Elucidating ICOs the media focuses on IT-geeks, regulators’ or potential users’ positions. In this article, a reader gets a glimpse of the topic from the investor's point of view, which is extremely important and is neglected at the same time
An ICO, Crowdfunding and Investors’ Interests
Before beginning it is necessary to stress the point that we are not talking about "micro-investors" supporting ICO projects that employ in one way or another blockchain / DLT - Distributed Ledger Technologies (subtle differences exist between blockchain and DLT that we ignore within this article). The lion’s share of all successful ICOs was conducted by the Internet community of crypto-enthusiasts, and projects’ ideas were related to new crypto-currencies or appeal to understandable and straightforward human interests - distributed social networks, sweepstakes, etc. Nowadays, thousands of DLT projects are initiated in various spheres of the world economy. Some of them will be in demand by governments, banks, and corporations, but most initiators of projects will have to enter the crowdfunding or venture capital market. Under these circumstances, it is unlikely that crypto-enthusiasts have enough resources to invest in all newly emerging projects. Also, it is doubtful they will have any interest in new, especially sectoral applications of blockchain technologies. Thus, working investment models to fund DLT projects becomes a critical factor.
Experts recognise three principal schemes to invest in DLT projects today:
1. First, a project developer issuing digital tokens to distribute them among the community of crypto enthusiasts (practically, repeating the model of Kickstarter and other internet crowdfunding platforms). Having developed the project with the use of initially collected money, the developer comes to the sources of venture capital to finance the project in full.
2. An initiator starts inviting venture capital investors to launch the project, and then conduct an ICO for total funding (a strategy opposite to the first one).
3. A project developer conducts an ICO in the one-stage scheme but issuing asset-backed tokens (taking real-world assets and putting them on a blockchain makes ICOs looks like IPOs - Initial Public Offerings of shares).
Meanwhile, a composite intangible asset-backed model to invest in blockchain projects is also possible. These projects will be initiated in logistics, industry, healthcare, etc., to be developed till the stage of a prototype. Project developers protect their interests adequately due to the use of a joint-stock or partnership form of intellectual property’s sharing. ICOs or the new form of corporate crowdfunding CSF (see below) would be sources of projects’ initial financing. Projects, capitalized and advanced in this way become attractive to venture investors. Due to the use of this model and regulators’ efforts to create a civilized crowdfunding market, ICO becomes a segment of it. In turn, crowdfunding is part of a comprehensive investment system to fund innovations, the system that includes venture funds, angel investors, corporations, government agencies (incubators and accelerators for start-ups), and micro-investors.
To express the essence of the changes in the ICO system we can say that “trust,” the concept underlying DLT itself, originally aimed at creating automatic mechanisms to replace the old "agents of trust" - banks, registrars and government departments. Today begins the struggle for the trust of real investors whose behavior, unlike the "irrational" micro-investors of ICO is entirely rational. Real investors would like to:
- understand the unique technological or business features of a project that make it attractive to invest into;
- see the financial justification (in figures and facts) of project organizer's promises – solid proof of potential profitability of a project;
- ensure that the intellectual property of the project is appropriately executed and protected;
- verify that the project organizers are acting within the framework of the current legislation (more precisely, they can adapt creatively to the constantly changing system of ICO / crowdfunding regulations).
Jurisdictions: Looking for the Promised Land
Until recently, a topic of jurisdiction seemed not to exist for ICO organizers who believed that there is no regulation in the market, so no need to think about legal forms and justifications. Within the last few months, they suddenly discovered strict rules in force. Not to mention the countries that have legally banned ICOs (China, South Korea) and the countries that have embarked on its stringent supervision (the USA, Canada, Japan), even the countries created a favourable environment for ICOs such as Singapore and Switzerland changed rules. Regulators make it very clear to crypto-community that time of unlimited freedom has gone. In any case - in the sense in which ICO organizers supposed these jurisdictions - as zones with no regulation. Regulation has become a fact although took different forms. Japan introduced an expensive (and almost prohibitive for start-ups) registration and certification of ICO organizers Singapore and Switzerland went their ways.
Not so long ago, The Monetary Authority of Singapore (MAS) regarded transactions with crypto-currencies as a barter - the purchase of virtual items or digital goods, but now they announced that digital tokens would be equated to securities. Along with the demagogic statement that there is no intention to regulate the circulation of cryptocurrencies, MAS stated that severe measures to prevent money laundering and other criminal activities would be applied to financial service providers and ICO organizers. The Swiss Financial Market Regulator, The Financial Market Supervisory Authority (FINMA) has published a guide that adapts the existing financial services regulation schemes to ICO. FINMA announced that it is currently investigating numerous violations of regulatory legislation. The ICO will now be governed by anti-money laundering and terrorist financing laws, banking regulations, securities trading regulations and articles of collective investment legislation.
The last two items of FINMA's guidance show the primary trend of regulation - towards the approximation of ICO processes to the "classical" investment schemes. The schemes in which investors’ investment are protected by legislative and procedural measures of due diligence. It is not necessarily an IPO scheme. Although the IPO model for project financing is well developed, it is labor-intensive, time-consuming, and rather expensive for start-ups. In addition to project financing, which is considered a low-risk investment, the venture capital industry focuses on the commercialization of technical or business innovations that promise high ROI but with some risk of failure. Venture projects do not necessarily use IPO mechanisms, but managers of venture capital funds and private angel investors, to a greater or lesser extent (depending on the scale of projects and its investment attractiveness, as well as the personalities of projects’ initiators) rely on due diligence and feasibility studies procedures.
Is it possible to ignore the regulation and take the risk to conduct ICO bypassing the regulators' traps? One must assume that today the risk is unreasonably high. The United States Financial Regulator The United States Securities and Exchanges Commission (SEC) has set up a special unit (Cyber Unit and Retail Strategy Task Force) to monitor misconduct in the DLT sphere, including ICOs. Cyber Unit, which declared its mission "to protect investorsэ interests," and promises to exchange information with appropriate government departments of other countries. One must not forget that after releasing of digital tokens and collecting cryptocurrency, the problem arises to exchange the latter for fiat money. And operators of crypto-stock-market and crowdfunding internet platforms have become obedient instruments of regulators. Offers such as establishing a Singaporean company with offshore bank accounts to conduct ICO, do not work, as well as misleading scenarios to issue tokens in the way to avoid attribution to securities or collective investment schemes.
An ICO vs. Crowdfunding: Secrets of Regulators
Regulators of all countries declare that their efforts in the field of ICO / crowdfunding are aimed at protecting investors’ interests, and regulations are only for the benefit of real projects’ initiators who are competent and have "genuine" intentions. Generally speaking, this statement is in favor of investors indeed because projects hastily made by naive and incompetent crypto-enthusiasts, or even scammers do not have any investment value. However, we need to understand the trend of regulation to plan investment in the blockchain somehow. It would seem that after a series of scandals involving some ICOs, a wave of prohibitions swept and a child was thrown out with water. But it is not entirely accurate - if we analyse the actions of regulators in countries where DLT development is an essential part of the overall innovation strategy, we can see a particular pattern. And this is not a dumb scheme to check any ICO with the Howey test - the judicial precedent of 1934 using SEC widely. Within the fundamentally new DLT technology, new regulation models are also required.
In Australia (by the way, the country of "common law" like the USA), the corporate regulator The Australian Securities & Investments Commission (ASIC) has just released new rules for ICO that "must be conducted in such a way as to justify investor confidence and comply with the laws." In addition to this goodwill, the document poses quite clear the legal and organizational framework for ICO, more precisely, the issuing of digital tokens. The type of tokens and purpose of its issuing is reviewed by ASIC in each specific ICO project. ASIC decide whether a case falls under the common law or corporation law (Corporations Act 2001) and its recent addition, the Corporations Amendment Crowd-sourced Funding (CSF) Act 2017.
ASIC seeks answers to three questions:
1. Could a token issued in an ICO be considered securities? Facts of ownership, voting rights or rights to participate in profits confirm that a token falls under the definition of securities. In this case, an issuer has to prepare a prospectus similar to those issued within traditional IPOs.
2. Could a token be considered an interest in a Managed Investment Scheme? If the value of the digital tokens acquired is affected by the pooling of funds from contributors or use of those funds under the arrangement, then an ICO fall within the requirements relating to Managed Investment Schemes. An issuer has obligations to disclose, register and license such a scheme.
3. Could a token be considered derivatives or non-cash payment facilities? In this case, the token derives its value by reference to something else and be considered a financial product. For example, an ICO could involve an option contract where investors would have the right, but not the obligation, to buy tokens at a set price on or before a future date. Non-cash payment facility - execution of payments for other persons, requires a license to work in financial markets.
If the answer to at least one of the three questions is affirmative, ICO is not allowed, but a project initiator has a chance to obtain investment financing via CSF - equity-based crowd-sourced funding. Licensed financial intermediaries who operate on online platforms provide a project initiator with appropriate services. Using an online platform, a project initiator offers shares and investors invest money in exchange for shares. Especially for this purpose, the new act allows issuing shares for an unlimited number of investors. An intermediary also serves as an escrow agent, holding the money until the transaction is completed. A significant limitation of this scheme is its scale - the assets and an annual income of an issuing company should not exceed $ 25 million jointly, and it is possible to raise up to $ 5 million in any twelve-month period. However, in the US where such a scheme is put into circulation, they set the limit even lower – just $ 1 million.
Distinct differences exist between ICO and CSF modes from an investor's point of view, particularly its liquidities. Tokens, in case of its free circulation within cryptocurrency market, are very liquid. The shares issued in CSF mode are not. But the important similarity between ICO and CSF are more relevant than the differences - in terms of reliability, both modes are approximately equal. For initiators of fake projects and projects without real business applications, the blocking opportunity to conduct an ICO is closed today. In the CSF mode, the online platform’s operator-intermediary is responsible for the financial regulator to checks projects carefully. Of course, in both cases, there are business risks that cannot be levelled out completely.