China and South Korea have banned them, and the US, Switzerland and Singapore have issued warnings about them, but in strictly regulated Germany, financial authorities have long kept silent about so-called initial coin offerings (ICO), a controversial way of raising money by issuing virtual tokens. Until now.
Germany’s Federal Financial Supervisory Authority (BaFin) issued a formal warning to investors to steer clear of ICOs on the grounds that they constitute “highly speculative investments” that contain “substantial risks.”
BaFin says: “Investors should be aware that a total loss of their investment is possible.“ It added that the huge public interest in the tokens “also attracts fraudsters.”
The risks include volatility in the price of the virtual currencies or tokens offered as part of ICOs, BaFin added. The secondary market for these currencies could be illiquid or even non-existent. A further problem is that the business models financed via ICOs are often at a “very early, mostly experimental stage” and are hard for investors to assess. The brochures are “often objectively insufficient, incomprehensible or even misleading.”
As if that weren’t enough, it warned that ICOs are “systemically vulnerable to fraud, money laundering and terrorism financing.”
ICOs are a relatively new phenomenon. There were 46 of them last year worldwide and the number has increased to more than 200 so far this year, raising more than $3.2 billion (€2.8 billion), according to the website Coinschedule.com, which tracks the market.
In Germany, Berlin entrepreneur Tobias Haag wants to raise €25 million with an ICO to launch his shopping app Wysker. He started selling “Wys Tokens,” which customers will be able to use as currency to shop on his platform later in November. Wysker is the first company to launch an ICO in Germany. Many others are preparing to follow suit, with five German ICOs already announced.
ICOs are “systemically vulnerable to fraud, money laundering and terrorism financing."
The investing fad has been fueled by the meteoric rise of the cryptocurrency Bitcoin, which rocketed to $7,000 in value this week despite being described by Jamie Dimon, CEO of J.P. Morgan Chase, as a “fraud.” The Securities and Exchange Commission, which regulates equity investments in the United States, says it is considering including ICOs as part of its remit.
In an apparent swipe at the German government’s inaction on ICOs, the German regulator complained that the “lack of legal requirements and transparency rules means the consumer is left to his own devices when it comes to checking the identity, seriousness and creditworthiness of a token offerer.”
Not everyone agrees with the warning. Fans wax lyrical about the birth of a new form of grassroots funding unfettered by banks and bourses. They see the dawn of a new era of democratically run companies where investors are directly involved in management decisions.
“An ICO is a way to easily address a relatively large audience with relatively easy means and to quickly collect a lot of capital in small tranches — globally, without involving a bank,” said Christian Storck, global co-head of innovation at the law firm Linklaters, outlining the vision of ICO enthusiasts.
But the reality is quite different. Even industry gurus like Julian Hosp, the Austrian founder of the cryptocurrency TenX, believe that most ICOs are doomed to fail. The main problem is that many start-ups lack a working business model and instead have a collection of ideas 20-30 pages long, known as “white paper” in the ICO scene.
Some ICO entrepreneurs try to recruit freelance writers to pen their business manifestos, and often they’re quite open about their ignorance. “We’re launching an ICO in the financial sector. We need an expert who knows Blockchain-/ICO Jargon, concepts and models,” said one advertisement posted on the global freelancing platform Upwork. Insiders see that kind of approach as a clear indication of naiviété and even possible fraud.
Investors receive tokens for their money. Often, it’s unclear what the tokens will buy them, if anything. “It could be usage rights for the company’s services, equity capital or a virtual currency that I might not even be able to end up exchanging,” said Mr. Storck.
In some cases the investments are just declared as “donations,” as was the case with the Swiss startup Tezos, which raised $232 million with its ICO. A survey by industry website Token Report said nine out of 10 tokens are used for speculation. Users hope their value will surge like Bitcoin has.
Even Germany’s newly-founded fintech industry lobby, the Blockchain Federal Association, has called for the ICO market to be regulated. “There should be a kind of quality control for ICOs,” the association’s general secretary, Friederike Ernst, told Handelsblatt. She praised the idea behind ICOs but added: “Unfortunately it’s true that many ICOs take place with fraudulent intent. They just want to exploit the hype to extract money from unknowing customers.”
But Sven Korschinowski, an expert on financial services at consultancy KPMG, said Germany would be ill-advised to choke off the ICO market with excessive regulations. Politicans and regulators should work to understand the technology before acting hastily. “On the one hand they have to protect investors. But on the other, they shouldn’t endanger the biggest advantage of ICOs — a simple and quick way of obtaining capital — through exaggerated rules,” he told Handelsblatt. “Regulation mustn’t obstruct innovation.”
But some regulation, even Mr. Korschinowski admits, would certainly be in order. “A company should have to present more than a five-page white paper if it wants to collect a double-digit million euro sum.”
Andreas Kröner is a financial correspondent for Handelsblatt in Frankfurt. Frank Drost covers financial regulation for Handelsblatt from Berlin, and Felix Holtermann is a finance editor in Düsseldorf. David Crossland and Chris Cermak adapted this story into English for Handelsblatt Global. To contact the authors: firstname.lastname@example.org and email@example.com