A week ago, I met the SmarTree core team in Seoul, Korea. Over our dinner with amazing Korean BBQ and Soju, our topic came across the recent fund-raising environment in the crypto space. It was interesting to note that the term “ICO” (Initial Coin Offering) which represented the most popular fund-raising method for blockchain projects in 2017 and 1H2018, was no longer at the heart of the conversation. Instead, “IEO” (Initial Exchange Offering), caught the curiosity of most of us at the table and led to a heated discussion.

A Win-win-win Situation?

The concept of IEO is not a new one. Instead of project teams issuing their tokens directly to investors through an ICO, IEOs only allow crypto exchanges to issue tokens to investors and collect funds from such investors for and on behalf of the project team. In return exchanges take a cut usually based on an agreed percentage of the total fund raised. Such a transition is a natural evolution of the crypto market. After reaching the peak of successfully raising US$4.17 billion worldwide in June 2018[1], ICOs entered its winter in the second half of this year. The reasons behind it are various, the most significant of which is the collapse of trust. Too many scams were proven and too many projects failed to proceed and succeed despite their genuineness. As such, investors’ appetite switched dramatically from investing in a mere idea based on blind trust to being distrustful and highly cautious on all the risks involved and requiring a minimal viable product. However, it is very difficult for investors to identify risks from a technical perspective as most of them are not IT or blockchain experts. In this regard, the crypto market calls for a more scientific way of connecting the projects and investors. IEOs make this possible, as the exchanges alleviate the distrust between investors and the projects by filtering the projects and picking the most promising ones for token offering. It is widely considered that such method provides ideal solutions to all parties involved, i.e. the exchanges, the project teams and the investors.

To Exchanges

There are currently 211 crypto exchanges worldwide listed on Coin.Market. It goes without saying that the competition is fierce, and the exchanges are looking for new ways of generating revenue in the bearish crypto market following the “Christmas fall” in December 2017. IEO is undoubtedly one of the most effective ways of bringing a larger client base, as well as increased trading volume, commissions and fees. Through IEOs, exchanges can also enhance their publicity and brand recognition.

To the Project Team

In order for a good project to survive, most of the resources need to be placed in IT development, R&D and security. Hence it is not uncommon that a project team lacks the expertise in AML and CFT checking, marketing and fund-raising which could be extremely time and cost consuming. With an IEO, the project team can save the hassle of doing things they are not good at and leave them to a party that can handle it in a professional and efficient way. IEO is a great example of labor division in the modern society. In addition, while nearly 90% of the ICO projects do not manage to list their tokens on an exchange[2], IEO brings a great benefit to the project team that their tokens can be listed on the exchange(s) immediately after the token offering is completed. By doing an IEO, the project team can eliminate the risk of failing to list their tokens and can easily save millions of dollars of listing fees that would have been charged by the exchanges nowadays in the case of an ICO.

To Investors

It is not hard to imagine how much easier it would be for an investor to rely on a reputable exchange and make an informed investment decision on an IEO, as compared to investing in a random ICO project with a whitepaper full of technical terms that no layman could possibly understand. Investors are also liberated from conducting due diligence on the project and the people behind it, disclosing their private information for AML and CFT checking to a team that may run away, and worrying that the tokens they bought will never be listed on an exchange and thus become non-liquid and worthless.

Potential Challenges

Considering the abovementioned benefits IEOs could bring, this upgraded fund-raising mechanism appears to be a perfect solution to the cryptocurrency ecosystem which achieved a win-win-win situation for the exchanges, the project teams and the investors. However, if you look closer and carefully examine the system with a magnifier, is it truly flawless?

Is the exchange trust-worthy?

Exchanges are the key of the entire IEO process. However, such fund-raising mechanism would only work based on the assumption that the exchange in question is a reliable and trust-worthy one. Both the project team and the investors need a middleman they can trust to carry out the whole process of issuing tokens and collecting funds, and to make sure that every stakeholder is fairly treated. But what if the exchange is in a biased position to list a scam project or to put the funds into its own pocket? Or what if the security of its trading system is comprised? Should the exchange be solely responsible for the stakeholders’ loss since it has the discretion of holding the IEO? Who can regulate and enforce its activities and performance? All these issues remain to be addressed before IEOs could work in favor of the stakeholders.

Do exchanges need a license to carry out IEOs?

Despite the decentralized nature of blockchain, in reality it is hard for the industry not to catch an eye from the authorities that govern the old world. With the increasing number of crypto exchanges being established every day globally, governments in different jurisdictions use different approaches to regulate the exchanges in the hope that investors’ interest will be protected to the largest extent. For instance, Japan chose a relatively straightforward approach of granting approvals to specific exchanges operated in the country. In September 2017, the Financial Services Agency in Japan approved 16 exchanges which allow cryptocurrencies to be either exchanged for fiat currencies or alternative cryptocurrencies. The Monetary Authority of Singapore (“MAS”), on the other hand, took a more arbitrary approach under the existing regulation framework that cryptocurrency exchange operators which allow trading of tokens constituting “capital markets products” under the Securities and Futures Act (Cap. 289) (“SFA”) will need to seek the MAS’ approval, recognition or exemption under the SFA. By contrast, Malta, the “blockchain island” in Europe, recently put their brand-new law (The Innovative Technology Arrangement and Services Act) which regulates the establishment and operations of crypto exchanges into effect. Finally, on 1 November 2018, the Securities and Futures Commission in Hong Kong (“SFC”), which is known as one of the most conservative and rigid regulators in the world, issued a statement on regulatory framework for, among other things, virtual asset trading platform operators (i.e. crypto exchanges). According to the statement, the SFC is exploring the possibility of regulating exchanges operated in Hong Kong under its existing powers and indicated that in the initial exploratory stage, it would not grant a license to exchanges.

There are certainly more regulatory frameworks being established and more bills being passed into law in other jurisdictions with respect to crypto exchanges. However, if I want to know whether exchanges need a license to carry out IEOs, I am afraid that I cannot find an answer in any of the above-mentioned regulations. Because all such regulations still remain at a very high level without any enforceable details as to the scope of services to be provided by the exchanges, their operational procedures, as well as the penalty mechanism in case of breach of obligations and so forth.

Conclusion

The regulatory development of crypto exchanges is still in its preliminary stage. In the absence of a comprehensive and mature legal environment for exchanges to function with credibility, it is difficult to judge whether IEO is superior to ICO and whether it will become the next mainstream fund-raising tool for blockchain start-ups. But what can be certain is that the market will always find its best way to evolve and to serve what ultimately matters: life-changing technologies.

[1] According to the statistics provided by  https://icowatchlist.com/statistics/year/2018.

[2] https://icoeconomist.com/index.php/2018/11/01/are-ieos-the-new-icos-what-is-an-initial-exchange-offering-ieo/