ICOs must be regulated to transform investing

Richard Blakesley, a partner at Capital Pilot and blockchain lawyer Florian Glatz explained the exciting potential ICOs offer if regulators allow it, in a research interview with FinTech Global.

There a new force emerging in the fundraising world. Combining crowdfunding with the regulatory-bypassing ability of cryptocurrencies, initial coin offerings (ICOs) allow blockchain projects and startups to raise money outside of the traditional VC world. The rapidly growing sales of these digital tokens has the potential to transform the nature of institutional investing if regulators allow it.

Speaking to FinTech Global in research interviews, Richard Blakesley – co-founder and CEO?at Capital Pilot, a company which?helps startups raise funding efficiently – and blockchain lawyer Florian Glatz explained the exciting potential ICOs offer as a medium of fundraising, but the need for regulation if it is to expand beyond the niche world it currently serves.

The advantages of ICOs over traditional fund raising

At their most basic ICOs are crowd sales of digital tokens representing equity in a company, which grow in value as the company does. Similarly to shares bought in an IPO, investors can sell these tokens for other cryptocurrencies they can then cash out for fiat currency. Whether these are the sale of a security or not, however, is the billion-dollar question hanging over the space.

The advantage for companies offering these token sales is it enables them to raise capital very quickly (be it in bitcoin or fiat currency) from around the globe without the long, time-intensive, paperwork-heavy process required to make deals with institutional investors.

Blakesley highlighted the risks that also come with many advantages of ICOs and said: ?Youre able to raise money from people with whom you have absolutely no contact, who are on the other side of the world and speak a completely different language. You have a theoretically global audience and particularly for blockchain related business you have a smart audience.p>

Those buying the tokens (i.e. Investing in the company or project) also gain an advantage not normally present in startup backing: liquidity.

Glatz said: ?Traditional equity-based investment is slow and cumbersome from the perspective of startups. For investors, the poor liquidity of startup equity is less attractive than the token model which simply converts one liquid asset into another.p>

At a time when some of the best funded VC-backed business, such as Uber and Airbnb, are choosing to stay private and put off IPOs for long periods, this innovation around liquidity becomes more appealing. Blakesley suggested: ?The ability as an investor to get in and out of deals in a liquid market without all the regulatory hurdles such as opening brokerage accounts, is an absolute key driver but at scale, will those advantages be able to persist? It questionable.p>

ICOs are currently self-regulated

?It kind of like the Wild West right nowaccording to Glatz, who said the lack of regulation would prompt many to ask ?how the hell is this legal?At present the niche nature of the ICO market is allowing it to survive. Rather than selling these tokens to a relatively uneducated public like in more traditional crowdfunding, blockchain developers and enthusiasts are selling tokens to a highly engaged and knowledgeable network.

?Right now, the investors that invest in ICOs know what going on,explained Glatz. ?Everyone is in the know and it a small ecosystem where it works. If ICOs should become bigger, however, in the sense that a larger number of people want to invest in it, the way it being done now is not up to standard.p>

The relatively small community engaging and participating in ICOs is currently self-regulating, with Glatz adding: ?We have over a long period of time developed internationally a certain set of minimum requirements that companies have to fulfil to allow investors to really understand what is being offered. What are the terms of the investment, what happens if things go wrong, what are the risks and challenges?p>

The involvement of regulators is inevitable

In the first five months of this year alone, $136m was been raised across 37 token sales according to ICO data firm Smith + Crown, and as the number of ICOs being held rises so too are the sums being raised. Aragon picked up $25m in less than 15 minutes this month for its management tool for decentralised businesses – the largest amount raised through an ICO. With the volumes at stake growing, it is inevitable that regulators will become involved soon.

?There isnt any doubt in my mind that an ICO is regulated activity,said Blakesley highlighting the UK Financial Conduct Authority approach of labelling anything ‘that could reasonably be thought of as regulated activity’ as such. For many enthusiasts of decentralised technology, the presence of regulators is seen as a potential disaster, especially considering the US SEC’s tendency to govern more dogmatically than the often-praised FCA.

For a regulator to declare tokens as a security would offer the advantage of clear sets of guidelines surrounding their sale – but Glatz is worried about the cost such a move would create for the industry.

?Compliance with securities regulation is costly and complicated,he said. ?That is diametrically opposed to the ad-hoc fashion in which blockchain startups today go ahead and raise venture capital from other blockchain enthusiasts. Increasing compliance cost significantly would prevent the space from developing its own self-governing rules.p>

If ICOs do continue to grow and attract more traditional institutional investors, as well as even members of the public, then regulation will be needed. Blakesley specifically highlighted the need for anti-money laundering efforts that can prevent ?a virtual, blockchain based company with no domicile and a business that is somewhat suspect issuing tokens representing ownership in it as a virtual business to an unsuspecting public.p>

Whatever moves regulators do choose to make, those involved at this early stage have their fingers crossed for leniency. ?Should regulators be smart and allow the current ICO market to evolve further in a self-regulated manner and should the ratio of honest entrepreneurs to scams stay manageable, ICOs could very well become a mainstream phenomenon,claimed Glatz.

Protecting the public

One of the most obvious comparisons for ICOs is the crowdfunding market, with the 2015 JOBS Act Title II in the US allowing startups to sell equity through campaigns for the first time. Where crowdfunding differs is the authority of the platforms through which businesses sell their equity and raise funding. Platforms like Seedrs and Crowdcube in the UK and CircleUp in the US carefully vet the startups shown on the platforms, and reject as many as 90 per cent of applicants so their investors see the best deals and avoid scams.

The ICO market does not have this curation and due diligence level, meaning it falls on the startup or project raising money to provide the information needed for investors to make a properly informed decision. ?Today, an ICO investor needs deep insights into the blockchain scene,said Glatz. ?A successful investor has to be able to understand which ideas have merit and which are simply too early or too unrealistic to come to fruition. Additionally, investors need to know the people active in the space to understand who are the true thought leaders that are capable of creating and executing on a vision.p>

This means ICOs are a long way off the kind of mainstream adoption that crowdfunding has garnered. Its advantages over traditional investing, however, could see more companies look to it rather than crowdfunding, which in the US is limited to just $1m per campaign. Blakesley suggests that over time a shift in supply and demand could mean we move from the present, where there is a strong appetite from investors looking to participate in ICO, to an environment where there are more companies looking for backers than those ready to buy tokens. For companies looking for funding, visibility will also become an issue as the space becomes more congested. Similarly to crowdfunding campaigns, it will become harder for companies and projects to be seen.

Institutional investors are becoming more involved

Traditional investors are already making moves in the ICO space, with heavyweight tech investors Union Square Ventures and Andreessen Horowtiz co-leading a $10m round for cryptocurrency hedge fund Polychain Capital at the end of last year. A new generation of investors is also seeking to make ICOs a core part of their businesses. Blockchain Capital reached its $10m target in just six hours of launching its ICO to invest in blockchain-based businesses, while Boost VC has announced it will invest directly into ICOs.

Glatz believes the growing presence of institutional investors will serve to aid the space development and, importantly, serve to enhance its ability to self-govern. He said: ?Institutional investors will help the ICO space to evolve more mature rules of self-governance and to set higher standards overall. This is essentially like regulators coming in and prescribing higher standards, however, solely based on incentives rather than threat of punishment.p>

The impacts of ICOs on traditional investing

Regardless of whether or not ICOs evolve to become a mainstream means of fundraising, the innovations enabled by the blockchain will have a significant impact on traditional investing. Equity crowdfunding platform Seedrs recently followed in the path of ICOs by launching a secondaries market to create liquidity in the early-stage startup investing market. The ICO market is small today, but the efficiency that the blockchain offers means it is already making an impact in the traditional paperwork-and-meetings-based VC world. ?ICOs are already disrupting traditional venture capital firms,claimed Glatz. ?Certainly, it’s still a tiny market compared to the global VC spending. But that is rapidly changing as the ICO model goes viral among founders and startups.p>

The real impact of ICOs may be in their potential to improve the existing investment world, and Blakesley suggested it is the potential combination of a regulated brokerage firm and an ICO that could prove the breakthrough for the industry. ?If you do something that has all the advantages of the blockchain world but is effectively backed by a proper prospectus youve slammed together this new medium for funding a transaction alongside the existing world of regulation,he said. ?And brought forward the point at which regulation can support rather than hinder this new marketplace.p>

? 2017 FinTech Global & Investor Networks Ltd

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