believe that ICOs have revolutionized the way companies raise money to build their products and deliver value to customers. Which side is right? To judge the viability of ICOs as a fundraising model, we must first touch on a few subjects: the origin of ICOs, how they have evolved, and the regulatory issues they face today.

A Brief History of ICOs

The first ICO occurred in 2013 and was built on the Bitcoin blockchain, as Ethereum had yet to be invented. The project, called Mastercoin, raised over 5,000 Bitcoin (~$5 million at the time) and has since been renamed to Omni. It wasn’t until Ethereum burst onto the seen in mid-2014 that ICOs started to take the shape we see today. Ethereum raised over $15 million while Bitcoin endured a rough bear market. The promise of a platform to build smart contracts, dapps, and eventually issue tokens (which came to be known as ICOs) attracted many who had bought into the decentralization movement.

Ethereum set the precedent as a platform upon which other projects could issue their own coins. Today coins can be issued on other smart contracts platforms like NEO, Stratis, and Waves, but Ethereum remains by far the most popular option. As a method of fundraising, ICOs have only become more popular. Compared to traditional methods like IPOs and VC (venture capital) rounds, ICOs allow companies to bypass tedious regulations and access a larger base of investors. A total of 871 ICOs raised a staggering $6.1 Billion in 2017, according to ICOData.io. We have come a long way since Mastercoin!

The Purpose of ICOs — Speculation or Innovation?

The reputation of ICOs as a method of fundraising has been tarnished by exit scams. An exit scam occurs when a group issues their own coin in exchange for Bitcoin/Ethereum. Then, instead of trying to deliver the product that was advertised in the ICO, the group disappears with the money they raised, and investors are left with a nearly worthless coin. Unfortunately, the same lack of regulation that makes ICOs an appealing venture for projects also gives rise to these types of potential scams.

How have so many people fallen for these types of schemes? The overwhelming reason that most investors buy into an ICO is the potential to sell the asset for a profit at a later date. This type of speculation causes otherwise rational investors to throw caution and due diligence out the window. From a report from Mangrove Capital released in October of 2017:

“If one had blindly invested €10,000 in every ICO, including the significant number of ICOs that failed, this would have delivered a +13.2x (1,320%) return.”

The staggering growth numbers do not tell the full story of the ICO scene. Despite raising billions of dollars, most people heavily invested in cryptocurrency can even admit that ICOs have not resulted in usable products. This Twitter poll gives some insight into the issue.

Initial coin offerings are based around a brand new class of technology that is already difficult to fully comprehend for programmers and developers, let alone for traditional investors. This lack of knowledge has directly contributed to the rampant speculation in cryptocurrency. ICOs have a long way to go before traditional investors can admit that they are a viable long-term fundraising option. Projects must prove that they can accept significant capital from investors during these coin offerings and fulfill their promises to deliver innovative products. Until then, skeptics have good reason to doubt the intentions behind a project raising millions of dollars with nothing more than a whitepaper.

Regulation is Coming

Not surprisingly, the explosive growth in ICO speculation and the persistence of ICO exit scams has warranted attention from regulatory agencies across the globe. China and South Korea wasted no time, announcing a ban on citizens participating in ICOs in late 2017, until there is more clarity on the subject.

Meanwhile, regulatory bodies in the United States have sent mixed signals. The average citizen tends to be skeptical of any government agency’s intentions, but it must be noted that the SEC’s established objective is to protect investors. On the topic of ICOs, their predominant message to US citizens to exercise great caution and conduct their own research when investing in coin offerings.

Setting a Precedent

On July 25th, 2017, the SEC issued a report analyzing the coin offering known as The DAO. The DAO ICO occurred in the summer of 2016 and is remembered for an infamous hack in which nearly one third of investor proceeds were stolen. The report concluded that DAO tokens were indeed a security, and the ICO represented a securities offering. Notably, the SEC also announced it would take no enforcement action.

Since their report on the DAO, the SEC has remained consistent on their interpretation of initial coin offerings. The United States held an important Senate hearing in February of 2018 in which representatives from the SEC, CFTC, and other organizations provided their statements on cryptocurrency regulation. “I believe every ICO I have seen is a security,” Clayton affirmed. Later in the hearing, he elaborated that, “ICOs that are securities offerings, we should regulate them like we regulate securities offerings. End of story.”

What will a regulated ICO market look like?

In times of uncertainty, it is human nature to fear the worst possible outcome. While many are fearing that US officials are preparing to stifle the progress of ICOs with strict regulation, they have expressed quite the opposite sentiment. The following excerpt is taken directly from the SEC website, from an official statement provided by Chairman Clayton in December of 2017:

“We at the SEC are committed to promoting capital formation. The technology on which cryptocurrencies and ICOs are based may prove to be disruptive, transformative and efficiency enhancing. I am confident that developments in fintech will help facilitate capital formation and provide promising investment opportunities for institutional and Main Street investors alike.”

If the SEC or any other regulatory institution did not want the public to be involved in ICOs or cryptocurrency, they surely would take a different tone. Time and time again, they have reiterated that they believe existing securities laws should be applied to ICOs and their teams in order to provide investors with the same protection they receive in the stock market. Chairman Clayton has been clear that he does not wish to see new laws for cryptocurrencies. Before long, we will see ICO teams working with the SEC to file proper documents before going to market, as Chairman Clayton has confirmed himself. Additionally, expect to also see the SEC regulating the trading of ICOs after they have reached the secondary market on exchanges.

Wrapping Up

At the end of the day, the market will innovate around regulation, while uncertainty will continue to put progress on hold. The entire community will be better off with sensible rules that hold bad actors and exit scammers accountable. If a company decided to issue stock to the public and then disappeared with the proceeds, their leaders would be jailed and sued. We deserve the same level of protection and integrity in cryptocurrency. The more we can weed out bad actors, the closer the public gets to adoption. Investors should welcome sensible regulation that will both protect their investments and hold teams accountable. Next week we will explore which ICOs have successfully raised capital and delivered on their promises, and how projects can follow in their footsteps in the coming era of regulation as a follow-up to this article.

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