While Initial Coin Offerings were recently only much discussed among crypto fans and commonly considered to be scams, they are now receiving more and more attention from the general public.
As venture capital firms and start-ups explore whether they are suitable as alternative forms of financing, conservative and institutional investors are also beginning to take an interest in investing in reputable, well-managed ICOs.
The OECD (Organisation for Economic Co-operation and Development) has now published a 72-page report on the nature of Initial Coin Offerings. It examines the question of whether ICOs are suitable as a form of financing for SMEs.
On the 72 pages ICOs are analysed in many respects, advantages and disadvantages are pointed out and the general legal situation of ICOs is discussed. The OECD’s verdict in a nutshell is: ICOs as financing instruments for SMEs offer a lot of potential, but only under certain important conditions.
An inclusive effect and low minimum investment as advantages of ICOs
One of the biggest advantages of ICOs over other types of financing is their inclusive effect. The authors point out that due to the efficient issuance of tokens by means of smart contracts, the lower administrative costs of the issuance, and above all the possible tokenisation of underlying assets (keyword “fractional ownership”), ICOs offer small investors access they were heretofore excluded from. In this specific case, of course, it concerns the ability to make early-stage investments in promising start-ups.
Wait a minute, what is “fractional ownership” anyway? The term describes the fact that tokens can be divided and investors can also acquire certain parts of tokens. As a result, it is possible for investors to participate in ICOs even with relatively small amounts of investment. This in turn has the consequence that the number of potential investors increases many times over, which of course also benefits the issuing company. Instead of pitching to a few investors, you can and must present your company to a broad audience of interested parties and make sure you reach them using appropriate marketing channels. Thus the topic ICO marketing comes into focus.
In some cases, token owners (after an ICO has been held) even have a say in the decision-making or governance of the company. This advanced setup is also enabled by the use of Smart Contracts. The authors of the report even go so far as to claim that „A company issuing tokens effectively enrols future users of its product (before the actual product/service is even operational)”.
Network effects as the biggest advantage of ICOs for blockchain-based companies
While the report generally evaluates the suitability of ICOs for SME financing, this question cannot be answered without considering the company’s business model and line of activity. The OECD stresses a major advantage of ICOs over other forms of financing, which has hardly been taken into account in the discussion so far: network effects.
Network effects are a concept that originates from the field of economics. They describe the phenomenon that as the number of participants in a network increases, for each participant the value of that network increases as well as the number of possible connections with other participants. In other words: the more users use an online platform or the more investors participate in an ICO, the more value is created for each individual participant of the network.
The authors of the report argue that ICOs enable the creation of such network effects. This is due to the mutually reinforcing influence of investors and users. Interested investors who also become users of the platform in turn increase the adoption rate of the platform, which leads to an increase in value of the entire platform. The increased value of the platform can in turn lead to existing users also wanting to become investors in the ICO, or further investors can be attracted “from outside”. Of course, it should be noted that not all participants in an ICO are really long-term investors but might be speculators. Network effects only arise through long-term investors and platform users. In contrast, when the number of speculators increases, the network effects achieved in the ecosystem start to decline.
For companies whose business model is based on the use of DLT or blockchain technology, these network effects can be seen in the course of an initial coin offering. The OECD therefore regards ICOs as a very promising financing method for such companies.
ICOs are hardly suitable for companies not using DLT technology
However, the author’s assessment is more critical for companies operating entirely without DLT/Blockchain. Since the network effect around the output of tokens does not arise in this case, the authors argue that ICOs with their given disadvantages are not worth the effort and the risk. Nevertheless, some companies have opted for ICOs, which, according to the authors of the report, is due to the fact that they want to exploit “the momentum of the market”.
If the business model does not require a blockchain, the benefits of an ICO would be limited to lower costs and accelerated raising of funds. Given the disadvantages of ICOs identified above and the fact that the need to use tokens in transactions (after the ICO has been conducted) can be an obstacle, the OECD strongly advises such SMEs to choose a different form of financing.
Further major advantages of Initial Coin Offerings
Apart from the extensively discussed network effects, Initial Coin Offerings offer a number of other advantages which are also discussed in the report. For one, there is the increased efficiency of raising funds, because investment transactions are processed automatically by Smart Contracts and the costly use of central underwriting bodies is eliminated. This in turn makes it possible for companies to address a broader target audience of potential investors, which also means a higher potential of funds to be raised. In some places there is even talk of a “democratisation” of the financing of SMEs, because powerful players have lost part of their influence.
This increased efficiency naturally also means a reduction in costs compared with other forms of financing such as an initial public offering, where high costs are incurred for the issuing bank and its underwriting services. Ideally, both the issuing company and the investors should benefit from these cost savings.
The Importance of Meaningful and Sustainable Token Economics
The authors also discuss in detail the importance and necessity of well thought-out token economics. By this they mean all decisions concerning the output and implementation of a token in the ecosystem of an ICO and the possibility of its use by users. In addition to the structure of the offer, this also includes the pricing of the token as well as sales models and distribution mechanisms.
The structure of the ICO offering is above all intended to ensure that the company succeeds in maintaining the highest possible degree of control over the performance of the token and that the risk of a future loss in value can be averted after the ICO has ended. However, this is made more difficult by the fact that it is hardly possible for issuing companies to estimate how high the financing requirements for future product development, marketing, etc. will be. If further tokens are issued at a later date after an initial ICO, this inflationary measure can, in addition to causing annoyance, result in a loss of wealth for token holders.
The use of minimum and maximum investment sums for individual investors as well as soft cap and hard cap for the entire ICO is presented as a measure to cushion these risks as well as possible. The formation of reserves which cannot be touched by the founders for a certain period of time is also a possible approach to remove uncertainty.
Global cooperation & the need for international regulation
As would be expected of such a supranational organisation, the OECD calls for closer international cooperation and debate on these issues. This would be the only way to create a secure and trustworthy framework, prevent legal and financial arbitrage by nations acting unilaterally, and be able to exploit the potential of ICOs as a financing method.
Hence, the authors write:
“Given the global nature of ICOs issuing and trading across borders, cooperation at the international level is warranted for a coordinated global approach that will prevent regulatory arbitrage and allow ICOs to deliver their potential for the financing of blockchain-based SMEs, while also adequately protecting investors.”
Unresolved problems, important disadvantages and minor issues with ICOs
But of course there is not only praise for ICOs as a form of SME financing. According to the OECD, there are currently many more obstacles, unresolved problems and unanswered questions that stand in the way of ICOs becoming a mainstream form of financing. So what are they? First of all, there is the regulatory uncertainty for investors and issuers resulting from a variety of factors. Often it is neither clear nor obvious which laws and regulations are applicable to a specific ICO. In addition, there may be a lack of supervision by a competent authority, which further increases the risk for investors. Of course, a lack of a legal framework also exacerbates the risk of possible violations of the law and criminal offences for the companies concerned.
Unresolved questions at the technological level, such as the legal enforceability and binding nature of smart contracts, also sow uncertainty and uncertainty. Since, as a rule, there are still no binding requirements regarding information duties, and whitepapers are not reviewed by independent institutions, this would further increase information asymmetries between founders and investors.
Another disadvantage is the difficulty of token valuation. Since many ICOs are made for companies whose solution is still in the concept stage, investments are often not yet matched by real market values. Conflicts of interest can arise if founders have already experienced a great increase in the value of their tokens after a token sale, without there having been any serious further development of the concept or product.
Yet it is also speculators who only invest in an ICO in order to sell the acquired tokens post-ICO at profit, that pose a threat to the value and stability of the token. In extreme cases, this leads to a situation where companies no longer have any influence on the value of their tokens. Since the company is paid for its services in tokens, such a development very quickly endangers the liquidity and continued existence of the SME.
Other disadvantages and risks are also highlighted. These include the difficulty of estimating the exact financing requirements in advance, the lack of mechanisms to prevent the token from losing value and the constant danger of hacks (whether on the website, crypto-exchanges or even the blockchain network through a so-called “51% attack”).
The solution: create legal certainty and exploit the potential of blockchain technology
What does the OECD report mean for SMEs and other companies planning to carry out an ICO or STO? The report represents a comprehensive and important starting point and justifiably draws attention to the dangers and risks. It should also be noted, however, that some governments have already addressed precisely these problems and come up with ways to resolve them.
Blockchain Island Malta is the first country in the world to have a clear legal framework for DLT technology. Many of the problems mentioned are completely mitigated, legal uncertainty eliminated. The Virtual Financial Assets Act provides for the mandatory implementation of AML and KYC procedures and defines disclosure requirements for companies and necessary elements that whitepapers must contain.
As the competent supervisory authority, the Malta Digital Innovation Authority (MDIA) examines all ICOs to be held in Malta in detail and must issue its approval. Once the strict requirements have been met in full, companies can get their DLT model licensed in one of 4 VFAA license classes and offer investors security. At the same time, the design of the framework offers the necessary flexibility to safely explore future applications of the blockchain.
Binance and OkEX, the crypto-currency exchanges based in Malta, can be contacted and, in the event of a successful listing, provide the company with the desired liquidity on the secondary market. In Malta, ICOs can only be applied for and carried out with the assistance of licensed VFA agents. This is a further measure to ensure a credible and trustworthy ecosystem.
- Risk-based approach to Supervision or Monitoring of VASPs (Virtual Asset Service Provider) - 11. November 2019
- The importance of AML compliance - 4. November 2019
- Malta as the ‘epicentre’ of security token financing - 26. August 2019
- Current developments in crypto currencies and the blockchain on Malta - 24. May 2019
- Regulation of crypto currencies and ICOs — International comparison - 10. May 2019
- MFSA Publishes Guidance Note Against Crypto Scams & Appoints First VFA Agents - 29. April 2019
- Blockchain & AI Summit Malta + Blockchain University Degree Malta - 20. March 2019
- MFSA Publishes Consultation Guide on Cybersecurity Regulations for Blockchain Companies and VFA Agents - 12. March 2019
- Malta’s New Tech Authority: Malta Digital Innovation Authority (MDIA) - 5. March 2019
- OECD report: ICOs for SMEs an appropriate form of financing — under certain conditions - 11. February 2019