The ICO comes alive

For the past weeks, we have been scoping a new stream of work looking at Initial Coin Offerings (ICOs) and digital token offerings. For those not yet familiar, ICOs involve startups creating their own digital ‘tokens’ which are bought by a crowd of investors, typically using cryptocurrency such as Bitcoin or Ethereum.

Sometimes described as ‘crowdfunding on steroids’, ICOs have exploded in the past 2-3 years as a funding mechanism for startups - and, to a lesser extent, for existing companies. It has been estimated that, in 2018, ICOs raised over $3.5 billion in Europe and around $7 billion globally, representing a significant proportion of funds raised by new ventures.

In some cases, these tokens act as quasi-equity, and hence are called ‘security tokens’. For example, the 'ELIO' token gives holders an explicit equity stake in Elio motors, which is aiming to develop something like the Sinclair C5 (but presumably without the lethality…).

In other cases, the tokens are effectively vouchers related to future participation in whatever ecosystem the startup is creating. For example, various organisations including Stroj, Filecoin and the SAFE Network are creating systems for decentralised cloud storage, where users can pay to store their own files, and/or be paid for offering unused storage space into the network - a bit like Bittorrent or early Napster, but with explicit economic incentives.

A different example is the Brave web browser, whose creator (Brendan Eich, also the creator of Javascript and co-founder of Mozilla) aims to shift the nature of online advertising towards a system where viewers are not merely passive recipients, but are rewarded for their attention, and are also able to make micropayments to the creators of online content that they like. In turn, this may help shift digital media away from the data-harvesting ‘surveillance capitalism’ model which has become increasingly unpopular with end-users.

In these latter examples, users pay - and are paid - with specific digital tokens, with the intention of creating a mini-economy around the system. This also gives people an incentive to help develop the system since, as it matures, the tokens typically become more valuable. These tokens are more akin to air-miles or luncheon vouchers than share certificates, and are often called ‘utility tokens’.

Unlike conventional crowdfunding, however, both sorts of tokens are usually tradable via online exchanges. This liquidity helps attract investors, and means that the overall ICO process has similarities both with conventional crowdfunding and with an Initial Public Offering.

The ICO is dead

Part of the attraction, at least initially, was the relative ease with which large sums were raised via ICOs: Filecoin raised $252 Million in 30 minutes; Brave’s 'Basic Attention Token' raised $36 Million in 30 seconds.

However, the sense of easy money inevitably attracted fraudsters: ICO advisory firm Statis Group estimates that around 78 per cent of the ICOs conducted in 2017 were scams (though only 10 per cent by value).

In response, regulators have started to crack down. In the US, the Securities and Exchange Commission decided at the end of 2018 that most tokens, even those professing to be ‘utility tokens’, were likely securities and hence fell under their purview. They prosecuted several firms for illegal securities offering, and at least one platform for operating as unregistered securities exchange.

Outside the US, Lithuanian blockchain bank Bankera was accused by Lithuania’s central bank of violating the country’s securities laws, resulting in many months of uncertainty before the investigation was dropped. The country has since created a dedicated blockchain regulatory sandbox and explicit guidelines for ICOs.

Yet, despite this, regulation is welcomed by many other blockchain entrepreneurs. Many businesses with whom we spoke felt that the space was tainted by earlier scams, and wanted some means by which to show that they were legitimate.

For related reasons, several blockchain entrepreneurs also declared “the ICO is dead”, eschewing the label in favour of other terms. Some, like ‘Security Token Offerings’ (STOs), make explicit their role as securities, and hence declare unambiguously that they must be issued in accordance with investor protection regulations.

New economic models

However, thinking of digital tokens simply as a novel funding mechanism misses their transformative potential.

Arguably, the dominant mode of innovation over the past decade or so has not been digital innovation per se, but business model innovation, enabled by new tools of digital coordination. Easier coordination enables new ways of creating and harnessing value, especially in situations where the cost of this would previously have outweighed the value generated.

This is exactly what we have seen with much of the sharing economy: as digital platforms have reduced the cost of brokering connections between unused assets and temporary users, entirely new marketplaces like Airbnb have emerged. (Stay tuned for upcoming work on digital 'innovation brokerage', too.)

Digital tokens aid this process by creating new ways of bringing together large, distributed groups of people in useful ways, whilst providing economic incentives to expand the community and to interact in reliable ways. The study of this emerging field has been labelled ‘tokenomics’ or ‘cryptoeconomics’.

Combined with ‘smart contracts’ - code which can transfer digital assets automatically under certain conditions - token payments are giving rise not only to the trading of various resources, such as disk space, discussed above, but also systems for micro-managing tasks like small-scale biomass trading, novel prediction markets, individual carbon credits, arbitration of minor disputes or crowdsourced counterfeit detection - tasks which would not otherwise have been feasible or worthwhile, or else would have relied solely on the goodwill of participants.

Reducing coordination costs can benefit every organisation, but has particular application in distributed systems, including decentralised autonomous organisations (DAOs) and ‘unowned protocols’.

Non-companies

Sometimes a startup isn’t the right vehicle to develop an idea: I’ve written previously about how we might be better off if Twitter were a protocol rather than a company, for example. And, as the Next Generation Internet project is exploring, similar arguments can be made about decentralising other functions like DNS, search, video hosting and email.

The problem, of course, is that building an innovation like Twitter requires raising a lot of cash and coordinating how this is spent (which is frequently why a startup is formed, as a development vehicle), whilst distributed systems need incentives for new users to contribute resources. Unfortunately, the difficulty in reconciling these means that many things that might otherwise be public goods are often under-funded.

ICOs and digital tokens are changing this, kick-starting the development of distributed networks or micro-economies which are eventually self-sustaining without a centralised owner or coordinator. This is not only creating new value but also changing the nature of organisations, blurring the lines between public protocols, private companies, social enterprises, cooperatives and mutual organisations.

What should we be doing?

There is clearly tremendous innovation already occurring in this area, but it far from clear that the UK is leading the field or embracing the benefits of tokenisation. Certainly, many blockchain entrepreneurs were of the view that the UK – despite unarguable strengths in fintech – is losing capital and talent to other locations which have a more favourable approach to token offerings.

So what should the UK focus on? More clarity from government and regulators? Greater public confidence? Clearer demonstrations and use-cases? Greater emphasis on social, ethical, political questions, rather than technology? Better data?

Over the coming months we will be running a number of events as well as issuing some tenders in this field. If you have a view or a specific proposal about how to promote innovation in this field, we would love to hear from you!

Thanks to all who participated in our roundtables.