Security Tokens and Stablecoins Quick Start Guide

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The ICO bubble

After the first ICO in July 2013, ICOs have quickly become a primary fundraising method for financing blockchain projects. Since 2014, blockchain startups have raised tens of billions of USD via ICOs. Reports on the total amounts that were raised via ICOs are not consistent. Many websites collect statistics on ICOs. We use data from https://www.icodata.io/, which claims to be the world's biggest and most accurate ICO database, for our discussions.

With data from ICODATA.IO, the yearly total number of ICOs and amounts that were raised between 2014 and 2018 are listed in the following table:

The preceding table shows ICOs taking off in 2016 and reaching their peak in 2017 and 2018. However, the yearly figures are not revealing enough. We need to turn to the monthly graphs (taken from the ICODATA.IO website under the Stats heading) of ICO amounts.

The following graph shows the monthly ICO amounts for 2017:

The following graph shows the monthly ICO amounts for 2018:

These graphs show that ICO activities reached to a hectic level in late 2017 and early 2018, and then retreated dramatically in the second half of 2018. The most updated figure from ICODATA.IO for January 2019 (as of January 27) is $3.6 m. This is back to the level it reached in January 2017, which is $14 m. Essentially, an ICO bubble has formed and burst within two years.

The gold rush leading to the ICO bubble can be exemplified by one example. In May 2017, a web browser called Brave completed an ICO by raising $36 m, which is the equivalent of ETH (156,250 Ethers) within the first 25 seconds!

The hyper on ICOs is a primary driving force behind a roller coaster path of the cryptocurrency values during 2017 – 2018. One main reason that led to the burst of the ICO bubble is a high failure rate in ICO funded blockchain projects. Less than half of ICOs have survived over four months after the offering, and near half (around 46%) of ICOs that took place in 2017 failed by February 2018. Consequently, ICO investors, who invested late, have suffered heavy losses. In many cases, they lost all their investments.

ICOs provide an innovative fundraising method that allows people worldwide to invest in groundbreaking blockchain projects. What went terribly wrong with ICO that lead to its dramatic downfall? Here, we list some thoughts on possible reasons:

An ICO does not require registration with a regulatory agency such as SEC. Regulation agencies do not have the necessary information to regulate and monitor ICOs.
An ICO does not involve an intermediary such as an investment bank to conduct due diligence verification on the company.
An ICO does not require a startup to provide detailed documentation such as the prospectus describing the company in detail.
Upon completion of an ICO, a startup is not required to provide financial statements as well as business updates to the public investors. Investors cannot effectively monitor the progress of the project that they have invested in. Investors also do not know how their money was used.
Via an ICO, investors purchase a coin or utility token, which is not tied to a real underlying asset or a share of the company. The coins or tokens become worthless if the proposed project fails or profits or coins are not delivered as being promised.
Early stage startups are not suitable to ordinary investors, who lack the skills and resources to make good investment decisions. This is a reason why, under security laws, only wealthy sophisticated investors (for example, accredited investors and angel investors), professional investors (for example, VC capitalists) or institutional investors (for example, pension funds and banks) are allowed to invest in IPOs and high risk startups. ICOs that allow ordinary investors to participate in such investments bypasses the well-tested rules in security laws.
ICO issued coins are to be traded at cryptocurrency exchanges, which are also not regulated. This opens a door to trading practices that violate security laws, for example, front running and painting the tape (also called washed trades). Front running refers to make a trade ahead of a client by utilizing knowledge on the client's trade for a profit. Painting the tape refers to a group of investors trading among themselves to generate an illusion of liquidity on a security.
Know Your Customer (KYC) and Anti-Money Laundering (AML) are not required for ICOs. This potentially makes ICOs an ideal tool for engaging illegal activities such as money laundering.
No thorough background checks on founders are conducted and revealed.

In summary, the ICO fundraising method lacks proper control. They are open to scams and fraud. SEC has alerted investors about pump and dump schemes in ICOs. In such a scam, scammers inflate the value of an ICO for generating interest and driving up the price of the coins. They then quickly sell the coins to lock in a profit. The UK Financial Conduct Authority (FCA) has also issued warnings on ICO scams. The European Securities and Markets Authority (ESMA) pointed out the high risks associated with ICOs and warned that investors could lose all of their money. China and South Korea have completely banned ICOs.

In addition, SEC has started to crack down on fraudulent and non-compliant ICOs. For example, on December 11, 2017, SEC issued an order against an ICO initiator, Munchee Inc., and declared it to be a fraudulent ICO. SEC also work on setting and enforcing standards in the industry. We will explain this in more detail in Chapter 3, Monetizing Digital Tokens Under US Security Laws. Social media sites such as Twitter, Google, and Mailchimp have banned advertisements of ICOs on their sites. Other sites such as Facebook, Snapchat, and LinkedIn puts restrictions on startups from promoting ICOs. Internet sites in China such as Baidu, Tencent, and Weibo have also banned ICO marketing. Similar actions were taken by the Japanese site, Line, and the Russian site, Yandex.

Early investors were rewarded handsomely in late 2017 as cryptocurrency prices reaching unprecedented high levels. Being encouraged by the high rewards, new investors chose to ignore these issues. As the prices of main cryptocurrencies such as BTC, ether, and XRP tanked, many investors suffered heavy losses. With their lesson learned from ICOs, the blockchain community now turns to STOs for addressing the non-control issue that's faced by ICOs and support the blockchain industry's future growth.