Initial spice offering
In 1602, wealthy Dutch merchants banded together and formed the Dutch East India Company through a royal charter. The merchants, formerly competitors in the spice trade, decided to join forces to exert greater control over the flow of spices coming in from voyages to the East Indies. The company became the first in modern history to conduct an IPO (initial public offering), raising funds to build a large fleet. The company’s shares were the first ever to be listed on a stock exchange, allowing investors to trade them in the market.
Fundraising has taken many forms over the centuries. The internet made it expedient to reach out to donors or investors worldwide. In 2008-09, firms such as Indiegogo and Kickstarter revolutionized crowdfunding with their innovative platforms, making it easier for entrepreneurs to access capital without going through regulatory hurdles involved in IPO’s. Triggered by the sudden and unexpected rise in popularity of blockchain and crypto assets, the last few years have brought to limelight a new force in fundraising – the ICO.
ICO’s or I See 0’s?
The term ICO (Initial Coin Offering) refers to raising funds by issuing new tokens or coins to the public. Investors participate by exchanging their crypto assets for the newly issued tokens. This is analogous to stock market investors committing funds to purchase newly-issued company shares in an IPO. However, ICO tokens usually do not represent equity in the issuing company. The first reported ICO was that of MasterCoin (later renamed to Omni), issued on Bitcoin’s blockchain in July 2013. The ICO raised 5,000 Bitcoins in the process, then trading at approximately USD 100 each.
Roughly a year later, Ethereum’s founders funded the development of its blockchain by raising 3,700 Bitcoins. They raised those funds, worth about USD 2.3 million at the time, within 12 hours. Ether was issued at a price of 30-40 cents each at the time. Ether’s price reached a peak of over USD 1,400 in January 2018, though it currently trades at USD 123.
Ethereum, launched in 2015, was a game-changer for token issuances. Its blockchain is coded in Solidity, a Turing-complete programming language. It allows for programming of complex “smart contracts”, which can perform transactions on the blockchain based on predetermined logic (like a series of “if-this-then-that” conditions). Such smart contracts also allow for issuance of fungible (such as ICO tokens) or non-fungible (such as Crypto Kitties) tokens on top of Ethereum’s robust and battle-tested blockchain.
ICO’s have transformed into a massive fund-raising industry in the last two years. As recorded by Conschedule.com, ICO’s have raised over USD 22 billion in 2018 so far, up from USD 6.6 billion raised in the year 2017. EOS and Telegram (the popular mobile messaging app), raised a total of almost USD 6 billion this year.
It’s the sheer size of funds raised, and lost, that has caught the attention of regulators worldwide. In a study published in October 2018, Ernst & Young reported that 86% of the ICO tokens issued in 2017 are currently trading below their issue price, and 30% lost substantially all of their value. It also noted that only 10 of the ICO’s were responsible for 99% of the total ICO gains.
Problem with ICO’s
The purpose of a majority of ICO’s to date has been to raise capital so that the issuing company can build the protocol on which those tokens can be used. The protocols in most cases have not yet been built at the time of the ICO’s. In fact, the Ernst & Young study also observed that at the time of publishing, 71% of the 2017 ICO projects still did not have a working prototype. Matt Levine, a Bloomberg columnist, described it the best; ICO’s are like if the Wright brothers sold air miles to finance invention of the airplane.
This means that most of the “utility tokens” have no utility, because the applications for which they were meant to be used don’t exist. There is no decentralization as the decentralized application doesn’t exist. The invested funds go to the founders, and there are no guarantees that the utility will exist in the future. Investors rely on the abilities of the individuals working on the projects to create the utility for those tokens.
Its due to these reasons that the SEC views such tokens as securities. They pass the Howey Test for the definition of securities. According to the decades-old test, a contract is an investment contract (and hence a security) if it satisfies the following criteria:
- It involves investment of money or assets;
- There is an expectation of profits from the investment;
- The investment is in a common enterprise; and
- Any profit comes from the efforts of a promoter or third party.
In essence, many of the ICO tokens are securities, but the issuers prefer labeling them as utility tokens to avoid dealing with regulators such as the SEC.
There are low barriers of entry for launching low-cost platforms that are popular for trading ICO tokens. These exchanges are not burdened with rules and regulations required to run traditional exchanges. Concepts such as KYC and AML are largely ignored, and they on-board any investor and trade any coin or token if the founders are willing to pay their fees.
Some of these exchanges may even engage in front running, washed trades (investors trading back and forth to drive artificial liquidity) or pump and dumps, and get away with it since they are unregulated.
Why STO’s may be better
A new form of fund-raising has emerged from issuers looking to develop and market their tokens in a more regulation-friendly manner. In an STO, or Security Token Offering, investors receive a security in the form of a token. Unlike ICO’s, STO tokens are usually backed by a known element, such as assets, equity, revenues or profit. They are akin to shares that represent equity stake in a company. In order to sell security tokens to the crowd, a company has to register the offering with a regulator such as SEC, which can be a difficult and expensive process.
Most of the STO’s are registered using one of SEC’s exemptions such as Reg D, which entails public offering of securities to accredited investors. This regulation means that a company can solicit only qualified investors, and investors must be verified through KYC procedures before they can participate in the STO.
Alternatively, STO’s may use Reg Crowdfunding (CF), in which both accredited and non-accredited investors can participate in the offering. The caveat is that an STO can raise a maximum of USD 1.07 million in a given year under this regulation.
A less popular but important regulation that an STO can use is Reg A+, which like Reg Crowdfunding allows the general public to participate, and the annual limit is increased to USD 50 million. Also, there is no lock-up period for trading the security tokens registered under Reg A+, unlike Reg D and Reg Crowdfunding (where there is a lock-up period of 1 year). However, the offering must be qualified by the SEC, which is not mandatory with the other exemptions.
Another common exemption used by issuers seeking global investors is Reg S. It prohibits issuers to solicit US-based investors, thus avoiding the need to determine whether an investor is accredited or not.
Other countries have different sets of regulations, but with similar high-level objectives of information disclosures and investor protection as the American regulations. In the UAE, Abu Dhabi Global Markets (ADGM) published their first guidelines in October 2017 on how token offerings and virtual currencies can be regulated. The head of UAE’s Securities and Commodities Authority (SCA) made in announcement in October 2018 that the SCA may soon allow companies to raise funds in the country, and that regulations around this may be released in the first half of 2019. Such support from the authorities would attract innovators, and encourage them to incorporate their companies in the country and raise funds through regulated STO processes.
What to expect in future
As the marketplace gets more sophisticated, there will be fewer scams and fraudulent offerings. Wary of the recklessness observed in 2017 and early 2018, the investors will express a greater demand for security tokens backed by assets. This is especially true for institutional investors, that are familiar with the risk-reward relationships observed in conventional securities and the regulatory frameworks governing the securities.
The owner-operator of the St. Regis Aspen Resort concluded its STO in October 2018, raising USD 18 million in the first token offering hosted on Indiegogo. Each Aspen Coin represents a share in a single-asset real estate investment trust (REIT) that holds the investment in St. Regis Aspen equity.
However, it will take some time before the ecosystem supporting security tokens can be built at the same scale as that exists for ICO tokens. Besides heavy upfront legal and compliance costs, the other major disadvantage of STO tokens is that they are not yet supported by big crypto exchanges such as Binance. Also, the lock-up requirements of Reg D and Reg CF tokens may not be popular with investors in current ICO’s. These investors enjoy the instant liquidity offered by crypto exchanges, an overwhelming majority of which are currently unregulated.
STO tokens will need to be traded on Alternative Trading Systems (ATS) or with broker-dealers, which are closely supervised by FINRA and registered with regulators such as the SEC. These ATS’s and broker dealers have high operational costs associated with supervision, compliance, hiring of licensed employees and training of staff. Platforms such as Coinbase and Indiegogo have made acquisitions and forged partnerships with registered broker-dealers to facilitate trading of STO tokens.
The Dutch East India Company was hugely profitable for its investors. At the peak of its share price, fueled by the tulip trade bubble, its market value rose to USD 7.9 trillion (in today’s dollars). Its investors did not have much influence over the company itself (they did not have shareholder meetings) besides the ability to buy and sell shares. Doubtless the well-timed and early movers were handsomely rewarded, and many lost their money when the tulip trade bubble had burst. However, it is safe to assume that every one of the numerous recovery cycles over its two centuries of existence would have attracted an increasing number of investors, issuers and brokers to the market. Similarly, interest of big investors will return and entry of regulated brokers will hasten if and when crypto markets recover from their current slump.