8.2 Understanding Initial Coin Offerings (ICOs) and Security Token Offerings (STOs) - Video Tutorials & Practice Problems

As we continue talking about the state of the blockchain market, I'm gonna drill down on initial coin offerings. And I'm also gonna be talking to you about security token offerings. So initial coin offerings are ICOs, security token offerings are called STOs. Let me explain to you more about each of them. In the case of ICOs, I wanna talk to you that they are similar to a Kickstarter and it's a crowdfunding campaign but using cryptocurrency. So where many of these ICOs initiated was somebody would come up with an idea for what would be a good in their mind a good application for cryptocurrency. They would put together a white paper and then they would put that white paper out into the open internet and just ask people to contribute to invest in these initial coin offerings. So in many ways, it's very similar to these Kickstarter or crowd funding approaches where somebody has an idea or have some sort of charity that people need to donate to and then the general market could simply just send money to be part of these ICOs. However, in the case of these ICOs you would get digital tokens in return and many of these digital tokens you could turn around and sell them to other people. So the objective for many people was to buy into these ICOs with the goal that eventually it would be able to turn around sell those ICO tokens and make money back. So it really wasn't like an investment in a charity for instance, you were expecting to get these digital tokens which you could turn around and sell. Now, what's incredible about this is that they were originally used by startups to bypass regulated capital-raising process. So much like in many cases when somebody wants to actually raise money you have to have certain regulations. Why? Because people are making an investment in a company for instance and you're buying shares. But in this case, in the case of ICOs people would just simply be able to buy these initial initial coin offerings by these digital tokens and they could turn around and sell them to other people if they wish to or trade them. But the people who put together these ICOs never had to go through a regulated capital-raising process that is they never had to deal with regulations or talking to the Securities and Exchange Commission or doing any type of regulations or filings they were simply just putting together an ICO, launching it into the world and raising millions of dollars. Now, a percentage of this new cryptocurrency that was raised with these initial coin offerings went to the early backers. And this was one of the key things that really just made this ICO markets so exceedingly wild west like because in the process the people that put together these ICOs had a guaranteed payout. They basically were able to sell this digital token that they sold through this ICO and because they had a percentage of that cryptocurrency that they owned automatically they would get to keep millions of dollars because they raised millions of dollars through the process of these ICOs. Now because of this it's facing increased regulation and legal actions because many of these ICOs wound up being scammed. Think about it, if you have an idea for something that sounds like a very exciting new development and you don't even have developers for it but you can put together a good looking website and you know how to put together an ICO smart contract process where you can actually sell digital tokens. You could basically just launch your own ICO tomorrow and raise millions of dollars. That is what the market looked like in 2017. But that has changed and that is because it's facing increased regulation and legal actions. As I mentioned, many of these ICOs have wound up being scams and many other people that were actually involved have wound up going in jail. There will be other legal actions coming down the pipe but just letting you know there's a lot of increased regulation going into the ICO market. Now, let me give you a comparison between IPOs and ICOs. Now you may be familiar with what IPOs are these are initial public offerings and you know that because companies that go public and stock exchanges have to go through the IPO process. This is a lengthy process and you have to get filings, you have to deal with the Securities and Exchange Commission you have to limits on who can invest and who can't invest in your different investments. So these IPO processes are very, very regulated and they take time. Now they are highly regulated and they take multiple months to happen this is very different from these ICOs. In fact, many of these ICOs you could basically just put together put up a website and you can basically launch it in a matter of weeks, or maybe sometimes even days. It's a very, very simple process and as a result many people were just getting scammed because for a while there, there was such a craze for these ICOs that even if they were not valid ideas people would wanna get into these ICOs and they would buy it. And other people would wanna turn around by those and try to flip them very similar to what happened with homes in the 2008 crisis, people would just buy a property even though they didn't know if it was a good property or not because they were trying to sell it and flip it. A lot of this is exactly what happened with the ICO market. Now, in the case of IPOs they must file with a Financial Industry Regulatory Authority FINRA and the Securities and Exchange Commission SEC. These are highly regarded and regulated institutions that make sure that these initial public offerings are actually subject to due diligence and checking at least there's some sort of legal entity ensuring that this is a valid investment of some sort. And before it actually makes it into an exchange to be able to exchange those stocks and people to sell those shares it's already been through this process. So it's a lot more regulated and a lot more controlled than what the ICO market is. Now, these are also subject to public reporting and what that means is that once a company goes public you can actually look at their books because they have to do public reporting of what are the results for the company. All of this is completely different for what ICOs did. When we look at the initial coin offerings and the way that they were structured it's really unclear what the regulations and the legality of it was as I mentioned many of these ICOs were basically just an idea somebody put together, they wrote a white paper, and then they put together a marketing campaign and try to raise funds from people buying cryptocurrency, which they would invest in these ICOs for which they would receive these digital tokens and then you would get these digital tokens that you could try to sell them on a cryptocurrency exchange. But the key thing is that many of these didn't even materialize, many of them didn't even develop the platforms that they said they were gonna develop even though they raised all those money. The ICOs were really, really unclear when it came to regulations. Now, another key thing is also that these digital tokens it's actually, there's a debate whether these tokens constitutes securities or not. And the reason is because there's a certain type of approach called the Howey Test in which you can determine if something is a security or not based on whether your goal is to eventually get an investment return from it. So if you actually get these ICOs, if your expectation is to eventually be able to sell it and actually make a profit from it well, it really is a security. So the question is, what is it? Is it just a digital token or is it really a security? And this gray area presents a big, big challenge which is why the Securities and Exchange Commission was so highly engaged into these ICOs because if in fact they were securities all of these would constitute securities fraud. Now the SEC has been issuing subpoenas to some of these firms that constituted ICOs because in a nutshell when you really looked at these initial coin offerings they were really issuing securities and because they didn't go through the process that the Securities and Exchange Commission specifies they were actually doing fraud. So you could not do these legally, and as a result, the SEC has been issuing subpoenas to these. Now, one category I wanna talk to you about now is what are securities and securities token offerings? Because this debate of whether a digital token is a security or not can be laid to rest if you define it as a security. So we can talk about securities token offerings. Now securities token offering is a fundraising mechanism that involves a token offering in which the tokens issued are deemed a security which derives its value from an external tradable asset as such STOs by default are subject to federal securities and regulations in order to be SEC compliant. So what an STO does is that it builds in a regulation framework around these digital tokens because you're starting from the premise that these digital tokens are securities. And in the case of these STOs, all those digital tokens are actually backed by assets which are tradable assets. So an STO basically builds a regulation framework around these digital tokens which you can do as a security token offering.