An Initial Coin Offering (ICO) is the process by which a company or consortium can raise the funding needed to finance a crypto project. The project could be the launch of a new cryptocurrency or a start-up idea connected with exploiting the benefits of blockchain technology.
The funding is raised through the issue of cryptoassets to retail and institutional investors. Cryptoassets can include cryptocurrency coins like Bitcoin or Litecoin or digital tokens.
Digital tokens can take many forms, including security tokens which could be an underlying asset, such as a share or bond; or a utility token which gives the holder certain rights, including for example, the right to purchase goods and services in a specified network or at a future date.
An ICO has also been described as a coin sale or a token sale in that the company (issuer) sells its own cryptocurrency coins or digital tokens, usually in exchange for Bitcoin, Ethereum or a fiat currency like US Dollars.
The first ever ICO was believed to be the launch of Mastercoin (now owned by Omni) in 2013, which issued digital tokens to raise £5 million in Bitcoin.
How does an Initial Coin Offering work?
An Initial Coin Offering (ICO) is often compared to an Initial Public Offering (IPO) and while in principle it works in much the same way; there is one crucial difference: subscribers in an IPO acquire an equity interest or ownership stake in the company; whereas, participants in an ICO acquire cryptoassets not shares.
In order to invest in the ICO, subscribers can either use another cryptocurrency or actual money (fiat currency) to purchase the cryptoassets (coins or tokens).
In return, investors typically receive cryptocurrency coins which can be traded (sold on) through a cryptocurrency exchange or digital tokens that provide specified rights and privileges.
The ICO process usually involves the publication of a document known as a whitepaper, which is similar to a share prospectus issued as part of an IPO.
An ICO whitepaper describes the project, the problem it is aiming to solve and the purpose for which the funds are being raised. It should include a business plan, the technology to be used and the experience, expertise and qualifications of the individuals behind the project.
Unlike investing in an IPO, with an ICO, there are no legal rights or protections and for the most part ICOs are unregulated with all the risks that go with that. Quite often, subscribers are simply investing in an idea.
What are the risks of investing in an ICO?
According to the Financial Conduct Authority (FCA) – the organisation responsible for regulating the UK financial services industry – “ICOs are very high risk, speculative investments”.
The value of cryptoassets used in ICOs are highly volatile and subject to considerable movements in price. The FCA has also stated that “if you invest in cryptoassets, you should be prepared to lose all your money”.
In 2019 alone, 518 ICOs failed, and around 1,900 have failed since 2017. However, some ICOs have made investors huge returns so investors are advised to be exceptionally cautious over which ICO to choose.
The FCA has issued a series of risk warnings as well as steps that investors can take to protect themselves against the risk of capital loss should they decide to go ahead and invest in an ICO:
- ICOs are invariably highly speculative and carry a high level of risk. Subscribers could be investing in an experimental project at an early development stage, with no established market. Many projects don’t expect to achieve economic viability for several years.
- Most ICOs are unregulated. If the platform in which you are investing fails and you lose your money, it is very unlikely that you will receive any compensation under the Financial Services Compensation Scheme.
- The whitepaper issued to explain the purpose of the ICO can be quite difficult to understand and sometimes misleading. Investors should carry out extensive research before committing capital to the project.
- The crypto marketplace is known to attract fraud and scams. Investors need to be very diligent especially when the ICO is presented with guaranteed or unusually attractive investment returns.
- Investors may encounter liquidity problems when converting cryptoassets back into cash. The ability to do so and the price achieved depends on supply and demand on the cryptocurrency exchange at the time of conversion.
Regulation of cryptoassets by the Financial Conduct Authority
There can a lot of confusion surrounding the different types of cryptocurrency coins and understanding the rights attached to digital tokens used in Initial Coin Offerings.
In addition, there can also be some uncertainty over regulation of cryptoassets. For example, certain tokens may be considered transferable securities by the FCA and will therefore fall within the regulatory framework.
To learn more about digital tokens and which types of cryptoassets are regulated, please click here.
