What are initial coin offerings and why are regulators starting to pay attention?

So-called initial coin offerings (ICOs) are a new way for blockchain projects to raise funds - and for investors to potentially lose money - and their popularity is accelerating.

Blockchain projects leverage the decentralised ledger system to provide disruptive solutions for managing all manner of digital and non-digital assets. It's better to think of the coins as tokens that provide their owners with access to the product of the company/entity issuing the token.

The first ICO of note took place in 2014 with the launch of Ethereum. Its coin, ether, is now the second most valuable coin in the digital currency world. Ethereum is a platform that allows developers to relatively easily and quickly build blockchain products. Many of the projects using ICOs to raise capital have products being built on Ethereum's platform, often describing their tokens as ERC20-compliant, meaning they can be used on the Ethereum blockchain platform.

We asked cryptofinance research group Smith + Crown to crunch the numbers on the sums raised by the exploding coin offerings. Suffice to say there has been a 1,000% increase over the amount raised in 2016 and we are only a little over halfway through the year - 69 sales raising $102 million in 2016 compared to 94 sales raising $1.2 billion in 2017, as of 25 July.

These figures do not include sales that failed to break through a $25,000 threshold and those sales that have subsequently returned funds to token holders. In 2013 there was only one token sale, raising a princely sum of $680,000.

One of the earliest (May 2016) and most successful fundraisings to date was that of The DAO (the definite article is part of its name) on the Ethereum platform. DAO stands for distributed autonomous organisation. Think of The DAO as a corporate entity without a centralised executive structure that is 'self-aware'. Anonymous token holders are able to take a view on which of the 'smart contracts' built on its system should receive backing. These decisions are made by using a system of consensus voting, which is what the tokens are for.

The DAO raised $150 million, although a hacker was able to drain ether to the value of $50 million out of the system, forcing Ethereum into a hard fork of its code in order to refund those affected. As a result, there are now two Ethereums, with Ethereum Classic being the original unforked version.

Regulator bares its teeth

However, the days of no regulation of ICOs are ending. On 24 July the US Securities and Exchange Commission (SEC) published an investigative report on The DAO and concluded that its token is a security.

It rejected the notion that The DAO is a 'virtual' organisation with no centralised control, concluding instead that the system's 'curators' were performing a centralised controlling role. The SEC found that the curators ultimately determine whether a project up for consideration actually gets on to the whitelist that allows it to be voted on and the order in which selected projects appear on the list, in addition to how long projects stay on the list.

This is a big deal because it means that someone can be made legally responsible for investor losses, for example in the event of a hack. The upshot is that blockchain-based coins and tokens could now be deemed to be securities as far as the SEC is concerned and, as such, would therefore need to register their offers with the authorities, unless they have a 'valid exemption'. The SEC's ruling is guided by the Howey test as to what is a security.

The Howey test is based on case law from 1946 when the US supreme Court ruled in favour of the SEC after it had determined that a company (Howey & Co) selling parcels of land which the new owner then leased back to the company, was in fact selling a security and should therefore register and abide by full disclosure rules.

The test states that if an investment is an 'investment of money from an expectation of profits arising from a common enterprise depending solely on the efforts of a promoter or third party', then it is a security. You don't need to be legally trained to have a go at applying the test in the real world. Taking into account the four legs of the test, it is possible to see how the majority of token sales would indeed fall inside the Howey test definition.

One of the likely grey areas is the 'promotor or third-party' leg of the test, given the decentralized nature of blockchains and their novel governance. However, bearing in mind the conclusion of the SEC's report on The DAO, this decentralisation is probably not going to be enough to fail the definition for being a security. Nevertheless, each ICO will have to be considered case by case.

Warning signs

Matt Kluchenek, a partner at US law firm Baker McKenzie, told Bloomberg: "What happened in the past is probably safe activity but if they want to continue to fund raise with tokens they will need to reconsider whether that fundraising complies with federal securities laws." He also thinks it is quite possible for that a promotor might "choose to call an ICO a security and market it as a private placement, they could still avoid a lot of securities laws; that's still a viable route".

But be warned. As Charles Hoskinson, a co-founder of Ethereum, puts it, "good business practices don't go away just because we have a new paradigm". He thinks the ICO craze is "a ticking time bomb". It is therefore incumbent on individuals and corporations considering putting money into an ICO that they do their own rigorous due diligence.

There are likely to be an increasing number of ICOs that will not be on offer to US investors, although regulation is welcomed by many market participants. The SEC has posted a useful investor bulletin on the issues surrounding ICOs and how to spot the possible fraudsters, which equally applies to non-US investors.

In short, the SEC's warning signs are: guaranteed high returns, unsolicited offers, sounds too good to be true, pressure to buy right now, unlicensed sellers and no net worth or income restraints.

You can take a look at any number of a growing cluster of websites listing past and future ICOs - for example, ICOchecker.com, tokenmarket.net, ICOtracker.net, smithandcrown.com and coinschedule.com - to get a feel for what's out there and the minefield it presents to a speculative investor trying to do their own due diligence on prospective investments. Smith + Crown attempts to do some of the due diligence for investors with a useful breakdown of each project, who's behind it, how the token sale is structured and so on.

We contacted the UK financial markets regulator, the Financial Conduct Authority (FCA), for its views on initial coin offerings. The FCA was not very forthcoming. Asked if it had any plans to regulate ICOs, a spokesperson for the regulator said: "We cannot comment on future policy. We don't regulate digital currencies and the distributed ledger technology infrastructure beneath them."

Interactive Investor will be speaking to a number of ICO issuers in the second part of our assessment of this highly risky, but possibly lucrative new space.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.