Initial coin offerings are the latest way for blockchain startups to raise capital and engage with their prospective client-bases. Investors have been making huge returns but the market has all the hallmarks of a bubble and is bound to burst sooner or later.

The initial coin offering market has been red-hot in recent months, with the total number of ICOs in the first half of 2017 surpassing the number for the whole of 2016, according to Santiment, a crypto-market intelligence platform.

Advocates argue ICOs, where companies create and sell a new digital token or ‘coin’ to investors to raise capital, offer issuers huge advantages. They allow issuers to raise millions with lower barriers to entry than alternatives like debt financing or an IPO and link issuers with investors that are also typically early adopters, beta testers, development contributors and evangelists.

While issuers are attracted to ICOs by the flexibility that is possible due to the lack of regulation around them, investors are principally in it for the returns. These have often been spectacular, with returns of 10 or 20 times the initial investment not unusual.

Such expectations ensure ICOs are often well supported, meaning issuers can raise significant sums. Nick Tomaino, principal at Runa Capital, an early-stage venture capital investment firm, reportedly estimated that blockchain projects going through ICOs can earn around 25x more capital than they would through traditional venture capital investment. But while this is certainly an attractive proposition for potential borrowers, it comes with inflated investor expectations that could lead to significant disappointments.

Inflated Expectations

Gavin Raftery, partner and chair of Baker McKenzie’s fintech working group in Tokyo points out that the name ICO is potentially misleading, given its similarity to IPO. “They are quite different,” he says, in particular because ICOs don’t give investors an equity stake in the business. “It isn’t clear that ICOs offer any real benefits over other (quasi) equity financing options already available. A lack of regulatory protections for investors is also a concern, especially given the potential levels of risk involved.”

It isn’t clear that ICOs offer any real benefits over other (quasi) equity financing options already available. A lack of regulatory protections for investors is also a concern, especially given the potential levels of risk involved.”

ICOs tend to appeal to specific types of venture, specifically protocols that trend towards being monopolistic public goods. For such companies being self-sustaining is often more important than being profitable and the emphasis is on cutting costs as much as possible so as to compete on efficiency.

Mitchell Loureiro, the marketing lead at Santiment, says: “Imagine monetizing [internet standards] TCP or HTTPS – it’s a strange thought. But with ICOs, we have a means of monetizing software networks in a way that creates incentives for them to make ever growing amounts of value for their users. This is the value of the ICO, and the monetization of blockchains.”

ICOs usually come in much earlier in the fundraising process than IPOs, often representing the first time a valuation is made, and are therefore appropriate in cases where an IPO would not be available. Traditionally companies might have looked at angel investors and venture capital, but ICOs attract larger sums.

ICOs also have advantages over debt financing, according to Travin Keith, marketing director and blockchain consultant at the Nxt Foundation. “Compared with debt finance, in the case where the tokens play an essential role in the product or service provided, it allows for the issuing party to treat the ICO as a presale,” he says. “With this, the issuing party only has to deliver the product instead of paying off the debt.” While there may be resources needed to be allocated to communicating with token holders, the costs may be less than the interest rate on the debt.

Adel, which provides infrastructure to help develop, support and fund innovative startups using blockchain technology, conducted an ICO in March 2017. “Venture capital is like a chess match,” says Adel co-founder Gabriel Dusil, explaining why it chose this route.

“The VC fund wants to maximise their ownership stake while minimising their capital investment. The startup entrepreneur wants the opposite. It’s a classic negotiation dynamic where each side wants to sell high and buy low. ICOs are different, there is no ‘us’ and ‘them’. It’s more collaborative.”



A regulatory wild-west

While ICOs remain entirely unregulated in the US and Europe, some Asian jurisdictions are already engaging with the market and showing real regulatory leadership. Stephanie Magnus, head of the financial services and regulatory practice at Baker McKenzie in Singapore, points out that the Monetary Authority of Singapore is not adverse to ICOs.

“It takes the view that tokens represent an underlying asset, much like a derivative, and regulates them as such,” Magnus says. “And the Hong Kong Monetary Authority treats it in the same way as it treats crowdfunding,” says.

The hype around the market and the early stage of its development ensures the attention of scammers and other fraudulent projects, leading to calls for greater regulation.”

Nevertheless, the rapid growth of ICOs and the lack of regulatory oversight in the West is causing concern in some quarters. The hype around the market and the early stage of its development ensures the attention of scammers and other fraudulent projects, leading to calls for greater regulation. Providing that will be a significant challenge from a technological perspective, given the decentralised nature of the blockchain.

In the case of an outright scam, laws protecting consumers against false advertising already give investors some recourse. But guidelines that incentivize ICOs to behave appropriately, and give potential investors a better understanding of what to look out for, would help the market. They would complement practical steps such as using escrow, independent audits and investment rating reviews, which are already provided by companies like ICOrating.

Reputation provides an incentive for borrowers to honour their commitments to investors, on top of any protections embedded into the design of the relevant protocols.

Regulators must tread carefully

If regulators want to reinforce all this with tougher rules, they must tread carefully if they want to avoid killing the market completely. There is evidence that while the lack of regulation keeps many potential investors away, others with a specific focus on cryptocurrencies take the opposite view. Adel’s ICO was the first to be marketed as anti-money laundering (AML)/know your customer (KYC)-compliant, which it hoped would reassure investors. The exercise had sought to raise 900 bitcoins (BTC) but ultimately achieved only €1m (roughly 433BTC as of 4 July 2017). Adel believes crypto-investors’ hostility to regulation may have contributed to the missed target.

Still, Adel co-founder Dusil hopes it will prove an important step towards encouraging other types of investors into ICOs, by legitimising the blockchain and bringing it into the mainstream.

“The ICO space is like the Wild West at the moment,” says Dusil. “There is too much risk and volatility for many mainstream investors. That’s why we wanted to be KYC and AML compliant, and be registered in the Isle of Man. It brings a foundation of legitimacy to our ICO funding campaign. How can you expect investors to put their money into ICOs when authorities could come in and shut them down at any time because of non-compliance?”

Yet this is precisely what many investors continue to do, in the expectation of returns that dwarf what is available in more mainstream markets. So far ICOs have been delivering, but it is surely only a matter of time before investors get burnt.

“ICOs are among the riskiest, most volatile investments,” says Santiment’s Loureiro. “Because they are a new asset class at its earliest stage of growth and exploration, prices fluctuate wildly. The current bull trend is pulling the entire market upwards but there’s no telling how high it could go, or when a correcting crash could occur,” he says.

Even its advocates admit ICOs look like a bubble, but if you strip away the irrational exuberance there is still a useful business beneath it. This can be reinforced by new regulations that offer access to the powerful tools provided by the blockchain while providing greater investor protections.

Loureiro says: “One thing is for certain; If blockchains really are the future of the internet – and I believe they are – those who invest at this early stage will receive incredible, jaw dropping returns surpassing even what was seen with Bitcoin early investors. The scale will be unimaginable.”