Blockchain-based initial coin offerings are an innovative way for digital projects to raise money from investors. We explain the instrument and examine the risks.
In February 2017, San Francisco-based hedge fund Numerai
released its own cryptocurrency, the Numeraire, to incentivise developers to work on models and deal with foreign transaction problems. It was just one of the 64 major “initial coin offerings” (ICOs) that landed in 2016
, according to US cryptocurrency research firm, Smith and Crown. But what exactly are ICOs and how are they changing the way business works?
ICOs, which can stand for either Initial Coin Offering or Initial Crypto Offering, involve blockchain protocols for raising money from the public in much the same way as a start-up would in an initial public offering (IPO). ICOs differ from IPOs, however, in that they aren’t yet bound by any specific legal frameworks or requirements.
What they are
Smith and Crown describe ICOs as similar to kickstarter campaigns, but the backers have a financial stake in the project. A project share-like tokens (such as the Numeraire) to early adopters in exchange for cryptocurrency, and this provides funds for project development. If the project is successful, the cryptocurrency tokens can eventually be traded like company shares.
Smith and Crown’s list of completed, ongoing and upcoming ICOs shows the diversity of offerings, many of which are far more complex than the simple transfer of payments and store of wealth that familiar projects such as bitcoin are known for. The list includes: Lunyr
, a Wikipedia-like encyclopedia that rewards users who post and edit; Augmentors
, an augmented reality creature fighting game; and Golem
, a decentralised supercomputer. However, a number of others have been refunded due to hacks and technology failures.
Think of it like buying in-app purchase tokens for an app that hasn’t been built.
Why they’re risky
“There are a lot of risks because it’s basically an unregulated investment scheme,” says Asher Tan, co-founder of personal finance firm CoinJar, through which people buy and spend bitcoin and other currencies. “In the nature of crowd-funding projects, some come to fruition and some don’t, as good as the technology might look,” Tan says.
“Think of it like buying in-app purchase tokens for an app that hasn’t been built. If the app never comes online, your tokens are worthless. But if it does work, and becomes popular, they might be worth a lot.”
...regulation in the US and around the globe is extremely young and being developed
Weighing them up
According to Alex Sunnarborg, technical analyst with CoinDesk, a digital currency news and information service, “ICOs are frequently ethereum-based tokens, which accept and distribute funds with a smart contract, and they often take funds from a global user base without accreditation requirements.” Ethereum, itself a cryptocurrency, is based on blockchain technology that allows for automated contracts.
Sunnarborg says ICOs help entrepreneurs raise funds from a larger potential investor base from around the globe in an “easier” process with fewer legal requirements, “perhaps because regulation in the US and around the globe is extremely young and being developed”.
“It also lets the retail public gain access to investment opportunities in early-stage projects that they usually can’t get into because of accreditation requirements and access,” he says.
The problems that beset ICOs are often inherently linked to their advantages. One of the problems, for example, is that some investors may be ineligible, meaning the legality of the investment is somewhat unknown and many issuers may even be breaking existing laws.
“Many investors may not be doing appropriate due diligence,” says Sunnarborg. “Or they may not be fully aware of the risks, which accreditation standards can help address. [There are also] things like third-party research or required documentation during a raise, which have yet to be developed.”
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