• Aug 31, 2019

Initial Coin Offerings, Security Token Offerings and Initial Exchange Offerings

Initial Coin Offerings (ICOs), Security Token Offerings (STOs) and Initial Exchange Offerings (IEOs) are different ways to raise capital through the issuance of cryptocurrencies.


1. Initial Coin Offerings (ICOs)

An ICO is a way of crowd funding which involves the issuance of virtual tokens to investors who have invested in the underlying project. In 2017, ICOs collectively raised over $14 billion in capital. It became rather popular among cryptocurrency investors as they yielded extremely high returns. Next, the most successful ICO in terms of returns to date according to ICO Stats, has returned 184,368% since its ICO in September 2013. (1) One study reported that a blind investment in every ICO to date, as of October 2017, would have yielded returns of 1,320%. (2)


All-time Cumulative ICO Funding

(Source: https://www.coindesk.com/ico-tracker, July 31 2019)


ICOs offer entrepreneurs a new platform for raising capital for their ideas without being constricted by geographical boundaries, having to pay hefty fees to investment banks or complying with cumbersome and unclear regulations. It allows anyone who has cryptocurrencies and has access to the internet to participate in financing new projects. The underlying technology also presents a possibility for financially underdeveloped countries to leapfrog their capital markets and financial systems. However, because of the lack of barrier to organizing an ICO and regulatory safeguards for investors, many people exploited ICOs to defraud investors amid the ICO craze. In fact, a study by Ernst and Young found that over 80% of ICOs conducted in 2017 were identified as scams. (3)


The booming ICO market eventually caught the attention of regulatory bodies all over the world, who struggled to determine whether or not cryptocurrencies are securities. While cryptocurrencies in the true sense of the word are not equities, many of the token issued in ICOs, under the current law, could be considered investment contracts especially in the early developmental phases when it is necessary for the developing team to lead the efforts to grow the network. (4) The SEC responded by turning to the landmark case, SEC v. W. J. Howey Co., (5) which gave rise to the Howey Test. Tokens which pass the Howey Test are considered security tokens, and those that fail the test are considered to be utility token. The SEC also recognized that this binary classification of tokens is not static, meaning that if the network native to the token becomes sufficiently decentralized, the token could be reclassified as a utility token, as was the case for Ethereum. The challenge remains for the SEC in clarifying the means of measuring the degree of decentralization and the point at which a cryptocurrency becomes sufficiently decentralized to be classified as a utility token.


As bearish sentiments prevailed in the crypto market in 2018, regulators all around the world continued working to understand cryptocurrencies, the implications of its potential widespread adoption and to regulate cryptocurrencies without stifling innovation. The divided opinions of the regulators on the matter are evident in the regulations that vary vastly from country to country. China had outlawed ICOs in late 2017 and it is speculated that India will ban all non-sovereign cryptocurrencies, while regulators in countries like Japan, Singapore and Canada have taken more favor steps to entice developers to build their companies in their cities. At the same time, it became clear that ICOs were a huge part of the cryptocurrency bubble. A study found that 86% of ICOs in 2017 were trading below their listing price as of October 2018. (6) Still, professionals in the cryptocurrency industry argue that the bear market has been good for the industry as developers were freed from distractions caused by the parabolic price movements and left them to focus on their projects, all the while as bad projects and scams were purged from the market.


More recently, the SEC has been actively cracking down on token issuers, signaling an increased confidence of the regulatory body in their understanding of cryptocurrencies. (7) Many professionals in the crypto community are following the ongoing case between the SEC and Kik Interactive, the issuers behind the KIN token, and they are hoping that the case would result in a greater regulatory clarity for ICOs.


2. Security Token Offerings (STOs)

The ICO mania in 2017 led to the recognition of the technological value tokens can offer to the capital market, giving rise to STOs. STOs, unlike ICOs, involves the issuance of regulatory-compliant tokens representative of ownership in an asset, or the entitlement to vote and/or a share of cash flows. It allows assets to be tokenized, meaning the ownership of a large asset such as houses can be made fractional with tokens, which can increase liquidity and access to a market which is open round the clock. These tokens can also be programmed. For instance, a tokenize loan could be configured to distribute interest payments and principal repayments to creditors holding the tokens without the need for any intermediaries.


Security tokens are issued on existing blockchain platforms such as Polymath, Swarm and Harbor, many of whom also provide custody solutions. Issuers in the U.S. can register with the SEC to issue tokens under Reg A+, Reg CF, Reg D, or Reg S. (8) Upon issuance, security tokens may be listed and traded on regulated exchanges like tZero, Blocktrade and Lykke.


3. Initial Exchange Offerings (IEOs)

IEOs are like ICOs, except that cryptocurrency exchanges undertake the task of selling the token on their platforms on behalf of the developers.


IEOs Launched on Binance Exchange (YTD)

(Source: https://coincodex.com/ieo-list/binance/, June 22 2018)


IEOs became popular in the aftermath of the cryptocurrency bubble in 2017 at a time when many cryptocurrency investors became skeptical about ICOs. Cryptocurrency exchanges responded by lending their credibility to token issuers. In exchange for a fee or a percentage of the total supply of tokens being issued, the exchanges would raise funds on behalf of the developers while performing due diligence on the project. Many major exchanges, such as Binance and Bitfinex, also issued their own tokens, which could be used by users not only to participate in IEOs, but also to vote on matters concerning the users of the exchanges and to pay for discounted trading fees.


The return on investment on some of the recent IEOs have been extremely rewarding so far. Of the IEOs launched on Binance exchange, which is the most popular cryptocurrency exchange in volume, the returns in U.S. dollar ranges from 235% to 1,093% year to date. IEOs can significantly reduce the risk of investors investing in fraudulent projects and eliminate KYC and AML processes for investors, as they would have cleared those processes when opening accounts on the exchanges.




Contributor


PrimeAlpha

Joseph Lee

Research Analyst


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