The access to distributed ledger technology that underpins ripple, ethereum, bitcoin and other cryptocurrency platforms has allowed companies to create their own digital tokens that can be offered to the public to generate funds.
These ‘initial coin offerings’ provide an alternative source of venture capital for start-ups and encourage innovation in how these digital tokens can be used. Between January 2017-February 2018, ICOs raised $4.5bn, outweighing venture capital investment in blockchain-related start-ups more than threefold.
In contrast to initial public offerings on stock exchanges, ICO issuers do not sacrifice equity for financing. ICOs also allow for borderless online sales with fewer points of friction. They typically bypass legal, jurisdictional and business hurdles, and investment is promoted directly to a global investor base. However, investors face major risks.
There is a lack of market security; 81% of ICOs are fraudulent, according to ICO advisory firm Satis Group. Investors buy into the promise of a digital infrastructure’s utility and significant returns without having access to the underlying product. They usually can’t consult business plans or accurate financial information about the issuer. These hazards are exemplified by the fact that only 8% of all cryptocurrencies make it on to exchanges.
Issuers are often anonymous and difficult to trace, making it easier for fraudsters to exit the market with investors’ capital. In addition, the method of investing adds a layer of ‘currency risk’, as investors must buy into ICOs through existing cryptocurrencies with high price volatility. This could make cashing out into a fiat currency especially costly.
As most digital tokens are issued without being registered as securities, investors are denied a number of legal rights. There are no shareholders rights, and a lack of liquidity preference in the event that the company defaults or becomes insolvent. This means ICO holders are unlikely to reclaim their initial investment. Furthermore, the absence of antidilution protection allows issuers to release additional tokens to generate more funding, diluting the value of initial investors’ holdings.
One way in which investors can find protection is to sell their tokens very soon after an ICO. This is a strategy that many venture capitalists follow to insure against devaluation. However, this only increases market volatility.
Determining what legal and supervisory framework a cryptocurrency falls under depends on how regulators classify it among asset classes. International coordination on this is lacking, and the various jurisdictions that do regulate cryptocurrencies categorise them in different ways. Others use a case-by-case approach to determine a cryptocurrency’s asset class.
These inconsistencies create the risk of regulatory arbitrage. Competition between regulatory regimes, as countries try to attract innovative companies, exacerbates this divergence between markets.
In the US and Canada cryptocurrencies fall into legal grey areas. The European Union is yet to formalise its approach, as the European Securities and Markets Authority is assessing how to apply Mifid II rules to digital assets. The Swiss Financial Market Supervisory Authority, Bermuda Monetary Authority and Gibraltar Financial Services Commission define cryptocurrencies as a separate asset class to which new regulations should apply.
Greater regulation will have a positive effect on ICOs and the cryptocurrency market only if it provides certainty about how markets will operate globally. Strengthening investor protection by providing assurances and improving transparency during ICOs could attract institutional investors, which would generate liquidity and support market stability.
Bhavin Patel is Economist at OMFIF.