What do Kickstarter and Blockchain fundraising have in common?
September 03, 2019
Importance of these Forms
In the first half of 2018, more than 17 billion dollars were raised globally through ICOs. At the end of 2017, one year after the SEC rules went into effect, small investors invested approximately $1.1 billion into U.S. equity crowdfunding. While these numbers pale in comparison to the $53 billion invested in U.S IPOs in 2018, many hope that both ICOs and Equity Crowdfunding will bring early stage investing to the masses and close the $60 billion dollar gap in available startup funding.
In 2015 the Securities and Exchange Committee adopted final rules permitting firms to engage in ‘equity crowdfunding’. This was the culmination of a multi-year long process precipitated by the Jumpstart Our Business Startups (JOBS) Act. The JOBS act was designed to make it easier for small businesses to raise capital. Firms can use equity fundraising to raise up to $1 million annually from online platforms, but sums must be raised in small increments from large numbers of ‘unaccredited’ investors. In return, the firm grants small amounts of equity to these investors. This is similar to a familiar Kickstarter-style campaign; however, rather than receiving a product at the end of the campaign, investors receive the equivalent of a share.
Crowdfunding’s Mixed Success
Despite the optimism surrounding regulation crowdfunding, the amounts raised have been small relative to traditional IPOs. Attorney Jo Won argues that the regulatory burden of disclosure is partially to blame for reduced uptake of the form. While similar experimentation with crowdfunding in the EU has created small business growth, concerns of fraud and high risk remain.
What is an ICO?
ICOs can be analogized to a crowdfunded fun-fair in which investors receive fair tickets instead of shares. While the operators of the fair may intend for the tickets to be used within the fair itself, they have some inherent value and can be redeemed for desirable goods or services (prizes and rides). An investor who buys tickets believes that the fair will be successful, and the tickets will appreciate in value. The investor can then sell the tickets to fair-goers or other investors for fiat currency, making a profit. The fun-fair tickets are akin to the ‘tokens’ of an ICOs: tradeable and redeemable records of ownership stored on a blockchain.
Problems with ICOs
However, ICOs, unlike fun-fairs, have to contend with some significant challenges. First, ICO token trades are difficult to reverse. There is no built-in technical mechanism for doing so and there is no centralized authority to whom one can appeal to change the ownership records on the blockchain. Furthermore, operators and token owners are frequently homed in offshore jurisdictions, reducing the effectiveness of domestic legal judgements. In many jurisdictions there is also no regulator ensuring that the token offerings are executed in a transparent and fraud-free manner. This lack of policing is in stark contrast to the developed investor protection regimes in traditional equity markets.
ICO Market Collapse
In mid-2018, researchers, including myself, highlighted these and other issues with ICOs. Simultaneously, reports of market manipulation and regulator concern spooked investors. In a matter of months, the ICO market cratered with the value of many investments declining by over 90%. This raises the question: is ICO investment yet another instance of ‘tulip mania’? A meager $118 million was raised by ICOs in Q1 2019. Even if the market can recover from this ‘crypto winter,’ it will require an investor protection regime on which investors can rely with greater confidence.
Haunted by the Past
This state of affairs parallels the information market failures that led to the securities legislation of the 1930s. Simon notes that in the absence of regulation, investors were “misled by exaggerated claims and inadequate disclosure.” This contributed to the boom of the early 20s and subsequent bust. In response, Congress created the Securities and Exchange Commission. The Commission was empowered to police disclosures and protect investors from fraud by intervening in a previously ‘disintermediated’ market. Those who peddle the virtues of decentralization should take history’s lesson into account: intermediaries can be a source of value.
Do We Need to Regulate?
Backers of ICOs have seen a significant decline in the value of their investments. However, regulators may not feel the need to intervene if investors are institutional. Regulators assume that such investors are sophisticated and can adequately assess the risk of speculative investments. In contrast, mom and pop investors have little ability to understand the tradeoffs involved. Regulators should first assess who is investing in ICOs, and on that basis decide if and how to intervene.
Crowdfunding or ICOs?
Properly structured regulation crowdfunding may strike the right balance for small time investors. Mom and Pop are better off dipping their toes into early stage ventures with the assurance that the SEC is guarding them against fraud. Rosy-eyed futurists must fortify ICO markets against mischief before inviting the hordes to cast their lots.
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The views expressed on the Student Blog are the author’s opinions and don’t necessarily represent the Wharton Public Policy Initiative’s strategies, recommendations, or opinions.