Insights at UBC Sauder

Raising business capital through blockchain: the ICO issuer’s “trilemma” explained

Posted 2018-12-18

The “brave new world” of blockchain, cryptocurrencies and digital assets is developing and changing at such a rapid pace, it’s hard to keep up – not only for the public, but for regulators, the financial industry and for entrepreneurs who are active and constantly entering into the space.

In this Q&A, we talk to Dr. Chris Rowell, a Postdoctoral Research Fellow and lecturer in Organizational Behavior at the UBC Sauder School of Business, who is currently researching the emergence of the global blockchain field, and discuss an interesting phenomenon his work in the field has identified: the regulatory “trilemma” faced by companies that want to raise funds via initial coin offerings (ICOs).

Can you explain the difference between a more general cryptocurrency like Bitcoin, and an initial coin offering (ICO) that a company issues to raise funds?

Yes, that is an important distinction. There are a few different definitions floating around which can get confusing, but generally the term “cryptocurrency” refers to digital assets like Bitcoin that are intended to function like money in general, and that have their own blockchain. Blockchain technology allows these cryptocurrencies to be owned and transferred without the authentication of any third-party intermediaries. So they exist on a distributed network of computers that nobody really owns or runs, and so has no centralized profit motive. This also means that they are likely never going to be regulated because, first of all, there’s no one to go after, and secondly, there’s no way for anyone to take control of the network without over 50% of participants agreeing with them.

Alternately, entrepreneurs have discovered that they can raise funds for their own companies to fund a specific venture through an initial coin offering (ICO). Often, they do not do this by creating their own blockchain, but rather create their own digital tokens on an existing blockchain such as Ethereum. So this brand new kind of technology has emerged, and this new funding practice started with it, and it proliferated very quickly over the past year. All of a sudden, we had an influx of digital financial assets that could be sold to virtually anyone in the world that had internet access.

The thing is, it was this regulatory grey area: no one was really sure how this actually connected to the existing financial sector, so lots of people were taking advantage of it – just issuing new digital tokens and selling them, making a lot of money for their businesses, and it didn’t seem like there were any hurdles to doing that. All of a sudden, you could just sell something online to anyone in the world, and raise huge amounts of money for it. But then, many of them started getting in trouble from regulators.

What was the trouble?

So in researching what was unfolding, we talked to people in the existing finance space, including regulators, lawyers, accountants, venture capitalists, and investment bankers, and then we talked to a lot of these entrepreneurs, the token issuers, and we found that the two sides had really divergent views of how they saw this new space.

It took some time, because regulation always lags behind new technology, but the regulators eventually said “ok, actually what you are doing is issuing securities in your company.” Especially if you are a private company, you need to know who your investors are – you need to perform certain checks of identity which prevents money laundering and other fraudulent activity. Investors in private ventures often have to be accredited investors, because the regulation exists to protect people that really don’t have the money to lose.

Now, the entrepreneurs didn’t understand why they should be regulated in this new space, whereas everyone from the existing financial space thought it was really obvious – to them, these ICOs closely resembled securities, and needed to be regulated. They couldn’t understand why the entrepreneurs would be doing this in the first place, but they really didn’t understand the technology that was facilitating it.

So there was this big gap in understanding between what this new technology was, what its capabilities and potential were, and why it was connected to the old established financial system. So this conflict started to unfold between the two sides.

Can you explain the regulatory compliance “trilemma” that you discovered?

Our research found that entrepreneurs issuing ICOs for their companies currently face a compliance “trilemma,” whereby they can achieve only two of the following three goals: cost-effectiveness, access to widely distributed investors, and regulatory compliance.

For example, an issuer can stay compliant for a relatively low price by restricting sales to a limited group of investors, such as their rich friends or large venture capitalists, because verifying their identity, country of origin, and whether they meet regulation guidelines to hold these types of assets is fairly simple and cost effective, but then they are sacrificing the scope of investment.

In the second case, where an issuer is trying to remain compliant with a wide distribution of investors, this is almost always cost-prohibitive and they end up forgoing the ICO entirely. The high cost is because issuers have so far been tracking their investors manually, which can become incredibly expensive considering that these assets, once issued, can change hands on the secondary market multiple times, and regulations are different in every country.

The third case was fairly common up until the beginning of 2018 – issuers were sacrificing compliance by directly defying regulators, selling widely and making a lot of money, while hoping to remain under the radar, but this is now catching up to them.

So what is the solution to the trilemma?

As a short term solution, there are new regulatory technologies emerging that allow ICO issuers to program rules directly into their tokens, which can make them automatically compliant with the financial regulations in countries where they are traded. Only people who are pre-approved, or have proved themselves that they are allowed to hold these assets legally, would be able to hold them. You’re effectively obtaining a license to hold these assets, and if you don’t have a license, the assets just won’t be sent to you, the trade will be blocked. This way, the regulators don’t have to worry about policing things, they can just set the rules, and then issuers can program these rules into their tokens so that they can be enforced automatically.

What about in the future?

In five years or so, I think these rules could be built directly into a blockchain network, that way nobody would be taking any transaction fees and nobody would really be profiting from it. It’s too hard to do at the moment, the technology is just not ready, and so it’s being handled by profit-seeking companies.

What will be really interesting is that once this happens, it will only be a matter of time before all traditional shares will be put on a blockchain, or will use some type of blockchain-like technology. It’s just so much easier and cheaper to keep track of, and to buy and sell.

So you think, at the moment we have these big exchanges that facilitate trades of shares between people, but supposing we could just issue them as digital assets, rather than share certificates as we do currently. Once this happens, what are these big stock exchanges going to do? How will they justify taking big transaction fees from people moving shares around when you don’t have to go through them at all?

What is next for your research in this area?

I think we would study deeper the conflict between the incumbents in the area and the entrepreneurs. All the incumbent lawyers and regulators were really unsurprised that these entrepreneurs were getting in trouble, but the entrepreneurs were surprised. So we want to actually study and model the translation process between those two groups more.

At this point, our research is very preliminary – we only have six months’ worth of data, so it’s not really theoretically interesting, it’s more of a snapshot of the industry, the current state of the blockchain and ICO market. There are some things that we want to look into more that would advance theory, but we would need more data on those specific things in the next phase, a bigger sample size, and talk to more people to confirm the early intuitions and observations that we have had. We would use what we have done so far as an example of a broader phenomenon that contributes to management/organizational theory, so we could build theory around it.

Dr. Chris Rowell is a lecturer in Organizational Behavior at the UBC Sauder School of Business. His interests focus on new market and industry emergence, digital platform strategies, and strategy and organizing in distributed networks. He is currently following the emergence of the global blockchain field with an emphasis on North America, and has worked with multiple organizations to advance their blockchain strategies.

Dr. Rowell will be teaching “Blockchain: Applications and Disruptive Opportunities,” taking place March 22 and July 18, 2019. This one-day Executive Education workshop will help learners understand the core concepts, implications and opportunities of distributed trust technologies such as blockchain from a business (non-technical) perspective, and how they will disrupt business and industry. For more information and to register, see the Executive Education course page here.