2019 was a terrible year for Initial Coin Offerings (ICOs), there were only 109 ICOs and raised funds for the equivalent amount of USD 371,209,025. This amount was 95% lower than the total funds raised in 2018 (USD 7,812,150,041)[1]. The possible reasons behind this dramatic decline in ICOs are actions taken by regulators in different countries, the bear market in 2019 and poor performance of previous ICOs[2]. This article focuses on why regulation of ICOs is important.
Economics of ICO
The principle behind ICOs is the network effect, as the number of people who accepts to do transactions in the ICO blockchain grows, the value of the tokens linked to the ICO will increase.[3] Two other ways to increase the token value are by guaranteeing the token scarcity and enabling holders to sell their tokens a secondary market.
Another benefit of the ICO network is that it reduces significantly transaction costs due to the elimination of intermediaries. The network/decentralization also offers the benefit of protection against hacking since the data base is saved in multiple locations, not one only.
Why ICOs should be regulated
Most securities market regulators mission is to protect investors and maintain fair, efficient and transparent markets. To protect investor and the market one of the key inputs which regulators have to ensure is available to investors and other stakeholders is information. The information published by ICOs promoters is not enough nor transparent. ICOs promoters issue white papers which don’t have an standardized structure nor they help investors to make an informed decision assessing the risks and benefits of buying tokens. Additionally, ICOs promoters don’t publish projected financial information or any valuation model that is used to set the token price or assess the profitability of the business to be funded by the ICO. Finally, once these companies start to operate, there’s no evidence of any governance structure in place to protect investors, or policies and procedures to protect token holders. In this context, there is a need for regulation to protect token holders.
To maintain fair, efficient and transparent markets, securities market regulators have centralized some roles in the securities market. Entities wishing to be part of the securities market have to go through an authorization process, implement policies and procedures[7], and have established safeguards that protect investors. ICOs are traded in many unsupervised exchanges and the tokens and digital assets traded are kept in unauthorized depositaries which exposes participants to risks. The worst case recorded was the loss of $ 145 million in digital assets of investors when the CEO of Quadriga died. The digital assets were stored offline in “cold wallets” which could only be accessed from the CEO’s personal computer.[8]
Regulation
The International Organization of Securities Commissions (IOSCO) is the international organization which membership regulates 95% of the world’s securities markets. The organization is recognized as the global standard setter for the securities sector.[4] On November 04, 2019, the IOSCO published a release[5] announcing the IOSCO FinTech Network has made an assessment on how the IOSCO Principles and Standards could apply to ‘Global stablecoins’ initiatives. A version of the report presented to the IOSCO Board is still pending release, this will contain regulatory issues arising from Global Stablecoins.
Most securities market regulators in order to fulfill their mission had taken different measures regarding ICO-related activity in their countries.
While some countries … have prohibited ICOs, other jurisdictions … require authorization for any issuance of tokens (no matter whether they are security or non-security tokens), and other countries … subject ICOs to a selective control ex ante to determine whether the offering involves security tokens and, if so, whether it complies with securities laws
The Law and Finance of Initial Coin Offerings[6].
So, what have regulators done about regulating ICOs? In the USA ICO’s are regulated if they represent security tokens after going through the Howey test “an investment contract exists when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.”[9] Although the framework hasn’t translated into a specific rule the guidelines help market participants assess whether the asset they want to issue or buy should or shouldn’t be regulated. Other countries that are taking a positive approach towards ICOs are Switzerland, Singapore, Australia, Japan, Thailand, among others.
There is also a group of countries in which ICOs are yet to be regulated. Russia has been working for more than two years in a regulation while UK has issued warnings to investors and has included ICOs in other regulations. Meanwhile other countries decided to plainly forbid the ICOs in their territory, China and South Korea.
The way forward
As stated previously there are many risks involved in investing in ICOs and in using services provided by other unregulated market participants. The regulation of ICOs should focus on information transparency and the supervision of the other entities participating in the ICO market to help mitigate the risks exposure of investors and help the market growth.
Regulators should agree on some common standards and practices for Initial Coin Offerings and the regulation of other participants in this market to prevent legal arbitrage and to boost token adoption on a multinational level because, in spite of the risks outlined here, funding companies through ICOs has benefits. And believe it or not, regulators do not want to prevent development; regulators job is to protect investors by ensuring they can make an informed decision and to make sure that markets operate efficiently to benefit investors and to contribute to the economic growth.
[1] icodata.io
[2] https://cointelegraph.com/news/report-icos-raised-118-million-in-q1-2019-over-58-times-less-than-in-q1-2018
[3] Katz, Michael & Shapiro, Carl. (1985). Network Externalities, Competition, and Compatibility. American Economic Review. 75. 424-40. (1985) define network externalities as the surplus that a consumer derives from buying a unit of the good due to the number of other agents who join the network associated with that product.
[5] Statement on IOSCO study of emerging global stablecoin proposals.
[6] https://corpgov.law.harvard.edu/2018/06/16/the-law-and-finance-of-initial-coin-offerings/
[7] Including Business Continuity Plan and Anti-Money Laundering rules.
[8] https://www.cnn.com/2019/02/05/tech/quadriga-gerald-cotten-cryptocurrency/index.html
[9] Framework for “Investment Contract” Analysis of Digital Assets. https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets
Strategy in the Age of Decentralization 