By Pavel Leonov
Friday, August 11, 2017
Initial Coin Offerings (“ICO”) have been one of the hottest financial products this year.
Since the start of the year, companies raised more than one billion dollars via ICO. Here are a few examples. In June, Polybius Bank, an Estonia firm that is looking to build a cryptocurrency-based online bank, raised $29 million. In July, a company called Dynamic Ledger Solutions raised over $200 million for a new cryptocurrency called Tez, which positions itself as a more secure alternative to the most popular cryptocurrencies, Bitcoin and Ethereum. And then in August, a company called Protocol Labs raised $250 million for a digital currency called Filecoin that can be used to pay for digital data storage.
ICOs have attracted so much attention that some advocates believe that ICOs trumps Initial Public Offerings, the traditional way for young growing companies to raise capital. The question is worth asking: what is the difference between Initial Coin Offering, and Initial Public Offering?
It is tempting to think that while in Initial Public Offering, a company receives from investors U.S. dollars, in Initial Coin Offering, as its name seems to suggest, the company receives cryptocurrency. Right?
Just like in a “normal” IPO, in an ICO the company receives U.S. dollars (or euros) from its investors.
The difference lies not in what the company gets, but in what investors get. In a traditional IPO, the investors would receive shares in the Company. In the Initial Coin Offering, investors receive newly created cryptocurrency, which they can then sell in exchange for dollars. If the cryptocurrency appreciates, investors make money.
The second difference is that the process for an ICO is much faster than an IPO. The IPO process takes months and involves numerous lawyers, auditors, bankers. An ICO is like IPO on steroids.
In the case of Protocol Labs, the entire process took only a couple of days, and involved none of the traditional intermediaries, like investment banks, even though the size of the offering was very respectable by the IPO standards. Banks usually make a 5% commission on an IPO. So, if the Filecoin deal would be an IPO, investment banks would receive a $12.5 million underwriting fee. The Filecoin ICO did away with the underwriting fee altogether.
The final, and probably the biggest difference, is that an Initial Coin Offering involves none of the usual regulatory, legal and other verification that an IPO requires. In a typical IPO, the company should have prepared audited financial statements, submit a lengthy document called prospectus that describes its business, and receive an approval from the Securities and Exchanges Commission. An ICO comes without any such strings.
Brief History of the IPO Regulation
To appreciate the significance of the fact that ICOs enable raising hundreds of millions of dollars without the regulatory burdens associates in IPOs, it is worthwhile to take a quick look how Initial Public Offerings came to be so heavily regulated in the first place.
It was not always this way. The regulatory process that prescribes how a company should conduct an initial public offering of its shares is a fairly recent invention.
Investing in shares of companies was a popular outlet for disposable income in the United States during the 19th century. Back then, IPOs happened without any regulation whatsoever. America in the 19th century was a wild capitalist jungle.
This did not prevent many successful companies from conducting legitimate share offerings. Some of these companies that raised money from investors in those early days, such as Chase Manhattan Bank, survived well into 20th century. The growth of the American railroads and the oil industry was financed by investors who invested in the stocks of Standard Oil Company and the like.
But the absence of any regulation made the American stock market a fertile ground for crooks of all sorts. Fraud instances were frequent. It was said that some promoters were selling investors nothing but empty promises of “blue sky.”
The problem with fraud became so serious that in 1911, the State of Kansas adopted regulation that required preparation of a prospectus, an information document that described the business of the company and disclosed the amount of broker commission. All other American states soon followed this suit. Such laws still exist in the U.S. and are known as the Blue-Sky regulation, familiar to anyone who worked on Wall Street.
Still, despite the reforms in the early 20th century, the American financial regulation remained light. No regulation existed at the federal level. This created loopholes for unscrupulous operators during the economic boom of the 1920s.
The most famous one was a Boston businessman named Charles Ponzi, who attracted money from investors by promising above-average returns. The returns were illusory, for Mr. Ponzi did not make any investments, but only attracted more money, using money from new investors to pay off old investors. It should be noted that over the years Charles Ponzi “inspired” many followers, including MMM’s founder Sergei Mavrodi in Russia.
In 1929, the U.S. stock market crashed. Many fortunes were lost as America fell into a severe economic downturn and the prices of stocks declined, on average, by 90%. Fraud was not the only cause of the problem, but it was one of the issues that President Roosevelt sought to address. In response to the economic calamity, in 1934 the U.S. Government created the Securities and Exchange Commission, which introduced strict standards for issuance of securities to investors, and effectively created the IPO standards that we know today.
An interesting piece of American trivia: the first chairman of the SEC was Joe Kennedy, a successful speculator, who made his first money as a bootlegger during the Prohibition. Overtime, Joe Kennedy acquired both great wealth and respect of the American establishment, so much so that his son would become America’s 35th President.
All this history is relevant because the stock market still lives under the rules established more than 80 years ago. Anyone working for an investment bank in New York is required to pass special exams that test the knowledge of financial products and regulations that were set up in the 1930s. Any company that wants to issue shares to investors needs to go through a lengthy process that takes at least six months to prepare the prospectus, audited financial statements, to receive the approval with the Securities and Exchange Commission, and comply with regulations not only at the Federal level, but whatever regulation may exist in each of the 50 states. The stock market regulation in other countries is different, but, as a general rule, all countries follow the American template.
Regulation vs. Financial Innovation
With Initial Coin Offering, all this regulation that took many decades to develop and refine goes out the window. It is hardly surprising: cryptocurrencies are such a novel concept that it does not fit any of the existing categories.
But because cryptocurrencies can easily be exchanged for dollars, the economic essence of an ICO is similar of an IPO – money today in exchange of hopes for future returns.
Any company can launch a digital currency, and offer it to hopeful investors, who tend to buy into new cryptocoin offerings based on very little information. This is not much different from the way companies issued shares in the 19th century, and it is not surprising that the SEC has already released warnings about the dangers of unregulated investment in cryptocurrencies.
Fortunately for investors, the cryptocurrency market has performed well. Four years ago, the price of one Bitcoin was around twenty dollars. Earlier this month, one Bitcoin was selling for four thousand dollars.
The underlying technology – blockchains – is certainly viable and powerful, and is a clear innovation in the world of information storage and exchange. The question is whether the world needs numerous cryptocurrencies.
For many years, Bitcoin was the only cryptocurrency. In 2015, a Russian programmer Vitaly Buterin launched a new cryptocurrency called Ethereum, which quickly gained a wide following. Bitcoin and Ethereum are now two largest cryptocurrencies. But there are many others.
The site coinmarketcap.com lists over eight hundred different cryptocurrencies, of which top ten have market cap over one billion dollars, and one of the smallest called PizzaCoin is just a couple of thousands of dollars.
Investors are clearly attracted to the idea of new cryptocurrencies because of outsized investment returns. The price of Ethereum went up 30 times during the course of 2017. The early investors in Filecoin on paper made 6X their money in less than one month.
The SEC expressed concerns about ICO, but no formal ruling issued so far. But for now, the party continues. As it has always been, technology and financial innovation moves much faster than regulation, and those who remain on the cutting edge – like ICO investors today – have an incredible opportunity to make a lot of money. Provided, of course, they know when to sell.