ICO: Caveat Emptor

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By Dave Remue (B-Hive)

The Chinese central bank issued earlier this week a freeze on funding through Initial Coin Offerings (ICO’s) since it has “seriously disrupted the economic and financial order.”  While some see this move as an attempt to control the flow of currencies out of the economy into international havens, many share the concerns raised by the Chinese regulators that some ICO’s are scams and pyramid schemes.

ICO’s have recently boomed as an attractive route for start-up funding.  A recent Goldman Report notes that ICO fundraising represented last year only a negligible role in start-up financing, but it has shown strong growth since April 2017, prompted by successes such as Gnosis - a prediction market where users can bet on outcomes of events such as elections -  which raised almost $12 million in less than 15 minutes by selling only 5% of its coin base, with the remaining 95% kept by the founders.  The offerings have shifted over the past year from core technology to a wide range of categories from markets, investment products to media. 

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In July 2017, ICO funding had completely outpaced traditional early stage VC funding, with an estimated $1.25 billion having been raised through ICOs in the first half of 2017.  

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This ‘token mania’, as referred to by Autonomous NEXT in their latest report, has triggered interest from companies with wide ranging interests and motivations. An informative and at times amusing column on the subject, is the ICOmedy series in the FT which recently spotted the launch of the DentaCoin ICO and questioned the usefulness of applying blockchain technology to their purpose.  “From the game-changing info pack: “Dentacoin is already used by over 6,000 people globally and is also accepted as means of payment at two dental clinics in Europe. Dentists can exchange DentaCoins tokens with patients for their reviews, while patients can utilize DCN tokens on various dental services or reserve tokens as an investment tool.”  Leaving Izabella Kaminska to comment on DentaCoin: “It’s at best — and that’s us being generous — a gift voucher. A reward point card. Or a trading stamp.”

In contrast to traditional funding or IPOs where the entrepreneurs offer ownership and control rights in exchange for funds, ICOs give investors tokens which they pay for using cryptocurrencies such as ethers or bitcoin. Issuance, ownership and transfer of such tokens are secured by a blockchain protocol.

Apart from converting their tokens back into cryptocurrency, tokens allow access to the company’s products or services.  The rights embedded in such tokens can include payment, access, profit sharing, contribution, block creation, governance and voting.  For example, Genevieve, a venture capital fund which raised funds via an ICO, offers its investors to vote on venture capital funding for small and local businesses. ZrCoin plans to extract zirconium from industrial waste and ZrCoins are backed by the zirconium to be produced.  Filecoin, which raised $250 million last month, allows users to receive payment in cryptocurrency for donating unused hard-disk space to Filecoin’s network.

In many cases investors take a leap of fate by handing over their funding based on a rudimentary white paper and a product that is not there yet.  Operating in market with very little regulatory oversight, there are for example no strict guidelines on the information to be included in the ICO white paper. Only a handful of ICOs have explicitly attempted to protect investors by incorporating best practices such as providing full transparency into their organisations, having trusted independent experts review their white papers and including regular audits of their code for security and other flaws.  Many ICOs are nebulous about governance on purpose: if the project is unsuccessful or the coin loses its value, the operators do not want anyone to be held responsible.

While blockchain technology holds much potential, even their biggest fans fear that the current ICO frenzy leaves the door too much open for fraud and speculation.

Regulators are slowly coming to grips.  On July 25 this year, the US Securities and Exchange Commission warned that from that day tokens would be subject to securities laws with the same legal responsibilities for investors. Last week Prostarr shut down its token sale midway and issued a refund after being contacted by US SEC investigators who questioned Prostarr’s compliance.  The Swiss authorities say that they are working on rules for cryptocurrencies and the Singapore central bank has warned about ICOs being vulnerable to money laundering and terrorist financing.  It is still a mixed scenery.  Let’s hope that a consistent approach emerges, globally, soon.

Calling all ICO issuers to proactively apply best practices in terms of transparency and investor protection. Buyer beware. 

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