Initial Coin Offerings: A Primer

We all know about initial public offerings. These events are held to issue new stock and sell them to the general population. The stock has value because it is a claim on the underlying assets of the company. However, very few of us are aware of the term initial coin offerings. These events are also known as “token sales” or “token launches”. In simpler words, initial coin offerings are like the IPO’s for cryptocurrencies. These events have been very successful in the year 2017 when the cryptocurrency market was booming. One company was able to raise as much as $34 billion in only 30 seconds! It is for this reason that there is a lot of curiosity around initial coin offerings. In this article, we will have a closer look at these coin offerings.

Initial Public Offerings vs. Initial Coin Offerings

There is a huge difference between initial public offerings and initial coin offerings.

1. In an initial public offering, companies sell ownership of their assets. The people who buy the stock end up becoming a partner in the business. The money thus obtained can be used by the company indefinitely to continue operations.

2. On the other hand, in an initial coin offering, no transfer of ownership takes place. In a token sale, digital companies sell tokens which will be an integral part of their online product once the company becomes operational. The benefit is that the company can know about the popularity of their proposed product. Only people who will be interested in the product at a later date will buy the tokens today!

Also, it needs to be noted that the company is under no obligation to refund the money taken from the investors. In effect, the company obtains interest-free working capital from the sale of these tokens. The investors, on the other hand, can use the token to buy the product once it is ready. However, they also have the right to transfer the ownership of this token to someone else. In both circumstances, the ownership of the tech company does not change hands. The tokens merely represent claims on the products of the company and not on the assets of the company.

In 2017, the quantum of money raised via initial coin offerings has been mindboggling. This model has started to worry investors since they believe that fields like venture capital and private equity will become obsolete since tech companies will be able to source money directly from the customers via initial coin offerings.

Problems with Initial Coin Offerings

Lack of Regulation: One of the biggest problems with the initial coin offerings is that they are unregulated. Tech companies smartly claim that they are selling a product and not a security. Hence, they should not be regulated. In the absence of regulation, investors are falling prey to pump and dump schemes. This means that willful investors are indulging in insider trading to raise the price of the token. Then they sell it to unsuspecting outside buyers, sell it at inflated prices and cash out. The United States has started regulating many of these tokens. Since they have the features of securities, they should be regulated as such even though they are technically products.

Ponzi Schemes: Many of the coins being sold via initial coin offerings do not even exist. For instance, in one case, investors were duped saying that the proceeds from the sale of the coin will be invested in the real estate market. The seller of these coins also claimed that they had a team of lawyers and consultants in place to proceed with the transactions. However, later it was found out that there was no team in place and also no investments were made in real estate. Instead, initial coin offerings were simply used by people as a way of embezzling money from gullible investors. Since the sale of tokens did not constitute a sale of a security, there were no regulatory checks. Therefore, it is necessary that initial coin offerings be brought into the regulatory ambit to prevent such frauds from happening in the future.

Safety Issues: Since these tokens are held in digital wallets, the investors are completely dependent upon these wallets to protect the safety of these investments. This means that if there is a security flaw, the value of the token can plummet within seconds. This has happened with a cryptocurrency called DAO. The wallets of various investors were hacked because of a small flaw in the coding. The end result was that tokens worth more than $50 million were stolen by online thieves. The investors did not have any possible way to protect themselves from the fraud. Hence, it can be said that there are grave safety issues with these offerings.

The entire world is protesting against the use of cryptocurrencies. China has made it illegal to issue and trade digital currency. Similarly, other countries like South Korea and Australia are following suit. In many countries like India and the United States, the trading has not been made illegal. However, banks and other intermediaries are not providing the network required to trade these currencies. Hence, it can be said that the future of cryptocurrencies, as well as initial coin offerings, is in jeopardy.