Yao Qian, author of the article, is the Director of PBOC Digital Currency Research Institute. This article represents only the author’s personal academic viewpoint and shall not be regarded as that of the organization he works for. The paper is first released on latest issue of Modern Bankers.

Yao Qian,Director of PBOC Digital Currency Research Institute (photo credit: Modern Banker)

Abstract:
ICO is becoming one of the important financing channels for blockchain startups. This article makes a comprehensive study on the connotation, categories and value assessment of ICO. The paper also compares ICO with IPO, equity crowdfunding and other financing methods and proposes specific framework and suggestions for ICO regulations with considerations upon the legislation practice of securities issuance and the current regulatory design. “Regulatory sandbox” is suggested as the practical patch to regulate ICO projects.
Initial Coin Offering

In recent years, a brandnew financing model called ICO has been developed from the blockchain ecosystem. Early ICO was interpreted as the Initial Coin Offering. Due to the sensitivity of private issuance of digital currency and different opinion on whether “coin” itself is a currency, the word “Coin” was once replaced by “Token” and added “Crypto” for modification. Thus, it’s more accurate to interpret ICO as Initial Crypto-Token Offering, which is to raise funds by issuing encrypted tokens. The so-called “tokens”, in reality, usually refers to a certain certificate as an alternative of currency that circulates within a certain range. This token can also be considered a Crypto-Equity that is distributed and circulated on blockchain.
ICO has become an important financing mechanism for the blockchain industry

ICO refers to the fundraising mechanism that a blockchain company or a decentralized organization issues cryptographic tokens and sells them to participants to get funds for project development, which is asset securitization of blockchain projects. Broadly speaking, except the issuance of pre-mine (genesis block at the initial stage of projects), ICO also covers token issued via proof-of-work (POW), proof-of-stake (POS) or mining rewards to incentivize miners to participate in the verification process to ensure network security under other consensus mechanisms.

Funds raised through ICO are often not denominated in fiats, but in Bitcoin, Ethereum or other digital cryptocurrencies. The selection of coin is usually based on the actual situation of the project, scope of target investors, investor convenience, market liquidity, the technical links with the ICO project and other factors. Prior to 2014, Bitcoin is the only token for ICO projects as their target audiences were highly overlapped with Bitcoin adopters. With the development and maturity of other blockchain projects, the value of tokens issued by some projects is acknowledged and their users continue to expand, forming its own independent community. Projects incubated from the community will accept their own tokens and Bitcoin when doing ICO. Take Ethereum for example, Ethereum-based projects will accept ETH and BTC for ICO.

At present, ICO has become an important financing mechanism of blockchain industry and has promoted technological innovation and development of the blockchain system on various dimensions. On the data layer, Zerocash extends the bitcoin protocol to achieve complete anonymity of transactions. On the consensus level, the Nextcoin ICO collects 21 BTC for the development of a POS-based blockchain. On the contract layer, Ethereum project raised more than 30,000 BTC to develop an unstoppable, censor-resistant, self-sustaining and decentralized smart contract platform. On the application layer, tokens issued through ICO are emerging for decentralized apps like payment, wallet, asset transactions, fund management, cloud storage, gambling, online games etc. ICO tokens can be transferred and traded but cannot be redeemed. There is no fixed period or fixed return. It’s price reflects the equity of the ICO projects.

According to the characteristics of ICO issuers, ICO can be divided into two categories. First is the entity-based ICO. For example, Lykke, a Swiss financial technology company, issued tokens and 100 Lykke tokens represents 1 share of the Lykke company. Token like this represents the ownership of shares (the right of knowing, the right of decision-making, the right of incoming and the right to claim residual value). Second type is ICO based on decentralized network, which has no real entities. Non-entity-bsed technical teams will be responsible for project initiation, tokens issuance, technology development and product operations. Funds are allocated by a technical team, a foundation or managed by DAO (Decentralized Autonomous Organization) model. In 2016, an ICO project called “The DAO” became the largest crowdfunding project in the world with more than $ 130 million raised via ICO. Three rules are adopted in the DAO model to achieve unity of capital ownership and management rights, and effectively protect the interests of investors. First the voting mechanism ensures fairness. All investment decisions are decided by the participants voting. Second, the smart contract mechanism ensures transparency. All projects are automatically executed with smart contracts, and the principal and proceeds generated by the project are returned to DAO through a smart contract. Participants’ right of information is insured by the automatic execution of smart contract and the open, transparent and distributed ledger. Third, foot voting mechanism ensures fairness. In order to protect the interest of minority group from being harmed by majority agreement, it’s designed in the DAO agreement that the minority can vote for another service provider to form a new DAO to protect their own interests.
How to assess the value of ICO tokens

The value of a stock depends on the future earnings (Payoff), which generally can be assessed by price-to-earnings ratio and cash flow discount method. However, some features of ICO tokens make it difficult to use the traditional stock valuation model for pricing. First, the high uncertainty of technological innovation led to invalid assumption of the continuation of blockchain projects. Second, it is difficult to predict future income of projects. Even the project revenue is predictable, P/E valuation cannot be employed as similar companies cannot be found in reality due to the unprecedented innovation of blockchain projects. Third, when we employ the cash flow discount method, it is difficult to determine the discount rate in addition to the unpredictable future cash flow. Theoretically, the discount rate is equal to the risk-free rate plus risk premium. The risk premium depends on the investor risk partiality and the risk of token. It is hard to measure the two factors in real life.

(To be continued)

It is especially crucial that the token valuation, the symbiosis between these tokens, investment, returns, and cashout are often not denominated in fiats due to the technical dependency. Such feature makes it difficult to assess token values. For example, assuming that the investment, returns, and cashout of a token are denominated in BTC, what is the risk-free rate of BTC when applying the cash flow discounting method? There is no such indicator in the market. If an indirect approach is taken like converting cash flow of Bitcoin into fiats, then an assessment model for Bitcoin shall be introduced and the relevance of the token to Bitcoin value should be taken into account. In this case, the traditional stock valuation model cannot be applied. So ICO tokens pricing requires new methodology. A viable idea is to use the option pricing method to consider the economic value of the token as a call option for the underlying value of the project.

Assuming that the project is denominated in Bitcoin and the future term is T, then the value of the project in future is S (T), and the value of BTC by that time is U (T), then the value of the project denominated in fiats is V ( T) = S (T) U (T), that is ①. According to the contingent feature of token income, valuation of token at term T is P(T)=max(S(T)–Z,0), in which Z is the threshold value denoted by BTC. If project value is lower than threshold value, it means that project fails and the token value is zero, otherwise the project value is S (T) -Z. To take things further, P (T) is written as max (S (T), Z) -Z. For simplicity, assume that Z is 1 then the token value can be expressed as P (T) = max (S (T), 1) -1, which is applied into equation ①. Using the option pricing method, we can solve the present value of the tokens denoted by BTC as P (0) or ②. Correspondingly, the present value in fiats is ③, in which ④, ⑤, ⑥, qv is the rate of increase of tokenized project valuation, qu is the yield of the bitcoin value, av and au are the corresponding volatility, P is instantaneous correlation coefficient between project value and bitcoin value. When we are doing project valuation, we need to include the current value V (0) of the tokenized project, qv the predicted future growth rate, бv is the volatility, Z the critical value of project failure, P as the correlation coefficient between the value of the Bitcoin. Yield of bitcoin value Qu and volatility бu could be obtained through data backtrack or prediction. The present value V (0) of Bitcoin can be represented by the spot price.

The advantages of the above valuation approach are: first, valuation is not based on the continuous operation of the project. Tokenized projects may be successful or not. Second, the valuation formula is independent of the risk-free interest rate. The formula also skips the problem of absence of risk-free interest of tokens in reality and the estimation of risk premium. Third, project value and the relevance with its parent project are taken into account, which is more in line with economic reality.

Similarities and differences between ICO, IPO and equity crowdfunding

The US Securities Act defines securities as any debt instruments or vouchers issued by the enterprise for the purpose of financing, including the shares of for-profit company, member’s rights of Limited Liability Company and the interests of limited partner. Meanwhile under the Howey test, security could be an investment contract that is “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” ICO tokens are basically in line with the definition and standards of securities, except that funds are not invested into enterprise. ICO is equity securities issuance activities just like IPO and equity crowdfunding, but there are differences in some aspects:

First, ICO financing accepts Bitcoin, Ethereum or other digital encryption tokens; IPO and equity financing accept fiats.
Second, the legal positioning of ICO is not clear and corresponding regulation is not available. Regulatory laws and regulations for IPO and equity crowdfunding have been established.
For example, the Securities Act (China and USA), the Administration Regulations for Private Equity Financing (China), the JOBS Act (USA) and so on.
Third, ICO are for blockchain industry. The issuer is not necessarily an entity and could be non-entity-based team. Issuers of IPO and equity crowdfunding are from various industries and must be enterprises.
Fourth, there is no limitation on the investors for ICO projects. Although IPO and equity crowdfunding are open to public, there are certain regulatory requirements for investors.
Fifth, ICO is not conducted via intermediaries, intead it runs on decentralized network. IPO and equity crowdfunding relies on securities brokers, crowdfunding platforms and other intermediaries.
Sixth, ICO tokens can be in traded in exchanges and various secondary market. Company stocks issued via IPO can also be traded in the stock exchange and other secondary market. But trading of assets issued through equity crowdfunding relies on OTC transactions.

Thoughts and Reference: ICO Regulatory Framework Design

In order to standardize the issuance and trading of securities, protect the legitimate rights and interests of investors, maintain the social and economic order and public interest, all countries have strict supervision of securities issuance. China’s current “Securities Law” also clearly stipulates that the public offering of securities must be legally reported to the securities regulatory authoritie or authorized department by the State Council for approval. Any entitiy or individual are not allowed to issue securities to the public without approval. At present ICO is at the edge of legal supervision, which is not conducive to the protection of investors or the healthy development of the blockchain industry. Therefore, it is of great significance to impose reasonable supervision to ICO as soon as possible.

After long-term practice, the regulatory approach and framework for equity securities has become mature. Focus of regulation lies on protecting the investors and the following regulatory logic: regulatory strength is proportional to the likelihood of damage to investor interests and inversely proportional to the investor’s professionalism and risk tolerance. For example, in view of the wide range of public interest involved in IPO, regulators take a series of strict regulatory measures on IPO. To be more specific, public issuance or sales of securities must be registered and audited to ensure the quality of listed companies. Issuers are prohibited from conducting general inducement and advertising behavior. Listed companies are compelled to make ongoing mandatory information disclosure, including the requirement to disclose specific information and all relevant additional facts. Listed companies are asked to be in line with anti-fraud regulations and other liability clauses. Some US state securities laws (“Blue Sky Act”) also require the state supervisors conduct a substantive review of the value of listed companies. For high-risk industries, regulators impose a limited scope of qualified investor to reduce public exposure.

In China, qualified investor regulation is imposed on NEEQ (National Equities Exchange and Quotations) and private funding. Only a public offering of restricted securities can be exempted from registration. As stated in Rule 506 of the Securities Act of the United States of America, the issuance of securities may be exempted from registration for the case that securities are sold to qualified investors (consistent with the net assets and income standards prescribed by the US Securities and Exchange Commission) and no more than 35 non-eligible investors. But the issuer has the responsibility to take appropriate steps to identify qualified investors. Private funding below $ 1 million and $ 5 million are exempted from registration as per 504 rules and 505 rules (but 505 rules and 506 rules set the number of non-qualified investors to no more than 35). The above exemptions limit the number of non-eligible investors and therefore do not meet the “long tail” financing needs of crowdfunding.

In order to promote and standardize the development of the crowdfunding industry, in 2012 the United States promulgated the ” Jumpstart Our Business Startups (JOBS) Act”. The JOBS Act liberalizes the registration of securities in small amount, allowing the annual issuance and sale of securities lower than $ 1 million to be exempt from registration without limiting the number of non-eligible investors (but with an investment cap). And as with the D regulations, the JOBS Act allows general inducement and advertising, as long as the issuer takes appropriate steps to identify qualified investors. There is no doubt that these exemptions raise the risk of damaging the interests of investors. Therefore, JOBS Act has taken two measures: first, the issuer is required to comply with information disclosure, anti-fraud and other liability terms; the second is to focus on regulating crowdfunding platforms, which are required to follow a number of regulatory requirements and obligations, including investor education, risk disclaimer, disclosure of the issuer information, determination of investor qualifications, notification and confirmation of transaction-related information, confidentiality of investor information, supervision of the issuer’s use of funds and whether the investment complies with investment restrictions, anti-fraud and so on.

In 2014, China released “Private Equity Financing Management Approach (Trial)”, which also removed the registration of crowdfunding projects and only asked the issuer to be a micro, small or medium enterprises and must be a real-name registered user on the platform. There is no investment cap on the crowdfunding projects. But a qualified investor must have financial assets of no less than 3 million yuan or his average annual income is not less than 500,000 yuan in last 3 years. The total number of qualified investors must be no more than 200. Overall, China’s private equity management approach is more “tolerant” to the issuer and only stress appropriate information disclosure obligations. It doesn’t raise high requirements for financial information disclosure, nor mention terms for anti-fraud and related liability terms. As with the JOBS Act, (China’s) Management Approach also focus on the regulation of crowdfunding platform, which is required to disclose information, educate and protect investors, review qualification and supervise the use of funds. Unlike the JOBS Act, the Management Approach prohibit publicizing, promoting or soliciting.

The incumbent regulatory framework has provided regulatory approach and experience for ICO regulation. In order to avoid legal risks, some tokens ICO are seeking legitimacy from the current IPO and equity regulation regulations, such as the “BCAP” Tokgo ICO, which is dominated by Blockchain Capital, Registered under the laws of Singapore and submitted the relevant legal documents in conjunction with the Securities Act D and the JOBS Act.

Suggestion: inclusive exemption for ICO projects
Based on the features of blockchain technology and industry, it might not be appropriate to simply apply the existing supervision framework of IPO and crowdfunding to ICO projects. Looking back at history, significant technological innovation has never been the result of government planning, design and dominance. Technology replacement, innovation and evolution rely on trial-and-error by a few “pioneers” and the survival of the fittest mechanism. As a cutting-edge technology that could subvert various fields of society, the blockchain ecosystem has been evolving in Darwinian style at accelerating speed. Old and outdated blockchain technology and projects will be replaced by more advanced technology and business models. Cryptocurrency that has real value will eventually be recognized by market and tokens with no value will be gradually eliminated.
In this process, preemptive and excessive intervention by regulator will damage the market’s automatic clearing mechanism. At the same time, features of blockchain technology like decentralization, traceability, tamper-proof, transparency and auto execution of smart contract has created a unique democratic management mechanism (like the DAO model), which, to a certain extent, also reduce the need for excessive regulatory intervention. In addition, ICO project is often in its technical incubation stage without a mature business model, coupled with the technical innovations. These factors make it difficult for regulators to make professional and appropriate assessment on the prospects and values of ICO project prospects and values like they approve IPO project. Therefore regulator is not fit to be a judge on the quality of ICO project. The best role for regulator is to be a “gatekeeper” instead of “scavenger” for innovation. Therefore, it is suggested to be tolerant of ICO and give some inclusive immunity in terms of listing approval, investor restrictions, publicity and promotion of the project.
First is to set funding cap and white-list management.
ICO issuers are not limited to entities but a funding cap shall be set. China’s equity crowdfunding regulation stipulates that the issuers must be small or medium enterprises, but most of the ICOs are based on decentralized network and therefore not related to entities. The nature of blockchain startups determines that the ICO issuer should not be limited to entities only. At present, there are ICOs for establishment of investment funds with large funding amount. In order to prevent private equity investment fund from regulatory arbitrage, it’s suggested to set funding cap for ICO and issue a project whitelist.
Second is the management of ICO financing plan

At present, most ICO projects adopt a one-time financing approach, which will mislead investors to believe that the project will be successful from the outset. Also from the perspective of risk control, traditional VC will invest small amount in early stage and assess risk and potential of the project later to determine further additional investment. Therefore the disclosure of ICO financing plan is also the focus of regulation.
Judging from value appreciation mechanism of blockchain projects, we can see that native tokens gain their credits and values by continuous technical effort, improving the indigenous service quality and attractiveness of the decentralized network, growing community to cultivate network cohesion and confidence. The participation of users and the expansion of network nodes is the fundamental basis for the value of ICO tokens. Holders of ICO tokens are not only investors, but also the participants and builders of the value network. The bigger the community, the more favorable for the value increase of the token.

But ICO investors themselves are immature and don’t have enough knowledge and information to evaluate the risk of projects. Most of the token investors are attracted by the huge return of Bitcoin and take for granted that ICO offers the same kind of investment. Therefore the introduction of staged investment of VC is favorable for the protection of investors.

Third is the issuer must disclose information continuously following strict regulatory requirement, anti-fraud and other liability terms.

Most of the ICO are being promoted in the form of asset sales. There are considerable amount of “scammers” in the market. With the development of ICO, it’s impossible for investors to study feasibility of every ICO projects. As transactions are openly conducted in an anonymous way, ICO could fall into disorderly speculation and easily-faked plot.
Therefore, it is suggested that the issuer should submit detailed disclosure information to the regulatory authorities before the ICO, including the project whitepaper, the development team (not anonymous), the business model, the fund allocation plan, the project features, the development goals, the development strategy, the risk assessment, ICO timing, ICO price assessment methods, and other information that may concern the interests of investors, and to ensure that the information disclosed can be publicly available to investors. Meanwhile the ICO issuer shall open source technical details 3-6 month before the launch of ICO. In view of the professionalism of ICO project, an independent, professional third party shall release an assessment report on the ICO to alert investors of risks. During the development stage of project, the issuer should regularly and continuously disclose information regarding the use of funds, other significant facts and progress. Significant spending should be reported quarterly and small amount can be revealed on annual basis. Finally, it should be made clear that the issuer undertakes legal responsibility for misstatement, omission of major information and fraud, illegal fund-raising and other criminal acts.

In addition, in the ICO process, the issuer has no right to choose investors and he does not know who the ultimate investor is. Without professional external resources, the issuer is not in position to provide reasonable and appropriate information to the outside world. Also the issuer is often technical person and does not have a professional advantage on the funding management. Therefore, it’s suggested to hire professional venture capital (VC) to participate in the operation of ICO (such as funds spending etc.), which can not only effectively enhance the transparency of ICO projects but also facilitate the innovation and development of the ICO projects.

Fourth is to strengthen the role of intermediary platform.

There are two approaches: first is to promote the establishment of ICO platforms similar to the crowdfunding platform. The ICO platform is committed to investor education, risk disclaimer, ICO project review, qualification, funds custody, pushing issuer to disclose information, monitoring of funds allocation, AML etc. Second is to regulate trading exchange, which should perform the duties like investor education, risk reminder, information disclosure upon listing of ICO tokens, AML etc.

Fifth, the regulatory authorities shall take the initiative to intervene at early stage and maintain regulatory intervention and restriction during the whole process.
To further protect the interest of investors, regulators should take the initiative to intervene early, strengthening supervision on behaviour, implementing regulatory sandbox, enhancing regulatory adaptability on blockchain technology. Regulator could try to predict failure points of ICO project through the monitoring of sandbox. By inquiry supervision, regulator conduct substantive audit on ICO projects from technical and business perspective. Regulator shall maintain regulatory intervention and limiting power throughout the whole development process of ICO projects. If necessary, direct intervention on ICO projects could be implmeneted to prevent damage to the interests of investors.
Sixth is to strengthen international regulatory cooperation and coordination.

At present, blockchain project is initiated and operated in a decentralized way without a clear legal jurisdiction. However regulators can put trading platform under regulation. With the development and maturity of decentralized exchange technology, trading exchanges also be decentralized. By then the regulation of a single country will fail and international regulatory cooperation and coordination will become particularly important.
Observation and Regulatory Approach: Regulatory Sandbox
It will take a long time for cryptocurrency ICO to get a clear legal positioning and the establishment of a complete and mature regulatory framework. Regulatory uncertainty will be the biggest political risk for ICO in the long run. According to the estimation of British Financial Conduct Authority, regulatory uncertainty will delay the listing time of Fintech innovations by 1/3, consuming 8% of the income of the product’s life circle, downplaying corporate valuation by 15%. From the perspective of national industrial development strategy, countries are fighting to seize the high ground of global financial science and technology innovation. For example, the United Kingdom clearly proposed to build a global financial technology center. As time waits for no one, it is advisable to implement regulatory sandbox policy for ICO. In the context of protecting investor interest, the regulatory authority may implement exemption or limited authorization regarding approval of ICO, investor qualification, publicity and promotion of the project within the framework of regulatory sandbox. ICO projects are allowed to conduct testing activities without worrying about regulatory consequences, creating “safe” innovation space for ICO projects, reducing innovation costs and policy risks.

At the same time, regulatory capacity and level must meet the demand as ICO project are often involved with network payment, asset management, financial transactions, digital wallet, supply chain finance, insurance and other advanced technology and concepts. Through regulatory sandbox, regulatory authorities can get involved in ICO projects at its early stage. Regulator can learn and fully understand the technical details, innovation and product features through positive interaction with innovators, analyzing and evaluating potential risks and problems, improving regulatory focus, tools, measures, rule and regulations with consideration of industrial development characteristics and trending. Eventually, the goal is to establish the ICO regulatory framework that is fit for blockchain technology innovation and industrial development nature. In view of experience from UK, Singapore and other countries, ICO regulatory sandbox could be carried out with the two following principles.

First is to choose the users of regulatory sandbox. User of regulatory sandbox should meet the following criteria: truly substantive innovation, solving the industry “pain point”, beneficial to consumers and the industry and ready to test.

 Second is the authorization and whitelist management.A white list and business entry standard could be set up for ICO projects. For projects with higher foreseeable risks, limited authorization could be granted. Taking into account the differences of ICO projects, “individual guidance” could be established for pilot program and separate applicable rules applied.

Third is investor protection. Participants who are fully aware of the potential risk, compensations and purposely expressed consent are admitted in the test program. ICO projects that are under test should develop plans for information disclosure, investor protection and compensation and get approval from authorities. Issuer of ICO must prove the compensation capacity in case that investor suffers from loss.

Fourth is supervision management. During the testing process, ICO project should report to the regulatory authorities on a regular basis and submit the final report to the regulatory authority after the test is completed. The supervisory authority oversees the whole testing process and reserves the right to shut down the test. After the test, the regulatory department assesses the results of the examination of the project and decides whether to implement it outside the sandbox.

It should be pointed out that the implementation of the regulatory sandbox is based on a financial regulatory system with sound and clear authorization. Currently countries that implement such sandbox mechanism are qualified for that. Both UK and Australia implement a clear “dual-regulation” mechanism (prudential supervision and conduct regulation). Singapore adopts a comprehensive financial regulation policy. Based on the current situation of China’s industry-based supervision system, if industrial authorization or permit policy is implemented, regulatory arbitrage or regulatory disorder might happen and the policy is not fit for innovation nature of ICO projects and testing purpose. Therefore, it is suggested that the financial regulatory coordination mechanism should be strengthened and lifted to a more efficient level, which will serve as the basis of regulatory sandbox.