Initial coin offering or initial con offering? A guide for the confused

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18 December 2017

A guest post from Dr Catrina Denvir, director of the Legal Innovation Centre at the University of Ulster

Denvir: Blockchain has the potential to bring about change in how legal obligations are recorded, enshrined and enacted

The internet has been awash recently with initial coin offers (ICOs). Although crypto-currency has been around for a few years, only recently have hip-hop stars got in on the action. ICOs are an initial public offering (IPO) of crypto-currency, but to understand that (or even to understand why you should care about ICOs), you have to understand what crypto-currency is, and the blockchain technology on which it relies.

Imagine there are two people, Tim and Sue. Tim has an apple, which he gives to Sue. The apple and ownership of the apple has been transferred to Sue physically and witnessed in real time. The transfer doesn’t require a judge to oversee the transaction, Sue saw the transfer and can be sure that the apple is now hers and Tim no longer controls it.

This validation is fine for physical objects (like apples, or money) but what happens when we’re dealing with digital apples? How do we know that Tim hasn’t made copies of his apple that he’s emailing to Sue and everyone else he’s ever met? This is what we call ‘double spend’.

To resolve ‘double spend’, we could have a ledger, put Bob in charge of it and make him responsible for validating the transactions. But, what if Bob isn’t trustworthy, and decides to add a few more apples to ledger for himself? We could get an institution like a bank to keep track of the ledger, but then we’ve lost control. That institution can impose all sorts of rules, or levy charges on us.

What if, instead of Bob or a bank controlling the ledger, everyone controlled it, and could view transactions and participate in verification using their computer? The ledger would exist, not as a document, or a spreadsheet but as a decentralised, anonymous and transparent algorithmic system connecting participants to each other directly (peer-to-peer).

A decentralised ledger alone would not solve all of our problems. We’d have to ensure that it couldn’t be tampered with and we’d also have to encourage people take part in verifying transactions. Even if verification could be automated so as to remove the need for people to physically look at statements (which it is), the system would still need electricity and computing power to run.

These issues are addressed through blockchain – a digital ledger recording all transactions in which (in this example) bitcoin is exchanged between users (peers).

Bitcoin mining is the process by which participants verify these transactions and earn a bitcoin reward. Bitcoins are effectively created (‘mined’ or ‘minted’) through verifying transactions. Verification maintains the ledger, and enables new bitcoins to enter into circulation – the conceptual equivalent of a central bank printing money.

Computers connected to the system (‘nodes’) undertake verification. A node might be a person with a laptop, or a number of people who have co-invested in hiring/buying servers.

Verifying involves bundling new transactions into a block in 10-minute increments, adding this block to the existing chain of blocks (containing historical transactions), and giving the block a fingerprint. The fingerprint reflects the content of the new block and the ‘imprint’ of the fingerprint of the previous block (i.e. the history of the chain as a whole).

So as to stop fingerprints getting bigger and bigger as the chain grows, they conform to a set digital length by being ‘hashed’ (transformed).

The fingerprint created protects authenticity. A fingerprint will only look the way it does if it is made up of the data that it is supposed to be made up of – if the blocks from which it was formed (chained) are legitimate.

For example, if your block fingerprint is green, then it is possible to confirm it is derived from a combination of yellow and blue fingerprints. Though impervious to tampering in principle, in reality human errors in coding can lead to security breaches.

As verification yields a reward, the system must pick which node ‘wins’ the task of verifying a particular block and adding it to the chain. Bitcoin does this by running a mini-competition whereby all nodes compete to guess a number. Guessing protects the system from tampering – the only way a node can arrive at the correct number sooner, is by guessing more quickly.

But computers are limited in how quickly they can guess and faster equipment cannot tip the scales to provide enough of an advantage. The first computer to guess the right number (not just any number, but a number which when transformed by an equation conforms to certain conditions) can verify the most recent block and claim the reward.

Bitcoin was developed as a proof of concept, purportedly in reaction to the public bailout of financial institutions in 2008. As a digital currency, it is both similar to and distinct from physical currencies.

Physical coins owe their value, in part, to the metal from which they are cast. But this value, like paper money, is also symbolic – reflecting economic conditions and demand. Similarly, whilst bitcoin has some literal value because the mining process expends power, it also reflects the perceived value of the digital economy/marketplace within which it exists and is used.

Bitcoin’s success has been underpinned, in the main, by the fact it enables anonymous trading. This feature compensates for the hassle associated with acquiring and storing the coin.

Owning bitcoin is ownership of a share in the ‘equity’ of the real or perceived value of the bitcoin system. If you own another form of crypto-currency, you own a share in the ‘equity’ of the value of that system.

It is perfectly possible (and indeed not uncommon) to release a crypto-currency, the only value of which is the prospect – however remote – of future appreciation.

As a share in the equity of the system, ICOs are (bubble-shaped) unofficial IPOs. Being unofficial, they avoid the regulatory demands associated with raising capital from banks or venture capitalists, who tend to want to know how you plan to use their money and are suspicious of answers that involve the words ‘retirement’ and ‘Belize’.

ICOs that must be purchased with bitcoin (and this is not uncommon) raise greater suspicion, given the difficulty of retracing investment monies in the event of fraud.

Escaping regulation does not mean that regulation isn’t warranted. Canada has decreed these tokens to be ‘securities’ and encouraged they are regulated as such, whilst China has prohibited ICOs as akin to pyramid schemes.

The success of bitcoin does not guarantee copycat coins will achieve the same traction. New coins must create demand and cultivate a user base by being better or different to that which is already available.

Ethereum’s ‘ether’ coins exemplify this notion of being different. These tokens/coins buy access to the Ethereum system, which provides developers with the tools to create their own blockchain applications (such as blockchain contracts).

Like bitcoin, users verify activity on the Ethereum blockchain and are rewarded with ethers, which can be used to purchase Ethereum services and pay transaction fees, or traded for other currencies. Of course, the system could accept money and pay out money, but doing so would undermine decentralization (and presumably any associated tax benefits).

The value of getting access to Ethereum’s developer tools underpins the value of the ‘ether’, but other coins have to be assessed on their own merits as to the value they add or represent.

That the Wolf of Wall Street is calling ICOs the ‘biggest scam ever’ (and he seems aptly qualified to judge) is unfortunate for blockchain as an innovation separate from crypto-currency.

Blockchain has the potential to bring about change in how legal obligations are recorded, enshrined and enacted. Lawyers should not see ICOs as merely a source of future litigation work, or a system designed to entertain day-traders, but rather as an example of what blockchain makes possible.

That is not to say that what blockchain makes possible, is also what we might see as desirable. ICOs are an extension of crowdfunding, sharing services and the gig economy. By virtue of their technological basis, these innovations often avoid having to abide by the legal standards that protect workers, investors and tax payers in the physical world.

So, whilst ICOs may emancipate participants from the expense, paperwork and rules imposed by centralised authorities, one must question at what cost, and to whose benefit.

Note: I cannot take credit for the apple analogy, much though I would like to. It was thought of by Nik Custodio and written about here.

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