Cryptocurrency mania continues to drive investor appetite for digital currencies, even as some hedge funds have grown cautious on the asset class. Bitcoin's extreme volatility may have begun to wear on some investors but others are using the current dip as a buying opportunity—albeit not necessarily for Bitcoin.
Though Bitcoin is the most prominent face of the current phenomenon, according to Forbes, initial coin offerings (ICO) exploded in 2017, raising a total of close to $5 billion in funding.
Some of these offerings provide investors with a way to gain real, perhaps even profitable traction into this new—and often not well understood—asset class without the huge outlay required to invest in one Bitcoin. Unfortunately the popularity and growing visibility of alt-coins has also fueled a variety of scams and outright criminal activity.
The crypto market has seen an escalation in the number of “pump and dump” schemes offering the naive or unschooled investor a chance to buy into a new digital offering at the earliest stages. Market manipulation is nothing new, even for a burgeoning asset class. Earlier this week, at a legal seminar in California, the Securities and Exchange Commission (SEC) Chairman Jay Clayton warned that some attorneys advising companies on ICOs are breaching their professional duties and could become targets of disciplinary actions themselves.
IPO, ICO or ITO
For those unfamiliar with ICOs—which have become a popular way for start-ups to raise funds without being hampered by the need to rely on middlemen such as venture capitalists and banks—an ICO is essentially a digital stock certificate. Think of it like an initial public offering (IPO) but the crypto version. ICOs are sometimes called ITOs for initial token offering.
How can investors tell the difference between a legitimate and potentially profitable ICO or relatively new crypto coin versus something that should be ignored or even avoided? Here are five things to consider:
1. Question How The Funds Will Be Used
Trace Schmeltz, a partner in the Chicago office of Barnes & Thornburg LLP, explains that any due diligence ought to include determining whether there are clear and precise uses for funds. He says:
“Ultimately, if a business plan or the expected uses of funds do not make common sense, an investor should run the other way. Second, every business model ought to stand up to the questions: (i) is this product or service needed and (ii) how many other companies are providing this product or service? Third, not everything can be "tokenized." In the early 2000s, Enron claimed that it could make a market out of everything. That turned out to be untrue—there is not a liquid market for everything under the sun nor is there a liquid market for electronic tokens that represent an opportunity to get your legs waxed.”
2. Understand The Risks
As can happen with initial public stock offerings, be warned that many ICOs fail to hit their promised goals, cautions Eddy Travia, chief executive of Coinsilium, a London-based firm that advises and invests in blockchain companies.
”Many ICOs will fail to achieve their goals, [which are] often quite ambitious, and the survival rate of startups in general (across all sectors) is low but in the case of token sales my main concern is that some companies and foundations sell tokens to members of the general public who do not understand the risks associated with these projects.”
3. Approach An ICO The Same Way You Would A More Traditional Asset
Gil White is the head of E-commerce and Crypto at HFN, a law firm based in Israel. He notes that proper due diligence is critical:
“Investors should approach an investment in an ICO with the same analysis as they would for any traditional investment. The viability of the crypto tokens is dependent upon an analysis of the underlying project and the token economics which support the currency issuance. The economic analysis of a Project based on cryptocurrency [should be] innovative but based on old-fashioned principles. Is the platform being developed something that will attract users? If not, the crypto tokens have no value.
4. Pay Close Attention To The White Paper
A white paper is perhaps the most crucial component of any ICO. It's created by the offering party prior to the coin's actual launch and should contain details investors must know before purchase including the commercial applications of the currency, its technological specifications, as well as financial details surrounding the offering and use of any funds raised. The white paper is the critical pitch document for potential investors.
Gil White points out :
“In analyzing a project, the ability of the company to deliver on the proposed project from a commercial and technological perspective is key. The white paper should clearly set out the project, the rights attached to the tokens and the risks associated with the venture. A well drafted, coherent white paper is a good guide as to the benefits of the company, its management and the likelihood of long-term success.”
Travia notes that Blockchain technology takes time to understand and white papers can be long and technical. As well, it's still a brave new world without the degree of legal protections associated with older asset classes such as equities and stock offerings:
“There are no rules for disclosures nor specific guidelines for the content needed in white papers at the moment and rights for token holders are mostly non-existent. This is why we support initiatives such as the DLT regulatory framework in Gibraltar and the Gibraltar Blockchain Exchange (GBX) which aims to be the world’s first regulated institutional grade exchange to support token sales.”
5. Not All Jurisdictions Support Or Accept ICOs
Dr. Jeppe Stokholm is a partner and general counsel at Black Swan, a VC firm based in Zürich, Switzerland. In a recent blog post he warned:
“Not all jurisdictions accept ICO’s/TGE’s [Token Generation Events]: On the 4th of September 2017, China’s Central Bank declared Initial Coin Offerings (ICO’s) illegal on Chinese soil, and asked all Chinese related fundraising activities to be halted immediately. The Peoples Bank of China said that those who had already raised money through Chinese ICO’s should provide refunds or face being “severely punished” according to the law.”
Though not every government has cracked down on cryptocurrencies with the severity of China's regulators, additional governing bodies in both Asia and globally have started paying closer attention to token activity.
Perhaps the number one rule for cryptocurrency investors remains the most basic: this is a new market which is not yet fully regulated. Therefore it continues to be high risk. Caveat emptor.