Since the dawn of the crypto asset space with bitcoin, the mainstream reaction has been somewhat wary and distrusting of many of the innovations we’re seeing. Yet, the growth of crypto assets has reached a tipping point, in my view, where it can no longer be ignored. If you consider the diamond industry is $250bn, the crypto asset industry is at $170bn and growing, this is something we can no longer ignore.
Against this backdrop of uncertainty and potential for fraud, money laundering and consumers losing out, it would be helpful to see the development of best practice and codes of conduct. Regulators and governments could look for these practices to help a nascent industry self-regulate.
- Crypto assets such as bitcoin, Ethereum and Ripple have reached mainstream adoption in many parts of the world, with retail investors now getting exposure. At the same time, we’ve seen China and other jurisdictions put in outright bans, while Japan and Switzerland seem much more open. The consumer is left in need of protection, and businesses require certainty as the market grows. The true transformative potential of crypto assets can be best realised when this happens.
- The development of token sale, token generation or sometimes colloquially ‘initial coin offerings’ (ICOs) represents an entirely new model of fundraising. Put simply, they allow startups to raise capital by selling digital tokens to investors that allow them to use the digital services that startups plan to produce, or sell them if they rise in value. Examples include Tezos (which raised more than $232m, Filecoin $252m, and EOS from Block.one, which raised more than $150m initially).
- A cross between crowdfunding and an initial public offering. Token sales enable new, innovative companies to test the market appetite for their ideas by tapping into an unprecedented supply of global capital through digital platforms and virtual currencies.
- This diversifies the funding options available for startups who have traditionally been overly reliant on geographically restricted venture capital, or crowdfunding services, while democratising finance for consumers.
- In an environment with increased investor protections and minimum standards, token sales could put jurisdictions that embrace best practice at the epicentre of the next phase of the internet’s development, with commensurate returns for investors and the local economy.
- If managed badly without protections or minimum industry standards, there is the potential for this to look like the railway bubble of the 1840s. We have seen recent work by Reuters suggesting that uncertainty in the “foundation” structure used by many token sales creates a number of risks.
- This blog post sets out a market overview of the risks token sales in their current form present, and the possible solutions and benefits to an economy that’s able to ensure these solutions are embraced and supported fully by the machinery of government.
This post discusses the ICO space in depth, but many of its lessons can be applied to the broader crypto asset space.
At the time of writing, £1.8bn globally has been raised through ICOs, with the vast majority being used to fund digital infrastructure (44.2%), such as new decentralised protocols, that could become the foundations for the next generation of Web 3.0 services.
Investor profile. While detailed information on the type of investors active in this market is limited, anecdotal evidence suggests it’s a mixture of sophisticated wholesale investors alongside retail investors with wealth generated in cryptocurrencies who are looking for yield.
Outline of the existing ICO process
- ICOs begin with the publication of a ‘white paper’ that outlines the basic idea behind the startup, alongside a broad business plan for the future – not too dissimilar to a prospectus issued to investors in an IPO.
- This is advertised on a range of websites and ICO platforms and discussion forums to generate interest.
- Then a smart contract is issued using the Ethereum platform, which automatically provides tokens on receipt of a virtual currency such as Ether or Bitcoin.
Issues with the current market
- Lack of standardised information: For investors contemplating investing any asset class, the availability of clear, concise and accurate information is vital for price discovery, and an understanding of the investment risk involved.
- Perception of risk: In the ICO market, investors are reliant on white papers, which are often nebulous documents written with varying degrees of quality and accuracy that can often make it difficult for investors to come to an informed position about a potential project.
- Potential market manipulation: Investors are often reliant on alternative sources of information, such as discussion forums, which are open to potential market manipulation.
- Variance in property rights: Part of the challenges faced by regulators in this space has been defining the property rights of each token holder. Exactly what rights each token provides an investor can sometimes be difficult to discern, and is often hidden in the small print.
- Token distribution: When token sales take place, sometimes sellers will distribute the vast majority of their stake to investors, and others will only distribute a minor amount keeping a majority stake in the project. The ownership structure for token issuance is currently opaque and difficult for investors to understand.
- Access to secondary markets: Secondary markets are another vital tool for price discovery. Some tokens are issued with limited ‘lock-up’ periods, where they cannot be exchanged on a secondary market and others are not. This is confusing for investors, and the transferability of tokens needs to be addressed.
- Investors’ blind search for yield: As with any new technological development, there is a significant risk of asset bubbles as investors overlook crucial details of a project in the search for yield. Balancing this with appropriate data and transparency will be crucial going forward.
Proposed policy solution
There’s a wide range of policy options available, from the draconian to the benign. However, we would caution against a potentially impractical ban that would damage the jurisdiction’s openness and opportunities for fintech innovation, and could prove ineffective. Token sales are by their nature international and could easily take place outside a given jurisdiction, and remain easily accessible to investors.
Therefore, we strongly believe that a government could work with leading proponents of ICOs to create a best practice guide for token issuance. We believe such guidance would provide a useful indicator to investors to understand the risk profile of token sales while nudging the industry to tackle issues in the current market, encouraging the adoption of professional standards.
The approach should take inspiration from peer-to-peer lenders in the United Kingdom, which, through the creation of the Peer to Peer Finance Association in 2011, established a stringent set of minimum standards for operators, and a code of best practice that has been adopted by the FCA. These broadly covered minimal capital requirements, segregation of funds, fair complaints handling clear marketing messages and much more – emulating much of the protections consumers would find in other financial services. This light-touch approach helped new market entrants to provide new services for customers, and has led to the UK becoming a global leader in P2P technology.
While it may be too early in the market for ICOs to expect a representative trade body, we believe it would be worthwhile exploring its potential with industry leaders. Alternately, a working group or committee could be set up to facilitate an open dialogue with the industry, and inform the government’s approach to ICOs. This would help a jurisdiction maximise the benefit of this emerging technology alongside engendering greater protections for investors and consumers.
Benefits of the proposed approach
Working together with leading industry participants and developing the framework for ICOs will have the following benefits for a jurisdiction that does so with intention and pace:
Democratisation of financial services:
- Consumers. By removing the intermediaries that have traditionally sat between investors and high-growth technology companies – predominantly venture capital funds – this enables investors to gain exposure to high-growth technology startups. In a low-interest-rate environment in the western world, consumers are seeing their savings in real terms being eroded through inflation.
- Professional investors. Similarly, in a world with excess liquidity and a lack of growth-yielding opportunities to invest in, the wave of innovation from the wider crypto asset space presents a new suite of opportunities investors already want to understand and get access to.
- For startups. New companies can test the market appetite for an idea directly, without having to spend months (or in some instances, years) pitching for investment with established investment firms.
- Policy. Enabling firms to access global capital reserves from ICOs will help to close the funding gap (especially late-stage scale-up capital) identified in the Patient Capital Review.
Creating GDP growth
- A burgeoning industry. While a small market in terms of capitalisation, ICOs are a leading indicator for all parts of the global fintech ecosystem, and by demonstrating that a jurisdiction is open to new forms of innovation, the associated value growth can be captured by an economy.
The crucial PR message for innovators: “Open for blockchain business”
- Where ICOs lead, blockchain follows. While views on the merits of individual cryptocurrencies are mixed, it’s clear that a government’s approach to the crypto asset markets will act as a global headwind for blockchain and decentralised application developers.
- Capturing the value. The lack of taxation, corporate structure or even best practice guidance in many countries, and mixed messages of others, prevents governments from capturing the value in a $170bn+ market. This market is more likely to grow over a 5-10 year time horizon than disappear, and is here to stay. Action now is critical to be the home of this technology.
While there any many benefits of the proposed policy option, it’s accompanied by the following risks:
- Retail investors may not always comprehend the risks involved, and any government intervention to work with the sector may be perceived that this is an endorsement of all crypto assets or token sales. Therefore, any public statement on crypto assets must be accompanied by a warning of the high-risk nature of these investments.
- Crypto asset scams require management. Prevalent in the press reports about token sales is the potential for scam coins, which are essentially nothing more than old-fashioned, traditional scams utilising modern technology. To mitigate this risk, the adoption of a code of conduct should professionalise the industry and educate investors sufficiently to stop most scam coin activity. These scams are international in nature and are happening already. Action here is necessary to prevent these scams from impacting the retail or wider investor community, as this asset class grows in international stature.
Cryptocurrencies and token sales are the next frontier in fintech. While many risks remain in the market, the overall benefit to society from an open approach to regulation will provide long-lasting benefits to the global economy and consumers.
The crypto asset space is a living experiment with real money, and people’s lives are now tied in to its success. Ignorance is no longer an option. However, learning from the P2P industry regulation in the United Kingdom, best practice led by industry initiatives are already being developed in a number of corners and require the support and experience of a jurisdiction. This action protects investors, creates growth and places a country at the forefront of the next wave of industry transforming innovation.
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– This article is reproduced with kind permission. Some minor changes have been made to reflect BankNXT style considerations. Read more of Simon’s articles for 11:FS right here. Image by Wit Olszewski, Shutterstock.com