Initial coin offerings are more than just another economic bubble

Increasingly, start-ups issue their own digital currencies through ICOs. Critics fear another digital bubble is forming, whereas tech enthusiasts predict a financial revolution

 
An ICO is similar to a crowdfunding campaign: investors purchase a slice of the issuing company’s currency reserves to fund a project or use it on the company’s platform as a token
An ICO is similar to a crowdfunding campaign: investors purchase a slice of the issuing company’s currency reserves to fund a project or use it on the company’s platform as a token 
Author: Alex Katsomitros
November 3, 2017

When Jorge Izquierdo and Luis Cuende founded Aragon, they had a digital revolution in mind. The company helps organisations build their management structures through blockchain, the distributed ledger that underpins digital currencies, also known as cryptocurrencies. But its founders’ ultimate goal was to build a network that would provide a universal digital jurisdiction to blockchain companies, entrepreneurs and investors.

The only thing missing was money and user engagement. Last May, they aquired both of these in one stroke, following the steps of other blockchain companies that have issued digital currencies through initial coin offerings (ICOs). “We realised that developing the software was not enough.

We needed $5m to fund development and a way to bring companies to the network. The best way to do that was to create tokens through a token sale,” Izquierdo told World Finance.

An ICO may sound like a digital IPO, but it is more similar to a crowdfunding campaign: investors purchase a slice of the issuing company’s currency reserves to fund a project or use it on the company’s platform as a token. In many cases, they resell their tokens on digital currency exchanges.

The experiment surpassed Izquierdo’s expectations. ANT, Aragon’s token, raised $25m from 2,403 investors in less than 15 minutes – the biggest ICO ever at the time. “We had previously seen some interest and expected to meet our market cap, but we thought it would take a few hours,” said Izquierdo.

The Spanish duo hadn’t disclosed in advance how much money they would raise to keep away ‘whales’ – speculators who, in Izquierdo’s words, “have tons of money, buy as much as they can, and then sell it on exchanges”.

The trick helped Aragon raise an impressive sum. But its founders were scared of their own success, according to Izquierdo: “We were worried that we had gone too far and had to turn away institutional investors.”

The coin-minting business has experienced unprecedented growth this year. Blockchain companies had raised around $700m through ICOs by mid-summer, seven times the figure for 2016, according to Smith and Crown, a blockchain research firm. Autonomous NEXT, a financial research provider, estimates the number to be even higher, at $1.3bn.

The boom has contributed to a rally in the price of digital currencies whose value approached a record $100bn in July.

Critics claim that ICOs have created a lawless marketplace of high margins and speculative bubbles. Others fear that this is a digital Ponzi scheme, constantly pushing investors to buy new cryptocurrencies of little real value with other cryptocurrencies.

According to Dr Garrick Hileman, Research Fellow at the Cambridge Centre for Alternative Finance: “While the ICO boom has attracted talented entrepreneurs who are capable of delivering truly innovative ideas, it has also attracted a number of unsavoury characters looking to make a fast buck. ICO investors need to understand this is very much a Wild West-type environment, and I expect a number of funded projects to end badly.”

Some companies openly embrace volatility and even mock the cryptocurrency frenzy. A cryptocurrency named Useless Ethereum Token raised $40,000 in July. Its pitch was honest and preposterous at the same time: “UET is a standard ERC20 token, so you can hold it and transfer it. Other than that… nothing. Absolutely nothing.”

But the ICO boom is also a by-product of broader trends in finance. Low interest rates in western markets have pushed investors to look for opportunities in unlikely places.

According to Tony Yates, Professor of Economics at the University of Birmingham and a former economist at the monetary policy directorate of the Bank of England: “There is still a huge demand for places to store savings and wealth, a feature of the last years since the emergence of the new Asian economies, which have wanted to export capital to us. This has driven up asset prices and probably stoked innovation in finance.”

But for Izquierdo, some degree of speculation is welcome: “Speculation shows that there is some value in the market. The fact that cryptocurrencies are tradeable allows miners [cryptocurrency enthusiasts who generate new currency units] to have a price in mind and know they will be able to convert to dollars anytime. It also brings early adopters who starting using Ether or bitcoin, even if they are doing it to speculate.”

A new way of fundraising
For start-ups, issuing digital money is an easy way to raise capital, unshackled from obligations accompanying traditional fundraising methods. Tezos, a smart contract platform, raised $232m in July, while Bancor Protocol, a token conversion protocol, raised $153m in June.

Even established companies are rushing to get a slice of the market. Kik Interactive, a Canadian company that has developed a messaging app used by over 15 million people, will issue 10 trillion Kin tokens to be used on its platform.

Cryptocurrency enthusiasts claim that ICOs hold the promise of democratising start-up finance. Pamela Morgan, a US attorney and CEO of Third Key Solutions, a consultancy specialising in cryptocurrencies, said: “ICOs give access to a vast and global pool of new investors who have been traditionally excluded from access to such investments. Start-ups now have a completely new avenue for funding, bypassing traditional venture capital models, which are themselves only available to few start-ups.”

But innovation creates legal grey areas, said Morgan: “Many [start-ups] are choosing to move forward without choosing a jurisdiction or clearly delineating rights and responsibilities. This creates a potential legal minefield for start-ups because, in theory at least, they are subject to the rules of investment in every jurisdiction where their investors reside.”

A regulatory quagmire
For regulators, ICOs pose a question that goes to the heart of the cryptocurrency conundrum – are they securities, commodities, currencies or something completely new? It is a hard question to answer, given that cryptocurrencies combine a security’s price fluctuation, a commodity’s scarcity and a currency’s use as a medium of exchange.

Some experts reject the view that new regulation is necessary. “Existing regulations that govern, say, banks, probably already cover [cryptocurrencies]. So they would presumably be categorised as high-risk and with no security for any such intermediary that wanted to hold them,” said Yates.

The ICO boom is also a by-product of broader trends in finance. Low interest rates in western markets have pushed investors to look for opportunities in unlikely places

But regulators worldwide have rushed to intervene, often sending contradictory messages.

In the US, the Commodity Futures Trading Commission classifies digital currencies as a commodity. But in July, the Securities and Exchange Commission ruled many cryptocurrencies will be classed as securities, a measure that will force issuers to register with the regulator.

In China, the government’s tight grip on monetary policy and the lack of investment opportunities has pushed investors towards cryptocurrencies. Around 83 percent of bitcoin trading in the first half of 2017 was carried out on renminbi exchanges, according to Bitcoinity, a bitcoin data provider.

ICOs were particularly popular among retail investors, incentivising the central bank to consider regulating ICOs and even issuing its own cryptocurrency. However, in a surprise U-turn, on September 4 the People’s Bank of China announced an immediate ban on ICOs altogether, citing a lack of regulatory oversight.

Unless increased regulation and greater scrutiny are introduced to the market, this ban may become a permanent feature.

For its part, the blockchain community is averse to regulation that may stymie innovation. Dan Larimer, a cryptocurrency veteran and Chief Technology Officer at Block.one, a start-up that raised $185m for its EOS cryptocurrency, said: “Regulators are the primary cause of bubbles in real estate, equities, and bonds, [so] how can we expect them to do any better in crypto? Attempting to prevent bubbles is price fixing and market manipulation, which will necessarily be biased in its application to the detriment of all.”

Breaking the law
As expected, the nascent cryptocurrency market has attracted its fair share of crooks. During CoinDash’s ICO in July, a hacker changed the receiving address, stealing $7m from investors. Aragon faced similar problems: “When our token sale ended, a friend texted me that there was a fake Twitter account claiming it was selling our tokens,” said Izquierdo.

The company promptly notified Twitter, which took the account down several hours later, but many investors had already sent money without ever receiving tokens. Many cryptocurrency exchanges have also been accused of facilitating money laundering: in July, a US jury indicted the operator of BTC-e, a digital currency exchange, who allegedly laundered at least $4bn for illegal activities such as drug trafficking.

Some regulators hope to tackle the issue by adjusting existing legislation. The European Commission has updated anti-money laundering legislation to include cryptocurrencies as vehicles for illegal activity. But education might be more effective than legislation, according to Morgan: “The idea that policymakers can ensure flows of money are not used for money laundering and fraud is a fiction. Instead, we need to educate people on how to identify fraud and enhance their critical thinking skills.”

Assuming that ICOs mark the beginning of a new era in finance, a different mindset is direly needed, according to Morgan: “Sometimes a change is so significant that when it comes along, we’re inspired to rethink systems entirely. Bitcoin, open blockchains, cryptocurrencies and cryptoassets are the catalyst for that sort of systemic evolution.”