Initial Coin Offerings (ICOs) could have a profound impact on the securities services’ operating model, provided that early-stage regulation of the market is sensible and well-thought out.
At present unregulated, ICOs are a form of fundraising, which take place on a distributed ledger with proceeds collected in bitcoin or ethereum.
The cryptocurrency funds are then funnelled into fin-tech start-ups – usually a blockchain or bitcoin company – allowing them to grow their businesses. While some ICOs may provide a return or dividend to investors, others give the buyer a token that grants them the right to use the product being developed at a discount or free of charge for a period of time.
Unlike a conventional security issued by a listed corporate, an ICO carries no voting rights or ownership rights, but potential returns can be obtained if investors cash out on the secondary market. It is a purely speculative activity.
The risks to end investors are huge, and it has precipitated a clampdown in major markets, most recently China and the US. The People’s Bank of China (PBOC) simply declared ICOs illegal and banned transactions from taking place in September 2017.
The US Securities and Exchange Commission (SEC) has adopted a less draconian approach, namely by demanding that ICO activity falls under US Securities law. The Hong Kong Securities and Futures Commission (SFC) said ICOs would likely be regulated, as did the Monetary Authority of Singapore (MAS).
The UK’s Financial Conduct Authority (FCA) – which is usually progressive on fin-tech matters – has publicly said that consumers should be careful about participating in digital currency transactions. Meanwhile, Quebec’s regulator – the Autorite des marches financiers (AMF) – is letting an ICO platform take advantage of its sandbox in what could jumpstart the sector, a marked contrast to what is happening in China.
The sums of capital involved in ICOs are still low, although fundraising in relative terms has skyrocketed. Data from Autonomous, a research company, indicated ICOs raised $14 million in 2015, increasing to $222 million in 2016, before hitting $1.2 billion in the first half of 2017.
Reuters reported ICOs in China alone raised $395 million from 105,000 investors since the beginning of the year, which probably sparked the regulators’ concern in the first place. Given ICOs clear association with blockchain, some believe regulators need to take greater note of this expanding marketplace phenomenon.
“Over the past two years or so, the blockchain (and bitcoin) industry has matured to the degree that it has shrugged off any early negative associations such as money laundering and drug trafficking that were initially associated (with them). I worry if an ICO in its current form went south, the reputational damage to blockchain could be significant, which is why it is great to see progressive regulators looking at it in more detail and scope, to ultimately capitalise on the huge opportunity that the ICO concept represents,” said Nicholas Bone, founder and CEO at EquiChain, a capital markets blockchain start-up.
Regulatory scrutiny will undoubtedly cause short-term damage to various cryptocurrencies’ values, however the long-term benefits of this intervention will be necessary if a larger market is to flourish. Some see an evolved ICO model as being a potential disruptor to the traditional processes by which securities are issued and acquired, which is saturated with intermediaries between buyer and seller.
To acquire securities in today’s market, investors may have to go through up to 10 or 12 layers of intermediation before they actually own the instruments. In its purest incarnation, an equity offering or other transaction enabled through a digital exchange – similar to an ICO – could potentially disintermediate a lot of the market infrastructure sitting in between investor and issuer bringing in enormous cost benefits for the end investor.
“The existing market infrastructure could change in an ICO paradigm. An ICO – issued by a major corporate – is unlikely to happen in bitcoin or ethereum cryptocurrency, but a fiat currency. Nonetheless, by definition, the involvement of custodians, central securities depositories (CSDs) and other intermediaries will be much reduced. However, there may be an infrastructure delegated with responsibilities by regulators to ensure the ICO market operates appropriately and in line with best practices and globally accepted regulations,” said Bone.
The last 18 to 24 months have been spent speculating as to what success blockchain and other innovators will achieve. There is no doubt that some of these providers solve real-life problems but banks and other major financial institutions are apprehensive about overly committing themselves to the technology, which is still being beta-tested, and whose status under existing regulation is ambiguous. The same is likely to ring true for ICOs.