FAQ: What are ICOs, Cryptocurrencies, Tokens, and Coins?
By DERRICK LEE March 3th 6m read
With the ease of creating Tokens on the Blockchain, a new form of fundraising called Initial Coin Offerings, has emerged.
What are Cryptocurrencies, Tokens, and Coins?
Oxford Dictionaries defines a cryptocurrency as “a digital currency in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank.” However, such a definition though widely used by the public, is misleading. This is because the definition overemphasises the function of cryptocurrencies as being a currency or money when nothing could not be further from the truth. The reason may be due to the fact that bitcoin (BTC) was the first and is the most dominant cryptocurrency with its main purpose as a “peer-to-peer version of electronic cash”.
Cryptocurrency is a name given to digital currencies that uses the blockchain technology. Cryptocurrencies are essentially digital programmable assets that can represent almost anything from shares in a company, vouchers, or even loyalty points. An example of a cryptocurrency is not created to be currency or money is ether (ETH), the second largest cryptocurrency at present. Its main purpose of ether is to be fuel used to run smart contracts on the Ethereum blockchain.
Cryptocurrencies is an umbrella term that refers to both Tokens and Coins. Tokens are cryptocurrencies created through smart contracts (small pieces of code) that are running on top of a blockchain. Tokens do not have its own blockchain. Today, Ethereum is the most popular blockchain to build tokens on with most abiding by the ERC-20 Token Standard. Coins, on the other hand, are the cryptocurrencies with their own blockchain. For example, ether (ETH) is the native cryptocurrency of the Ethereum blockchain. Projects will then launch their own tokens on top of the Ethereum blockchain. The Bitcoin blockchain too has its own coin called bitcoin (BTC).
What is an ICO?
1. What is an Initial Coin Offering (ICO)?
An initial coin offering (ICO) is a sale of digital tokens created by the project to raise funds from the public. In most cases, the funds raised will be used for the development of the project. The digital tokens will give token holders certain uses and rights and these vary widely from project to project. The tokens could be used as a medium of exchange to settle transactions or be used to incentivise the public to adopt the project’s technological solution. Some rights given to token holders could be voting rights on important decisions of the project or right to future profits made by the project, albeit such tokens may be construed to be securities in most jurisdictions. There are also instances where tokens will give holders no rights at all.
Initial Coin Offering (ICO) is also known as Initial Token Offering (ITO) and Token Generation Event (TGE). These different naming conventions all have the same meaning. Among the three terms, Initial Coin Offering (ICO) is the most commonly used.
2. Is an ICO similar to an IPO?
An Initial Public Offering (IPO) is the very first sale of a private company’s stock to the public to raise investment capital with part of the stock being traded on a stock exchange. Just like an IPO, an ICO is primarily used to raise capital and is the first sale of digital tokens by the company to the public. After performing the public sale, the company may decide to list their tokens on a cryptocurrency exchange. However, gaining listing is not compulsory.
Depending on how projects decide to structure the characteristics of their tokens, the rights and uses of digital tokens can represent a wide variety of things including stock of the company. In theory, ICOs can encapsulate IPOs and the securities market. Whether or not such a vision will come into fruition will come down to many factors including but not limited to regulatory clarity and receptiveness of incumbents.
3. What is the regulatory stance of conducting an ICO?
When it comes to virtual currencies / digital tokens and raising funds through an ICO, different countries abide by different sets of regulation. Do check with your legal advisor before purchasing tokens during an Initial Coin Offering.
4. What are the types of tokens out there?
Most of the digital tokens present today are Utility Tokens with functions varying from a means of exchange, fuel to run smart contracts, to loyalty points. Given that security laws around the world have yet to provide a robust legal framework, most projects are refraining from offering Security Tokens and are sticking to Utility Tokens instead.
5. What are the risks of backing an ICO?
Just like investing in the stock market, there are risks when backing ICO projects. As much as we attempt to weed out bad projects, backers are strongly encouraged to do a full due diligence on the projects that they are interested in backing. Though non-exhaustive, some risks are listed below.
a. Most ICOs are launched by startups and the chances of failure are high.
b. There may not exist an active or liquid market for the tokens to be bought or sold after the ICO.
c. There is no guarantee or assurance of any success of the projects.
d. The price of tokens may be very volatile.
e. The projects may turn out to be scams or fraudulent.
f. Given the lack of regulatory clarity, projects may deemed to be illegal and be shut down by regulators.
6. Serving one master instead of two
For a project to be successful in the long run, the project needs the support from the community. This is why ICO is sometimes colloquially referred to as Initial Community Offering. The community, being such an important factor in determining the success of ICO projects, will influence the project team to bend to the demands of the community.
One of the most pressing demands by the community is for the project to return value back to token holders. To skirt securities laws, ICO projects are always trying to legally structure the rights attached to their digital tokens to only encompass those that are utility in nature. However, purchasers of their tokens are always expecting a return on their investment. Being beholden to the community, ICO projects are thus influenced to act in ways that will attempt to return value back to token holders through an appreciation in the price of their token.
To solely return value back to token holders, many ICO projects are registered as not for profit foundations. The value of the project will only be concentrated in the tokens. By having no shareholders, the value of the project will not be diluted. The project will not have to juggle its servitude between two masters.
However, there are many ICO projects that are registered as a private limited. This means that these projects have shareholders who have a vested interest in increasing the value of their shares in the company. The value of the project will thus be split between shareholders and token holders.
7. Liquidation preference
Additionally, when it comes to liquidation preference, shareholders are placed senior to that of token holders. This is because token holders, in most cases, having no other rights apart from utility rights, will be entitled to nothing. However, in most cases, token holders were the ones that put money into the company's project. However, given that shareholders of the company may be placed senior to token holders, shareholders are to entitled to the funds that token holders have previously put up during a liquidation event.