When cryptocurrency started to gain momentum not too long ago, the curiosity surrounding Initial Coin Offerings (ICOs) also thickened. ICOs have been a fertile ground not only for start-up businesses to thrive but also for buyers to invest in audacious yet promising projects.
Before you start thinking about taking part in an ICO, it is important for you to first be familiarised with what it is and how it works.
What is an ICO?
An initial Coin Offering is a kind of crowdfunding in which new cryptocurrencies are released and sold to investors in exchange for other cryptocurrencies like Bitcoin or Ethereum. There are also projects that accept fiat money such as US dollars. Instead of shares, the investors are given electronic tokens or coins which signify their stake in the project and their share in the profit from its eventual success. Through this, blockchain technology developers and other start-up companies are able to raise the amount of funds needed to support their project.
If the targeted funding is met and the project succeeds, the tokens or coins bought by investors then turn into functional currencies. Although very limited information is revealed about the project upon announcement, those who invest in these new cryptocurrencies do so because of the probability that in the future, the coins may be worth a lot more than the money they initially spent.
The use of Initial Coin Offering to fund new cryptocurrency-related projects has continually increased since its inception in 2013. It has paved the way for start-up companies to be able to raise capital more quickly. With its growing popularity in a dynamic digital era, it just might completely transform the traditional financial system we know today.
History of Initial Coin Offerings
The first ever ICO, which was hosted by Ripple, took place in 2013. Ripple Labs developed a payment system and made approximately 100 billion XRP tokens which were then sold to investors in order to fund their platform.
In the same year, a few other projects started to use the same crowdfunding scheme. Mastercoin proposed the idea of creating higher level protocols based on the existing Bitcoin network and introduced improved regulations for contracts. This would result in the production of new currencies without altering Bitcoin or calling for the establishment of an alternate blockchain to manage new regulations.
At the time, Mastercoin intended to issue new currencies to refine the stability of Bitcoin and provide a new value to the existing Bitcoin network. This added layer could give Bitcoin users the opportunity to produce new smart contracts inside the Bitcoin system. These smart contracts were used to facilitate and enforce the negotiation of contracts, which permitted smart properties like bonds and stocks to be electronically traded.
Lisk is another cryptocurrency that relied on an ICO for funding. It has maintained a steady growth since it first sold its tokens for approximately $5M in 2016, encountering only a few minor setbacks in the following months.
In 2014, Ethereum sold its tokens for 0.0005 Bitcoin each and gained roughly around $20M. Its notable success further propagated the advantages of smart contracts.
ICOs continued to gain popularity in 2017. By that time, there had been 18 websites tracking and analysing the development of ICOs. One of the biggest projects funded by an ICO was the messaging app Kik. The developers were able to raise close to $100M after issuing $50M in tokens to multiple investors.
How does an ICO work?
For every ICO, there is a particular funding goal that must be met. This is why every token issued has a fixed price which doesn’t change for the duration of the entire period of the ICO, therefore making the token supply stagnant.
Even with a constantly changing funding goal, a stagnant token supply can still be maintained. In this case, the amount of tokens to be distributed would depend on the amount of funds received.
Another case is having a dynamic supply that depends on the amount of funds coming in. In this case, the price of each token is fixed, but each time a token is sold, another one is created. A limit can be set with regards to the time frame or funding goals.
The ICO process begins with setting up the blockchain and protocols where ICO data is made known. The developers mine for coins to be sold at the ICO from several websites associated with cryptocurrency. This phase is where they market their upcoming project in order to attract as many investors as they can. It usually lasts for a month, targeting both institutional and small-time investors.
After the marketing campaign, developers establish an exchange resembling that of a stock exchange at an Initial Public Offering (IPO). At this point, it is important for investors to open an account with the said exchange so that they can purchase the new cryptocurrency using either fiat money or existing cryptocurrencies.
Advantages of ICOs
The main advantage of ICOs is their potential to democratise opportunities for wealth generation which is manifested in the following:
No Accreditation Needed
Anyone can buy tokens during an ICO. You don’t have to be an accredited investor, unlike in an equity sale. There is no required net worth in token sales because upholding such a restriction could cripple the information industry. This also leads to a significant increase in the overall buyer base for financing start-ups.
Decentralisation
Another highlight of ICOs is the accessibility of token sales. They can be put up for sale internationally and on the Internet. Digital currency transactions occur from different countries across the globe. This permits a more instantaneous approach to financial transactions without the presence of intermediaries like central banks which traditional funding entails. Because the sale of tokens is open to the entire population, it can raise funding more efficiently than the conventional equity funding for a start-up company.
Huge Profit Potential with Fewer Restrictions
ICOs offer a tremendous profit potential for both investors and project developers. The project being funded is not subject to direct taxes, unlike companies that rely on IPOs for initial funding.
Faster Liquidity
In contrast to the traditional way of investing in start-up companies, ICO tokens are liquid. A price is attached to each token immediately upon its sale in an international open market, and investors have the freedom to cash in and cash out whenever they please, converting their ICO coins into other cryptocurrencies without any hassle, especially if demand is high. ICOs allow for a much faster liquidity rate, unlike equity sales where it takes years for seed money to be liquidated.
Criticism and Risks of Investing in ICOs
Although there have been plenty of success stories from those who have participated in an Initial Coin Offering, the risks behind it should also be carefully examined. Some of these include:
Unpromising Projects
Not all projects are bound to succeed, and in these cases, the tokens you initially purchased could potentially lose their value. You could end up losing a large sum of money by investing in a development with a feeble foundation.
Lack of Regulation
In the cryptocurrency economy, it pays to be sceptical and heedful before investing your money in start-up companies. Regulation over ICOs is still weak considering that this crowdfunding mechanism is done over the Internet using digital currency. These conditions make it difficult for regulators to ensure the protection of the buyers’ sensitive information. Alongside the perks of cryptocurrency transactions being decentralised is the susceptibility of your stored ICO tokens to being hacked by anyone.
Fraudulent Projects
There are project developers who disappear once the fundraising process is completed. These fraudulent projects might be quite effective in deceiving even the most prudent investors. If you fall into this kind of trap, there is little to no likelihood of recovering your money. Always be diligent in doing your research to ensure that the project you are investing in is not a scam. Check reviews and analysis done by people also engaged in the business to verify an ICO’s credibility. Crush Crypto, Bitcoin Talk and Reddit are popular platforms where members discuss and analyse ICOs.
Fluctuating Token Value
The value of ICO coins or tokens changes very quickly depending on their popularity. Because the tokens are highly connected to other tokens in the market, their values tend to rise and fall together. This applies even to projects that don’t have much in common with each other. This makes it difficult for you to diversify and broaden your investments.
Are ICOs Legal?
The answer to whether or not ICOs are legal remains unclear. ICO tokens are not sold as financial assets but as utility tokens which provide owners access to a certain network. They are only considered digital goods and cannot be deemed as a type of financial security.
Stable regulation for ICO funding is still in the works. This makes it very swift in terms of financial procedure but also high-risk without an experienced lawyer to guide you. However, there are certain jurisdictions that regulate ICOs in the same manner as IPOs being regulated by the government. This is evidently due to the remarkable growth spurt of decentralised autonomous organisations (DAO).
Generally, the future is bright for Initial Coin Offering regulation, and it is likely to gain widespread attention sooner or later. But keep in mind that there is also a trade-off in this scenario. Compliance with standard rules of regulation could lead to a more bureaucratic process, eliminating this emphasised advantage of ICOs over conventional funding schemes.
Regulation
The rapid boom of Initial Coin Offerings has driven more and more entrepreneurs and project developers to participate in this phenomenon. In fact, more than $8 billion was raised through ICOs in 2016 while the three biggest IPOs only made $5 billion in January of 2018. With that, there has also been plenty of progress in the regulation of ICOs, taking into account reported incidents of market manipulation, fraud, and cyber theft. Each country has a different approach in regulating cryptocurrencies.
Just recently (April 2018), China has temporarily banned all ICOs until regulatory policies are put into effect. All proceeds raised from previous ICOs were returned to the investors. But other countries have a more open attitude towards ICOs.
The regulatory status of ICOs depends on the nature of the cryptocurrency, the jurisdictions of its issuance and the rights associated with it.
There are two main token categories to consider: utility tokens and security or asset-backed tokens. Utility tokens allow the investor to trade the token for another good in the future and have free-floating prices in the market while security tokens provide the investor with an underlying asset which can be assigned a certain value. Security tokens are more likely to require regulation because they are directly related to the development of the company or project.
Due to the token classification, issuers find it complicated to choose which countries they are allowed to sell their tokens in, and in turn, buyers have a hard time understanding the kind of regulations that apply. However, this challenge isn’t hindering many different countries from implementing a more rigid regulation.
The UK Financial Services Commission is establishing a set of criteria for authorised sponsors of ICOs who will be monitoring compliance with certain financial security standards. The US Securities and Exchange Commission has also announced its authority to implement federal securities.
The application of existing securities to regulate ICOs is also being adopted by Canada, Singapore and Australia.
Warning on the moneysmart.gov.au website
Exchanges that Trade ICOs
A digital currency exchange is a business that lets customers trade using cryptocurrencies in exchange for other cryptocurrencies or fiat money.
Bittrex remains the largest cryptocurrency exchange which doesn’t accept fiat money, only tokens. This is where most ICOs want to be registered in.
Poloniex also accepts token deposits alone, but it is reportedly challenging for ICOs to be listed here due to stringent criteria.
EtherDelta is known for frequently updating their list of newly issued ICO coins but is not recommended for beginners as trading here might be quite tricky.
Binance, based in China, is considered to be one of the fastest growing exchanges and lists new tokens according to market demand.
You can learn more about ICOs on the MoneySmart and Investopedia websites. About regulations, check ASIC.
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