ICOs and Traditional Finance
By: Shaan Ray
Tags: ICO, Cryptocurrency, Bhq Contributors, Blockchain, Initial Coin Offering

The fast-paced world of finance was caught off guard by the rise of ICOs and cryptocurrencies in the past year. Blockchain entrepreneurs have used ICOs to challenge traditional fundraising processes, getting the attention of traditional financial players, regulators, and big companies.

What is an ICO?

An Initial Coin Offering (ICO) is a method of raising initial funds for a blockchain-based business from people and companies. ICOs are also sometimes referred to as Initial Token Offerings (ITOs) or as Token Generating Events (TGEs).

In traditional fundraising, a new company would sell angel investors and venture capitalists preferred stock to raise initial funds. With a track record of success, a company could later go public, by selling shares (that represent ownership in the company) on a stock exchange in an Initial Public Offering (IPO).

ICOs differ in several important ways from venture capital and IPOs. In an ICO, rather than stock, tokens on a blockchain are created and sold to the public in exchange for funding for a company. Unlike stock, the tokens do not represent any stake in the company. In several (or even most) cases, ownership of a token does not represent any legal rights.

ICOs therefore represent a novel way for blockchain startups to gain funding by selling tokens in a globally distributed, peer-to-peer manner. Purchasers pay for the tokens with cryptocurrency and sometimes, fiat currency (such as US dollars).

Cryptographic Tokens

There are two classes of ICO tokens: asset-backed tokens (which are pegged to a digital or tangible asset) and utility tokens (which are used to buy goods and services in a micro-economy on the company’s blockchain). Some utility token sales are similar to raising money through a Kickstarter campaign: for the issuing company, they fulfill the dual purposes of raising funds and locking in sales. In these utility token sales, the purchaser of a token also becomes a customer of the company’s product or service.

An ICO almost always has an accompanying whitepaper that describes the project, its intended product or service, the token, the expected uses of the funds raised, the leadership team, and the underlying technology.

Purchasers of ICO tokens can have one or both of the following objectives: speculation (in which purchasers hope that the value of the token will appreciate and they will be able to sell it for a profit) and use (in which purchasers are excited to use the product or service and are purchasing the token, presumably at a discount, to access these services later).

Buyer Beware

So far, purchasers of ICO tokens have usually been let down. In April, it was reported that 80% of ICOs are scams and only 8% reach exchanges. A common type of ICO scam is the “exit scam,” whereby a company sells tokens and simply exits the market with the funds raised. Since the tokens in these scams do not represent any legal rights and the whitepapers only represent intended uses (and not binding promises), the purchasers are out of luck.

Additionally, even non-scam ICO businesses can easily fail, just like any business. Therefore, ICO investors should use just as much due diligence as they would with any other investments or purchases.

Traditional Finance Disrupted

ICOs were meant to provide a decentralized, open source fundraising method not subject to SEC regulation. However, through speeches, guidance, and enforcement, the SEC has signaled its intention to crack down on scams and subject tokens to securities laws if they have certain characteristics. Therefore, recent ICOs have sought to sell tokens only to certain kinds of investors, so that the ICO will not have run afoul of new laws even deemed securities by the SEC.

Ironically, the emerging regulatory regime has resulted in mainstream popularity for ICOs and a strengthening of their disruptive power. As ICO activity continues to pick up pace, banks and investors are scrambling to understand the blockchain space, token dynamics, and possibilities for instant settlement of trades.

The rise of interest in cryptocurrency over the past year resulted in the creation of more cryptocurrency exchanges, which are similar to foreign currency exchanges. The next step is likely the inclusion of ICO tokens on these or similar exchanges. We are likely witnessing the beginning of a platform war between groups of traditional financial players and upstarts for which ICO exchanges will gain critical mass.

Conclusion

For several years, cryptocurrencies and blockchain-enthusiasts existed on the fringes of traditional finance. In the past year, a dramatic rise and fall in the price of Bitcoin brought cryptocurrency and its underlying blockchain technology into the public consciousness. Charlatans seeking easy money capitalized on the first wave of ICOs and often cheated token buyers. The SEC took notice and an ICO regulatory regime is now emerging. Meanwhile, the pace of ICOs has quickened and traditional financial players are attempting to become leaders in this space rather than become disrupted by it. Large, established businesses (such as Telegram) have conducted ICOs to meet their funding needs, and these trends can be expected to continue. The advent of programmable money will eventually transform finance and other industries with high transaction volumes.