Business Times (BT) reports that the initial coin offering (ICO) fever appears unabated in 2018, with some US$6.3 billion reportedly raised in the first three months of 2018 alone – already more than double the amount raised in all of 2017. As mania grips the investing community at large, regulators are raising scrutiny over these newfangled fund-raising tactics.
The ICO trend has already prompted many regulators to issue warnings of the risks, with the US Securities and Exchange Commission (SEC) going so far as to launch a fake ICO as a form of investor education.
What many have observed – and warned against – is the aggressive window-dressing that has drummed up hype for the ICO market. Many ICOs have a dodgy reputation, observers say.
“Investors should not be distracted by the accelerated pace and scale of ICO’s social-capital and attention gained through marketing amplification, and recognise that its prices are volatile given the attached frills,” says a spokesman for Singapore-based consultancy Practical Smarts. “This is further compounded with the effects of FUD (fear, uncertainty, and doubt), and FOMO (fear of missing out) sentiments.”
The term ICO riffs off IPO, an initial public offering through which privately owned companies sell shares in themselves to the public. But while an IPO prospectus is hundreds of pages long and needs to be greenlighted by the stock exchange, an ICO’s “white paper” to sell digital tokens is more of a marketing brochure and needs no approval.
While investment bankers fill the order-books of IPO, fund-raising for an ICO often takes a route that is much less rigorous. For example, PolicyPal Network, an ICO project to disrupt the insurance business, raised some US$20 million through names such as Fenbushi Capital and TenX by “word of mouth”. Its public crowdsale was drummed up using “bounty marketing campaigns”, says its founder Val Yap.
Amid such newfangled ways of seeking funds, a Singapore family office ICH Group recently had to refute through its website, claims that its founder and chairman, Danny Toe, is an adviser to a Chinese ICO project, Odyssey Coin. It is understood that Mr Toe only had a casual conversation with the ICO team. Mr Toe’s name has been removed from the project, BT understands.
Likewise, a startup founder told The Business Times that she had asked through LinkedIn to learn more about a blockchain project, and was instead asked to become an adviser for the project. She declined.
Then there’s the notion that digital tokens are traded on exchanges, which look like regulated securities markets due to quoted prices. But in reality, cryptocurrency traders here have told BT that these exchanges operate like over-the-counter platforms. The US SEC chairman Jay Clayton has raised his concern that many cryptocurrency trading platforms are referred to as ‘exchanges’, calling the appearance “deceiving”.
“In reality, investors transacting on these trading platforms do not receive many of the market protections that they would when transacting through broker-dealers on registered exchanges or alternative trading systems, such as best execution, prohibitions on front running, short sale restrictions, and custody and capital requirements,” he testified to the US Senate in February, highlighting the “substantially heightened” risk.
US regulators are probing major crypto exchanges over price manipulation. This comes amid scepticism that cryptocurrencies are widely traded on “exchanges”, making the term “currency” another misnomer of this trend.
As an example, an estimated 1,000 Bitcoin holders hold 35 per cent of all Bitcoins in circulation, reports showed, suggesting that these Bitcoin “whales” are wielding outsized control of the cryptocurrency’s trading activities. There are about 11 million Bitcoin holders in the world today.
To add hazard to that asymmetry, cryptocurrency trading platforms are susceptible to hacks. Just this month, two crypto-exchanges in South Korea reported yet more heists that wiped billions off the value of the crypto-market.
Yet the ICO trend shimmers with the gloss of legitimate finance, when it is held aloft by former bankers bearing gifts. In February, a group that included former Goldman Sachs executives brought in some ICO candidates to Singapore. The event held at the high-end Equinox Restaurant was run by a company called Spartan Group that calls itself an ICO specialist. In March, Spartan’s website said it had a “fully licensed” crypto fund. Its LinkedIn says it is headquartered in Singapore.
BT attended the event, which had presentations from Chinese-speaking individuals. China has banned ICOs. BT asked Spartan among other things, where the licence was from, whether it earned a cut from ICOs, and its due diligence process. The group did not respond to questions sent multiple times by email. By June, the group has changed its website to remove reference to a full licence of its fund. But on a blog post, it is still promoted as having a “fully licensed crypto fund”.
In its strongest reprimand linked to cryptocurrencies, the Monetary Authority of Singapore (MAS) in May warned eight crypto exchanges in Singapore, saying that they must consult the regulator before trading in digital tokens that look like securities or futures contracts. MAS also stopped an unidentified ICO issuer from continuing with its ICO as it had broken rules.
“To date, no ICO issuer is regulated by MAS,” a spokesman said. “MAS strongly encourages consumers to deal only with entities regulated by MAS, so that they will be protected by the laws administered by MAS.”
To understand the hype, one has to unpack how ICOs relate to blockchain – a technology that promises to cut out pain points behind processing all manners of transactions.
Blockchain or distributed ledger technology is used to create and keep records of information, such as transactions. This ledger can confer rights to an asset from ownership of stocks, to diamonds, farm animals, and to a home, and can be digitally shared among financial institutions, regulators and asset owners.
One can say a distributed ledger is, in effect, a more sophisticated shared database through which transactions can be signed. But there are practical advantages to this.
Even as the world has become more globalised, backend infrastructure has not caught up. For one thing, reconciliation of accounts remains painful because of the costs and time involved. This is particularly so for cross-border transactions. The best opportunity for distributed ledger technology likely remains in trade finance. It takes about a day for physical goods to be shipped between Singapore and Indonesia. But the trade finance documents take a week to process. Trade finance documents fundamental to a trillion-dollar business still remain in paper, creating fraud vulnerabilities.
Paul Sin, who leads Deloitte’s Asia Pacific Blockchain Lab, points out that sending customer information offshore from China is an actual criminal offence, due to the privacy laws. But the consultancy has worked with a Chinese insurer to sign off on transactions with a bank in Macau by using a distributed ledger.
“Blockchain becomes so powerful in business partnership scenarios where data can be synchronised real-time,” he tells BT.
Banks are examples of institutions that are identifiable, and for the most part, they are trusted agencies backed by rules to check against abuse. So when banks create a blockchain network among themselves to exchange trade-finance documents across borders, they typically build on an existing network through a more efficient piece of technology. This is known as a permissioned blockchain.
“The blockchain is still used to trigger the traditional payment gateway,” says Deloitte’s Dr Sin. “In a permissioned blockchain, it processes thousands of transactions per second. We do not want anonymous parties in business scenarios. If let’s say, five banks are trying to prevent duplicate financing, why would HSBC want to be anonymous? It doesn’t make sense.”
But an ICO is a different animal. An ICO is a project that claims to be using blockchain technology to mainly bring about anonymous peer-to-peer transactions to circumvent the incumbents such as banks, which charge customers for participation in traditional payment networks. And several ICO projects can claim an aim to create a new network between untrusted and unknown actors.
For transactions to go through such a network then, they would have to go through an additional layer of verification and checks. This is done through mining, or an act of verifying code through solving equations quickly with computing power. When the validation is correctly done, a new “block” of information is created. A link of “blocks” creates a blockchain.
For software developers to build such radically new networks, they would need to spend cryptocurrencies, typically Ethers, to access a computing platform known as Ethereum to build their blockchain projects.
Here’s where the other digital tokens sold through ICOs presumably come in. ICO issuers sell their brand of digital tokens in exchange for Ethers, which are used to power the experiment. ICO issuers also take Bitcoin in exchange for their digital tokens, with the money going towards not just “fuel” to develop blockchain projects, but also for expenses such as marketing.
Buyers of these new cryptocurrencies latch onto ICOs with a naked belief that these digital tokens give them a piece of a new, untapped network that will explode in value. ICO ideas have included peer-to-peer insurance networks, social-influencer networks, and travel networks.
But this also means that billion-dollar valuation of ICOs today also represents the value of Bitcoin and Ethers used to build those networks. And the trading of digital currencies fluctuates wildly.
Hacking incidents on separate South Korean crypto exchanges in June alone led to billions wiped from the crypto-market, on top of millions worth of coins stolen. This reflects as well that long-term “investments” in cryptocurrencies are giving way to short-term speculation, reported the Financial Times this month.
Deloitte’s Dr Sin says: “People also have a misconception – because what you raise is Bitcoin or Ether, you still need to liquidate, and there are not many exchanges with that depth. Let’s say you raise hundreds of thousands in Bitcoins. Where can you get the fiat currency?”
Wild Wild West
It comes as no surprise that Wong Toon King, who has launched a travel blockchain ICO through Wegogo to raise US$88 million by late July, sees ICOs as leading investors into the next Internet wave. Mr Wong is known for founding Singapore’s first company to invest in Internet businesses, SilkRoute Ventures, in 1994. “We believe the blockchain will become the primary protocol in the evolution of the Internet for all value and transactions. As such, billions of research, venture and corporate funding are going into innovations, engineering and startups to make the public blockchain robust, scalable and fast,” he says.
“If you remember the same issues we had with the early public Internet, that it was slow, that it could not support video and moving images, and that it was not safe for e-commerce – all these issues have been resolved for the public Internet today.”
Yet, Mr Wong himself has called out the ICO market for its Wild Wild West nature, and noted that blockchain technology is still in its infancy. A Bitcoin transaction today is, in fact, a slow-going digital event, taking about 10 minutes to complete.
Of course, speculative bubbles come in all forms. The SEC did not say how many have been duped by its fake website for its brand of digital tokens, known as “HoweyCoins”. (“Howey” was an inside-joke wink at a 1940s Supreme Court decision that defined a security). But in 2003, it similarly created a fake hedge fund offering to warn investors against heavily inflated returns. In a respectable display of humour, the regulator called the fund Guaranteed Returns Diversified Inc, or GRDI (read: greedy). That website got some 80,000 hits and application submissions in about five months. Both GRDI and HoweyCoins used jargon and pumped-up marketing figures to entice investors, mirroring the inflated claims of some ICOs.
Many ICOs, for instance, have claimed that their new projects can create efficient networks through the use of “smart contracts”, described in effect as code that can run transactions automatically. But as research from blockchain startup R3 showed, the term “smart contract” alone can be misleading and questionable.
“There are often situations where a simple piece of code is claimed to be a smart contract when, in reality, it is neither ‘smart’ nor technically a ‘contract’. A smart contract is not simply any piece of self-executing computer code, but is rather an agreement whose execution is both automated and enforceable,” R3 says.
While digital tokens fall under a grey area, Long Jek Aun, partner, Simmons & Simmons JWS, notes that regulators will watch for the structures of such ICOs, to determine how they should be regulated.
Indeed, the MAS spokesman notes that the treatment of a token here is based on the characteristics of the token. Under the Securities and Futures Act, an investment arrangement that is marketed as selling Singaporean investors a right to participate in returns from the scheme’s property will be considered as a collective investment scheme, which is regulated.
Peiying Chua, a counsel at Linklaters Singapore, says that under Singapore’s upcoming Payment Services Bill, the regulatory burden would soon fall on intermediaries who trade virtual currencies, including crypto exchanges.
As it is, it is increasingly difficult to register onto cryptocurrency platforms, so much so that things have taken an ironic twist. Deloitte’s Dr Sin observes that in Hong Kong, it takes more time to get an account to trade cryptocurrencies than a banking account. “They are so rigorous that even an e-statement cannot prove your address. You need to give them a physical, paper-based, statement.”
Lawyers expect enforcement to continue. But as TSMP Law’s joint managing partner Stefanie Yuen-Thio points out: “If Joe Public sees the word ‘blockchain’ and ‘ICO’ and cannot wait to throw his hard-earned cash into the latest fad without understanding what he’s buying, no amount of public education is going to reverse his loss.”