What Is Being Disrupted by Initial Coin Offerings?
Initial coin offerings (ICOs) have the potential to dramatically change how firms raise funds enabling less costly, more transparent, more accessible, and faster access to capital. The total amount of funds raised by ICOs was over $5.6 billion in 2017. However, in 2018, the market capitalization has fallen from $57 billion on January 13 to $15 billion on August 26 according to a recent report by Biasi and Chakravorti. While such volatility is common for new types of assets especially those based on new technologies, a significant reduction in ICO and cryptocurrency price volatilities is necessary to encourage greater entry by traditional investors. Similar to other sources of funding for startups, there is a high probability that firms issuing ICOs will fail. Half of the ICOs started in 2017 do not exist anymore according to Morris.
As discussed in previous blogs, the impact of disruption may force incumbents to change their fee structure or increase accessibility, participate in new markets, or exit. While it is too early to observe the long-lasting impact, ICOs have already started to increase the availability of funds to firms although there are key challenges that remain. While not part of mainstream finance yet, ICOs are starting to receive more attention from incumbent financial institutions.
ICOs offer firms an alternative means to raise funds from venture capital firms or crowdfunding platforms. Unlike venture capital and similar to crowdfunding platforms, ICOs are available to the broader public with certain restrictions. ICOs have started to compete with venture capital for early investment in certain sectors. For example, from January 2017 to the end of February 2018, ICOs delivered 3.5 times more capital than venture capital firms (VCs) for blockchain and blockchain-adjacent deals according to Rowley. However, as a funding source, venture capital funding dwarfs ICO funding. For example, in the first two quarters of 2018, venture capital raised $119.8 billion globally compared to $12.0 billion for ICOs.
Although the main purpose for ICOs is to raise funds, ICOs differ on what token holders receive in return. In some cases, ICOs are used to sell goods and services in advance and are categorized as utility tokens. Other ICOs have similarities to equity in the sense that their investors receive dividend streams based on the revenue streams of the issuing firms. However, token holders do not typically have ownership interests. These types of tokens are called security tokens.
ICOs leverage the infrastructure created by cryptocurrencies. This infrastructure allows for decentralized transactions without intermediaries. The three main features of Bitcoin, the first and most popular cryptocurrency, are (1) digital native currency with no central authority, (2) incentive structure to verify transactions, and (3) immutable blockchain that makes it nearly impossible to change past transactions.
Ethereum expanded upon the benefits of the Bitcoin blockchain by integrating easy to code state-contingent, verifiable, and storable contracts for the delivery of funds in exchange for goods and services in the future. These contracts are commonly referred to as smart contracts because they are state-contingent. In addition, Ethereum made it relatively easy to introduce dApps (decentralized applications) on their platforms. Greater ICO issuance has started to slow down the Ethereum platform. The Ethereum community has been considering various modifications to its protocol to improve its transaction speed while maintaining its security.
The regulatory framework surrounding ICOs continues to develop. Market participants that I spoke with would encourage public authorities to create a regulatory framework that would allow differentiation between themselves and bad actors. Clearly, there are tradeoffs between over and under regulation, especially in a nascent market.
A key issue is whether ICOs are securities. If so, their regulation would be governed by securities laws. The U.S. Securities and Exchange Commission has announced recently that generally ICOs should be viewed as securities instead of utilities that allow access to or payment for services.
Some countries such as China and South Korea ban ICOs although South Korea may lift the ban soon. Given the global nature of the market, coordination across markets would be necessary. This regulatory uncertainty across and within borders also adds to the volatility of this market. For more discussion of ICO regulation in different countries, see Biasi and Chakravorti.
Challenges and Opportunities
I offer the following conclusions regarding the future of ICOs. First, from a technology standpoint, cryptocurrencies along with the new infrastructure connecting computers that host dApps will enable a more efficient allocation of goods and services. The underlying technology has the potential to improve financial markets by reducing frictions and increasing transparency.
Second, as the infrastructure continues to develop, these platforms must be able to process a greater number of transactions per second to compete with incumbent financial platforms. Some platforms are looking to increase transaction speeds from 15 transactions per second to over a million per second. However, there is a distinct trade-off between complete decentralization, and transaction speed, and efficient energy consumption.
Third, the governance structures of these systems are still in their infancy and challenges will need to be overcome. Cryptocurrencies and ICOs are governed by communities of users without a central authority. However, during security breaches, e.g. The Dao, relatively fast decision making is necessary that may require a centralized authority (Biasi and Chakravorti discuss The Dao and other specific ICOs).
Lastly, given the global nature of this market, coordination among regulators across countries will be necessary. As we learned from the financial crisis last decade, cross-border spillover effects are real and difficult to insulate from.
Even with these challenges, ICOs will disrupt financial markets in a positive way but investors and regulators may need to buckle up for the bumpy ride.