It is less than five years since in July 2013 J.R. Willet did the first ever ICO (Initial Coin Offering) for the Mastercoin. Since then ICOs have raised cumulatively more than 3,7 US$ billion until December 2017. The year 2017 saw the explosion of the funds raised with this new funding technique. It is interesting to note that the historical high of deals closed by traditional Venture Capital (VC) — approx. 19.000 — is coincident with the beginnings of the ICOs in 2014. Since then the quantity of VC deals has dropped by almost 50% to approx. 10.000 deals in 2017. Moreover, the fact that the amount of money invested in VC has not dropped by the same amount, it is evidence that traditional VC is now focusing on less but larger deals. This means that VC does not fulfil the early funding needs of start-ups which then have turned to ICOs in order to raise funds.
Also crowdfunding has shown all its limitations when compared with the ICOs. There are numerous examples of start-ups which failed to raise even a few hundreds of thousands with crowdfunding campaigns and then raised millions in the first day of an ICO. Take Kickstarter — the most successful crowdfund — they raised less than 3,5 US$ billion in 8 years compared with the same amounts raised by ICOs only in the two years 2016 and 2017. No wonder that both Kickstarter and Indiegogo are now pushing forward their own ICO platforms.
Advantages of ICOs vs. traditional funding
So what makes ICOs so appealing?
It is essentially the access to a liquid market. It is the possibility to “digitize/tokenize” any assets and trade it on a global market where one can tap into investors from all over the world without the need of financial intermediaries. In other words, it is the “democratization of entrepreneurship” and the end of the monopoly of traditional financial institutions on funding ideas and creativity. It is potentially a unique opportunity to scale and develop new ideas and products in each field of application, from consumer products to technology, to science and medicine, to the purest advanced research in any such fields where raising money traditionally is very difficult. It is an enormously powerful tool which will enable “creators” to retain more effectively the control and the ownership of their ideas and creations, without the need to sell out to the finance industry.
The ICOs have also many practical advantages compared to traditional funding:
- the access to a boundless worldwide market of potential investors compared to a small elite of venture capitalists;
- the lack of the usual barriers and constraints that make accessing traditional VC funding difficult, such as geographical limitations, language and cultural barriers, social class barriers and networking barriers. VC has also high costs of funding in terms of equity share to be given up and high share capital dilution;
- the liquidity of a boundless worldwide secondary market in which tokens/coins, shares, bonds, commercial papers, derivatives of any type of assets, you literally name what, could be traded;
- the flexibility in designing the token-instrument — as well as the features and the rights that one can attach to it — is unconstrained;
- just as the ICOs will “democratize entrepreneurship”, tokens will “democratize investing”. This will do to the investment market what the internet did to the media. “Amateur” investors will become like tweeters and bloggers in the media today;
- the token aligns the interest of the entrepreneur and the investors very effectively. The investor buys the token because he shares the objectives of the project, loves the technology application, likes the developer and its team, he is happy to use the application and profits from the appreciation of the coin if the market develops. He always has a way out if he does not share the project anymore. In traditional VC the corporate structure is closed, it is not flexible. Also, the participation of the investor in the capital of the company via traditional VC frequently creates conflicts of interests, whether it is on the strategies, on the distribution of profits or future investments. It would be interesting to ask Bill Gates, Elon Musk or Steve Jobs if they could go back in their early days and — having this new opportunity — if they would go again with a VC or an ICO. Clearly traditional VC has also its important advantages, such as bringing on board experienced and competent investors who can contribute very specialized knowledge and networking capabilities in key areas such as finance, marketing and business development. But comparing VC with ICOs is not the purpose here as it is not advocating if one is better than the other.
The Social value of the ICO
So far the large part of ICOs have raised funds for the financial sector. But ICOs will be even more important and disruptive in social or scientific fields. Take an industry with a bad reputation, lots of money and strong lobbies: Big Pharma. Stories abound about experimental drugs that can cost a fraction of existing drugs and be more effective, but never make it to production because they challenge existing “blockbuster” drugs which net the industry much bigger gains.
Luckily today a bright researcher has a new opportunity. Raising funds with an ICO may effectively end up stimulating competition in a sector which is substantially run as a cartel. The same goes for researchers who are fighting against rare diseases. A rare disease is defined in the EU as affecting less than 1 in 2000 people which may still add up hundreds of thousands or even millions globally. Since those numbers do not make it profitable enough for Big Pharma to develop an experimental drug, a researcher has now the option of reaching out directly to the patients and raise funds from them with an ICO campaign. Even a few hundreds of thousands raised will go a long way stimulating the research and saving people´s lives. I cannot think of a better social enterprise than this, where the interest of the drug producer and that of the patients who finance the venture are so much aligned and convergent. If the drug is successful it goes into production, the patients/investors buy the drug, a market for the drug develops and the token appreciates and lives are saved. It works just like the old fashioned cooperative, except that the opportunity now is to tap into a worldwide boundless cooperative. ICOs will have limitless opportunities of use in social ventures.
The status of regulations
It is commonly heard that the sector is like the “wild west” and it is unregulated. This is not correct. There is plenty of regulations at all levels. The question is whether new technological creations such as token/coins or cryptocurrencies fulfil the current definitions of securities/stocks, money or e-money. If yes, existing regulations will apply, if not then we may discuss if and what kind of regulation may be appropriate. In my opinion regulators shall refrain as much as possible from new regulations. What is needed is some coordination to clarify mainly in which cases coins/tokens are to be considered equivalent to securities. The example of Switzerland is illuminating of a generally balanced approach which aims at clarifying upon which conditions token/coins or cryptocurrencies are falling within existing laws, without the need for additional regulation.
Unfortunately, instead of taking Switzerland as an example, central bankers, regulators worldwide and even the G20 have lined up recently to call for cryptocurrencies and ICOs to be regulated.
“Tokens could post substantial risks for investors and can be vulnerable to financial crime without appropriate measures,” the finance ministers and central bank governors of France and Germany said recently. Moreover, “In the longer run, potential risks in the field of financial stability may emerge as well”. IMFs Head Christine Lagarde has released a chilling Blog titled “Addressing the Dark Side of the Crypto world”. According to Lagarde, one of the major perils of Crypto-assets is that they are “potentially a major new vehicle for money laundering and the financing of terrorism.” Here my comments on what to read between the lines of Lagarde´s Blog and generally on the ongoing “terror” campaign unleashed by the elites upon Bitcoin, ICOs &Co.
More disclosure rather than regulation
Don´t get me wrong. Of course there must be concerns for retail investors but — as Switzerland has effectively demonstrated — this does not mean necessarily that new regulations are needed. Retail investors are easily protected by ensuring that they are given correct and transparent information. Disclosure is the key, not additional regulation. From the investor´s point of view the main issue is to make sure that there is no room for fraudulent schemes. This is easily done by ensuring a few things:
- transparent corporate documentation and a minimum set of disclosure requirements;
- clarity as to which rights are attached to the tokens and how to enforce them;
- protection of the funds invested, which shall be deposited into an escrow in a reliable jurisdiction and released only upon fulfilment of the conditions set out in the Whitepaper. An option would be to require that the escrow shall be situated in the country of residence of the investors, regardless of where the company is actually registered. Multiple escrows in different jurisdictions may be an efficient and cost effective way of protecting investors. The escrow must be managed by an accredited financial intermediary. Smart Contracts can be deployed as well.
The above may well be sufficient to discourage plain fraud schemes. Then a proper due-diligence does the rest (scroll down the page to reach the right article). Once appropriate disclosure is ensured, then retail investors should take responsibility for their choices. Historically, the biggest risk lies within the well regulated traditional financial sector where — when things go wrong — millions of people lose their lifesavings. See what has happened in 2007, the banks´ predatory lending practices which led to the sub-prime crisis and the bailout costs for the global economy.
So if money laundering risks alleged by the regulators are in fact negligible and can be easily dealt with the existing KYC/AML regulations and fraud risks to retail investors can also be effectively reduced with more disclosures as indicated above, what are the real risks for the sector?
Personally, I believe that the biggest risk is not the lack of regulation, but most certainly overregulation or bad regulation which may cripple the experimentation and the funding of creative ideas. Just to understand what overregulation and bad regulation can do to the sector, look no further than the “infamous” New York´s State BitLicense which has been granted only to a handful of larger operators and caused the mass to pack their bags and move to more relaxed jurisdictions. If you read through the 44 pages of compliance requirements you cannot avoid thinking that the only reason to make it so burdensome was to actually cripple the sector.
Why do I see this as the biggest risk? Because the financial sector stands to lose big if they do not get soon a firm grip on the sector. Just think for a moment: a boundless, decentralized, liquid market where you can trade any assets. There will be no need for brokerage houses or intermediaries as we know them today, which may well be replaced by an open source node software like the XU. The trades will settle in seconds, with direct peer to peer payments made via mobile phone and without need of a bank account. Tokens will obliterate stocks as the most traded instrument in a large, open, decentralized, transparent market running 365days/24hours on the Blockchain.
Is this a fantasy? In technology terms sure not, it is more or less just around the corner. And this is what the financial industry is scared off. They risk losing the monopoly on money creation and on wealth expropriation which is effectively achieved through the systemic manipulation of the current financial system. For the deep pocketed financial industry more regulation just translates into more costs which they can simply pass on to consumers or just absorb to achieve a competitive advantage, but for all the innovators this is a matter of life or death.
STOs will be the Future
ICOs have grown so rapidly also because they exploited an unregulated market loophole and — to be fair — the SEC is not wrong when they state that most of the utility tokens issued were in reality more like securities. Therefore it is safe to assume that, as the regulators will start to issue their guidelines — hopefully just like Switzerland did — this loophole will be soon closed. This means that the opportunity to do an ICO — the unregulated way like we have seen so far - will be limited to “real” utility tokens. Accordingly, unregulated or little regulated ICOs, will likely maintain their importance to fund mainly tech and innovative start-ups and social ventures where utility tokens will not fall within the application of securities laws.
But what about the rest then? What about the largest part of the market, all those more mature and proven businesses which are still interested in the ICO model as a new way of raising funds? Enter then STOs (Securities Token Offerings). STOs are today substantially unknown, but their potential is huge. Just recently the first ever Real Estate STO worth US$ 400m has been announced.
Equities, loans, real estate, anything that is considered today by applicable laws as a security or asset can be tokenized. While securities´ laws will clearly apply to this category of tokens, the attraction for mature businesses is to tap into a highly liquid, borderless and decentralized market. Just imagine if the US$188billion IPO market slowly migrates to STOs and then just a tiny fraction of the current global debts, derivatives and commodities market follows suit (difficult to quantify, it is a mind-numbing number in the quadrillion league, see here for a visual representation of money markets today).
In addition, a wave of STO deals is to be expected to come soon also from the traditional VC industry, in order to exit and liquefy the many otherwise illiquid shareholdings they hold in portfolio.
STOs will also impact the internal and organizational structure of corporations as we know it. Think about the back-office work and the intermediaries involved in handling dividend payments and voting rights for securities listed on traditional exchanges and how the whole process could be streamlined with tokens and smart contracts.
Tokens will also allow corporations to run a much more decentralized business model. Just watch the growth of “network companies”, with very little internal corporate structure and a decentralized mass of stakeholders coalesced around the common project, who share in the Project´s value growth via the token.
The future of the ICO´s is likely to shape the future of the Blockchain. The two are locked together. Real innovation on the Blockchain can happen only if creators will remain flexible and unconstrained in their ability to raise funds. It is no coincidence that Ethereum made it with an ICO. Which VC firm would have funded Vitalik Buterin´s dream back in 2014 with ca. US$18m? None.
Disruptive innovations will not come from big industry players: IBM did not create Apple, Hilton did not create Airbnb, Wal-Mart or Metro did not create Amazon, and bankers did not create Bitcoin or Ethereum. It will be the young creative start-ups which will shape the future and they desperately need a simple and flexible funding mechanism to leverage their ideas.
Despite the fact that some of the risks highlighted above remain, young and bright technologists will continue to experiment, create and innovate and eventually those innovations will prevail and will quash the attempts of powerful lobbies and special interests groups to firm their grip on the sector. Only those who will understand early enough that this moribund financial system is ripe for a change — and that Bitcoin, Blockchain, disintermediation, peer to peer exchange of values and more honest money are here to stay — will survive. It is only to be seen which — among those who will resist the changes — will be the next Kodak or Blockbuster. For the ones who will not oppose but adapt and embrace changes, will win.
“Change is the law of life. And those who look only to the past or present are certain to miss the future” — John F. Kennedy