The Fundamental Structure, Implied Benefits and Process of Initial Coin Offerings

As anticipated, once the blockchain technology have been introduced, several usages have followed. In particular, with the increasing development of the market of ventures based on the blockchain, a new and more suitable form of raising capital for these projects was necessary (Fisch, 2018; Momtaz, 2018; Rhue, 2018). Indeed, the Initial Coin Offering arose as a novel source of finance and immediately increased and revolutionised the market competition (Bourveau, 2018). However, as Zetzsche (2018) and Martinez (2018) points out, it not anymore addressed to only the blockchain community as the groups of investors and the purposes are rapidly enlarging and the phenomenon has already become global and relevant in size.

Firstly, after having highlighted how authors describe the phenomenon, it is important now to consider the fundamental aspects of this innovative method of raising funds. Therefore, the Initial Coin Offering, which can also be called “token sale” or “crowdsale”, can be considered as a hybrid fundraising instrument of the most traditional IPO and the more modern crowdfunding. Indeed, through an ICO, a start-up can issue a stock of specific crypto tokens for sale and those tokens can be used as the medium of exchange for accessing the digital platform created by the start-up itself (Catalini, 2018). By buying the tokens issued, in exchange for cryptocurrencies or fiat currencies (more rarely), the investors provide the capital that is committed, generally, to the early-stage development of the venture or project (Catalini, 2018). Technically, an ICO relies on a smart contract developed within a blockchain platform and it contains the address under which the exchange of cryptocurrencies and tokens among investors and ventures takes place (Rhue, 2018). In particular, most ICOs use the Ethereum platform whose core attribute is precisely the smart contract and the possibility to easily program guidelines on which the ICO system is built and launched (Martinez, 2018). Indeed, Ethereum, with its ERC-20 protocol, suggests a standardised infrastructure to generate new tokens on its blockchain platform (Martinez, 2018).

Beside of the technicalities, in order to later proceed on studying the benefits and risks of Initial Coin Offerings, it is equally important to understand the basic procedure and structure of this method of raising funds. Firstly, to attract investors and give them information about the project, the creators should make the White Paper circulating in their website (Collomb, 2018). It is a document that basically produces the typical business plan and it should contain the project’s objective, management team, idea, product, roadmap and all the necessary data of the ICO process that an investor might need for taking an informed decision (Benedetti, 2018; Bourveau, 2018). Despite the importance of the White Paper, according to Martinez (2018), its structure is not yet regulated and there is not a standard model to be followed. As a consequence, in general, the ICOs prospectus contains almost only a technical explanation of the underlying technology of the project (mostly blockchain ventures) and the benefits that it can bring to the users. In the next chapter, when studying all the potential risks that an ICO embodies, I will recall this point as the lack in information disclosure and in the guidelines for the white paper composes the main reason that generates asymmetry information (Martinez, 2018). However, at this stage, during which the announcement of the ICO is communicated through conferences, meetings, online, and social media, the tokens that have been developed by the issuers should not be yet usable and functional (Collomb, 2018). Indeed, as Rhue (2018) clearly specifies, before launching the ICO, the venture requesting for capital must also define the total supply of specific tokens, the token decimal , the initial value of a single token and in addition, the cryptocurrencies accepted in exchange. In particular, also Conley (2017) highlights the relevance of the creation of a fixed number of tokens and to clearly announce it before selling them. Moreover, once reached the maximum number declared, the venture should not issue these specific tokens again, otherwise problems of pricing, opportunistic behaviour and speculation are likely to arise (Conley, 2017).

Afterwards, it is common to have a pre-ICO, or pre-sale of tokens as it is allowed to investors to purchase the tokens before the beginning of the official crowdsale (Martinez, 2018). The pre-sale, usually being defined with different smart contracts from the crowdsale, offers discounts and, therefore, investors are able to buy tokens at cheaper prices and, sometimes, to obtain extra bonus (Martinez, 2018). As a result, it is apparent that early buyers have several advantages. However, Martinez (2018) specifies that, in the majority of the cases, start-ups offer the opportunity of a pre-ICO especially to “accredited” investors, which constitutes a greater portion of the funds raised during this stage.

Subsequently, the official sale of tokens to the public takes place according to the guidelines published on the relative White Paper. At this stage, the exchange of tokens and cryptocurrencies between issuers and buyers occurs through the code or address being provided. As explained before, the cryptocurrencies that are accepted are specified in the initial document; if not, usually the most commonly traded are recognised (Martinez, 2018) There is not a general principle that concern and manage the duration of the ICO, since it can be fixed or can neither be stated; it can last few seconds, weeks or months (Collomb, 2018). According to Martinez (2018), the length of the ICOs’ call might vary on the nature and on the objectives of the project, indeed the larger the network is needed, the longer the ICO will last. Alternatively, as Collomb (2018) reminds, token issuers often determine the closure of an ICO’s crowdsale when the “cap”, or the pre-set maximum amount, is reached. Equally, also a minimal threshold is set and if not achieved, the project and the ICO are likely to be cancelled (Collomb, 2018). However, Bourveau (2018) specifies that there can exist both capped and uncapped ICOs.

Furthermore, it is fundamental to state that one of the major features of the ICO is to provide to token holders the possibility to create a secondary market by exchanging the tokens bought and, as a result, to generate liquidity out of their investment. Indeed, Momtaz (2018) argues that, since the main source of liquidity for investors is to trade the tokens acquired through the ICO, the objective is to insert it on the list of a token exchange after the closure of the ICO’s crowdsale. The trading takes place on the crypto market for tokens, which is still based on a blockchain system and it ensures verification, authentication, security, anonymity and data integrity (Bourveau, 2018). For example, some of the major public exchange platforms where tokens are listed and traded are Binance, Bitfinex, Bittrex, Kraken and Poloniex (Bourveau, 2018; Momtaz, 2018). However, if there is no exchange that accepts a specific token and its relative project, the ICO is destined to fail and, already at the beginning of the year 2018, it has been reported that almost half of the 2017’s ICOs failed (Momtaz, 2018).

The undefined framework of token properties

As anticipated before, there is not a complete and comprehensive definition of the ICO mostly due to the fact that the tokens issued can have different properties and rights embedded. Indeed, also in the literature it is confusing as the term “token” is often utilised for the more general term “coin”. In this section, after a deep study of several papers, I will provide an outline of the attributes that a token can assume. However, it is fundamental to keep in mind that, at a technical level, all tokens have the same principles and basis of the blockchain system and cryptography (Shroff, 2018).

To distinguish the types of coin, firstly, it is appropriate to mention the “cryptocurrencies coins” or “currency tokens” which generally denote a digital medium of value exchange and operate as a currency (Allen, 2018; Bourveau, 2018; Fisch, 2018; Shroff, 2018; Zetzsche, 2018). Secondly, there are the “infrastructure coins”, as defined by Bourveau (2018), which support the creation of a new platform with the development of smart contracts. Thirdly, there are ICOs’ tokens that are denominated often differently and not all authors include the entire range of properties. Indeed, Bourveau (2018) appoints them as “utility coins” as, generally, they deliver to token holders the benefit of receiving products or services that have been previously revealed in the White Paper. For example, these digital tokens can give access to the platform, to the system, or might receive other benefits made accessible by the project and the decentralised service in question (Adhami, 2017; Pilkington, 2018, Shroff, 2018). Likewise, the utility tokens might entail future rights that the holders have obtained during the ICO (Allen, 2018). However, the specific rights that a token conveys can differ and they might embody several subcategories: the “usage token” which provide rights of usage like a license to utilise a software program; the “community token” that gives the membership in a community; the “participation tokens” which allow to be part of the governance and often the voting rights (Zetzsche, 2018; Collomb, 2018). Indeed, tokens could resemble features of securities, assets or equity, by inferring traditional stocks’ ownership or control rights but there are also emerging types such as the reputation or reward tokens; or they could exhibit entirely new properties in the future (Fisch, 2018, Nica, 2017). In particular, among the “equity tokens” which generally provide the rights to participation, there are the “investment tokens” or “security tokens” that allow the holders to obtain a share of future profits, dividends or other financial returns made available by the platform (Allen, 2018; Collomb, 2018, Shroff, 2018). Moreover, other tokens could embody the rights of ownership of an asset, a property, or a commodity and they are nominated “asset-backed tokens” (Collomb, 2018).

After having understood that a digital token can embed several characteristics, it is worth emphasising the fact that all the above-mentioned rights are not exclusive to one another, and the outline is evolving over time with new properties (Collomb, 2018). Moreover, as the author (Collomb, 2018) highlights, since a token does not have a global accepted legal status, it is not appropriate to categorise it in a clearly prearranged legal category such as an investment contract. Nevertheless, it is now clear that tokens, being primarily used during the ICO process in an exchange with cryptocurrencies, they entitle the holders to exercise diverse rights and they are always secured with their cryptographic code and protocol (Collomb, 2018). Notwithstanding this undefined framework of tokens properties, as explained, authors agree on the fundamental attributes of the ICOs and on the benefits that this fundraising method can convey.

The implied benefits of Initial Coin Offerings

In principle, as anticipated in the previous sections, ICOs and tokens are based on the blockchain innovative technology which ensures integrity, security and transparency. These distinguishing features have the potential to convey a multiple beneficial effect to all the involved parties. From one hand, it is therefore possible to reduce the transaction fees of raising funds, by circumventing intermediaries and financial third parties such as crowdfunding platforms, banks or credit card circuits (Adhami, 2017). From this perspective, the incentive is addressed not only to new ventures and start-ups that are facilitated in the fundraising process, but also to investors and token holders as the investment costs are radically reduced with an ICO. Moreover, from the other hand, the underlying technology permits to decrease the size of the governance system of a financial institution and the level of supervision needed (Nica, 2017). As a consequence, participants and issuers of an ICO are not only attracted and advantaged by the low-cost transactions, but also by the decline in time required for the development of the entire process.

Afterwards, as already mentioned in the section of the blockchain, the distributed ledger technology system makes the ICOs favouring open-source projects and decentralised businesses (Adhami, 2017). Indeed, the author (Adhami, 2017) argues that the ICOs are capable to create a large built-in customer base and positive network effects across the platform community. This can be attainable thanks to the potential of the system to generate a relevant network during the entire process of the ICO. Moreover, all the engaged participants have the possibility to check the trading in tokens, which remain the only instrument permitting the access to the digital platform (Catalini, 2018). Indeed, it is also important to remind that the technology allows to keep the anonymity of the users by ensuring a high level of transparency and security (Conley, 2017). In turn, the direct positive consequence of network externalities is that the coordination is facilitated among subjects involved in the digital ecosystem (Catalini, 2018; Fisch, 2018). Moreover, as a chain, by avoiding managerial problems, the network effects just mentioned have the potential to be leveraged.

Another fundamental benefit which attract token holders investing in an ICO is the opportunity of liquidity and the high returns in the near future. Indeed, according to Adhami (2017), the token process envisages the issuers and the holders to generate a secondary market for their investments that is high liquid. As already considered in the previous section, the possibility to trade tokens in the dedicated market once the ICO is concluded composes the major advantage of this fundraising method. Comparatively, Adhami (2017) reminds that the more traditional methods of raising capital are actually illiquid for several years, whereas tokens can be traded straightaway. Moreover, as Martinez (2018) brings out, the secondary market is easily accessible thanks to the peer-to-peer network that the blockchain technology platform develops. As a result, Trautman (2018) considers the Initial Coin Offering an efficient method of raising capital with no precedents mostly due to the main benefits of minimal costs and notable liquidity.

To generally conclude this section, it is necessary to recall the matter that in the literature there is not yet a comprehensive definition of the evolving ICO phenomenon and of the properties related to the tokens. Nevertheless, it is equally significant emphasising the fact that numerous authors approve some definite and constructive features that, in turn, generate benefits that should unquestionably be considered when describing ICOs. In conclusion, the method in question generates a great discussion in the literature since it is revolutionising the financial industry, and it is, actually, providing a solution to the several inefficiencies emerged during the last decades. Notwithstanding this positive overview of ICOs, it is necessary to deal also with the more damaging topic of the risks involved in the process. Thus, the examination of the next chapter is focused on the shortcomings, on the risks and on the deregulation issue that characterise the ICO mechanism.