Shifting our focus away from ICOs

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  • May 8, 2019
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ICO, which stands for Initial Coin Offering, is a fundraising method usually implemented in the launch of a new product or service. The company sells a predefined number of digital tokens (coins) to the public, in exchange for cryptocurrencies or fiat currencies. This seeks to gain interest from investors in the project. Once invested, the investors receive tokens (coins) issued through the ICO. Unlike Initial Public Offering (IPOs), where investors have a stake in the company after purchasing shares, investors only profit if the value of the token increases from its base price. This can then be traded through an exchange or privately to increase profits.

What are ICOs

ICOs involve utility tokens which are meant to be used on the network platform that they represent. So, you only need to start an ICO if the token will be used within the platform.

A Study from Statis Group shows that about 80% of ICOs analyzed have been scams. This makes investors scared and disillusioned with the current system. Despite all the regulatory pains, scams and low success rate of ICOs, the funds raised have almost tripled to approximately €20 billion in total volume in 2018 compared to €7 billion in 2017. But how far they have fared in business terms is a pertinent question, as we see that 55% of ICOs failed to complete their project in the second quarter of 2018, according to a report from the agency ICORating.

Although the ICO market is growing, there are few incentives to generate capital gains for investors due to there being little accountability or regulatory bodies governing ICOs.

This has ultimately led to the creation and launch of security tokens. Jay Clayton, the SEC Chairman, noted that ” I believe every ICO I’ve seen is a security and therefore we should regulate like we regulate any other security offering” which resulted in the birth of Security Token Offering (STO).

What about STOs?

Unlike utility tokens, STOs generate security tokens which are actual financial securities. These tokens are backed by something tangible like assets, profits or revenues of a particular company.

STO volume has been on the rise since last year, as more and more people become concerned about the issues plaguing ICOs. STOs attract more institutional investors as they have an extra layer of safety for investors in the form of regulation. A report from PWC Switzerland outlines that the ICO funding volume by quarter has decreased in the last two years, whereas the funding volume for STOs are on the rise. This conveys the fact that STOs are gaining traction.

Research from Konfidio has explored the different STOs that have recently launched, all of which are in the process of raising capital. These STOs are collated according to their country of origin. We found that more than half of the STOs conducted/announced so far are in the US. Germany comes second with 15% of all STOs planned. The numbers are pumped up by Neufund’s numerous partners. Singapore comes third with 6.3% due to the prevalence of tokenized funds. Other notable mentions are the UK, Netherlands, Sweden and Canada.

% of STO by country

Most of the STOs are in private placement, but some the STOs went public during late 2017 and early 2018. These have successfully raised millions for the projects. The top 10 STOs are listed below according to the amount of funds raised.

Top 10 STOs sorted by amount of funds raised

Are IEOs the answer?

Initial Exchange Offering (IEO) is a new type of blockchain based fundraising which serves as an alternative to an ICO. It seeks to bolsters trust and security for investors. At its core, the IEO is basically an ICO but run through an exchange which executes the fundraising process for the token issuers. After the issuers pay a listing fee, the exchange lists the tokens on the platform to be purchased by potential investors. This in a way is beneficial for 3 parties, namely the idea/owner of the project, the investor and the exchange itself. The advantage of having an IEO over an ICO is that in an IEO the exchange conducts the necessary KYC and AML procedure for investors. This allows them to officially and safely to transfer funds, which establishes security and trust. The exchange also screens the company before it allows it to raise funds on its platform, giving a vote of confidence for investors.

Nowadays we see an increasing number of market participants have started developing IEO platforms. Binance become one of these pioneers when it released its IEO platform Binance Launchpad. Although the first traceable IEO was carried out in 2017 by the GIFTO and Bread projects on the Binance platform, this way of raising money became popular only in early 2019. BitTorrent, which was bought by TRON, carried out their token sale in January 2019 and raised $7.2 million. The hard cap was hit in less than 15 minutes during the sale. Another notable sale that performed even more successfully was by Fetch.AI, which hit its hard cap of $6 million in just 22 seconds. After observing the success of Binance Launchpad, other exchanges announced their own IEO platforms. Some of the other notable exchanges are BitFinex, Upbit, Kraken, Coinbase, Bitstamp and BitFlyer.

Finally, for a project to qualify for an IEO it is suggested that they meet the following criteria:

  • Sound business model
  • Technology
  • Target Audience and Market Size
  • Core Team with strong expertise in development
  • White Paper and Tokenomics
  • Minimum Viable product/product prototype
  • Growth projection
  • Investors and Partners
  • Competitor Analysis
  • Legal Opinion
  • Public Relations
  • Marketing

ICOs created havoc for investors when they became popular as most of them turned out to be scams and full of fake promises. STOs provides a better alternative by bringing in security tokens, backed by assets with additional regulation. IEOs provide increased levels of trust as well, as exchanges are the ones who are conducting the crowdsale. They then take care of due diligence, significantly reducing the number of scams on the platform and therefore helping to guard investors. Overall, STOs and IEOs seem to be a more informed way of fundraising in the crypto world and the next crypto trend.

New Methods of Raising Capital

The starting point for any new business to grow to its full potential is to raise capital. The traditional way of doing this is to seek out venture capital funds, angel investors or equity/debt financing. However the major drawback with all these ways of raising capital is that equity must be provided in order to receive these funds.

New ways of capital raising over traditional funding

Due to this equity tradeoff in traditional funding, Initial Coin Offerings came into the picture as a viable alternative. The concept of raising capital without losing equity attracted issuers in large amounts. Another advantage is that the issuer gains access to a global network of investors that can fund new ventures. This increases the liquidity and the speed at which these projects can be funded. To give an example in June 2017, Mozilla’s founder raised $35m in under 30 seconds for a new web browser start-up named ‘Brave’.

For issuers ICOs present a global, decentralized investment opportunity for funding their blockchain based services through issuing tokens. This is coupled with the advantage that any equity raised is also non-dilutive. For investors, issued tokens provide only a function of utility in the service. Any appreciation in value will come from an increase in popularity of the service and respect of the project’s underlying ideas.

With all the positives in place this looks an exciting place to be. However there is a downfall, in that anyone can launch an ICO. This lack of governance has led to an increasing amount of scams in the recent past. The adoption of blockchain technology has therefore been limited due to its association with such incidents. The Security Token Offering (STO) is seen as an improvement to this situation, as the token is identified as a “security” to reduce scams and protect investors. STOs are based on assets that are tradable, deriving value and compensation or profits from the associated business. This of course is not the same as with ICOs.

ICOs remain unregulated

The proliferation of scams, a lack of investor protection and the nonexistent conduction of AML/KYC procedures in ICO’s have alerted regulators all over the world. Therefore, some jurisdictions have been taking proactive steps in the creation and development of regulatory frameworks/guidelines to bring legal certainty to the area. This has been the case in Malta and Switzerland, where Financial Authorities have issued a set of rules of how to assess and treat ICO’s (issuers and cryptocurrencies).  Nevertheless, regulations are still in the early stages and there is no overall consensus on how to treat ICOs.

Moreover ICO’s (utility token) do not grant any more value to investors other than their use within specific ecosystems, as opposed to security tokens where investors are given tangible rights. These include shares in profit, corporate ownership and participation. Furthermore, security tokens resemble traditional financial instruments and fall under the scope of existing securities market legislation.  

STO Regulation under different jurisdictions

STO’s follow traditional legislation and are therefore subject to Initial Public Offering and/or Private Placement regulations. These involve legal certainty (bringing a clear set of rules to the participants) and the reduction of fraudulent investors entering the market due to obligations of performing KYC. This is prior to entering any business relationship.

In the U.S. any security offering made to U.S. residents must either be registered with the SEC or be exempted under the Securities Act of 1933. The security tokens need to follow regulations D, S, A+ and CF.

In Europe, when conducting a Public offering issuers require a prospectus to be registered with the Financial Authority in the relevant jurisdiction. This is where the security token is expected to be issued and must comply with extensive disclosure rules. These all endure after the public offering is finished. On the other hand, private placements (falling under exemptions set by law) are usually offered to a limited number of qualified investors and only require documents such as a Private Placement Memorandum (lighter than Prospectus) and Subscription Agreement.

Tech Enablement & Legal Translation

The most popular vehicle for ICO’s has been the ERC-20 token standard on the Ethereum platform, however new standards have emerged for STO’s, most notably ERC-1400. This protocol is backwards compatible with the previous standard, but adds new features that are required for the more restrictive nature of a security token.

These are:

  • Ability to organize tokens into partitions or tranches.

STO tokens may be partially fungible, meaning that some tranches of tokens may behave differently than others and have specific restrictions assigned to them. For example, they could be vested for different periods of time depending on the issuance date. The standard doesn’t define how the different tranches might behave, but provides a way to create the groupings.

  • Ability to assign arbitrary data to transfers, and apply arbitrary logic.

Security tokens can have a number of restrictions on transfer rights. The tokens may belong to a locked-up tranche, the sender and receiver may need to be whitelisted through KYC/AML, or there might be a limit on the number of individual owners of the token. There is also the possibility that the issuer or regulatory body needs to approve the transfer. The ERC-1400 standard provides a way to attach arbitrary data to a transfer, which can then be used by the inbuilt token logic to determine if the transfer is allowable. A readable reason can be given after any query as to an allowable transaction.

  • Ability to grant rights to perform forced transfers.

Since security tokens are subject to many regulations, it may be required that certain parties have rights to transfer tokens without the need of the owner’s consent. Such situations may include dealing with fraud, lost private keys or court orders. The standard defines how such rights are assigned, managed and executed. It also puts weight on the transparency of such operations, which may be viewed by the blockchain community as running against the decentralization ethos.

  • Ability to link documents to the token.

Usually security tokens have contractual rights and obligations associated with them. It’s useful to allow all the involved parties access to the legal or otherwise relevant information pertaining to the token. The ERC-1400 standard includes a specification of how these documents may be linked to the token and then accessed by the user.

The ERC-1400 has gained traction and approval from the community, and there are open-source reference implementations available. There are also other standards developed, mostly by companies offering platforms for launching STOs. One example of this is Polymath.   

Capital Market Disruption

The legal spectrum on ICO’s is still in its genesis and only a few countries have made regulatory approaches.

One particular case is Malta, a jurisdiction with a robust legal framework that regulates crypto assets, related services providers and Distributed Ledger Technology (DLT)/Blockchain. The legislation is principle based and has been supplemented by regulations, rulebook and guidelines. These have all been issued by the Malta Financial Services Authority (MFSA) as the competent regulator. The Financial Intelligence Analysis Unit (FIAU) in also assists in anti money laundering and the combat of funding terrorism aspects. Furthermore, Maltese legislation is based on three fundamental pillars: Investor protection, financial market integrity and financial stability.

Switzerland has taken a slightly different approach in placing guidelines on how to apply financial market legislation to ICOs. These guidelines categorize tokens into three types: payment, utility and asset tokens which are directly connected to the level of legal and compliance requirements to be met.

Despite the effort made, these regulations are lacking in universality as they are only applicable within their own jurisdictions. In this regard, the European Parliament has planned a discussion over ICO’s by the end of the year, but until a legal framework is in place any passporting to another EU country will not occur.

Standard Legal Framework for STOs

As opposed to ICO’s, STO’s have a standard legal framework applicable across all countries in the EU – Prospectus Directive. This Directive has created a unique regime regulating content, format, approval and publication of any Prospectus. The prospectus’s aim is to ensure investor protection at the time of security token issuance. It must contain clear, detailed and comprehensive information for investors and be registered with the Financial Authority where the STO will be conducted. Once the Prospectus is duly authorized by the competent authority, the Directive grants to those carrying out the STO the right to market freely within the EU.

Role of Konfidio Token Advisory

Konfidio Token Advisory combines the collective technical experience and knowledge of its advisors in order to navigate a proposed STO or IEO launch. For those not fully acquainted with the whole process, from token creation all the way through to marketing support, the Advisory can provide support in all areas. The days of unregulated ICO campaigns are firmly in the past, and those wishing to create and sell tokens must make sure they are fully compliant with the law. In partnership with Fexserv, Konfidio Token Advisory offers unparalleled regulatory advice. Whether looking at the tokenomic design of a security token or its eventual licensing, the Advisory will provide sound legal advice and guidance to ensure regulatory compliance.

Creating a white paper for a STO project, including all tokenomic design and detailing of a project’s background, can be completed by Konfidio Token Advisory. After discussing the desired aspects and requirements of the project, the Advisory can create a custom designed white paper from which a token can be created. Equity exchange, utility token dividends and other advanced tokenomic concepts are within the range of expertise of the Advisory team.

For those looking to fill out a prospectus in order to launch their security token, Konfidio Token Advisory is able to help take clients through the whole process in an efficient and professional manner. When looking to be regulated through either Malta or Germany, the Advisory’s partners Fexserv and Hyazinth will provide expert legal advice and utilise their prior extensive experience with the field.

Comprehensive marketing assistance and packages are also on offer when working with the Advisory. These services have been successfully used with Germany’s first regulated STO Bitbond and with other clients. From community management to website development and bounty campaigns, all marketing aspects can be run, managed and completed by the team.

The Advisory is also able to draw upon its extensive network of investors to help with private fundraising for a security token offering. Utilising it’s links with Kintaro Capital, the Professional Investor Fund of the Konfidio family, the Advisory has access to a team of financial analysts and researchers that can help with a STO launch. Detailed financial reports and analysis are also available upon request.

With the experience of the Konfidio Blockchain Venture Studio at hand, the Token Advisory has the ability to provide both blockchain development and auditing. Willing projects can turn ideas within a whitepaper into actual live products with the help of the blockchain development team. The Advisory can also supply accredited blockchain auditors who can complete the thorough evaluation needed licensing under the VFA.