Cryptocurrencies and the underlying technology have split existing financial and technological opinion, most notably JP Morgan’s CEO Jamie Dimon espousing a lack of confidence in bitcoin, going as far to call the platform a fraud. The most recent comments against the Initial Coin Offering (ICO) mania comes from Kyle Bass, a Hayman Capital hedge fund manager, who commented that many of the ICOs that occurred this year are frauds.
Speaking with Bloomberg, Bass commenced the question on bitcoin by recalling a bad guess: “Early on I summarily dismissed bitcoin and I shouldn’t have.” Like ICOs, bitcoin was also initially treated negatively by traditional and mainstream financial institutions, however, in recent years it has gradually come to be understood. ICOs on the other hand, rest in limbo, awaiting the move from regulators, yet, investors are not waiting, but instead perpetuating this ‘mania.’
As Bass comments, without the necessary regulation in place, the dangers of ICOs are readily apparent, namely the lack of true business model behind some of the ICOs and the lack of requirements for a working product or service. With this in mind, and given the recent moves by some governments (China, South Korea and Australia), what is in store for the Crypto market?
Bitcoin, ether and ripple have been very active in the past few months – from bitcoin’s fork and move to a second hard fork to ethereum’s upgrade to the Byzantium method as well as facilitating greater innovation in the platform’s ecosystem and ripple’s continued expansion into Asia and partnerships with banks. The potential in the market is monumental and the dangers surrounding ICO mania have done little to dampen the spirits of investors. Whilst the ban certainly provoked a reaction in the news, spectators on all sides of the conflict will have watched with baited breath as bitcoin saw a dive to $2,981. However, just two days later, its value bounced back toward $4,000 and now rests at over $4,500. Speculation arose as to whether or not the cryptomarket is experiencing a bubble, then questions followed as to if it would burst. What is certain, investors are not put off by tangible connections to black money, nor threats of heavy regulation. For now, the gold rush will continue, as Bass opined, and the big three – bitcoin, ethereum and ripple – are going to transform into an established asset class over the next few years.
Alternative coins have sprung up in the shadow of bitcoin, promising different services and platforms for business growth. For example, Golem seeks to use cryptocurrencies as a method of renting computer power from other individuals around the globe, attempting to create a global network of supercomputers. Such innovation and future technologies are being spurred by the interest in cryptocurrencies and massive influx of investment into the cryptosphere, as a result of the ICO mania. Over $2bn has been raised by ICOs, allowing start-ups to sell ideas to investors without the lengthy, difficult and tedious process involved in other capital fundraising methods.
The Difficult Question of Regulation
One can argue that cryptocurrencies task one with seeing legal regulation in a different light. Attempts by Australia’s Security Regulatory body shows there is a gap in regulation relating to ICOs, as the guidelines seek to extend several laws to cover the new method of raising funds, but falls short, somewhat, as nuances in the ways cryptomarkets behave were certainly not reflected in the principals espoused.
As Bank of America’s chief of operations and technology officer, Kathy Bessant opined that digital currency is not something new, it has been utilised for a while in all manner of transactions. It is not the technology that is in contention, specifically blockchain is not being demonised but instead is being adopted to accomplish remarkable things, such as enhancing cybersecurity and changing existing practices, including the legal profession. Nor is the idea of cryptocurrency in contention, as sovereign bodies look towards creating their own.
What is in contention is the lack of regulation of a system that is decentralised. Kathy Bessant echoes these worries, adding that the practices around these de-centralised platforms are not entirely transparent. Due to this, issues exist where the lack of trust can be abused, allowing the facilitation of black money usage.
To use bitcoin as the central example, it is built on a trustless system where the two people do not need to know or trust each other to transact; bitcoin’s blockchain replaces the central figure in the transactions. Every transaction is recorded in a ledger that is then distributed to each node and updated upon each transaction. Such a system is hard to hack due to the distributed nature of the ledgers, meaning that data is hard to retrieve. Whilst the system is anonymised somewhat, as individuals do not need to use their legal names, the ledgers are public, meaning that anyone can read them. As a result, given enough information, an individual’s transactions can be traced, as was the case with Silk Road, an underground black market operation that was thwarted by the FBI.
Compared to standard digital banking, when using bitcoin one does not know the sender nor the receiver’s true identity, leading Kathy Bessant to comment that anonymous currency, “flies in the face of every construct known to transparency in the movement of money and how we use it to prevent and detect other really important forms of crime.” The key issue, therefore, is the de-centralised and pseudo-anonymised transmission of currency.
The Need for the ICO: The IPO of Cryptos
Raising Capital is vital for successful business and the ICO is the latest iteration in such processes. Crypto-companies and start-ups produce different financial and technological products and services and exist in an entirely different financial spectrum, using de-centralised technologies. As such, it logically follows that new regulations and laws are needed to safeguard investors’ interests and ensure good corporate governance inside this new sphere. Just as the Limited Liability advent and the company as a separate legal entity changed corporate practices, so too cryptocurrencies require thought or else the potential to be had with these technologies will be squandered and lost.
As explained, an ICO is a method of crowdfunding to facilitate the launch of a new cryptocurrency or tech development. A crowd sale of a crypto asset is a term one could use. An ICO uses this cryptocurrency to raise capital by issuing an asset specific to an application or service on a general blockchain (such as applications on the ethereum blockchain) or one that exists as its own blockchain (like the Tezos token).
The unregulated nature of an ICO lends itself well to companies and small start-ups wanting to avoid the tenuous, overbearing and restrictive regulations of IPOs or other fundraising methods. Tokens do not represent a share of the equity of a business; and they do not confer ownership, meaning a CEO or investor does not need to reduce his ownership of the company. The freedom that ICOs currently present enables small start-ups to seek much-needed capital.
However, as aforementioned, ICOs can currently act as a tool for nefarious individuals to carry out dark intentions. First, unlike IPOs, companies that have yet to produce any real or tangible results are raising massive sums through ICOs, due to the unregulated nature of the ‘listings.’ Fundamentally, this presents an issue whereby individuals could be pitched an idea that is easily overstated or unrealistic, due to the lack of regulatory oversight and auditing. This facilitates reckless investing. Second, stemming from the lack of regulation and the fact that having tangible results is not necessary for an ICO, there is a serious opportunity for ICOs to be fraudulent.
The potential is that an ICO allows a small start-up to work on an idea and fund development of a potential technology by selling this idea to investors using a token that will be used as part of the platform itself or that can be traded. The issue is that such a potential is dampened when regulations would stipulate stricter requirements, perhaps along the lines of IPOs. However, contrary to that, imposing requirements and minimum standards to be adhered to would clean away the deadwood from the market, strengthening ICOs and the value that is generated. Regulation of some sort would legitimise the market.
Like IPOs for companies, the ICO is a prime fundraising method for crypto start-ups. We must not squander this potential by viewing these advancements with tinted lenses of historic laws. This is a fundamental issue. Ultimately, the current lack of transparency has led to ICO valuations resting on face value; whether investors like the idea, whether the managers appear trustworthy, the strength of white papers and target use cases. As such, there are several factors that create uncertainty when investing, making such prospects inherently risky.
The Move to Greater Certainty
Internal, self-regulation could be on the horizon, with projects like Balanc3 seeking to demystify ICOs and increase transparency, with the hopes of holding token generators to account. In a quasi-crypto accounting platform, by offering data from expenses such as wages and travel to a breakdown of other crypto-assets owned by the companies, Balanc3 hopes to develop a new way to value ethereum-based token sales. In a demo to Big Four accounting firms and blockchain adopters, Balanc3 used data from early adopters, Aragon (valued at $56m), Digix (valued at $140m) and Gnosis (valued at $142m). Whilst getting companies and start-ups to turn over all addresses associated with the offering will be a tough sell, the push for greater self-accountability is to be admired.
However, whilst such an effort is noble, other arguments still remain for tighter regulation. First, the system requires ICO holders to opt in, thus limiting its effectiveness across the board. Certainly, opting in can offer legitimacy, possess greater benefits for future investors and help reach budding investors, but it does not prevent abuse of the system. Again, merely requiring higher standards for ICOs is not enough, whilst it makes it harder for illegitimate ICOs to bite the cherry, unless such a system becomes near mandatory, it is simply a hurdle rather than a protective measure. Fundamentally, as Balanc3’s Griffin Anderson states:
“What you’re starting to see is the first step to the industry saying, ‘we’re going to take charge, we’re going to hold ourselves to a higher degree of standards and accountability… Regulation may still be needed.”
Secondly, from the investment point of view, regulation is needed to ascertain investor rights. Classification is key, and securities carry legal responsibilities for both the investor and the recipient of investment. ICOs, on the other hand, so far have only ‘caveat emptor’ and nothing more. Buying into an ICO grants no equity, nor voting rights (unless the company explicitly grants access to them). Such companies and start-ups are harder to hold to account – with less regulation on how to handle ICOs than exists with IPOs and other financial mechanisms, disgruntled investors have very little recourse outside of any (if any) contractual duties.
Thirdly, regulation can help instil good faith principles, along the lines of Balanc3’s premise. By mandating white papers, financial reports, auditing and other protection requirements, regulators can encourage ethical practices and provide protection to investors by developing good faith practices within the market. Through a grass-roots approach, heavier regulation will not be needed as the practice of self-regulation will be strong enough in the veins of the market to weaken many illegitimate attempts to abuse the ICO. Interestingly, Balanc3’s project appears to be an attempt to centralise part of the market, providing best practice for ethereum-based ICOs. Using such platforms in conjunction with minimum mandatory requirements can offer legitimacy for coins and protection for investors, whilst such platforms would not have a monopoly on control, reflecting the community at large. Having a single body in control of all things cryptocurrency would damage the market.
Crypto-Valley – Switzerland as an ICO Haven
A further community effort to self-regulate comes from The Crypto Valley Association (CVA). CVA is a Swiss-based not-for-profit association supporting the development of blockchain and cryptographic related technologies and businesses, published a series of codes of conduct to foster good practice, and “bring clarity and confidence towards a new, rapidly-growing asset class.” Comparatively, as noted by Ian Simpson, head of marketing and communications at Lakeside Partners (an early-stage investment firm in Zug, Switzerland) the country’s legal and political system mirrors the principles within blockchain, as the Swiss cantonal system consists of 26 semi-autonomous regions with a rotating federal presidency.
Combined with the talent and interest in Switzerland, the principles in the self-regulating codes, such as peer-to-peer review and no all-powerful central figure which are principles that exist in the blockchain community, Switzerland has become a haven for ICOs.
As a result, attempting to regulate each currency as an identical platform would fly in the face of the innovation present in the market. Regulators need to consider how the market will grow in the coming years and pass laws accordingly. In the interim, ringfencing cryptocurrencies by regulating investors and ushering protections from the consumer onward could buy some time to issue greater regulations down the line – it is erroneous to ask technology to wait for the law to catch up. Mandating minimum requirements of investors, from experience to capital, this will ensure inexperienced investors are not caught up in the fray.
Furthermore, working with self-regulating bodies such as the CVA is key to implementing regulations whilst also maintaining a strong community. Ultimately, the community will be more knowledgeable than the regulator, thus such bodies will do well to work with individuals that can educate them on a system they have no power over.
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