By Richard Lee, Co-Founder and Head of Execution, FENIX
Much has been written about the demise of the ICO and the collapse of the prices of digital currencies, as well as the development of a new product, security tokens, which are distributed by way of STOs, or security token offerings. While the principal of ‘some security being better than no security’ rings true to many, much of the commentary on the relative benefits of each type of offering avoids the fundamental question – does a security token provide greater tangible benefits to token holders?
Why did ICOs come about?
In order to make a fair assessment of this, it is important at the outset to take a step back and look at what an ICO is – In it’s simplest form, the ICO was the creation of a new tool to allow very early stage (and high risk) tech projects the ability to raise funds through crowd sourcing.
Why? Because before the ICO, funding routes for very early stage asset-light companies were limited:
- Private money– While it was possible for a new project to access private money through VCs, funds or high net worth investors, with limited alternative sources, securing an investment was often difficult or on unattractive terms;
- Debt– In most cases, access to debt was impossible without assets to secure a loan against; and
- Public capital markets– The only true way to raise money publicly was through the listing of shares on the capital markets and these projects would fail to satisfy the criteria to list and trade their equity on public stock exchanges – they were too early stage and didn’t meet any of the trading or profitability requirements, because they were very early stage and in many cases, pre-launch.
The underlying principle of the ICO was that it created a tradable token that was arguably not a security and therefore was not subject to the authority of securities regulators. It did this by arguing that the utility nature of the token made it different from a security and therefore not subject to regulatory oversight.
By separating the token from the equity, it meant that new tokens were only used within the ecosystem and did not confer any control or ownership of the underlying business to token-holders. This of course also meant that a token holder had no influence or security in the event of the demise of the underlying business.
Faced with a new class of utility tokens coming to market, the majority of securities regulators, and notably the SEC, adopted a wait-and-see approach and were initially opaque in defining whether a digital currency constituted a security, allowing it to watch the market develop before introducing its regulatory regime.
And why did ICOs go wrong?
These digital currencies caught the imagination of a huge pool of capital and aftermarket trading led to massive price appreciation and therefore returns on sale by token-holders. As a result, swathes of new projects sought to raise funds through ICOs and millions around the world sought opportunities to buy into this new high return market that had very little by way of regulation. Rapid growth with few barriers to entry and little oversight invariably led to disaster…
Issuers rode a bubble of investor demand – people flooded into the market to make multiples of their initial acquisition price, without knowing anything (or very little) about the project that they were buying into. In order to access this wave of demand. Issuers were increasingly trying to force a square peg into a round hole, pushing limits to identify blockchain uses for their project and to seek to class their tokens as utility tokens.
I have sat in many meetings over the last two years seeing people getting funded after presenting to a roomful of people who didn’t even speak the same language. People didn’t understand the risk profile of what they were buying, and frankly didn’t care. It was classic bubble mentality, much like the tech industry at the turn of the century – fill your boots with every opportunity you could get your hands on because you just couldn’t lose.
And as more and more people tried to come to market, the model underpinning the business got increasingly perverted. By the end of 2017, the ICO market had reached a point where the model itself was broken – just as they had succeeded before, regardless of what the underlying project was, now the ICO structure itself meant that projects were failing before they had the chance to prove their worth to the market.
So why did it go so wrong?
For the purpose of this article, I am not talking about the shams and the frauds that flooded the market – they deserved to fail and did. I am instead referring to those many good ideas and uses of the blockchain and digital currencies that still failed.
To understand why token prices collapsed after completion of an ICO, one needs to look at some common problems with many ICO projects:
- Projects raised money too early– ICOs were raising their funds on the back of little more than an idea and a work-map to deliver a launch, often as much as 18 months into the future.
- No execution track record– While many of these projects were based on good ideas, many of the teams had little experience in executing product launches. And with as technical a product as the blockchain, people looking at the projects often didn’t ask the questions they would when faced with more traditional businesses.
- Projects raised too much money in one go at the start– The ICO was considered a one-stop fundraising solution – raise everything up front because you wouldn’t get another chance. In fact, I recall a number of expert advisors telling me that it was unacceptable to hold tokens in treasury to raise money post launch of our ecosystem. This had two issues (i) the price of the tokens at ICO was low because it included a significant haircut to address the execution risk of an unlaunched product and (ii) it meant that ICOs were issuing massive amounts of tokens at the outset.
- Token-holders were allowed an immediate exit– With token-holders seeking immediate liquidity to allow them to realize gains (if they were able to sell their tokens for more than they paid for them), tokens were often tradable on exchanges months, if not years, prior to the launch of a project and importantly before the purchase of any tokens for utility purposes.
But why did the market collapse?
Determining the price for which a token can be sold on an exchange is very simple. If demand for the tokens exceeds the supply of tokens available for sale, the price will rise, and conversely, if there are more tokens for sale than there is demand to buy the tokens, their price will fall.
In the early days of hysteria around ICOs (in many cases, driven illegally because the market was completely unregulated), massive waves of demand bought and kept buying the limited numbers of tokens available for sale at the ICO and then in the aftermarket. This drove the token prices up, often to many multiples of the original price. Everyone made money and the clamor of people wanting to participate led to a constant excess of demand for tokens – it was a frenzy that fed itself.
With very few, if any, projects having launched and generated users for the ecosystem, the only persons holding tokens were those who had bought the tokens with a hope of gaining a financial return (we call those people investors) – There were no users buying the tokens for the utility which the token professed to have.
And this lack of token-holders other than investors led to the inevitable collapse of the ICO market. If we look at what actually happens at an ICO in terms of supply and demand:
- Say I need to raise $10 million to launch and rollout my project and wish to do that by way of an ICO.
- I then offer $10 million worth of tokens in my ICO (supply) to investors (demand).
- In most cases, I sell as many tokens as I can at the ICO ie I satisfy all of the demand.
- When I transfer the tokens to those investors and they pay me cash, the demand for those tokens has been satisfied and those token holders now want to sell their $10 million worth of tokens to make money. In other words, they shift from being demand to becoming supply.
- But where is the demand to buy these tokens being offered for sale going to come from? Everyone who wanted to buy tokens did so in the ICO, and there is not yet any ecosystem where a token holder could use the tokens. Further, if its still 18 months to launch, there isn’t any clear reason that people are going to want to buy tokens for a long time to come.
With lots of supply of tokens and very little, if any, demand, the price of the token can only go in one direction and once people start losing money, supply increases (people decide to sell to cut their losses) and demand falls (no one wants to buy something today that is going to be worth less tomorrow)…
Couple that with people selling the sector as a whole, and you had a bubble that collapsed as fast as it developed.
Why did STOs come about?
The advent of security tokens arose because many of these projects failed completely or more importantly, people lost substantially all of the value in the tokens that they had acquired. People blamed the losses on lack of control over management and wanted to have some form of security that gave them comfort that they would have recourse to their investment if the project didn’t deliver as it promised.
In order to address investor concerns, people created a new class of token, the “security token”. The security token has a number of key characteristics:
- It’s a security– As suggested by its name, it conceded that it was a security. This meant that it would come under the auspices of securities regulators and therefore would be subject to disclosure and other requirements, as determined by those regulators.
- It looks like equity– A security token adopts much of the characteristics of equity:
- It was underpinned by assets of the business, meaning that holders of tokens would at least have something to enforce against and recoup their losses if the project failed;
- It often required a path to profitability and to distributions to tokenholders; and
- It often allowed token-holders measures by which to control management of the Company.
On the face of it, these are good things, but the question that needs to be asked is “are security tokens always better than utility tokens”?
- Do we need tokens to be governed by securities regulators?ICOs are high risk ventures and therefore have a high risk / reward profile, one which is fundamentally different from that of listed equities. While they are not for everyone, there is certainly a market of people willing to participate in opportunities of this nature.
There is a strong argument that the minimum listing requirements for equities are not suitable for tech projects of this nature, at the stage at which they are seeking to raise money – operating track records (and associated financial disclosure) | profitability tests | minimum size | asset and other ratio requirements.
For securities regulators to set rules in line with their existing equity products just means that we are adapting guidelines that didn’t work for this type of company in the first place – if they did, there would have been no need for the ICO market to develop.
- Is security worth anything?Many blockchain companies or companies that have gone to ICO have very little by way of assets to act as security. As such, even if they give token-holders recourse to all of the assets of the business, does it actually help them at all – at the end of the day, 100% of nothing is still nothing.
- Security tokens can’t be utility tokens– If security tokens act like equity and give token holders rights over assets, access to dividend streams and / or control over the running of the project, then it is impossible that these tokens be used for true utility purposes.
If security tokens aren’t the answer, what is?
While there may indeed be circumstances where a security token offering may make sense, the question remains as to whether there is a viable option for true utilty tokens. Our view is yes, and we have spent a lot of time considering how to launch a project and a utility token in a way that allows the ecosystem protection while it grows to a point of sustainability.
We describe what that launch process in a separate article from my co-founder, Allan, who introduces the principle of the Responsible Coin Offering, or RCO, which at its core, makes the initial distribution of a utility token in a manner that is responsible when looking at all key stakeholders.
By way of introduction, the key tenets of an RCO are as follows:
- No public listing of the token may occur until the business has been launched with an operating ecosystem and completed software.
- The ecosystem must be the primary venue for creation of the demand for the utility token – not trading of the token on an exchange.
- There must be a solid plan in place for the business to demonstrate significant commercial prospects within 90 – 180 days after launch.
- Principle dissemination of tokens post launch IS to satisfy demand for the utility of the ecosystem in an ordered and fully disclosed manner.
- Carefully calibrated numbers of tokens may be released for purchasing on a coin exchange at predisclosed stages of the growth of the underlying ecosystem.
The release of tokens is to be governed by smart contract, which is subject to stipulated and disclosed conditions that are implemented to encourage token stability in the initial rollout of the underlying ecosystem.
Our fundamental belief is that the RCO structure is designed to allow the utility ecosystem to grow through its very early days in an ordered manner without the undue pressure arising from tokens initially being predominantly held by investors.