Like new cryptocurrencies, ICOs are moving through the growing pains of early adoption, including market volatility and a host of compliance and security issues
A quick look at the headlines will tell you that interest in cryptocurrencies and ICO skyrocketed in 2017 – a trend that is continuing into 2018. As a new form of fundraising for businesses, Initial Coin Offerings – or ICOs, also known as token sales — alone raised nearly $2 billion last year. Often perceived as the answer to traditional venture funding routes, organizations have increasingly relied on ICOs to help generate hundreds of millions of dollars in mere hours. Perhaps not surprisingly, ICOs are becoming more and more popular for cash-strapped startups who have often been shut out of traditional VC channels or risk watching their equity disappear with round after round of traditional financing.
For blockchain startups, ICOs check off a lot of boxes, and the benefits are numerous. Unlike traditional funding paths, ICO issuers will still own 100 percent of their company after the token sale and fund their project while it’s still being conceptualized. Richard Kastelein wrote in the Harvard Business Review (March 2017) that ICOs “allow startups to raise funds without having equity stakeholders breathing down their necks on spending or prioritizing financial returns over the general good of the product or service itself.”
So, what’s the catch? There are a few.
In addition to the numerous benefits, ICOs also come with a new set of challenges. Like new cryptocurrencies, ICOs are moving through the growing pains of early adoption, including market volatility and a host of compliance and security issues. But in the year ahead, these are some of the most significant trends we can expect around ICOs in 2018.
1. SEC Crackdown on ICO Compliance
Looking ahead, the regulatory environment is going to become more intense in 2018 and the ICO fundraising phenomenon will complicate an already murky regulatory environment for emerging companies. Going forward, it’s likely that the SEC will crackdown on unregistered ICO securities and token sales this year.
For myriad reasons, the legal status of ICOs remains unclear for securities regulators, many of whom are still debating whether ICOs are a security or asset. Even after the Security and Exchange Commission (SEC) weighed in with Release No. 81207 (July 25, 2017), opinions still vary greatly as to whether a token is a security.
The confusion is further compounded by definitions that vary from country to country. Countries like Switzerland and Singapore, for example, are burgeoning havens for cryptocurrency because they agree to fintech rules, treating cryptocurrencies as assets rather than securities. Other countries, like the US and Canada, are claiming that existing securities laws may apply to any use of distributed ledger technologies (“DLTs”), which includes blockchain, as part of financial products or services.
Further complicating the issue is that the SEC declined to provide any standard benchmarks, instead emphasizing that each sale must be considered on an individual basis. Jay Clayton, the chairman of the U.S. Securities and Exchange Commission recently said, “We have seen instances where companies seem to have had trouble raising money in a traditional private placement and then have switched to an ICO in order to raise the money. The business hasn’t changed substantively, but it’s a form-over-substance way to raise money. That is troubling.”
That said, comparisons can certainly be made between ICOs and equity crowdsourcing, and many anticipate that regulatory bodies will eventually lean in that direction. With crowdsourcing, the SEC ultimately capped the amount of money that could be raised without some of the regulations being involved to $1 million. Companies under the that proposal would have exemptions available and be able to raise capital from a larger pool of people – a stipulation that can be applied to any crowd sale, and potentially encompass token sales as well.
However, if regulators do recognize ICOs as securities, users will have to adhere to KYC (Know Your Customer), which verify the identity of investors, as well as Anti-money Laundering (AML) regulations. For companies considering ICOs, these new compliance mandates could present even more obstacles to conducting legal and compliant token sales, and going forward, they’ll need to balance the risks of regulation with the extra rigor that compliance requires.
Also read: The top 4 reasons why ICOs fail
2. Increased Security Risks
The lack of regulations make ICOs a potential for fraudsters and others who are not registering their offering or otherwise providing haven necessary safeguards for the public. Because an ICO is not regulated or registered, users will not be reimbursed if something were to go wrong.
Granted, organizations might still be extolling the numerous benefits of ICOs as a quick and easy way to generate much-needed funding. But the same murky regulations around them also make them a potential magnet for cybercriminals, fraudsters and others who either don’t want to register their offering or fail to provide adequate security to the public. For backers who have a financial stake the process, an unregistered ICO holds the potential for devastating losses– with ICOs that are neither regulated nor registered, investors are often not able to recoup their assets if something goes wrong.
Meanwhile, risks are also elevated due to the potential for lost keys. In conventional financing structures, the issuer is a trusted third party — those that lose stock certificates will easily be reissued a new one. But the security and integrity of private keys issued during ICOs is more complicated – largely due to the irreversible nature of digital currencies. Investors who lose private keys for their wallet or whose wallet is otherwise compromised likely won’t be able to retrieve their tokens once they’re gone.
As it is, new reports and articles emerge on an almost daily basis warning that we need to protect the general public from the impending onslaught of boiler room con-artists. And as ICOs becomes more mainstream, the potential for fraud will inevitably increase.
Also read: 7 deadly ICO sins that will scare away your investors
3. Volatile Cryptocurrency Market
Regulations shifting toward cryptocurrencies globally will cause more instability in the market.
It’s safe to say that the future of cryptocurrencies remains unclear at best. And current forecasts aren’t immediately promising. In January 2018, Bitcoin fell 18 percent, and its top rival, Ethereum, fell 23 percent.
The volatile cryptocurrency market is being fueled by new restrictions placed by China and South Korea, and soon Russia, in an attempt to regulate the crypto-craze and the cryptocurrency market in its entirety. The new set of punitive restrictions is anticipated to have a big impact on ICOs in 2018, already triggering several panicked sell-offs. Thus far, Bitcoin, Ripple, Cardano, Stellar, IOTA, and Ethereum dropped in value, with additional minor currencies like Bitcoin Gold and TRON falling even harder. Altogether, the total valuation of the crypto market has fallen by tens of billions of dollars.
Perhaps as expected, public perception has taken a nosedive. Currently, a critical mass of ICO detractors are demanding structure and investor protection, pointing out the scams, insisting on more control, and saying that without equity, investors won’t have enough skin in the game. While Jeff Garzik, a leading figure in the blockchain community, calls ICOs “transformative,” he also maintains that 99 percent of those ICOs will be “garbage,” adding “It’s like penny stocks but with less regulation.”
In short – the market has already experienced its share of volatility, with the potential for even greater anticipated instability down the road. And because the token sales are not uniformly regulated, investors can’t rely on the same insurance protections as they do with publicly traded stocks.
Preparing for the Future of ICOs
Above all, organizations considering ICOs as a viable fundraising tool need to be prepared to comply with KYC and AML regulations voluntarily, with the expectation that they will be enforced in the near future. That means they will need to conduct their due diligence in legal structuring and documentation in early stages of the token sale process – a precaution that will likely put a stamp of legitimacy on the project, boost public perception and garner credibility with customers down the road while keeping the majority of regulators and auditors off founders’ backs.
Ensuring that ICOs are aligned with KYC/AML regulations will lay a foundation for almost certain and more punitive compliance enforcement down the road. But more than that, businesses that spend time and resources to do this due diligence will also get a leg up in protecting themselves from potential fraud and other risks from security loopholes around unregistered ICOs. At the end of the day, being prepared on the compliance front will go a long way to put them ahead of competitors while shielding them from a potentially more turbulent journey in the ever-changing cryptocurrency market.
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Frank Marques is an ICO Expert at Jumio.
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