How do ICOs work?
An ICO works by offering investors utility tokens in exchange for cryptocurrency like Bitcoin, Ether, or other forms of currency, including fiat. These utility token give the investor a kind of ownership of the product or output of the company in the future. However, it doesn’t entitle any form of ownership of the company in the same way a stock or bond does – i.e the token is not backed by any tangible asset. The only way the investor sees a return is if the value of the token he or she owns goes up. This occurs if the company is successful and starts to produce tangible value. Inherently, this is a very risky form of investment since the contract essentially gives no rights to the investors and no actual stake in the company. In many cases companies have simply walked away with the money, never to be seen again.
However, the appeal of ICO’s are strong. They allow companies to raise capital outside of the bureaucracy and red tape of the traditional finance system and don’t require the equity of the company to be sliced between different investors. On the buy side, they enable individual investors to jump on the success of future start-ups, without going through traditional brokers or paying far higher prices than seed or institutional investors in regular IPOs.
However, the promise of get rich quick ICOs and the lack of regulation have severely damaged the reputation of ICOs.
Who’s the new kid?
Introducing the Security Token Offering (STO). This is where the wording becomes important. An STO occurs when the tokens sold to investors are backed by a tangible asset, they are known as security tokens. Confusingly, a company may issue an ICO where the tokens sold are not utility token but security tokens. By our definition this is an STO not an ICO. The key difference is that security tokens give investors real value in the company, allowing them rights such as dividends, voting privileges, and equity. This gives a layer of protection to investors not seen from ICO’s because an STO comes under security regulation and will be protected by the relevant regulators.
What are the downsides?
One of the major downsides of an STO is that it involves centralised backing since the instrument is recognised as a financial security. This means that it must comply with existing regulation and the government overseas its trading. Whilst this is good for reducing the risk on investors and protecting the market from fraud it means that legal costs go up significantly. It also negates one of the core principals of blockchain technology by involving a centralised system.
Moreover, STO and ICO contain such subtle differences that an ICO could easily be miss sold as an STO. This could undermine the market and has been a cause for concerns for regulators. In fact, in many cases investors are unaware whether they’re buying utility tokens or security tokens and companies are issuing security tokens without any regulation.
Will governments and regulators get behind STOs?
Governments and regulators have been approaching the crypto market cautiously ever since it appeared a few years ago and the stories of fraud around ICO’s seemed to validate many people’s concerns. Accountability and protection within the market appears to be very low and the lack of government support was justified in many cases. However, as STOs come under legal protection as a security the government and regulators can’t ignore it.
Furthermore, there appears to be a change in narrative from the key institutions within the global economy. For example, in mid-November Christine Lagarde, speaking at a fintech festival Singapore, said that Central Banks around the world must embrace the digital revolution. Highlighting that harmonious relationship between centralised institutions and digital players would produce the best of both worlds for all parties: a regulated but quick, easy, and secure digital payment infrastructure.
The ICO has drawn a lot of criticism since it appeared on the scene. This hasn’t reduced its popularity too much, with the demand for digital based funding using blockchain still very high. However, the STO has a clear advantages over the ICO; it comes under securities regulation, making it more likely to be accepted by the traditional financial industry whilst giving investors much greater protection. Hence, in 2019 and beyond we expect the STO to soon replace the ICO as the chosen form of offering for blockchain based companies.