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What is initial coin offering and how it works?

The developers, businesses and ordinary people are increasingly using the Initial Coin Offering, which is also called the ICO or the sale of tokens to raise capital. Such activities provide fair and legitimate opportunities to attract investment. Nevertheless, new technologies and financial products related to the ICO can be misused to attract investors with the promises of high profitability in the new investment space. Providing this material, we begin a series of articles on crypto-currencies in order to acquaint you with the current issues of regulating a new and actively developing sphere of investment. Virtual coins or tokens are created and distributed using the distributed registry technologies or distributed storage of reliable records (blockchain technology). Recently, the sale of virtual currency through the ICO is more and more popular. The buyers (investors) can use funds to purchase money (for example, US dollars) or virtual money to buy virtual coins or tokens. The creators (promoters) provide the buyers with the information that the capital raised from the sales will be used to finance the development of the digital platform, software or other projects of this kind, and that virtual coins or tokens can be used to access the results of development, their use or for any other type of participation in the funded project. However, the authors of unsuccessful projects that did not collect the necessary funding must return the invested funds to their owners. After the issue, the virtual coins or tokens may be resold to other persons in the secondary market, virtual currency exchanges or other platforms. Depending on the facts or conditions in each individual ICO, virtual coins or tokens that are offered or sold can be treated as securities. Thus, the US Securities and Exchange Commission (hereinafter – the Commission) in its most recent investigation report in accordance with paragraph 21 (a) of the Law on Securities Trading of 1934 determined that if virtual coins or tokens are securities, then the offer and sale in the procedure of ICO is subject to regulation in accordance with the federal legislation on the securities. In its report of July 25, 2017, the Commission described the investigation of the activities of the virtual organization DAO (Decentralized Autonomous Organization) and its use of the technologies of the distributed registry and blockchain to simplify the offer and sale of the DAO tokens to increase capitalization. The Commission applied the existing federal laws of the USA to the new concept, having established that the DAO tokens are securities. It should be noted that those who sell and offer securities in the United States are required to comply with the existing federal securities laws, regardless of whether these securities are purchased in virtual currency or distributed using blockchain technology. In order to bring a little clarity to this new and complex sphere, we will consider the basic concepts that should be understood if you wish to invest in crypto-currencies or tokens. What is blockchain? Blockchain is an electronic distributed register or list of records, very similar to the ledger, which is supported by various participants in the computer network. The system uses cryptography to process and check the transactions in the list, providing the existing and potential users with the assurance that the records are protected. The most famous examples of blockchain are Bitcoin and Ethereum, which are used to track the transactions in bitcoins and ethers, respectively. What is a virtual currency (crypto currency), a virtual token or a coin? Virtual currency is a digital representation of values ​​that can be sold digitally and they function as a means of exchange, units of account or means of accumulation. Virtual tokens or coins may also represent other rights. Consequently, in some cases, tokens or coins will be considered securities and cannot be legally sold without registration in the Commission or in accordance with exemption from registration. What is a virtual currency exchange? Virtual exchange of currencies is a person or organization that exchanges virtual currency for real money, funds or other forms of virtual currencies. Virtual currency exchanges usually charge a fee for their services. Secondary trade in crypto currency can also be made at the exchange. This may be an unregistered exchange of securities or an alternative trading system governed by the securities laws. Accordingly, when buying and selling crypto currency, you may not have the protection that is provided in case of acquiring shares listed on the exchange. Who issues virtual tokens or coins? Virtual money is issued by the virtual organizations, or other companies on attracting investment. A virtual organization is an organization embodied in the computer code that runs on a distributed registry or in a blockchain. The code, often called “a smart contract”, serves to automate the certain functions of the organization that may include the release of certain virtual coins or tokens. The above DAO is an example of a virtual organization. The key points that need to be considered when deciding whether to participate in the ICO (for example, the United States) If you intend to invest in the ICO, below you can find what needs to be considered when making a decision.
  • Depending on the circumstances, the proposal may contain an offer and sale of securities. If this occurs, the offer and sale of the virtual currency must be registered by the commission or conducted as such that are not subject to the registration. Before investing in the ICO, ask the developer if the virtual coins or tokens are securities and whether the proposal is registered in the Commission. When registering, you need to remember a number of important points.
  • if the developer claims that the proposal does not require registration, and you are not an accredited investor, you need to be very careful – most exceptions have net worth or income requirements;
  • although, the ICO is sometimes described as crowdfunding contracts, it is possible that they are not offered or sold in accordance with the requirements of the Crowd Funding Regulations or with federal securities laws in general.
  • Find out what your money will be used for and what rights you get from virtual coins or tokens. The developer must have a transparent business plan, which you can read and understand. The rights that are granted to you as the owner of tokens or virtual coins should be clearly stated in this document. Also, you need to make sure that you can get your money back, if you want. For example, find out if you have the right to return a coin or token of the company or receive a refund. Can you sell your coin or token? Are there any restrictions on the resale of coins and tokens, etc.?
  • In the event if a virtual token or coin is treated as securities, the requirement is set by the federal or state legislation of the US: the professionals in the sphere of investments and firms that offer, participate in the transaction or advise on investment issues should get licence or be registered.
  • Ask whether the blockchain is open and public, whether the code has been published and whether the digital security audit has been conducted.
  • Scammers often use innovations and new technologies to enforce fraudulent investment schemes. Scammers can attract investors by advertising the ICO’s investment “opportunities” as a way to join this ultramodern space, promising or guaranteeing high investment returns. The investors should always be suspicious of non-transparent sites, solid sales and promises of disproportionate profits. In addition, it’s relatively easy for the people using blockchain technology to create the ICO that looks impressive, even if it’s actually a scam.
  • The virtual currency exchanges and other organizations that hold crypto-currencies, virtual tokens or coins may be subject to fraud, technical malfunction, hacking or malicious software. There are also cases of theft of crypto currency by the hackers.
Investing in the ICO can limit your ability to return funds in case of fraud or theft. Despite the fact that you will have the rights in accordance with the federal securities laws, your ability to return investment can be significantly limited. If you or a company that issues crypto currency, becomes a victim of a fraud or theft and lose tokens, coins, other virtual or even real money, the possibility of refunding your funds can be severely limited. You should also pay attention that third-party “wallets,” payment systems and virtual currency exchanges, which play an important role in the use of crypto-currencies, may be abroad or act illegally. The law enforcement officers may face special problems when investigating the activities of the ICO and, as a result, the means of protecting investors will be limited. Among the main problems are:
  • Tracking money. Traditional financial institutions (for example, banks) are often not associated with the ICO or transactions in virtual currency which makes it difficult to track cash flows.
  • The international component. The ICO, transactions with virtual currency and the users cover the whole world. Although the Commission regularly receives the information from abroad (for example, through cross-border agreements), there may be limitations on how it can use this information, and it may take more time to obtain it. In some cases, the Commission may simply not be able to obtain the information from the individuals or organizations located abroad.
  • Absence of a central regulatory body. Since there is no central authority that collects the information about virtual currency users, the Commission should generally rely on other sources for this type of information.
  • Freezing or providing a virtual currency. The law enforcement officers may have difficulty with freezing or investor funds that are stored in virtual currency. The virtual currency purses are encrypted and, unlike the money stored in a bank or brokerage account, virtual currencies cannot be held by the outside keeper.
Be extremely careful if you find any of the following potential signs of investment fraud.
  • “Guaranteed” high investment yield. There is no such thing as a guaranteed high investment yield. Be careful with someone who promises that you will get profit from your investment, with little risk or no risk at all.
  • Offers without obligations. Sales without obligations can be a part of a fraudulent investment scheme. You should be extremely cautious when receiving such proposals for investment opportunities, especially if you did not ask for it and do not know the sender.
  • It sounds too good to be true. If the investment proposal is too good, then it is most likely to be fraud. Remember that investments that bring high returns are more likely to occur with higher risks.
  • The persuasion to invest money right now. The scammers often try to cause a sense of urgency to get an investment from you. Take time-out for a detailed study of the proposal, before you transfer your money.
  • Unlicensed salespeople. Most fraudulent investment schemes involve the participation of the persons whose activities are not licensed, or firms that have not been registered.
  • No requirements for the size of your income or capital. Federal securities laws require the securities to be registered by the Commission, if the exemption from registration is not applied. Many exceptions for the registration require the investors to be accredited; some others have investment restrictions. Pay special attention to the private (that is, unregistered) investment offers that do not request information about the amount of your equity or income, or existing restrictions on investing.