2020 was a year to remember for the equity markets – The free fall in March, The bull run of December and some spectacular Initial Public Offerings (IPOs). Thinking of bull runs, the Bitcoin definitely won that race, with approximately a 300% increase since the beginning of 2020. In this blog, I present to you an interesting concept, amalgamating IPOs and cryptocurrency.
Blockchain and Cryptocurrency
Blockchain can be understood by understanding the problems caused due to centralization of data. Centralization of data makes it easier to hack. Think of it as keeping all your valuables in one room of the house. In case a thief plans well and breaks into this room, it will be very easy for him to loot. Instead, if the valuables were hidden across the house, there would be a lesser risk of losing them all in case of a theft.
Blockchain solves this problem. The data is split into multiple “blocks”, each with a unique encrypted address, which can be stored anywhere on the network, which is usually the internet. And the entire system integrated in a way that if any block gets corrupt, a replacement out of the multiple copies would itself come and take it’s place. Hence the name “Blockchain” i.e “a chain of blocks”. I like to think of blockchain as a Phoenix, the ancient Greek bird which could regenerate from it’s ashes.
Cryptocurrency is an application of blockchain technology. It is not currency in real sense, as it is not issued by the central bank of any country. Rather, cryptocurrency is developed by an algorithm, which varies the quantity in circulation based on demand and supply. As blockchain technology has very low susceptibility to hacking, creation of counterfeit cryptocurrency is a rare possibility.
Bitcoin is an example of cryptocurrency. Over time, many new cryptocurrencies have emerged, controlled by different algorithms.
Initial Coin Offerings
An Initial Coin Offering (ICO) is a spin-off of an IPO. Startups often resort to non-institutional sources of funds, as they may not be able to fulfill debt covenants like a certain amount of assets to mortgage. Among non-institutional sources, crowdfunding is quite popular. It is a method through which the general public contributes capital towards a new business. It is usually successful where the prospective business may be beneficial to the public at large.
In ICOs, a new startup offers a “token”, in the form of a new cryptocurrency to investors. This is a new cryptocurrency and not one already in circulation. In return, it receives legal tender currency, which it uses to run it’s business. The investors can then hold the cryptocurrency and sell it when a good opportunity arises. This can happen only when the new cryptocurrency is popular enough to establish it’s own market.
This entire process is similar to an IPO, with a token of cryptocurrency replacing shares. However, it is an easier option for startups in countries where cryptocurrencies are popular, as ICOs are almost unregulated compared to IPOs.
Problems with Initial Coin Offerings
ICOs come with many risks. A study by Wharton Business School, University of Pennsylvania found out that nearly 76% of ICOs are frauds. Fraudsters raise funds, give investors worthless cryptocurrency and then abscond. Further, cryptocurrency is illegal in many countries, and is not recognized a legal tender in many others. This means that investors who have been cheated may have no recourse to law.
Startups themselves are risky enough. Coupled with the risks of cryptocurrency and weak regulations, an investor in an ICO has bleak chances of earning a positive return.
Cliché as it may sound, do you think ICOs will be the next “New Normal”? Let us know!
Priya DCosta
( An longer article on the same topic was also published by the author in the Newsletter “The Future Chartered Accountant” by Thane Branch of the Institute of Chartered Accountants of India – https://drive.google.com/file/d/16K8BG0pt-Ftk7s5sUxRxMmfa1GrPkX2u/view?usp=sharing )
Literary References
https://www.investopedia.com/terms/b/blockchain.asp
Photo references
Major Cryptocurrencies : Equity Trust https://www.trustetc.com/blog/cryptocurrency-types/
Fraud Warning: LeapRate https://www.leaprate.com/experts/tom-cleveland/the-anatomy-of-an-initial-coin-offering-ico-fraud/
