The past 12 months has seen a rapid rise in popularity of cryptocurrencies and initial coin offerings (ICOs).
Whilst the media hype has brought crypto out from the shadows, many are still far from certain as to exactly what it is and the part crypto and ICOs can play in the global economy.
It might surprise you that cryptocurrencies have been around for almost a decade now, with the most famous, Bitcoin, being the first such currency to hit the mainstream market.
The genesis of cryptocurrency was born out of the global financial crisis, as a reaction to the government bail outs handed to the very financial institutions that were behind the crash. By utilising blockchain technology (being an identical ledger shared and verified across a myriad of computers), the developers of cryptocurrencies were able to circumvent the need for third party intervention and bypass banks and regulators.
Put simply, cryptocurrency is money, digital money. So when you hear stories of MtGox or other exchanges being hacked and currency being stolen, that is akin to 1850s cowboys stealing cash from banks in the Wild West.
Traditionally, we think of money as legal tender determined by government. However, where people are willing to exchange goods and services and attribute value to a digital currency, that too will constitute money. Governments around the world are reviewing their stance on crypto given the recent spike in interest and may indeed legislate that it becomes legal tender. In April 2017, the United Kingdom Financial Conduct Authority launched a consultation on virtual currencies. Its resulting view is that a cryptocurrency may fall within its regulatory regime, depending on its individual structure and features.
Evolving from cryptocurrency have been ICOs. These are an increasingly popular way for companies (predominantly those utilising blockchain technologies) to raise funds by issuing tokens to prospective investors. An illustration of a typical ICO is outlined below:
Investors pay for these tokens using a mainstream cryptocurrency (usually Bitcoin or Ether). Tokens are not shares and typically do not have the characteristics of equity, for example they do not have dividend rights. Some have said these tokens are more akin to donations and provide only non-monetary returns (e.g. services or products, similar to Kickstarter). However as these tokens can be traded with other third parties, investors may receive returns if they are able to find buyers for their tokens at a higher value than they initially paid.
The real benefit of tokens is that they are embedded with bespoke rules. For instance tokens may entitle holders to certain controls over the company or certain rights akin to shares. On the flip side they can also be embedded with code to ensure the funds received are used for the original purpose identified (i.e. the company founders are unable to simply pay themselves a bonus). The rules are embedded in what is known as a "smart contract", which forms part of the token. If the rules are broken and there is a breach of the smart contract, funds can be immediately returned to investors.
The downside to ICOs is their inherently risky nature, particularly in relation to the volatility in the exchange rates and prices of cryptocurrencies. At the time of writing this article, many mainstream cryptocurrencies had dropped in value by over 35% in less than a week! Accordingly, it would be prudent for businesses undertaking an ICO to hedge against these risks.
Cryptocurrency and ICOs are still in their infancies and are extremely complex in nature. The law and the regulators are constantly playing catch up in this arena. If you are considering making an investment in this industry, caution and professional advice should always be sought.