According to the digital currency site CoinDesk, more than US$2billion was raised in initial coin offerings (ICO) in 2017 and the trend is expected to continue. This is the first of two articles looking at ICOs and their regulation.
What is an ICO?
An ICO is a way of raising capital. A company develops and sells units of a new virtual currency (often called tokens) in exchange for fiat currencies or cryptocurrencies, in effect the company is crowdfunding using blockchain and cryptocurrency technologies. Tokens may also be issued as a reward for services provided to the issuing company eg promotion of a product.
Tokens can be divided into two types:
- Security tokens – these are akin to shares in the sense that they can have rights and entitlements attached to them, such as profit sharing or voting rights.
- Utility tokens – these tokens can be exchanged by the holder for goods or services offered by the issuing company and may also be called payment tokens. The most common form allows the holder digital access to an application or service on a blockchain–based platform.
Tokens can be traded between whoever holds them. Typically the tokens have rights attaching to them which are set by the issuing company. There is no market standard as to the rights attaching to tokens.
How does an ICO work?
ICOs are generally announced online. Typically the issuing company will publish a white paper setting out details of the project being funded, the economic terms of the issue and the timetable. Generally, a subscriber is required to transfer cryptocurrency to an online wallet or to the designated address of the issuer. In doing so, the subscriber accepts the terms and conditions of the offering. Tokens may also be issued as reward for other actions eg providing information. Once the ICO is completed, the tokens are transferred to the subscribers’ online wallets or designated addresses.
The issuing company may have its tokens listed on a cryptocurrency exchange.
Advantages of ICOs
- Convenient for blockchain technology users - attractive for companies that are themselves involved in blockchain technologies which can be dependent on networks. If users of networks are also token holders, they will be invested in the success and growth of the network.
- Quick and targeted fundraising - can target large markets online and is potentially faster than traditional fundraisings. Confirming subscriptions and allocating tokens should be simple to implement using distributed digital ledgers.
- Liquidity - if tokens are popular, they will be liquid, much more so than shares in a private company.
- Regulation - there is a perceived lack of regulatory barriers (however see Part II of this article re regulatory framework).
Disadvantages of ICOs / cryptocurrencies
- Liquidity - tokens may not be directly or readily exchangeable into fiat currency.
- Uncertain basis of valuation - token prices may not be based on their fundamental value or utility – ie they are valued at expected resale profit rather than underlying utility.
- Security/ownership - it is generally unclear how a holder of tokens could enforce a claim to ownership against a third party, should a token be lost or stolen (eg due to hacking or flaw in technology).
- Consumer protection - consumers who purchase goods or services using cryptocurrencies may not be covered by existing consumer protection laws.
- Costs - at this early stage, and if the issuing company is doing it in a proper manner, the transaction costs of an ICO will be high. However, as the market evolves, transaction costs should reduce.
- Money laundering - given the nature of blockchain technologies and potential for participants to hide their identities, there are concerns that virtual currencies may be used for money laundering. This leads to reputational issues. There may also be difficulties for issuing companies when seeking to bank fiat currency converted from cryptocurrency, as banks generally require the sources of funds to be identified.
- Data protection - there may be inconsistencies between the nature of blockchain technology (which cannot be edited or destroyed) and Irish and European data protection laws.
- Regulatory issues - ICOs are not specifically regulated and participants may not get the same level of information that they would in respect of a share issue, however a number of regulators have issued alerts to consumers, investors and firms reminding them that existing regulations may apply to ICOs but also including warning regarding the nature of ICOs emphasising that they are highly speculative.
EU Commission Fintech action plan
The EU Commission have committed to reviewing ICOs throughout the course of 2018, with a view to identifying whether specific regulatory provisions are required. See here the Commission Fintech action plan, issued in March 2018.
See part two of this article about regulatory framework for ICOs here.