Author: James LoBuono, Business Development Head, Cognitir
Projects and startups financed through blockchain are coming under sharply closer scrutiny in the wake of the 2017 bubble.
Much progress has been made in terms of regulating and legitimising the space, but we may still be years away from widespread proliferation.
Following the stratospheric rise in cryptocurrencies at the end of 2017, many can recall that things did not fare all too well for the majority of investors supplying capital to seed stage projects in the form of tokens and coins. This was especially clear for fledgling platforms funded on merely an idea only. Hundreds of millions of dollars and then some were raised for such projects on public blockchains like Ethereum. Prior to 2018, crowdfunding on blockchain was commonly used as a way to skirt traditional securities laws in places like the US. According to Statis Group, over 80% of the initial coin offerings that were launched during 2017 were outright scams and frauds.
Similar to the aftermath of other prior revolutions in finance, including the Dotcom Bust, some order has started to creep its way into the blockchain world as the smoke clears. Slowly but surely, guidelines and platforms are being deployed to formalise funding through blockchain. Silicon Valley titans including the famed Andreessen Horowitz see blockchain as a natural next step towards radically improving the financing process for startups. This is supported by the firm’s creation of a $350 million crypto focused fund along with other large-scale endeavors. In addition to participation by venture capital stalwarts in the space, numerous blockchain integrated services have emerged as some of the go-to names to support the issuance of tokens that represent actual ownership (known as security token offerings or “STOs”) in a private company or startup.
Going back to the fundamentals of blockchain technology generally, open public protocol layers like Ethereum and Bitcoin are decentralised ledgers in which all transaction records are updated in an immutable manner through the consensus of a peer to peer community. This compares to traditional non-blockchain ledgers that rely on a trusted third party to maintain and update all records. Ethereum differs from Bitcoin in that Ethereum allows for more computational flexibility through its Turing completeness. In simple terms, this means that Bitcoin is good at tracking the movement of value, but it cannot incorporate the programming of complex business logic (smart contracts) in the same manner that Ethereum can. Given these additional capabilities, swaths of projects during 2016 to 2017 utilised the Ethereum blockchain to issue tokens in exchange for bitcoin and other currencies. Smart contract functionality enables embedded business processes (conditional logic along the lines of “if this, then that”) in a manner that can be summarised on the most basic level as follows: if x amount of bitcoin is sent to a designated project wallet address, then issue in return, y number of tokens that represent some form of stakeholdership in the project. These startups could be anything ranging from an attempt at creating a decentralised version of a Twitter or an Uber, to a new online gaming venue that is completely decentralised in a peer to peer architecture. Tokens issued in countless scenarios were not even backed by anything of real-world value, namely ownership in the organisation to begin with.
Fast forward to the second half of 2018, and now well into 2019, the financing processes for companies participating in capital raises on public blockchains like Ethereum have legitimised rapidly. This evolution has been driven by those committed to the greater good ideals of blockchain’s transparency to revolutionise finance, as well as by the crackdown of regulators protecting investors from buying what appear to be deemed unregistered and highly risky securities. In many cases, token issuance should be viewed as the floating of securities since an investment of money is being raised from those with the intent to profit at the hands of common enterprises managed by others (check out the US Howey Test for more).
The emergence of security tokens forms a way of creating digital representations of ownership in an asset on the blockchain in an attempt to comply with common global securities and anti-money laundering regulations. One of the core aspects of compliance in large markets like the US is that formalised token issuance processes work to make certain that only qualified and sophisticated (also known as “accredited”) investors can participate in the offerings. We may now begin to see the pure digitisation of ownership and transfer in highly illiquid assets consisting of art, real estate, and private partnership interests become dramatically streamlined as a result of this evolution.
In some respects, regulated token offerings can start to serve as a bridge from traditional finance to the blockchain, creating fractionalised ownership of just about anything, with the ultimate ability to create active global markets 24/7/365 on top of base layer protocols including Ethereum. One such example is TheArtToken, which is backed on a one to one basis by a collection of well-known contemporary art. The goal for assets like these is that they can be listed on select global exchanges, and ultimately create unprecedented liquidity and fractionalised ownership in illiquid alternative assets like art.
While developments like the above are no doubt promising, much is still left to be accomplished before we see highly streamlined 24/7 trading markets for alternative assets and startups.
Bringing structure and regulation to blockchain finance is no doubt highly constructive and should ultimately support platforms such as Ethereum and others as the backbone behind decentralised digitised finance. Key remaining challenges include working towards uniform smart contract standards across multiple jurisdictions, deepening KYC/AML governance, and the emergence of leading global liquidity venues to name a few.