Regulatory and Market Challenges of Initial Coin Offerings

In the aftermath of the 2007–2009 financial crisis, a series of alternative financing solutions have emerged, of which one of the most successful are Initial Coin Offerings (ICOs). ICOs are a way to finance early-stage innovations. An ICO represents the first public offering of a crypto-asset that, in most occasions, bundles a currency, a utility and a financial security. ICOs are supported by Blockchain protocols and are therefore often characterized as being decentralized, disintermediated and unregulated. The first characteristics are a direct effect of the Blockchain protocol, the last results from the active desire of entrepreneurs to avoid regulation and from the passive role regulators assume, adopting a wait-and-see approach. This laissez fairapproach of regulators is explained by the perceived benefits that ICOs can generate such as allowing investors to meet lenders bypassing traditional financial intermediaries and obtaining financing at reasonable prices, accessing a broader base of potential investors, mitigating credit rationing problems, reducing unemployment, and democratizing the access to profitable investment opportunities. 

Although ICOs experienced a spectacular growth rate, both in terms of number and volumes issued during 2014–2018, they have also been vilified in the media, which often portray them as the wild west of financial markets. There is now a consensus that the current situation is unsustainable given the problems that the ICO market presents.

In a recent paper, ‘Regulatory and Market Challenges of Initial Coin Offerings’, we analyze to what extent these concerns are justified, how the ICO market is addressing its problems, and the extent to which the problems and solutions proposed are likely to shape the future the of ICO market.

Our analysis shows that the problems currently afflicting the ICO market such as scams, deceit, market manipulation, copycat projects, complexity of securities, etc, are to a great extent due to a regulatory vacuum. Furthermore, we observe that the ICO market is also a target for hacking attacks, something that completely contradicts the perceived security of the Blockchain protocol. We find it quite worrying that such a new, revolutionary market already displays many of the problems of traditional financial markets, and that these problems were exactly the ones observed at the genesis of the 2007–2009 financial crisis. 

In what concerns the efforts of ICO market agents to mitigate its problems we observe two complementary approaches. On the one hand, there is a technological approach through the development of solutions for the design of smart contracts, for improving transparency and enhancing the protection of the IT systems overall. On the other hand, there is an effort to develop self-regulation and standards that address most of the problems of the lack of transparency and of proper accountability in the whole ICO process. Given that many of the economic problems of the ICO market are also an expression of asymmetries of information, we also observe that new firms such as exchanges and ratings agencies enter the market to mitigate this problem.  

Regardless of these efforts and developments, recent evidence show us that most of the identified problems persist, raising the prospects of a regulatory response. We conclude that this may be the right time to regulate the ICO market. Firstly, it is clear that the self-regulatory efforts have been unable to solve the market problems. Secondly, the ICO market is already suffering from these problems, presenting for the first time in 2019 an important decrease in the number of ICOs and in the amounts raised. This contraction of the market has surely affected the attitude of ICO market agents towards regulation and it is even expected that some agents may welcome a stricter regulatory approach.  

Finally, and based on our results, we predict that in the near future, although the Blockchain protocol may still be characterized as disintermediated, decentralized, and unregulated, the same will not be true for the ICO market.

Ricardo Correia is an Assistant Professor of Finance at Universidad Autónoma de Madrid.