Initial Coin Offerings (ICOs) are a largely unregulated means for companies to raise capital without undertaking the costly and legally intensive process of an initial public offering (IPO).
Purchasers of ICOs receive tokens, similar to shares in a stock offering. Like an IPO, early supporters in Initial Coin Offerings hope to profit from an increase in value of the ICO tokens as the company or product matures. When ICO issuers flourishes, early investors can be rewarded greatly.
With the potential of massive returns, ICOs have captured increased public interest and token sales often make the financial pages. This graph from Google Trends shows the exponential increase in search traffic for “ICO” in the fourth quarter of 2017.
But there’s a reason that U.S. and Chinese wannabe-investors are typically excluded from most high-profile ICOs these days – government regulation. Or, perhaps more pertinently, the fear of imminent imposition of as-yet uncodified regulations.
Nobody wants to be issuing a token that could be construed as a security, especially not to unaccredited investors. Anti money laundering regulations might even come under the microscope and that’s when things get really messy.
The famous Howey Test, created by the US Supreme Court to see if a transaction qualifies as an investment contract, already hangs over a lot of tokens like the Sword of Damocles. That Howey Test could be a painful moment for the cryptocurrency market and that explains why industry insiders have been trying to drive regulatory frameworks of their own in recent months.
Cryptocurrency Scams Are Common
To begin with, a largely unregulated market with many participants looking for quick riches, breeds scams like roaches. OneCoin, described as a Ponzi scheme by The Atlantic, defrauded investors of over $350 million with blockchain technology that was a “glorified Excel spreadsheet and a fugazi portal that displayed demonstrably fake transactions”.
Besides outright scams that don’t have any blockchain technology at all, ICOs also face risks associated with exchanges that may be vulnerable to technological errors and exploits. One investor lost $70,000 worth of ether on a failed purchase attempt for the AirSwap ICO. Just this month, BEE token investors lost hundreds of thousands of dollars in a phishing attack. Investing in ICOs carries extremely high risk with the potential for extremely high reward.
Using the term “investing” to describe ICOs results in controversy and debate. Currently ICOs have insisted they are not securities offerings, however regulators may soon begin to clamp down. If that happens, a token sale will be a whole different proposition.
As reported by Fortune, Securities and Exchange Commission (SEC) Chairman Jay Clayton made a strongly worded statement on ICOs:
“First, and most disturbing to me, there are ICOs where the lawyers involved appear to be, on the one hand, assisting promoters in structuring offerings of products that have many of the key features of a securities offering, but call it an “ICO,” which sounds pretty close to an “IPO.” … I have instructed the SEC staff to be on high alert for approaches to ICOs that may be contrary to the spirit of our securities laws and the professional obligations of the U.S. securities bar.”
AML/KYC regulatory requirements are examples of rules that some ICOs may not be following. KYC regulations stand for “Know Your Customer” and are the process by which a business verifies the identity of its customers, for example by requiring copies of passports or other forms of government identification. Accredited investors is a common term, but it isn’t always true.
AML regulations are “Anti-Money Laundering” rules designed to help detect and report money laundering or terrorist financing activities. Compliance with AML/KYC regulations will be an important step for companies wishing to issue securities in the form of tokens or coins.
One interesting company which hopes to transition ICOs from an unregulated market to a mainstream financial product is Polymath. The goal of Polymath is to provide a service which allows the issuance and trading of security tokens while meeting all applicable regulatory requirements. Polymath aims to guide companies through the complex and expensive technical and legal challenges of a token launch.
But as an indication of the complexity and depth of the issue of securities regulation, partnerships are paramount – Polymath is working with IdentityMind Global, a digital identity-based compliance, risk management, and fraud prevention company, and Agrello, which adds smart contract expertise to the mix.
“We know a stampede is coming from capital markets to blockchain. Polymath is creating the technology platform that helps to form the basis of a security token. In this new world, regulatory compliance and insight into the identity of issuers and investors is a must if sophisticated financial products are going to migrate to the blockchain.” – Trevor Koverko, CEO of Polymath
Compliance on token sales from ICO issuers is not a bad thing, since those companies that show good faith in their willingness to work within a broad framework that we might define as “the spirit of the law” may not be penalized for failing to abide by the letter of the law. It’s the same reason that many taxpayers, without clarification on exactly what the IRS wants, will likely find that their willingness to declare *something* is better than a reticence to declare anything.
The story of ICOs continues to be written. It remains to be seen if the legacy of ICOs will be tarnished by scams and hacks, crippled by regulation… or possibly continue to evolve, and change the way companies raise funds in the future.
Financial Disclosure: The author holds long positions in Bitcoin and Bitcoin Cash. The author holds no short positions. The author holds no positions in Polymath or any other company discussed in this article.