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The End for ICOs?

Before reading this article, please read our disclaimer found at the bottom of the article or here.

One of the worst weeks for cryptocurrencies

Introduction

Last year we saw the bulk of the development of a new type of industry and funding. Even though Initial Coin Offerings (ICOs) have existed for over 3 years, we saw the most amount of ICOs and the largest ever happening between September and December 2017.

An industry worth half a trillion just a month ago has suddenly lost almost $200 million dollars worth of its market cap in only 4 weeks. Welcome to the second week of March of 2018, probably the worst ever for the cryptocurrency world.

The market is incredibly volatile, but losing so much so quickly has created a lot of fear and lack of trust for the industry. There were a set of 3 events that triggered the collapse of the market this month.

We will discuss the events that caused the collapse, as well as the misconceptions and unregulated practices that allowed the environment to develop to its current state.

Image from: Coin Market Cap Global Charts found here.

The Problem

At its core, the problem of ICOs is predicated on the fact that a lot of people made a lot of money from purchasing tokens developed by some companies, and set at some completely arbitrary value. Then those investors would advertise their earnings and others would follow, inadvertently causing a pyramid scheme-like behavior.

One of the most problematic aspects of this behavior is how successful it is.

  1. Company A uses Blockchain because:
    1.a Company A has an idea, usually an existing market, but with Blockchain
    1.b Company A needs to fundraise but can’t find investors through traditional means
  2. They create a 20 page document discussing this idea, but leave out any important details regarding the corporation, experience, traction, etc
  3. They create a campaign to raise an arbitrary amount of money in exchange of an even more random amount of tokens
  4. The promise is that the tokens will have a core functionality in the product, with some heavily implied description that the token’s value will rise as the company develops
  5. Company partners with PR company and advertises token sale through social network
  6. Primary investors purchase said token and go to social media to advertise it
  7. Secondary investors purchase the token therefore raising the value for primary investors
  8. Primary investors make a huge profit and advertises it
  9. Cycle repeats with new Company B

There is a reason that fundraising is really difficult. And that is that private investment, and accredited investors have a lot of options, and your company has to make sense in multiple dimensions in order for them to consider it the best use of their money.

Even after months of negotiation and work, very few companies raise their initial seed round, and many less are able to fundraise after that one. The idea is that a token sale would fit nicely between a Seed round (or original fundraise) and a more serious Series A round.

The reason that it is so difficult, is because giving money to new companies is inherently extremely risky. The founders are young, inexperienced, it’s a small team, the markets they are competing against are fairly developed, and they have to execute faster, better, and stronger than anyone else before them, in order to win big. And the investors need to win big, because for every 10 companies they invest in, only 1 or 2 will become profitable.

The Events

The idea behind Securities Commissions is to protect the citizens of its jurisdiction from fraud, and from such risky investments. The idea is that without vetting a company, it is impossible to make a good prediction of its success, and if someone does not dedicate their full attention to investment, they will most likely make fatal mistakes and lose a huge amount of their savings. Thus the creation of a body to regulate misbehavior and investment practices.

The idea of securities commissions is as old as stock trading itself. As such the regulators have carefully been examining ICOs. This new type of investment strategy is strange, it is not quite a formal funding round (no stocks), but it is also not exactly a crowdfunding campaign like kickstarter (you get a token, not a product, and the token may increase in value).

The weird nature of these tokens left the commissionaires perplexed, and many of them decided to wait before making clear guidelines about what would be considered a security and what isn’t. The lack of clarity allowed a game of dancing in jurisdictional grey areas that is currently played in the ICO world. To make things more complex, the token sale is opened worldwide, and it makes it exceedingly difficult for the regulators to reach consensus (ha!).

The SEC Announcement

On March 7th, 2018 the United States federal regulators, the Securities and Exchange Commission (SEC) provided the following announcement:

“Online trading platforms have become a popular way investors can buy and sell digital assets, including coins and tokens offered and sold in so-called Initial Coin Offerings (“ICOs”). The platforms often claim to give investors the ability to quickly buy and sell digital assets. Many of these platforms bring buyers and sellers together in one place and offer investors access to automated systems that display priced orders, execute trades, and provide transaction data.
A number of these platforms provide a mechanism for trading assets that meet the definition of a “security” under the federal securities laws.”
— Via Statement on Potentially Unlawful Online Platforms for Trading Digital Assets found here.

The announcement discusses how many exchanges and other ICOs are actually breaking the law by selling and trading unregulated / unregistered securities. This comes as no surprise for many who have followed the industry.

It is true that while many (if not most) ICOs break the law, the commissionaires have also done a poor job at making it simple and accessible for people to even know if what they are selling is a security. It is estimated that a company will spend $50–100k just figuring out that question per jurisdiction they are interested in selling to.

Our hope is that the process will become much more clear and mainstream as we see regulation pur in place.

The Google Announcement

This week, Google decided to

“In June 2018, Google will update the Financial services policy to restrict the advertisement of Contracts for Difference, rolling spot forex, and financial spread betting. In addition, ads for the following will no longer be allowed to serve:
Cryptocurrencies and related content (including but not limited to initial coin offerings, cryptocurrency exchanges, cryptocurrency wallets, and cryptocurrency trading advice)”
- Google’s Financial Services Policy website found here.

This will not only affect ICOs, this message applies to anyone that is planning on advertising any information regarding cryptocurrencies which includes the exchanges, the wallets, and legitimate pieces of software attempting to make the cryptocurrency user experience better.

Many critics see this move as extraordinarily hard and naive, due to the fact that many ICOs, exchanges, and products are legitimate and have taken proper measurements with regulators in order to receive approval, and explain their technology. Google has decided to take a broad approach and ask questions later. Further delegitimizing the entire field.

The Environment

Too many (bad) ICOs

It is estimated that there are over fifty ICOs every month now. Entire websites have spun with the whole purpose of keeping track of such events and try to have some way of analyzing or at least comparing each of them.

Examples of such platforms are:

The sheer volume of new ICOs has also caused an oversaturation of the market, and even with all the tools available it seems harder than ever to make a decision, and to select a winner.

Concerns regarding Ethereum

One of the most overlooked aspects of the challenges ahead, are the technical ones. Most ICOs are currently being developed as ERC20 tokens, that is, the tokens have been developed using Ethereum Virtual Machines, and suffer from huge scalability and pricing issues.

Those issues include:

  • Scalability: Only a certain amount of transactions can be transacted per unit of time, as more companies use the framework, the more it gets clogged
  • EVM Prices: The cost of processing power for ETH companies keeps rising
  • Transaction Costs: The cost of actually transferring money keeps increasing over time

Many others have started to work on new Blockchain technologies that solve some of these issues, in what is sometimes called Blockchain 3.0, examples are:

  • Stellar
  • IOTA
  • ArcBlock
  • Many others

Conclusion: The Future

Blockchain and other Blockchain-inspired technologies are incredibly powerful, and provide a new layer of understanding about transmitting data and value. In an era where the exchange of such will become incredibly important, cryptocurrencies have developed a new way to see the world that is more free, faster, and more practical.

The reality is that private funding is a difficult exercise. Investors care mostly about profiting from their investments, and they should. But crowdfunding is different, when people give money to a Kickstarter Campaign they are not giving it to make money, but they are doing so, because they want to see a new product become a reality and realise the dreams of the developers.

When you combine both markets, you need to do so in a way that satisfies the incentives of both parties: money, control, and the development of a legitimate product. We believe that cryptocurrencies are one, if not the best, solution to achieve this hybrid.

However, we also believe that in order to satisfy both incentives, there have to be tight, and extremely clear rules about how to proceed. The different commissionaires and legislators have acted extremely slowly, while technology will keep increasing its pace.

The only way to move to a brighter future is through a clear marketplace, and a clear set of rules on how to place in such market. Without a list of “do’s and don’ts” there will continue to be problems and people punished in every area.

We are hoping that the future brings clarity and reasoning, and that will create a good environment for people to build successful and valuable companies through new technologies, including Blockchain. We are also expecting to see the rise of Stable Tokens, as a consequence of legislation. Stable tokens do not change in price, and are therefore only attractive to those seeking to fundraise, without providing speculative investment value.

If you fear that your company is not following regulations, please contact securities attorneys or your local regulators. Our parent company, Durata can help to guide you in the right direction as well.

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