From What I Read: Initial Coin Offerings

Before beginning with the essay/article, I’ll give a short description of what From What I Read is about: a monthly summary write-up (in 5 main points) on several articles and publications about a certain subject topic.

My readings on the topic of Initial Coin Offerings (ICOs) are from an article each in The Edge Weekly, Blockgeeks Inc, The New York Times, and MIT Technology Review. Detailed references with links will be included at the bottom.

What is the subject about?

From the readings, several main keywords appear: “like IPO, but not shares” and “crowdfunding”. And you get the gist: ICO is a way to raise funds where investors receive digital tokens in exchange of currencies, though usually cryptocurrencies like Bitcoin and Ethereum.

ICOs are mostly issued by start-ups to fund the development of their projects, which mostly leverage on the blockchain technology. Even the ICO process uses the blockchain technology.

Anyone who has bitcoin (BTC) or ether (ETH) can invest in an ICO, which gives the crowdfunding nature of ICOs. And like an IPO, start-ups sell a portion of pre-created tokens to these early backers of their projects (while usually allocate a portion of tokens to themselves), but be not mistaken: these tokens are not shares of the start-ups, but rather digital assets that would enable the holder to access the new product from the project. This too will be elaborated further in the coming sections.

How does it work?

The following write-up assumes the reader to have some foreknowledge about cryptocurrencies and the blockchain technology. If you have not done so, you may learn about it here as well as many other sites elsewhere. UPDATE: I wrote a post on this site too.

While the concept of raising funds is similar to an IPO, an ICO and its token operates like a cryptocurrency: an ICO usually has a hard cap on number of coins in existence; the token is stored, transacted and enabled on the blockchain which verifies the transaction and serves as a record of its legitimacy; tokens can be sold and traded on cryptocurrency exchanges if there is demand for them; there are miners of these tokens to maintain the functioning of the blockchain.

In the example of Filecoin, token holders would get service like cloud-storage space, miners earn tokens for providing storage or retrieving stored data for users, and that the tokens are the method of payment for storage.

However, most ICOs do not have a complete product as of writing yet, so people buy tokens to speculate on the value of the service in the future.

Many ICOs leverage on the Ethereum blockchain since it “unleashed the power of smart contracts” with its ERC#20 standard. Prices of ICOs are usually independent of BTC and ETH despite leveraging on the blockchain behind them.

Extra: To watch how an ICO is launched, Bloomberg has a video on that.

How does it impact (in a good way)?

For start-ups, ICO is a mean to raise funds without selling stock or going to venture capitalists, which means more control for the developers throughout the project. The developers could protect the open-source nature of the eventual product since there are no owners to speak of. And since ICOs are global through the blockchain, issuers are able to raise funds globally, and has proven to raise more funds than conventional methods such as VC funds.

ICOs function as a “decentralised” enterprise which could enrich anyone who holds or mines the token upon the success of the project, and not just the executives and developers of the project. ICOs also impact the blockchain through exploring ways to connect the application of the blockchain with the token, and to leverage smart contracts to add more features to these tokens.

What are the issues/challenges?

The notoriety of ICOs stems from the fact that it is unregulated, and hence inviting many fraudsters and scammers to take advantage of the (recent as of writing) hype around cryptocurrencies to “make easy money or pull pranks”. And since there is no central authority to collect user information that is globally in ICOs, individual investors have to bear pretty much the totaility of responsibility without much legal recourse should the ICO invested failed, lost, stolen or simply ended up as a scam.

On the regulatory front, ICOs present a grey area, since some tokens are like buyer-seller relationships, while others function more like stocks. While China and South Korea have outright banned ICOs, the U.S. ruled several tokens to be regulated as a stock and to be governed under laws on securities. Increase in regulations would on the other hand increase cost and effort for the start-ups to comply to them.

ICOs are prone to hacker attacks, in which one prominent case involving $80 mil of the DAO tokens being hacked. Since the transactions are blockchain-based, they are also unfortunately irreversible. Basic coding errors can also be exploited by hackers to steal the tokens too.

Investors should also bear in mind that investing in ICOs are essentially investing in start-ups, and since most start-ups eventually fail, this would present a heightened risk for ICOs. According to one article, there are about 80-90% of all ICOs are questionable.

Furthermore, services in almost every case of ICOs have not been fully developed, and hence ICO investment is a bet on the service promised will be completed. The service promised are described in a white paper, which is where the valuation of the ICO is based upon: these start-ups may not have customers, revenue or working product when issuing an ICO.

How do we respond?

The article in The Edge Weekly basically summed up its advice in two words: caveat emptor. The burden falls upon the individual investors to do their due diligence and to assess the viability of a certain project that issues an ICO. The investor should question the rationale of the start-up to raise funds through an ICO: whether it is necessary to use the blockchain technology for the idea to work. The investor should also investigate the background of the ICO issuers, and to read the white paper of the token that funds a certain project (and even so, there is still risk that what was promised on paper and even in sample codes may be bogus).

Since hacker attacks are more prevalent on cryptocurrency exchanges, the article advises investors to use private wallets to store the ICO tokens instead of being on the exchange. Ultimately, one should have prior experience in buying and keeping cryptocurrencies before investing in ICOs.

All the readings seem to acknowledge voices that warn about ICOs being bubbles, and therefore caution should be exercised. However, this piece of innovation in fundraising seems to be staying around for the next few years, and that we as a society, whether through regulators or otherwise, should decide how we can leverage on the innovation moving forward.