Barely a day passes by now on the internet when I am not offered to subscribe to the ICO (initial coin offering) of a new currency. If the statistics are to be believed, there are 11,000 of these new currencies, of which 1,200 or so are capable of being traded on the various cryptocurrency exchanges which have popped up around the world in recent times. But why are there so many of these new currencies popping up and how do they differ from one another? Richard Tall at DWF explains.

Cryptocurrencies - the 'next-gen' currency  

The first cryptocurrency was Bitcoin, and this has been with us since 2009. Bitcoin has in reality only been in the public consciousness for the last three or four years and most cryptocurrencies have been created within that time period. As it is now mainstream, Bitcoin can be used as a means of payment either through transfer over the internet, or by use of bank cards which are linked to accounts denominated in Bitcoin. In the modern environment, where so few of us use cash, it has the same sort of functionality as a fiat currency, albeit that the numbers of traders and businesses which are prepared to accept it remain in the significant minority.

Like Bitcoin, most new cryptocurrencies have their genesis in smart contracts. A smart contract is a computer protocol which enables a contract to execute automatically. The basis of a smart contract is that if X happens then Y will flow from that. Most of us would recognise that as a conditional contract, but a smart contract enables this obligation to happen in the decentralized world for those who sign up and agree to its protocol.

The rise of the token

The vast majority of new cryptocurrencies do not create their units in the same way as Bitcoin, though. A Bitcoin is created by solving an algorithm, the reward being generated through proof-of-work. Generally, most new cryptocurrencies being made now are offered as a token which is created by the originator and then traded through the blockchain. This is known as a proof-of-stake. An ICO in these circumstances will simply offer tokens for subscription by investors, usually to raise money for the next stage of development of their project, and in many ways an ICO shares many characteristics with an IPO of a development stage company. Many of us will remember the dot com era, where numerous companies sought funds to take themselves to the next stage of development, with the investors being asked at IPO to invest in the idea rather than a revenue, or indeed profit, generating business.

Coins and tokens - the regulator's perspective

The similarities between ICOs and IPOs have not escaped the attention of regulators. An offer of shares or bonds is clearly within the bailiwick of regulators and so both are subject to a host of legislation. However, the general mantra with an ICO and a cryptocurrency is that they are "unregulated." Bearing in mind money laundering and anti-financial crime legislation, "unregulated" is entirely inapt as a tag. Equally, little thought has been given by ICO originators as to the true nature of what is being offered. The SEC (the US Securities and Exchange Commission) has recently ruled that ether (the tokens behind Ethereum) are securities, on the basis that they are an investment contract (investment of money in a common enterprise with an expectation of profit). Accordingly, the SEC's view is that ether offers should have been conducted in accordance with securities laws. Many other regulators are issuing similar warnings, and making the point that simply because a new technology is being used it does not mean that the resulting token is outside long-established principles of consumer regulation. As a broad rule of thumb:

  • If a token offers voting or similar rights it will be treated as a security, as it shares its characteristics with shares;
  • If it offers redemption it will be an instrument creating or acknowledging indebtedness, or colloquially a bond;
  • If it derives its value from fluctuations in value of another asset it is likely to be some form of derivative.

Whether an ICO is of any merit depends ultimately on the utility of the token offered and what it is capable of doing. Clearly the aim of most ICOs is for the value of the token to increase over time, and any investor needs to look closely at whether that will ever come to pass. Equally, those originating ICOs need to exercise extreme caution in relation to the terms of the tokens offered and the jurisdictions into which they are offered. This is a red-hot topic for regulators who definitely do not share the view that this arena is "unregulated".