Blockchain project Tezos raised $232 million-worth of bitcoin and ether in mid-July 2017, breaking the record for crowdfunding through an ‘initial coin offering’ or ‘ICO’. This figure surpassed both the $150 million funding for the Bancor project in mid-June, and the Basic Attention Token which raised over $35 million in just under 30 seconds on its release in late-May.

The emergent phenomenon of ICOs could prove a viable alternative to venture debt or equity financing. At present however it is highly risky business for investors, and has prompted the Securities and Exchange Commission and other regulators to scrutinise ICOs under existing investment securities laws.

What is an ICO?

An initial coin offering is the exchange of bitcoin or ether for ‘tokens’ (or ‘coins’), issued for the purposes of crowdfunding a decentralized blockchain project. 

Projects are extremely diverse in scope and ambition. The 150 ICOs in the past year ranged from digital advertising and online gaming to solar energy trading and land registration. Such projects are increasingly built on the Ethereum network, as tokens compliant with the ERC20 coding standard can be easily exchanged for ether through the use of a smart contract.

Tokens are distinct from equity or debt securities. Ownership of tokens rarely confers any ownership, voting or dividend rights, other than the right to use them on that project’s platform as a means to obtain services.

A token’s value is instead derived from function and speculation. An investor expecting to execute a high volume of transactions within a project may seek to accumulate a stockpile of tokens at below-market value during the ICO. At present however, speculation remains the overwhelming driving force behind token prices. Investors buy early in the hopes a project’s success will inflate the token’s tradeable value when the token is eventually released on a cryptocurrency exchange. 

What are the risks?

The ICO mechanism provides an opportunity for investors to fund emergent technologies relevant to a range of existing industries. By contrast, investment in cryptocurrencies and tokens is also risky and highly volatile. We have identified three primary sources of risk to potential ICO investors:

1. Fraud and lack of regulation

The issue of a token requires little more than coding a simple smart contract. More sophisticated developers may publish a whitepaper, which is often extremely ambiguous by the standards of a traditional equity or debt prospectus. The ease of issuing an ICO and a lack of regulatory oversight has resulted in a significant majority of recent blockchain projects proving to be, at best, business model-less and profit-less ventures, and at worst, fraudulent enterprises.

2. Susceptibility to market manipulation

Large market participants and project developers are often able to dominate token supply through ICOs. Examination of a popular token issued for an online gaming platform reveals that the top 10 investors collectively hold 68% of all tokens, with the top 100 together holding 87%. This is characteristic of most ICOs, with a small minority of investors (so-called ‘whales’) holding a significant majority of tokens. This renders tokens highly volatile and susceptible to market manipulation.

3. Cyber-security and hacking

The recent popularity of blockchain projects and the irreversible nature of decentralised ledgers makes ICOs a prime target for hacking. In June 2016, exploits in the coding of the DAO project led to $50 million in DAO tokens being redirected to a hacker. In July 2017, the website advertising one project’s ICO was compromised, with more than $7 million lost. 

How have regulators responded to ICOs?

The unprecedented pace and growth of blockchain technology and ICOs has prompted urgent review by financial regulators. Freshfields Digital maintains a snapshot of regulatory treatment of cryptocurrency.

Russian media reported in July 2017 that the State Duma was considering new legislative frameworks to verify smart contracts, “identify users and protect the rights of the holders of tokens to fulfil the obligations of issuing companies.”

Of particular note, in late-July 2017 the Securities and Exchange commissioned published a report which found that certain case-study tokens fell within the SEC v Howell definition of ‘investment securities’. As such, issuers of tokens must comply with registration requirements under Section 5 of the Securities Act 1933. While no enforcement action was proposed at this time, the SEC made clear that US federal securities laws encompassed “virtual organizations or capital raising entities that use distributed ledger or blockchain technology.”

Update (13 Aug): In August 2017, the Monetary Authority of Singapore (MAS) released a statement addressing ICOs. Recognising that tokens 'vary widely' in nature, the MAS noted that some tokens could represent ownership or a security interest in an issuer. Such tokens may therefore 'be considered an offer of shares or units in a collective investment scheme under the Securities and Futures Act (SFA). Digital tokens may also represent a debt owed by an issuer and be considered a debenture under the SFA.' Issuers of such regulated digital tokens in Singapore would be required to lodge and register a prospectus with MAS.