The similarities between an initial coin offering and an initial public offering end as soon as one looks at the regulations that govern both processes. In this witty tour through many of the things that might go wrong, a crypto-regulatory expert speaks out.

Never before have I felt so old than when I read the following headlines.

• "Could This Millennial 'Crypto' Tech Visionary Be The Next Jack Ma?"
• "The Game is promoting the initial coin offering of a company owned by a former Miss Iowa who is looking to usher in the weed revolution."
• "Filecoin's ICO shatters record."

Who on earth is Jack Ma, who or what is The Game and am I the only one who thinks that the ICO (which, in my world, stands for the Information Commissioner's Office) should be gearing up for the General Data Protection Regulation (GDPR) and not playing with crypto currency?

Of course, the acronym 'ICO' has now taken on a new meaning - Initial Coin Offering. Similar to a normal Initial Public Offering, an ICO allows a company to raise funds for its new product but, rather than selling shares, it creates a crypto-currency and then releases some percentage of its newly created 'crypto' to investors who buy early and provide the funding for the new project. Those investors then hope that the value of the newly created crypto will go up in value.

Just like a regular IPO, the firm offering the ICO will have some form of product that needs funding - often a piece of software built on the blockchain technology which underpins the crypto-currency. Examples of this are firms like Everex (a Blockchain-powered remittance service) or MaidSafe (a firm which offers a decentralised internet stored on the computers of its users).

After the initial ICO, the newly created crypto can be traded and sold in the same way as a regular share of a business in an IPO. A number of exchanges exist on which to do this and the number of different cryptos that can be traded is significant (circa 900 crypto currencies as of now).

Investors can make their initial investment with either a fiat currency or another cryptocurrency, such as bitcoin, but the similarities between an ICO and an IPO end once we look at the regulations that govern both processes.  

An IPO is a highly regulated process. The brokers who are involved in it must be regulated. Specific detail must be provided in the prospecti. Every investor - and the firm offering the IPO - has to be subjected to some 'due diligence' and once the IPO is complete the firm must post its profits and financial information regularly.

With an ICO, the regulatory burden is far less. Zero indeed.  

Although the US Securities and Exchange Commission states that some forms of ICO may be regulated, the majority are not. This is because the coins being offered are not considered to be securities. This creates a lack of oversight and the potential for fraud.

How could a financial criminal, or someone who wishes to exploit investors unfairly, abuse an ICO? There are many opportunities for the guileful.

Straight fraud

As was seen with the ICOs for MatchPool and the Evolution Marketplace, once investors have given their funds to a firm that is offering an ICO, they cannot retract them. They are not held in escrow and are not protected by any regulatory requirements. If the offering firm is corrupt, it can simply pocket these funds.

The identities of the individuals behind an ICO are often hidden. LotCard, for example, is a recently launched ICO whose registration refers to a PO box in Grand Cayman with no details about the actual owner or holder. In some cases the individuals only provide a nickname, so it is possible that they will never be found if they melt away with the funds.

Hacking and cyber-failures

Some of the world's best coders are developing ICOs and the technology behind them. This is not going to stop hackers from trying to spot and exploit weaknesses in security.

As the sums of money involved in ICOs increase, so does their attractiveness as a target. CoinDash, which lost $7 million (£5.43 million) and the DAO, or Decentralized Autonomous Organization, which lost $50 million in 2016, show that wherever there is money, there will be hackers.

There is also the possibility of internal frauds and ne'er-do-wells being involved in the ICO who can then claim to be the victims of a hack while syphoning off funds into their own accounts. Again, with no verification of identities or bank accounts it becomes increasingly hard to tell perpetrators from purveyors.

Pump and dump

Since the firm that offers the ICO is the holder of the bulk of the newly-created crypto coin, it could simply use the hype of the ICO to raise the value of the new crypto and then, at a later date, dump its coins while the price is high. Because no insider-dealing rules apply here, individuals can hype up an ICO and then sell off their holdings once the value starts to climb.

Since ICOs are so public and they create such a stir on social media, the tradable value of such coins often jumps on the day of launch, which creates immediate value. After an ICO had taken place, crypto coin Gnosis was trading at around 3 times its original ICO price, with a peak of 5 times. This was a great return, but at the top of the tree the founders still owned the majority of the crypto.

A fraudulent ICO may be able to loot its victims and allow its organisers to escape before anyone even notices that the product that they were offering was entirely fictional.

Usefulness in laundering other cryptos

In the same way in which individuals send funds overseas and change the currencies they hold, launderers could move funds between multiple offerings or multiple ICOs or trade cryptos across multiple exchanges to muddy the waters and make the trail harder for investigators to follow.

Firms such as BitLaunder (a subtle name if ever there was one) and even larger exchanges offer a bitcoin 'mixing' service that takes thousands of bitcoin wallets and swaps them with other people's to hide the trail. It is the equivalent of putting all of your cash in a pile and then sharing it back out.

In theory, all transactions on a blockchain are public. Some firms such as Dash, Monero or Zcash, however, offer crypto that is anonymous. An ICO for one of these products, funded in BitCoin, would allow criminals to fund the trades with the proceeds of their crimes. These funds would then disappear into the pool of the crypto and be anonymised.

Pyramid schemes

Onecoin, a crypto, was linked to the sale of educational materials, or so OneCoin Ltd claimed. According to some sources its main activity was the buying and selling of OneCoin to investors who were then encouraged to attract more investors.

Using phrases such as “The earlier you get in, the more you make” and offering returns on trades which seemed to hold out the promise of doubling your money without the underlying asset ever increasing in value, OneCoin was fronted in London by individuals known to operate in the murky “multi-level marketing” space (not a pyramid scheme - no, that would be criminal) using high-energy, high-pressure techniques to bring on new investors who would then be encouraged to get their friends and family to invest.

The constant references to Bitcoin investment and the possible returns were clearly designed to encourage gullible “investors.”

FOMO

The SEC, the Monetary Authority of Singapore and other bodies highlight a number of issues with the security of an ICO and note that “it is relatively easy for anyone to use blockchain technology to create an ICO that looks impressive, even though it might actually be a scam.” The Financial Conduct Authority, for its part, recently noted that its prime concern was that individuals may not understand the risks associated with such investments.

A lack of understanding of the underlying technology, a lack of opportunity for the general public to see how an ICO works and the uncontrolled use of social media hype to inflate prices, coupled with 'FOMO' (Fear of Missing Out) have often resulted in such products being inflated in price and achieving valuations that are simply unrealistic for the entirely unproven technology that they represent.

The potential for losing everything

On this basis, investment in an ICO is a highly risky activity and the level and type of 'due diligence' needed before one makes an investment is likely to be much more complex than for a regulated product. Although every offering has a 'white paper' on its site, this often concentrates heavily on the crypto being offered and says little about the merits of the underlying product to be funded. There are no regulations to dictate the contents of such a white paper, so it often fails to do the same job as a useful prospectus.

This may make it hard for advisors to assess ICOs properly. Although the high figures and seemingly spectacular returns to be had will attract many investors, the risk of fraud and criminality created on the back of these new technologies, and the potential for losing everything, should not be underestimated.