On ICOs and tokens

Part of the limited knowledge and confusion about Blockchain is due to its connection with cryptocurrencies and tokens, terms that are unclear to most people. In fact, these units of value may vary significantly depending on the type of blockchain in question.

A token is a specific digital resource that provides control and can be reassigned to a third party to exercise that control. In practice, it can take many different forms, for example:

• It is what advances the blockchain. Given that its operation requires work and energy, the token is the reward for the miners to find the solution that allows them to incorporate a new block, and it is also the price that miners establish for entering third party transactions in their block.
• It is the reference to a redeemable asset. The asset is something whose value can be translated into economic units. The traceability of that asset can be carried out in the blockchain by assigning it to a token. This allows other functions besides the mere registration of ownership of the asset, since it can also be divided into smaller units and have their property distributed, gain security through encryption, or incorporate elements of management and negotiation through the “smart contract”.
• It is a capital or a property right. Those who invest in companies developing blockchain applications receive tokens that will gain value if the initiative is successful, and that can be traded or exchanged. They are like share certificates that are not subject to the financial markets regulation.
• It is a coin. The token is also a payment system for different products or services. This functionality is not highly developed yet and is characterized by its high volatility. It is assumed that buyers are willing to assume the high risks of the exchange rate.

Beyond the terminology, you have to identify the tokens with some of the functions they can perform: to finance a project by different and more efficient means, serve as “currency” for the payment of some services, serve as investments, to speculate … The appearance of Initial Coin Offerings (ICOs), where these tokens are offered to the general public, makes it necessary to understand the function of these instruments. Let’s see some examples:

First example. Today, entrepreneurs have different options to finance their projects. Leaving aside the loans, you can access the different alternatives of Seed Capital, Series A, B …, of investment funds. And even, at the beginning, the terrible FFF (Family, Friends & Fools). In recent times, crowdfunding helped financing projects of reduced size, by providing money from many small investors, not in exchange for shares of the new company, but for the future product of the company. These modalities of crowdfunding have already been regulated, with greater or lesser fortune, by the supervisory authorities to prevent small investors from being scammed.

Well, if instead of crowdfunding we use an ICO where we offer tokens to be exchanged for a future product of the company, we begin to see the similarities. It is not so distinct, although it is possible to identify at least three differences:

1. The token is negotiable and exchangeable (certainly, with different degrees of market depth)
2. The dimensions of the ICO – at least the successful ones – tend to multiply several times the volume of funds usually obtained by crowdfunding.
3. Regulation has not yet reached the ICOs in most countries.

This is a simplified example of how ICOs can be an alternative to other possible sources of financing.

Second example. Let’s see now a case referred to the Investment Funds (in any of its variants). Saving the differences between them, an investment fund works as an accumulation of money contributed by a number of investors, and managed by people who invest that money in different companies, bonds, stocks, etc. People who have invested in shares of the investment fund expect returns on their investments.

A token can perform similar (not identical) functions. Through an ICO, money can be raised in exchange for some tokens (here the similarity with the shares), and later invest that money in other companies, bonds, stocks, etc. There are already ICOs of this sort.

One can ask why use an ICO instead of a fund. These are some of the reasons:

• ICOs’ regulation is non-existent in many countries, while is very complex in the case of investment funds.
• The token of an ICO is directly saleable to third parties, without the complexity of the funds.
• The volume of investment funds is normally much higher than that of the ICOs.

Third example. This case will bring us closer to the theoretical boundaries of financial products. Let’s imagine – a pure mental exercise – a prestigious educational institution that does not receive enough income and is going through a time of economic distress. They could decide to sell today tuition rights for future years: those who buy those future tuitions can send their children to that university, as long as they meet the established access requirements. This operation can be done through an ICO, where the promoting institution gets money today in exchange for tokens that give the right to access future courses without paying anything else. If someone decide not to follow those paid programs, could always resell the tokens.

This use of the tokens, depending on the final details, is known in the financial world as a “Derivative Product”: either options, or futurer. They could even be identified as loans.

Final example. Here we have the case of pure financial speculation. As in other financial products, a person buy a token, thinking that the price will go up, to resell it later. In fact, this has been the case of multitude of successful ICOs. The speculator may be well informed, or not (which has been the most usual scenario…).

As always, the way to distinguish between a well-designed ICO and a pure speculative maneuver to raise funds by sheltering in the Blockchain hype and the absence of regulation, consists in the careful analysis of the project, the tools, the team, and the market research. The accuracy to be applied is the same as for any financial instrument. Unfortunately, the experts in this type of analysis are not abounding, but we can help from BlockTac.