Why and how regulators should embrace ICOs?

The history of the financial investing world is full of innovations that created new avenues for opportunity but also encouraged fraud and ‘irrational exuberance’, forcing authorities and regulators to step in and protect citizens from the dangers of unregulated financial activities. Bitcoin, cryptocurrencies and ICOs are simply the latest in a long line of financial innovations that should and will be embraced by regulators to ensure they are conducted in the correct manor. Let’s take a look through some of the key events in financial history and how they have led us to where we are now.

The Solomon vs. Solomon ruling allows for future financial innovation-1896)

One of the largest events in the evolution of human innovation was the verdict in the landmark case of Solomon vs. Solomon Corporation in 1896 in the UK which meant that shareholder running the company were segregated from the liabilities of the company itself. Business owners and shareholders could become more enterprising, and if their business did not work, they will not have to be held hostage to the demise of that company. Arguably, if this ruling did not happen, we may not have witnessed the tremendous innovation we saw in the last 120+ years from millions of entrepreneurs.

The great depression leads to the SEC and the enforcement of regulation — 1934

In the early nineteen hundreds, ravenous, inexperienced investors were pumping money into the stock market which was growing in importance (sound familiar?). This inevitably led to Black Tuesday and the great depression. The US government responded by setting up the SEC and giving it far reaching powers to enforce financial regulation.

Regulation failures set the scene for the birth of Bitcoin — 2008

On the 15th September 2008 we witnessed the $653bn bankruptcy of Lehmann Brothers the largest corporate bankruptcy in history, despite being highly regulated by several global authorities.

This and other bankruptcies (eg Enron’s $60bn bankruptcy in 2001) lead some people to question whether the current corporate structures we find in large corporations are the right way to go. Let’s examine this.

There are various stakeholders involved in governing a company. Directors such as the CEO and CFO hold shares in the company and focus on short term profitability to satisfy their shareholders and their fiduciary duties. Then we have shareholders who hold great influence over company directors and are notoriously driven by short-term profits. The regulators seek to minimize the opportunities for companies to engage in unsavory tactics to generate profit. Most customers of the company have very little say in how things are run. It is this structure that led to the thinking around a different financial model after the 2008 financial crisis.

Disaffection leads to the foundation of Bitcoin — 2008

The world’s first cryptocurrency, Bitcoin was introduced in a whitepaper in November 2008, a few months after the Lehmann Brothers bankruptcy, for one major reason — to get away from a centralized system where financial institutions, states and regulators were not trusted and users had more say in how things are run. Bitcoin has been one of the major disruptions of the 21st century. Who would have imagined in 2009 that people would be giving away almost $5,000 of their real hard-earned money for 1 virtual coin of a digital currency which nobody owns, no central bank guarantees, is not backed by any gold or any other asset.

Enter the ICO — 2013

The incredible rise in the value of Bitcoin led to the creation of the most exciting funding innovation in recent history — the Initial Coin Offering (ICO). Simply put, an ICO is the advanced sale of a platform’s crypto-currencies or tokens, to fund the development of fund raising company’s platform and product. These tokens can be easily sold and traded at anytime, on all cryptocurrency exchanges depending on their demand, providing liquidity to investors and vital early stage funding for entrepreneurs. These tokens are essentially the incentives, for several market participants to use and grow the platform in a decentralized manner. Such incentives are paramount in making a decentralized eco-system operate sustainably.

Much like the cryptocurrencies that fund them, ICOs have experienced exponential growth in 2017 and in the past few months have raised more money than early stage VC funding has, a cool $1.5billion. Companies like Filecoin, Bancor, Tezos, EOS.io have each raised more than $150 million in a matter of hours making ICOs an incredibly successful instrument to raise funds for the development of a new application or platform.

Why ICOs make sense

These are the key reasons, why ICOs have enjoyed so much success:

  • There is a willingness among the community to decentralize control, away from large corporations
  • Investors are participating very early on in the process, hoping to repeat the success of early stage Bitcoin investors who saw its value rise from a few cents to $5,000+ within 7 years, creating generational wealth for some investors.
  • The surplus money people generated from early investments into cryptocurrencies are being re-invested into new cryptocurrencies.
  • A genuine desire to fund some interesting causes and projects that are closer to the crypto-investors’ hearts.
  • Limited liquidity (supply) of tokens means that as the use of token and platform grows, the value of tokens should grow as well, generating strong returns for the early-stage crypto-investors. ICOs are also beneficial to smaller investors as early stage crypto-investments are not limited to private investors or VCs, anyone can take part in a token sale, similar to the concept of Kickstarter, where people fund or support projects which they feel would be successful and effective.

Looking at ICOs from a regulator’s perspective

It is a regulator’s job to protect investors from unscrupulous activity and with ICO investments at record levels, it’s no surprise that regulators have stepped in to limit unsavoury activity and encourage best practice within the ICO community. The challenges regulators face include founders raising funds through ICOs with nothing but a whitepaper then disappearing, difficulty governing cryptocurrencies that are hard to track and companies choosing ICOs over traditional fund raising methods to avoid being regulated under the usual securities laws.

· Regulators have started to respond since July 2017:The SEC has said that if the token is a security, then it falls under the Securities Act

· Canada, Singapore, Hong Kong, have echoed similar statements with a warning to investors to be cautious in their investment process.

· China has banned all ICOs within the country. The ban is thought to be temporary while they figure out how to regulate ICOs. Sooner they come with guidelines, better it would be for removing such wide blanket bans.

But if we take a step back, the idea of Bitcoin was to get away from centralization, including regulation. If we introduce new coins / tokens in some regulated environment, are we not defeating the purpose of cryptocurrencies? Are we not trying to create new breed of tokens that can shift the economic structure of companies but then regulating them back so they become securities? Realistically, regulation is unavoidable as there is now far too much money involved in ICOs and cryptocurrencies, so much like the peer-to-peer funding industry actively sought out and encouraged financial regulation, the ICO industry should work with regulators to draft laws that protect investors and prevent illegal activity whilst still encouraging innovations in technologies and corporate structures. These would be my suggestions to regulators who would be considering regulating ICOs:

1. Introduce KYC processes within ICOs

This can be useful for various compliance requirements such as:

· Tax laws (helping tax authorities figure out if some investors had realized or unrealized profits on their tokens).

· Ensuring any country-specific compliance is met.

· Protecting against money laundering.

· Allowing for a certain accredited investor base for certain kinds of ICOs.

2. Introduce guidelines for ICO documentation and process

Potentially inspired by existing IPO and other fund raising processes:

· Clearer disclaimers marked in the ICO papers about investment risks.

· Ensuring company exists by including its registration / audit reports, etc.

· Including comprehensive details about the team, product and business.

· Post investment audits are periodically shared with the investors

3. Classify the tokens before regulating them

As Canadian regulation says, each token is different and should be evaluated independently (CSA staff notice, 46–307 “Crypto currency offerings” released by CSA Canada):

· Tokens that are cryptocurrencies like Bitcoin or Ether could be regulated in a similar way to the fiat currencies.

· Tokens that mimic securities — that give ownership in the company, are for profit investments, etc. may be regulated within existing or enhanced Securities laws.

· Tokens that are for in-platform use only may continue to be unregulated or lightly regulated if needed. In principal, they are very similar to loyalty points, frequent flyer miles, vouchers, or even tokens for games. These are typically not treated as securities and for now are generally not regulated.

ICOs have witnessed incredible growth in the last few months but may face some challenging times while regulators figure out what to do to them and certainty returns to the market. But I truly believe that constructively curated regulation that encourages ICOs to challenge imperfect corporate structures can lead us to a much better decentralized digital world.

ICOs — Why they work and What to watch out for?

It wasn’t very long ago that Bitcoin and other similar crypto-currencies disrupted the financial ecosystem. It surpassed the US Dollar, other fiat currencies and even gold. Pretty soon it earned the title of “digital gold” and broad the fame, and infamy, that would inevitably come with such a moniker. Similarly, other crypto-currencies like Ethereum tripled in value and Ripple skyrocketed. The whole ecosystem of crypto-currencies exploded with their total market capitalization rocketing past $100 billion, as this blog was written. Large Investment Banks like Goldman Sachs and Fund Managers like Fidelity are taking these currencies seriously now. This rapid momentum has led to the birth of more than 900 crypto-currencies, all looking for a piece of the action.

This rapid growth also drew attention to a key technology that crypto-currencies rely on — blockchain. People soon realized that blockchain technology could be used for an incredible variety of use cases with companies like IBM, financial institutions and other big players placing big bets on the technology, which we do not agree with, by the wayas decentralisation is lost when institutions use blockchain for running their eco-systems.

In 2013, this all let to the creation of the most exciting funding innovation in recent history — the Initial Coin Offering (ICO). Simply put, an ICO is the advance sale of a platform’s crypto-currencies or tokens, to be used within their platforms or outside, in advance, to fund the development of their platforms. These tokens can be easily sold and traded at anytime, on all crypto-currency exchanges depending on their demand. So, an ICO is when a company raises money in bitcoin or other crypto-currencies for the technical development of their projects. These tokens are essentially the incentives, for several market participants to use and grow the platform in a decentralised manner. Such incentives are paramount in making a decentralised eco-system operate sustainably.

Much like the crypto-currencies that fund them, ICOs have experienced exponential growth in 2017 and in the past few months have raised more money than early stage VC funding has, a cool $1.2billion. Companies like Filecoin, Bancor, Tezos, EOS.io have each raised more than $150 million in a matter of hours. ICOs so far has proved to be an incredibly successful instrument to raise funds for the development of a new application / platform.

These are the key reasons, why ICOs have enjoyed so much success:

  • There is a willingness among the community to decentralize control, away from large corporations, large internet firms and financial regulations.
  • Investors are investing very early in the process, hoping to repeat the success of early stage Bitcoin investors who saw it’s value rise from a few cents to $4,900+ within 7 years, creating generational wealth for some investors.
  • The surplus money people generated from early investments into crypto-currencies, is being re-invested into new crypto-currencies.
  • A genuine desire to fund some interesting causes / projects that are closer to the crypto-investors’ hearts.
  • Limited liquidity (supply) of tokens means that as the use of token and platform grows, the value of tokens shall grow as well, hence fetching decent returns for the early-stage crypto-investors.

ICOs also carry a key benefit for the little guy that in that early stage crypto-investments are not limited to private investors or VCs. Anyone from any part of the world can take part or invest in any company that is offering their tokens for sale. Very much like the concept of Kickstarter, where people fund or support different projects which they feel would be successful and effective so the potential of the project plays an important role in raising funds during an ICO. These projects are usually technology driven and somehow relate to crypto-currencies, blockchain and decentralization.

In order to achieve mass appeal, the whole ICO process generally remains quite transparent and open all the way to the completion of the fundraising. ICOs are also comparatively easier and faster than traditional VC and angel fundraising, which usually takes at least 6 months for a Series A raise.

What are the general challenges with ICOs?

Like any new industry or innovation, ICOs have many challenges as well. Several projects have been, and may continue to be funded on random ideas including: an average team, unqualified project plans with a weak whitepaper, and a website. And importantly, no product / MVP to show. How is an investor to know if the concept works and whether the team can actually build it if there is no demo?

Here’s what you can do as a potential ICO investor to help avoid these pitfalls:

  • Spend some time doing proper due diligence for each ICO plan.
  • Do a lot of research on the team behind the ICO, they are the ones that are going to deliver the success or failure.
  • Read reviews done by third party investors, authors and critics of the ICO plan and then make up your own mind.

You need to answer these question in your own mind: “Do I think this team can successfully build and grow this concept?”

  • Are they creating the project to raise funds through ICO or are they running the project and exploring ICO as one of the fund raising alternates?
  • Do they have an MVP (minimum viable product), and team, and clients / users? This should help one differentiate from idea stage investing versus business scale up investing?
  • How will the company use the funds in building / scaling their business / project?
  • Test to see if they fully understand their token structure.
  • Are they getting enough tokens for the investment?
  • Have any other investors been offered more discounts on the same tokens in recent past?
  • Are the tokens integral to platform’s success?
  • Consider getting a third party crowd sourced technical reviews (github for example) on token structures as well as token privacy / security

The considerations mentioned above are mostly the same steps an angel investor or VC would take when assessing an investment, just adapted for the ICO environment. If ICO investors start pursuing the same diligent approach to their investments they will be able to find much more ‘investable’ ICOs and it would also help the maturing of the industry.

ICO boom vs Dot Com boom

The ICO hype is comparable to the Dot Com boom in 1990s. Most business plans with a website idea were getting funded. The bubble eventually burst, and thousands of companies with flawed business models were instantly purged but those that were credible survived, creating incredible value eg Google, Amazon, eBay etc. All ICO investors should challenge themselves to find the next Bitcoin or the next Google amongst the upcoming flurry of ICOs by identifying sustainable and scalable businesses.

There is a lot of debate as to whether ICOs are any different to VC or angel funding. At the end of the day, ICOs are a new way of raising funds for good business ideas just like any other form of investment. VCs arguably bring more value with their team’s experience and network contacts, as well as the money they invest. Either ways, there will be space for Angel investors, VCs, Crowdfunding platforms, and ICOs. We believe all these eco-systems can co-exist.

Legal challenges of doing ICO

There has been significant negative media coverage in August 2017 around jurisdictional backlash against ICOs. In my humble opinion, the negative news, especially their titles (like can you be hanged in china for doing an ICO) had been exaggerated and misrepresented the crux of the jurisdictional stances.

Let’s evaluate in which scenarios you should or should not do an ICO,

1. If you are truly planning to run your platform / business as you say you will and with integrity — An important aspect of fund raising is to be honest about it, whether you do it through an IPO, or VC, or Angels, or Crowdfunding, or ICO. If you misrepresent anything (especially intentionally), or do not do as you say you would, then you can get into trouble. It can be due to regulatory reasons or legal battles with investors or possible in some other way. There are millions of cases around the world where regulatory crackdown or investor lawsuits have caught the people behind scams eventually.

ICOs are no different. If you are doing an ICO because you believe its a quick way to raise money and then run away (as you believe ICO investments through cryptos are anonymous), then think again and ideally do not do it. You can get caught years later and face severe penalties in different jurisdictions.

But if you truly wanna run your business and build community / platform, you can consider doing ICO.

2. If you are raising ICO by possibly offering your Coin / Token as a Security, without complying with Securities laws — If your coin / token classifies as a security (there are several tests for this in different countries, including as defined by investor bulletin ” Initial Coin Offerings” dated July 25th 2017, issued by SEC US and CSA staff notice, 46–307 “Crypto currency offerings” released by CSA Canada), then consider registering your token under the Securities Act in respective countries. FYI, Canada has clarified in the example, that if your token is used for play games on a platform, then it may not be a Security.

i.e. If your token is to be mainly used for your platform’s services, and you are not selling it as for profit as investable instrument, then it may not be a Security. In which case you may consider doing an ICO.

As an important example, think about Airline’s frequent flyers miles. They can be bought, but are useful mainly for airline’s travel, upgrade, lounge access and other similar services primarily. Or think about loyalty schemes from various companies. I do not think they are considered as Securities anywhere in the world (barring a few exceptions), and are regulated under Securities Laws. (PS: They may be liabilities on your balance-sheet though)

– Regarding the stance of other countries on ICOs, Singapore and Israel have cautioned the ICO investors and are likely come out with guidelines soon.

– Given a major chunk of the Bitcoin is in China, several ICOs focus on Chinese investors. And due to several ICOs potentially not being integral, Chinese Authorities have also said they will come with firm guidelines and given their stricter regulations, it’s risky to do an ICO there.

– Japan and Australia seem positive on the ICO market (or not negative for sure)

– BUT no regulator has banned ICOs, or issued firm guidelines, at least as yet.

As a matter of abundant caution, several ICOs are currently not permitting US residents due to strict nature of Securities laws. Some may omit Canada, Singapore and China too. (This information is updated as of 2nd Sep 2017)

3. Your local jurisdictions must be followed— You can do an ICO, if your country of domicile has not banned it or issued guidelines against it. Make sure you comply with other applicable laws too. For example, if your country is domiciled in countries like India, its highly risky to do an ICO, because even crowd-funding is not allowed in the country, and authorities can come back with retrospective rules (as on date, authorities have cautioned investors against crypto investments like bitcoin, which are not even recognised in any rules, laws, or even the constitution of the country yet). Most countries including Israel, Singapore and many others have said they will come with firm guidelines soon, until then they have cautioned all investors to buy carefully in any ICO.

4. If you are unable to deliver the platform where services against the tokens can be used This is a possoble scenario. If you are unable to deliver services as expected to your token owners (assuming it’s because execution did not work out as planned due to lack of technology delivery, or your ability to deliver, or lack of build out of needed community / traction or something like that), then token holders may individually or as a group pursue legal action against you / your company, in their own or your company’s jurisdiction, as per applicable laws.

But if the non-delivery is not intentional and is due to external circumstances, then this legal action should be defensible I imagine. It’s no different from the failed projects crowdfunding, which is fairly established in most jurisdictions.

5. Be prepared for investigation in next few years, as majority scam ICOs may lead to wider regulators scrutiny of several ICOs — Again, as long as you are running it like a professional business with integrity and complying with accounting / audit standards, you should be ok to do an ICO .

6. Be prepared to follow guidelines in the future — ICOs may come under existing securities guidelines, or specific new guidelines under some / multiple regulations, that may be manageable for you as long as you are running it professionally and willing to comply with all existing and new regulations.

Also, rather than becoming too negative due to media headlines, lets realise a few facts here,

– No jurisdiction has banned ICO yet. they may do it, or they may regulate it, or they may classify and regulate it as a security, if it is so.

– According to stats floating around, ~$1.5bn has been raised from 100s of ICOs, from global investors. Its not that significant an amount (in grand scheme of things), if you compare to how much some startups may have raised recently from professional investors or crowdfunding, considering even single countries like US or China or India, for example. (not to say that if you commit fraud during/after the ICO, you can still get caught, otherwise, I would not worry too much)

– One reason ICOs have become “easy money” is because of rise in bitcoin (and other cryptos) value to manyfold within few quarters.

– So, it may not be as good as we want it to be, but not as bad as it seems

And of course, if this is still too complicated and unclear, there are several well established ways to fund your project, through Angel investors, VCs, Debt funding, etc. They maybe harder, but more predictable in terms of applicable compliances around them across all jurisdictions.

Hope this analysis helps. “Happy ICO”, “Happy Investing” and most importantly, “Happy Changing the World”.