Initial coin offerings (ICOs) – the risks of investing

ICOs refer to a digital way of raising funds (usually for tech start-ups) in which investors pay in cryptocurrencies (such as bitcoin or ether) and in return receive a proprietary “token” relating to the start-up project e.g. the right to access and use a software application. The bet is that the project will be popular and generate demand for the “tokens” therefore increasing their value and allowing those who bought the “tokens” to benefit from its appreciating price which they can then sell on the secondary markets.

It would be fair to say that the market for cryptocurrencies, which currently has a total value of over $150bn, has somewhat exploded. This year alone has seen some start-ups raising extraordinary amounts of money through ICOs in a very short space of time – Brave, a web browser start-up, raised $35 million in 30 seconds and Block.one, a blockchain start-up, raised $185 million in five days. Indeed, even celebrities are publically jumping on the bandwagon with the likes of Paris Hilton tweeting that she was investing in the LydianCoin ICO which aims to raise $100million.   

However, despite its surge in popularity, ICOs have attracted a lot of scepticism. Concerns over the potential risks of cryptocurrencies has even led to some countries and companies banning their use - only recently, the People’s Bank of China made the use of ICOs and the launch of digital currencies illegal on the basis that it constitutes illegal fundraising.  Last month, the Financial Conduct Authority issued a stark warning over the use of ICOs stating that they are “very high-risk, speculative investments” and that one should only invest in an ICO project if you are “prepared to lose your entire stake”. 

So, what exactly are some of the salient risks involved from an investor’s perspective?

•  Unlike most traditional securities such as shares, which are subject to regulatory requirements and financial disclosures, most ICOs are completely unregulated. This is compounded by the fact that ICOs are often marketed through “white papers” which usually sets out a very basic business plan that does not have the level of detail demanded by most professional investors. Indeed, the FCA has warned that “white papers” may be “unbalanced, incomplete or misleading”.  

•  The value of a “token” is vulnerable to extreme price volatility and market manipulation particularly as the market price is largely driven by speculation on the secondary markets. There is also usually very limited publically available information that could help an investor ascertain the fair value of the “tokens” in question.  

•  “Tokens” do not typically give the investor any stake or voting rights in the company. This means that investors are simply betting that the value of the “tokens” will increase over time as well as leaving them susceptible to potential fraud by issuers who may not have the intention to use the funds raised in the way that was originally set out in the “white paper”.  

•  Whilst there may be promises of stringent security, ICOs are still vulnerable to cyber-attacks. Only earlier this year, the Decentralised Autonomous Organisation lost around $150m of investors’ money after its system was breached allowing its funds to be siphoned off by a cyber attacker. 

•  ICO projects are typically in very early stages of development making them riskier investments. Given that most companies raising money through ICOs are start-ups and may generally lack strong governance, there is a real risk of mismanagement after receiving large amounts of money in a short space of time. 

•  The transfer of “tokens” using cryptographic addresses can hide the identity of the parties, which makes it difficult to implement any KYC checks for the purposes of anti-money laundering and terrorist financing, which means that an investor may be negatively impacted if an ICO project that they have invested in is investigated for any alleged illicit activities.  

As such, whilst there is a lot of money that can and has been made through ICOs, given the current lack of any adequate regulation, it is crucial that investors fully understand the risks and volatility involved, conduct due diligence in a way a traditional investor would (to the extent possible) and only commit the cash that they are prepared to lose. In the meantime, given the risks involved, there is every expectation that regulators around the world will keep a close eye on ICOs, so it will be interesting to see how they grapple with meaningfully regulating and ring-fencing this relatively new form of fundraising.

For further information on the regulation of ICOs, please read this post about the SEC announcing a new Cyber Unit to investigate ICOs and cryptocurrency misconduct and this post on the regulatory landscape in Asia on the Freshfields digital blog.