In this life we must die several times to then reborn. And the crises, although frightening, serve to terminate an epoch and inaugurate another.
Eugenio Trías[1]
I. Introduction
Within an unclear legal framework — and even believed non-existent — , the challenging Initial Coin Offering turned into an increasingly prominent fundraising mechanism for new companies and a great investment opportunity for retail investors, reaching overwhelming numbers all over the world during last years.
However, while the global ICO market became ‘too big to ignore’, many cases of undesired behaviour and scams occurred, generating some alarm in the participants and attracting the attention of regulators. And, along with it, at the end of 2017, the ‘crypto winter’ started.
In this context, we have been witnessing an abrupt downtrend of the ICO market from the second half of 2018, where there was no lack of experts who declared the ICO’s death. But before taking that step, it is necessary to go beyond all the frenzy period and analyse the performance of the ICO as a financial vehicle from its origins, as well as the benefits and features of the ICO, which includes face the scope of its regulation.
II. The rise and fall: a death foretold?
The advent
In the financial world reigned by intermediaries, when the efforts of regulation were focusing on crowdfunding, the market of capital raising were impacted by the revolutionary blockchain [2], which — from the wave caused in the payment system with cryptocurrencies — brought a new mechanism to raise funds, named by the blockchain community as Initial Coin Offering (ICO).
Following the technology on which it is based, the ICO was conceived to finance blockchain projects through the sale of tokens[3], which involves get funding with cryptocurrencies from a group of investors who believe in a specific project, in exchange of a piece of the new protocol that such project will develop in the blockchain.
As noted, the idea of the ICO was to disintermediate the entire traditional financing process that new businesses face, and go directly from “inspiration to realization”, leaving aside in this way the traditional financing vehicles, such as seed capital, venture capital, private equity and Initial Public Offering (IPO).
The spread
After the launch of the first ICO in 2013 with Mastercoin[4], ICOs were deployed only in the blockchain ecosystem; but soon, as the cryptocurrency market grew globally with rampant speculation about its value, without a clear applicable regulation — and for that reason, without entry barriers — , the ICOs became the incredibly quickest and simplest instrument to obtain exorbitant funds and profits.
Thus, the ICOs attracted all types of investors (retail and institutional lately) and entrepreneurs (mostly startups and SMEs, including those with businesses that did not rely on blockchain) around the world. Like the Wild West but in the digital world — where the freedom of its participants prevailed — , the so-called “ICO Gold Rush” was unleashed.
Thereby, in the pursuit of incredible high investment returns on the side of investors, and large amounts of financing with only whitepapers and advertising pitches on the side of entrepreneurs, the ICO industry grew by leaps and bounds becaming an industry of billions of dollars: In just 12 months between late 2017 and early 2018 — following the bullish trend of cryptocurrencies — , the ICO market boomed reaching about $ 12 billion, where, for instance, only Telegram raised $1.7 billion, while EOS $4.1 billion.
The flaws
Operating as a free market due to the lack of clear legal frameworks, its flaws easily brought investor lawsuits. The doors were opened not only to legitimate innovative business developers, but also to bad actors, who took advantage of the ICO boom, making scams or frauds (such as ponzi schemes).
Indeed, while the phenomenon of ICO is new in the financial world, its market flaws are the same as always (moral hazard, adverse selection, insider trading, market manipulation, etc), and the fact that its participants acted outside existing regulatory frameworks caused these flaws were deployed throughout the ICO market, generating huge losses for investors.
The level of simplicity (KISS) to raise funds was going against the standards required for an investment decision, which are guided mainly by the integrity and transparency principles in Securities Regulation.
In many cases there was an absence of due diligence, standardised financial reporting, prospectus (containing the main risk factors of the company and its businesses, the limit and destination of the resources raised and the applicable regulations for example) and corporate governance. Instead, several funders of the projects released whitepapers with poor information — they even did not mention the name of the company or its address — focusing on marketing techniques (using even celebrities), and they did not establish or disclosure anti dilution practices (like Gnosis in April 2017), as well as limits that indicate financing plans for their projects that justify the amounts raised (Tezos in July 2017).
Likewise, many of the investors participated in ICOs not because they believed in a specific project or the intrinsic value of one token, but because of FOMO (fear of missing out) and the greed emotion, encouraged to buy in short time periods (minutes or seconds) to obtain better bonuses, but falling in pump-and-dump schemes. Thus, it has been pointed out that ICOs presented unsustainable increases away from its fundamental value[5].
The call of regulators
Evidently, this exuberant growth did not go unnoticed. Besides cryptocurrencies, the ICO market called the concern of regulators. The first responses from national regulators around the world were given: from warnings and guidances in most of the cases, to investigations with reports and shutdowns (e.g. DAO and Munchee cases from United States, published in July and December 2017, respectively), and outright bans (e.g. China in September 2017).
Most regulators coincide that, although ICOs are currently not governed by specific regulations — with some exemptions like Bermuda recently — , depending on its characteristics, the tokens offered in ICOs may constitute securities or financial instruments, as well as the activities involved in ICOs may be regulated financial investments activities, and therefore, ICOs may fall under existing legal regimes.
Thus, some ICOs may come within the scope of Initial Public Offerings (IPOs), private placement of securities, crowdfunding or even collective investment schemes, for instance; whose determination will depend on the evaluation case by case made by the financial regulators of each jurisdiction where the ICOs take place, where, for example, the criteria of the famous “Howey Test” of the United States — which analyzes if any transaction is an “investment contract” — will be considered.
These messages warned the general public about high risks of participating in ICOs and due there are actually legal frameworks applicable to ICOs, those who are involved in conduct and activities without complying the applicable rules would constitute a breach, being subject to enforcement proceedings.
The expected fall
Considering all of the above, many analysts (among them, Jamie Dimon and Warren Buffett) announced that the rise of cryptocurrencies and ICOs represented a bubble — comparing it with dot-com and tulip bubbles — that would burst at any moment.
Then, after Bitcoin reached a historical price of $20,000 in December 2017 (from $900 in January 2017), the value of bitcoin and all other cryptocurrencies declined in volatile operations in the following months, what was called the ‘crypto winter’.
And so finally, the fall expected happened: from mid-year 2018 the downtrend of the ICO market started and, comparing the 6 billion raised in the Q1 of 2018 with the 900 million raised in Q1 of 2019, the ICO market down in 97%.
“The party was over”, “the ICO is basically dead”, it was said.
(…)
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See the Spanish version here:
Initial Coin Offering (ICO): vida, muerte y regulación
[1] Philosopher (Barcelona, 1942–2013). Original Spanish passage: “En esta vida hay que morir varias veces para después renacer. Y las crisis, aunque atemorizan, nos sirven para cancelar una época e inaugurar otra”.
[2] Blockchain is a type of distributed ledger technology (DLT) that records transactions in a synchronized network using cryptography and consensus mechanism, characterized by transparency, immutability and security, making possible exchanges between two parties (peer-to-peer) without the need for a “trusted third party”, which means a dramatically cost transaction reduction. For an analysis of the legal and the regulatory issues of DLT.
[3] The token is a unit of value of the project developed in the blockchain, which serves as an entry in said blockchain and incorporates a bundle of rights, privileges and obligations.
[4] J.R. Willet, developer who wrote “The Second Bitcoin White Paper” for the launch of Mastercoin in 2013, is recognized as the creator of the ICO.
[5] Nathan J Sherman, emphasizes that unlike previous bubbles, they at least had commercial values. On the contrary, ICOs in many cases had raised millions without a legitimate purpose, such as “Trumpcoin” or “Dogcoin”. See: A Behavioral Economics Approach to Regulating Initial Coin Offerings, 2018. The author e<https://ssrn.com/abstract=3243028>.