Initial coin offerings (ICOs) and token sales have exploded in popularity over the past 12 months.
By October 2017, more than $2.3 billion worth of ICOs had completed in 2017, representing a 1,000% increase on the previous year.
At the same time, regulators have begun looking much more closely at this fast-rising investment vehicle. Some countries have banned ICOs and token sales altogether.
There are good reasons for the hype and equally good reasons for financial regulators to ban them.
While the United States' Security and Exchange Commission (SEC) hasn't outright banned all token sales, it's moved to bring them under similar regulations as stocks traded in an initial public offering (IPO). Savvy businesses looking to get around this increased regulation have now moved toward offering use tokens.
Like most things connected to the rapidly developing world of blockchain technology and cryptocurrency, ICOs and token sales are a dizzying mixture of finance, cutting-edge technology, and volatility that makes them both alluring investments and investments that are difficult to understand.
- So what exactly are ICOs and token sales?
- How does a use token differ from the type of token sale that the SEC is cracking down on?
- Why might use tokens be a fundamentally flawed investment model?
What are ICOs and token sales?
An IPO happens when an established company wants to generate funds by going public. It offers shares of the company for sale to the public and can quickly make enormous sums of cash to help the business grow. In the United States, all IPOs are strictly regulated by the SEC.
ICOs, created as a 21st-century spin on the IPO, are usually conducted long before a company has achieved success.
In some cases, ICOs and token sales take place before a company even has a viable product. They are used as a form of crowdfunding, similar to platforms such as Kickstarter and GoFundMe. The initial idea was that investors would get a slice of ownership in the company in exchange for funding their early development.
Why are governments cracking down on ICOs and token sales?
The main advantage of ICOs and token sales as a funding method was that anyone could create them without SEC approval. That allows unproven companies with bold new concepts to raise cash to make their ideas a reality quickly. The downside is that ICOs and token sales provide scammers with an incredible opportunity to make a quick buck.
The problem of fraudulent ICOs quickly became a huge issue in China, where the government controls investment markets much more strictly than in the United States.
With few options available for investments with a high risk/reward ratio, many Chinese investors plowed huge sums into ICOs and quickly lost everything.
As a result, the Chinese government issued an outright banned on all forms of ICOs and token sales in September 2017, while also shutting down exchanges trading in cryptocurrencies such as Bitcoin.
Other governments, including those which are otherwise friendly to Bitcoin and other cryptocurrencies, have taken similar measures. South Korea is the world's largest per-capita investor in cryptocurrency. Soon after China outlawed ICOs and token sales, the South Korean government did the same.
In the United States, the SEC made it clear that any ICOs and token sales which offered a share of a company in return for money should be subject to the same strict regulation as traditional IPOs. That has led many overseas-based ICOs and token sales to prohibit participation by American investors.
Despite the risks, ICOs and token sales are a revolutionary new form of direct investment in companies. Many investors still see them as a chance to take a gamble on making huge profits by backing upstart tech companies. Those tech companies see token sales as an unrivaled tool for quickly generating vast sums of cash to fund their ventures.
Start-ups, hoping to avoid falling foul of the SEC, are now offering a new form of ICO. Instead of providing investors a slice of their company, start-ups are instead offering use tokens.
How are use token sales different to other ICOs and token sales?
The SEC has a straightforward method for determining when an investment is considered a security.
The Howey Test identifies securities as being when investors exchange cash for a share of future rewards. Any investment which fails the Howey Test is subject to strict regulation by the SEC.
A lot of ICOs and token sales are securities according to the SEC's definition. Investors exchange cash for a share of the company, hoping that stock will appreciate in value as the business grows. By offering use tokens instead of shares in the company, start-ups can provide an investment opportunity that doesn't fall foul of the Howey Test.
How do use token sales work?
In a use token sale, early investors by coins or tokens which will later be used to buy goods or services via the company's platform.
These coins or tokens are typically exchangeable for cryptocurrencies such as Bitcoin or Ethereum. Every time somebody uses the company's service, they pay in these use tokens. The idea is that as the company's reputation grows, the use tokens will rise in value.
On the surface, this seems like a fantastic solution to the problem posed by SEC involvement in ICOs and token sales. However, there may be some huge drawbacks to this investment method that haven't come to light yet.
What are the potential problems of use token sales?
The whole concept of use token sales as an investment opportunity is that use tokens for a given platform will increase in value as more people want to use it.
There are numerous potential problems with this idea.
As use token sales are such a new concept, none of these have yet caused significant problems for any service. Some companies may have thought through these issues and already dreamed up creative solutions. But given the murky history of ICOs and token sales and their enormous potential for fraud, these drawbacks are something of which every potential investor needs to be aware.
The early investors in a use token sale are likely to be much more interested in making a profit than actually using the service. It's therefore in their interest to hold onto the tokens and try to make as much profit as possible. If enough investors adopt this strategy, there won't be enough tokens available for the service to be usable.
Many investors in ICOs and token sales use a spray and pray investment strategy.
There's no sure way to know which start-ups in this space will be huge players in the future and which will vanish without a trace. With some many investments to manage, it's unlikely many of these investors will be taking an active role in exchanging each of the use tokens they hold.
The idea of use tokens being a speculative investment vehicle also makes the service they support much less attractive to end users.
If the price of a service is in constant flux, customers will shy away from it.
If the customers are using the service to support a business, they won't be able to budget in advance for the cost of the service.
Just as the investors will be banking on the price rising, customers may hold back and wait for the price to fall. That could create a perfect storm where nobody exchanges use tokens, and the service dies as a result.
So do use token sales make sense as an investment opportunity?
In conclusion, use tokens are a novel and unproven concept, just like many other aspects of the emerging blockchain and cryptocurrency fields.
Whether or not they'll look like fool's gold or a solid investment five years from now is anyone's guess.
But investors should be aware of the risky and unproven nature of use tokens before getting on board.