About ICOs

 

Investing in ICOs represents the most speculative form of venture capital, comparable to private-placements that occur before companies seek capital raises via an Initial Public Offering (IPO) by becoming listed on an exchange; however, there are many differences (and increased risk) in crypto-financing compared to traditional methods.

Recent ICO Statistics

Investors have recently flooded ICOs, as the prospects of the underlying products that are proposed to be built on systems that run on Distributed Ledger Technology (DLT) also known as blockchain technology is expected by many to be revolutionary, which has led to a sharp rise in recent ICO funding as seen in the graph below from CoinDesk.

 

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As technology developers look to integrate digital tokens (smart contracts) into the user experience of their related product/services that are integrated with blockchain, crypto-financing via ICOs has recently emerged as an alternative to traditional financing.

Cryptocurrency Competition

Blockchain technology helps run cryptocurrencies like Bitcoin (BTC), which recently hit a market capitalization of over $70 billion in August 2017. Bitcoin’s blockchain protocol uses a public/private key system, where each public key address (bitcoin address) is controlled by a private key, and no trusted 3rd party is required to send Bitcoin to a Bitcoin address, as the entire network verifies itself with each transaction.

This trustless peer-to-peer component is one of the main appeals of Blockchain technology that helped Bitcoin grow. The excerpt below can be seen from the white paper of Bitcoin’s original protocol proposal that made its blockchain possible.

 

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source: Bitcoin.org

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Bitcoin is supported by miners who help process transaction across Bitcoin’s decentralized network in return for a fee. Many other cryptocurrencies use a similar approach to compensate miners and validate transactions on their respective blockchains, but their protocols may differ as well as the methods for achieving consensus. These differences are driving further innovation and interest in blockchain technology.

Growing Interest in Distributed Blockchain Networks

Many major global banks, prominent venture capital firms, and even governments (and central banks) have already invested considerably in blockchain technology, for use in private or public distributed networks.

 

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source: CBInsights

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As private start-ups and companies continue to try to raise money via ICOs to build their products – which may rely on smart contracts that operate within specific blockchains (or off-chain), investors are betting on finding solutions with the potential to transform industries beyond finance and society at large.

A Decentralized Future

The promise behind trustless distributed networks is that they can affect social change while transforming industries, according to a research paper by the World Economic Forum (WEF) titled “Realizing The Potential of Blockchain” published in June 2017.

 

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Source: Satoshi Nakamoto – bitcoin.org

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According to the WEF report, the eight stakeholders that influence the blockchain ecosystem include developers, academics, innovators, non-governmental organizations (NGOs), government bodies, venture capitalists, banks and financial services, and last but not least individual users or citizens.

Steered by Stakeholders

Developers and innovators who are working on finding the next best approach are collectively helping to drive innovation in this field which is being funded with billions of dollars from institutional and now retail investors.

Individual users, in return, help drive change through their interaction with products and participation in ICOs and by using cryptocurrency which is being increasingly integrated into the global capital markets systems including banking and online brokerage investing.

In addition, the market capitalization of cryptocurrencies continues to reach new highs, hitting nearly $150 billion with Bitcoin representing nearly half of the value, according to data from CoinMarketCap as seen in the excerpt below as of August 17, 2017.

 

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source: CoinMarketcap

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In a peer-to-peer network where there is no middleman or trusted third-party needed as transactions are held, processed, and verified by the crowd, many new ideas are coming forward that will be built on DLT-powered blockchain networks, with potential application to nearly any industry where digital technology is used.

Investors are helping fuel this growth in blockchain by funding deals including ICOs with their risk capital and may receive potential incentives to use any resulting product or service that the ICO issuer aims to create, yet there are many headwinds that participants may face.

ICO Challenges for Startups and Investors

Just as many blockchain startups failed to raise a second round (Series B) after their initial Series A round of funding, the majority of firm’s raising money via ICOs may also naturally fail to either raise more capital or eventually succumb to burn rate or a failed or obsolete product. Meanwhile, there have already been reports of scammers using ICOs as a means to dupe investors, including cryptocurrency boiler room operations.

To highlight one of the challenges that are prevalent today, the Italian Competition Authority recently took action against an ICO issuer due to its unbalanced marketing messages which promised lucrative returns to its ICO investors. The Monetary Authority of Singapore (MAS) had also issued warnings to digital token investors in August, with tips on what to look for to avoid scams in ICOs, as part of its announcement to help protect investors.

There’s also been a rise in phishing scams and Ponzi schemes on Ethereum, with nearly 10 % of all money raised from investors thus far via ICOs having fallen victim to cybercrime, through August 2017 as per the excerpt below from Chainalysis:

 

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ICO Filtering Dilemma

Finding an ICO that will eventually turn into a highly successful business can be very difficult even for the smartest investors (just as with traditional investing in startups) even when a product looks truly promising and is backed by a genuine business plan, existing product, and experienced management team. This challenge is multiplied further as many good ideas for use on blockchain are freshly emerging.

Investors and companies both face steep challenges and risks in order to have a chance to succeed. ICOs are usually funded by investors that exchange cryptocurrencies (bought with fiat money) in return for digital tokens (coins) from the ICO issuer.

While digital assets such as cryptocurrencies are a form of smart contracts, and smart contracts may control or hold tokens, not all smart contracts or tokens have any inherent value on either public or private markets where cryptocurrency exchange and trading takes place.

Public blockchain networks such as Ethereum run on open-source code that lets anyone deploy their own smart contract – and modified code where tokens can be created out of thin air – and this is being used as a funding mechanism for ICO issuers to provide tokens to investors in return for their invested capital (comparable to issuing shares).

 

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ICOs are Extremely Speculative: Token (Smart Contracts)

Some companies in this field will indeed change the world and several have already done so, by using blockchain technology. However, many tokens offered via ICOs will remain or end up worthless, while some may grow in value or offer their holders the benefits they initially sought by supporting the company’s product via the ICO or subsequent capital raise.

It’s important for investors to realize that digital tokens (created by smart contracts) may not always convey any ownership rights to any underlying assets or hold any tangible value.

Furthermore, even if an ICO is not an outright scam, tokens could still be rendered useless or worthless – even if they eventually become tradeable on an open market in the future, due to a failed product, lack of interest or liquidity, among other risk factors.

These risks are multiplied by the fact that many startups will naturally fail, and furthermore because many blockchain and emerging cryptocurrencies are competing against each other for market share.

Some blockchains will eventually become obsolete, abandoned or unsupported, as better systems and products emerge that may or may not be cross-compatible, as older systems are replaced.

Coupled with the risk of loss due to technical glitches or theft of digital assets by hackers, ICO scams, and another inherent risk involved with the transfer and protection of digital assets, investing in ICOs is one of the most extremely speculative forms of crowd-driven venture capital investing that is currently available.

Tokens That Fluctuate Versus Tokens That Cannot

Tokens issued via ICOs may, however, have some form of utility such as conveying voting rights to the holder or may provide a discount for the user to buy the company’s product or use its service, among other utilities.

Meanwhile, other tokens may appreciate based on specific future events or targets/milestones that trigger liquidity events, in addition to any rights or utility within the proposed product where they may be usable.

These two key differences between tokens – that have the potential to appreciate versus tokens that do not – was the subject of the U.S. Securities and Exchange Commission (SEC) warning at the end of July that noted some tokens offered in ICOs (that can fluctuate or increase in value) could be deemed securities and therefore must be regulated when offered to US investors.

Jurisdictional Differences

Knowing the difference of whether a token can fluctuate in the future or not is just one of many types of material information that investors should know when conducting due diligence, beyond the usual white paper or presentation that is offered by ICO issuers.

Furthermore, while major regulatory hubs may still be years away from developing viable rules to regulate blockchain networks and ICOs, even after Australia’s government recently announced it would, many issuers are moving to offshore jurisdictions to launch their ICO leaving even less protection to investors.

Call For Best Practices and Industry ICO Standards

Financial Commission supports the clear need for best practices to be established for ICO issuers, and its ICC that is supported by foreign exchange and cryptocurrency market experts will help support this effort.

Financial Commission’s ICC will work on establishing a baseline of best practices and standards that every ICO issuer should demonstrate and as part of the ICO Certification process.

Financial Commission is ideally positioned to provide this service thanks to its organizational structure and experience in working with international companies including in offshore jurisdictions.

Financial Commission welcomes Financial Services (Finserv) industry experts including within the fintech community to apply for committee roles within the newly created ICC to help support this effort of creating standards for ICO issuers. Click here to learn more about our ICO certification process.

Challenges for Blockchain: Methods to Achieve Consensus

As newer emerging cryptocurrencies aim to differentiate their approach to how their blockchains and/or smart contracts operate, competition remains fierce among smart contract and blockchain developers.

Consensus is needed to verify transactions using a trustless distributed ledger, yet the methods of how consensus can be approached are evolving. Ethereum, which has its own cryptocurrency token called Ethereum (ETH), also known as Ether, has been used by many ICO issuers for its ERC20-complaint smart contract.

The Ethereum network is preparing to shift towards Casper, a proof-of-stake model for consensus to be derived, compared to its current proof-of-work model.

Bitcoin also uses a proof-of-work model to achieve consensus, which can be subject to attack if a majority of the CPU power is controlled by nodes that cooperate to attack the network or if they are able to outpace the longest chains to redo the proof-of-work and alter the network history. This is explained in the abstract made by Bitcoin’s infamous inventor Satoshi Nakamoto in his original white paper, seen in the following excerpt:

 

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source: Bitcoin.org

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What’s driving blockchain innovation?

Methods for determining consensus within blockchain networks are being challenged as blockchains compete to differentiate themselves while attracting developers to build products on their specific decentralized systems and open-source protocols.

While each method to achieve consensus has its pros/cons within a specific blockhain protocol, the various methods of approaching how consensus is derived are part of what is driving new innovative approaches to cryptography. These protocols use complex mathematical algorithms to derive consensus, which affects how the blockchain operates and the smart contracts that run on them.

Achieving consensus

In the proof-of-stake model proposed by Casper in Ethereum, miners have a “stake” as small bets are made to guess the next block (consensus direction) within a system, where correct bets are rewarded while incorrect bets are penalized, leading to miners who are incentivized to align themselves with the consensus (when betting) to avoid being penalized and earn a reward. This is known as consensus-by-bet, as seen in the excerpt below from Ethereum.org:

 

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source: Ethereum.org

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Both Ethereum and Bitcoin have experienced hard-forks, which is another challenge that is driving innovation with new protocols, and there are hundreds of additional cryptocurrencies and blockchain networks evolving, where the potential for forks exist where networks split into two.

Hard-Forking: Evolve or Devolve?

Bitcoin has its own dedicated Blockchain network protocol, although recently experienced hard-fork in early August 2017 where a portion of miners on its network voted to spin-off and create a new network called Bitcoin cash (BCH).

Soft-forks are temporary compared to hard-forks which are when permanent changes that occur because nodes that haven’t been upgraded to support the hard fork are unable to validate blocks that were create using the new consensus rules implemented by those supporting the hard fork.

Hard-forks including user-operated-soft-forks (UOHF) and miner-operated-soft-forks (UOSF) can be thought of a natural evolution of blockchain networks, yet just as with survival of the fittest, only the most flexible protocol that gets supported will survive and scale.

Furthermore, another potential hard-fork called Segwit2x may occur in November 2017 on the Bitcoin protocol, causing yet another cryptocurrency to branch off from the bitcoin blockchain, as seen in the blog excerpt:

 

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Since smart contracts are used to create tokens in ICOs, often on Ethereum or other blockchain protocols, the potential for forks is an important component of the ICO certification process as there are over 600 cryptocurrencies (smart contracts) as of August 2017 that have emerged and many are built on top of other blockchain networks or use their own.

Evolution of New Smart Contract protocols

As many smart contracts will be limited to the underlying code they use, and the networks they run on, and any of its protocol limitations, the need for best practices to be established is crucial for both the startup community, existing stakeholders, and investors that support it.

This is especially important as large amounts of investors’ money has been lost due to either faulty code in smart contracts which was exploited by users who were able to gain access via loopholes in the smart contract.

Ethereum is planning to shift to Metropolis as part of its 2017 roadmap released in February, as a number of enhancements are proposed, including ease of programming, account abstraction, and anonymity improvements, in an upgraded version that would cause it to branch off in another hard-fork expected near the end of September 2017.

 

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source: ETHNews.com

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As part of the upgrade to the Casper algorithm that uses a proof-of-stake approach to mining, the planned difficulty-bomb that would act as a stepping-stone for Casper to be added later will not be included in the September Metropolis hard fork and is instead expected to be included in a subsequent hard fork, as per Josh Breslauer in post on Steemit.

Furthermore, smart contract protocols are evolving and the legality and enforceability of how global legal systems will approach smart contract law when it comes to legal disputes is a key area of discussion within the industry, and following the creation of the Enterprise Ethereum Alliance.

Revolutionary Transformations: Now and in the Future

As intense development and innovation continue in this promising field where technology will largely be widely decentralized in the future, there are still many headwinds and challenges that the industry will face and across many verticals including technological, ideological, legal, regulatory, ethical, and finally political.

Blockchain technology should persist as a new transformational vehicle that fuels the 4th industrial revolution that has already begun thanks to distributed ledger technology and proven by existing attempts such as Bitcoin which have succeeded in surpassing market capitalization of PayPal, for example, inspiring hundreds of new cryptocurrencies, blockchains, and new technologies that will run on and off blockchain technology.