Initial Coin Offerings (ICOs) are powering an investment "explosion" globally - but there are pitfalls.

Healthy scepticism coupled with real opportunity is how potential investors should approach the next big financial disruptor exploding around the globe – ICOs (Initial Coin Offerings).

ICOs are attracting something of a global gold rush as some investors are attracted by potentially high rewards and Anand Reddy, a partner at PwC New Zealand*, says there are undoubted opportunities in the cryptocurrency and ICO environments.

However, there are also pitfalls. Reddy says "looking at how ICOs can solve important problems and build trust in society" is the best position to take.

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An ICO is a new way for businesses to raise capital, powered by the same blockchain technology as bitcoin. ICOs increased in popularity last year alongside the spike in value and interest in cryptocurrencies like bitcoin and Ether.

Investors and innovators are taking advantage of ICOs' ability to improve the way people can participate in financial markets – illustrated by the sharp increase in the number of downloads Coinbase, the world's best-known exchange for cryptocurrencies, has received recently.

Reddy says late last year Coinbase was the most downloaded app in Apple's free app store with 100,000 new accounts created in November alone.
In their short life span thus far, ICOs have raised about US$8 billion – most of it last year, as technology companies sought funds from investors to develop their projects, services and growth.

In an article published last week, Techcrunch, capturing data across 527 venture capital rounds and ICOs in 2017 and the first two months of 2018, said ICOs made up almost half the number of venture capital rounds announced by blockchain and blockchain-related companies. But the ICOs realised 3.5 times the amount of capital than non-blockchain start-ups.

One high profile ICO involved New Zealand blockchain company Centrality – which raised a staggering US$80m (NZ$100m) through an ICO run out of Singapore.

Investors with cryptocurrency receive tokens that can carry certain rights, usually falling into three groups – a token permitting ownership or usage rights to access the technology being developed (sometimes called a utility token); a token that resembles a financial product (a type of digital security) and one which acts as a payment mechanism or store of value (a currency token).

"It's important to understand these tokens don't necessarily equate to (nor are they always intended to act as) shares in a company," says Reddy, adding that there are some key advantages with an ICO, compared to traditional tools for raising early stage capital.

First, it allows start-ups to access a wider pool of capital. Anyone with access to the internet can participate in an ICO and, with lower transaction costs, smaller token investments are economically feasible. That is helped by the fact that cryptocurrencies are highly divisible, meaning investors can choose exactly how little or how much they wish to invest and receive a proportionate amount of the platform's tokens in return – attractive for those who don't have a large amount to invest.

Second, funds can be raised quickly. The decentralised nature of blockchain technology means transaction time and cost is greatly reduced, with funds raised through peer-to-peer transactions. In comparison to shares offered in equity crowdfunding campaigns, tokens are also more liquid, because they are usually listed on secondary market crypto-exchanges such as Coinbase.

Third, ICOs provide investors with greater ability to invest directly in a disruption they are passionate about – and potentially in a whole new asset class. In an increasingly digital world, Reddy says moving towards a tokenised economy is an interesting concept.

But while there are potentially great returns on offer should cryptocurrency investors back the right tech start-up, Reddy warns there are plenty of risks and challenges too:

• High failure rate – Only 48 per cent of ICOs were successful last year. "They often are aimed at start-ups in high-risk areas so many will not come to fruition," he says.
• Hackers – There have already been some high-profile cases where hackers accessed founders' and investors' e-wallets, stealing the digital currency inside.
• Regulations – Regulators are playing catch-up but will catch up, he says, and innovators and investors will both benefit from clearer regulatory guidance.
• The EU, Germany, Canada, Hong Kong and Singapore have signalled they will regulate and the Securities Exchange Commission in the US has warned about "unlawful online platforms trading digital assets" and says some ICOs will be subject to securities laws. Switzerland has said its intention is to make the country an attractive location for ICOs and Japan has recognised bitcoin as legal tender and has authorised 11 cryptocurrency exchanges.
• In New Zealand, the Financial Markets Authority is one of the regulators which will oversee ICOs. How an ICO is regulated will likely depend on the substance of what is being offered – with further guidance likely to be provided by the FMA over the course of the year.
• Determining the New Zealand tax implications of an ICO remains a grey area for investors and innovators. Like the FMA, the IRD are likely to provide more guidance on ICOs soon.

Reddy says ICOs are a viable way for start-ups to raise capital but, as with any emerging technology, there are risks for investors: "That, plus the inherent risk of investing in start-ups, means education is vital."

*ICOs and cryptocurrencies will be the subject of the next PWC Herald Talks event, to be held on March 21 at SKYCITY Theatre (sold out), followed by The Piano in Christchurch on March 22nd. https://www.pwcheraldtalks.co.nz/