At this time, there are already thousands of cryptocurrencies out there—with more in the making. Have you ever wondered how some of these new cryptos came to fruition?

Although we can’t speak for all cryptos, some of the biggest cryptocurrencies, including Ethereum (ETH), have spawned from initial coin offerings (ICOs).

What are ICOs and how do they work?

An initial coin offering (ICO) is like a fundraiser for cryptocurrencies. People put money into developing crypto and in return, they’re rewarded with new tokens. Then, the ICOs take the money they raised and use it for the development of the coin.

When an initial coin offering begins, a full whitepaper is published, outlining what the project is about, the need it’ll fulfill when finished, how much money it needs, how many tokens the developers will keep, what kind of funds will be accepted, and how long the campaign will run. During that campaign, supporters of the project buy tokens using crypto or fiat currencies.

Suppose the project is able to raise enough money within a specific timeframe (successful ICO). In that case, the funds raised will be used to pursue the goals of the project. However, if the project doesn’t achieve the minimum funds (unsuccessful ICO campaign), the funds can go back to the investors.

This kind of campaign was popularized in 2014 when it was used to help develop ETH. Since then, there have been hundreds of other initial coin offerings looking to get funded.

Many people compare ICOs to initial public offerings (IPOs), and in a way, they’re kind of similar. It’s just that initial coin offerings are the cryptocurrency industry’s equivalent. However, the goals and situations of the two are typically different. ICOs are usually more of a fundraising mechanism, while IPOs are used for already-established businesses looking to sell the company’s partial ownership to obtain funds.

If you buy shares from an IPO, that essentially means that you own a percentage of the company. On the other hand, if you buy tokens from an ICO, that doesn’t necessarily mean that you own part of the project.

How are ICOs regulated?

Initial coin offerings are regulated differently depending on where you are in the world. For example, in the United States, ICOs are completely legal. However, the Securities and Exchange Commission (SEC) uses something called the Howey Test to see if the ICO is a regulated security offering or not. The regulations in the European Union also closely mirror the U.S. approach.

The Howey Test determines if a transaction is considered an “investment contract” and therefore subject to securities law and regulations. If an ICO is considered an investment contract pursuant to the Howey Test, it may be regulated like any other public stock, registered, and must follow strict securities laws.

Essentially, all of that means despite ICOs not all being regulated, the SEC may still intervene. Take the Telegram incident as an example. In 2018-2019, the Telegram Group raised 1.7 billion USD in an ICO. However, the SEC took issue with their activities because of alleged registration failures by the development team.

Last March, the District Court for the Southern District of New York issued a preliminary injunction. The injunction resulted in Telegram having to return 1.2 billion USD to the investors and then pay a civil penalty of 18.5 million USD.

What are the risks of an ICO?

As with almost anything in the cryptocurrency market, there are definitely risks with ICOs—for both buyers and organizers.

Despite more regulators figuring out how to regulate cryptocurrencies, the market is still very under-regulated. There won’t be anyone to help you if the ICO you invested in turns out to be a scam or if the project fails. ICO organizers, on the other hand, can fall into a trap through financial regulations.

As an investor, here are a few risks to take note of:

  • The hype can sometimes exceed its actual value.
  • You run the risk of investing in fraud or a pump-and-dump system.
  • It can sometimes be hard to get the full picture of an ICO before you invest.
  • The price of the tokens can be purely speculative and wild fluctuations are possible.
  • There’s sometimes limited transparency on the progress and issues of a project.

As an organizer, here are a few risks that you should know about:

  • The uncertainty in regulations can lead to extra fines, costs, or penalties.
  • You have little to no information about token holders.
  • You take responsibility if the security of projects is jeopardized and ultimately damages investors.
  • The interest in ICOs has been on the decline since 2018.

Both buyers and organizers face risks and must carefully weigh them out before putting any money or work in.

How to spot fraudulent ICOs

Unfortunately, there are many bad apples out there just waiting to lure unsuspecting victims into investing in a bad offering. If you see a project that you’re interested in investing in, look out for possible red flags:

  • People from the development team using fake social media profiles or fake identities
  • The whitepaper and business model are unrealistic
  • There is no working prototype
  • The development team’s roadmap isn’t clear
  • The team lacks relevant experience
  • The team’s code doesn’t transfer code to GitHub
  • The PR work isn’t credible, or there’s no positive mention of the project
  • The team doesn’t use an escrow wallet to deliver investor funds to developers only if specific criteria are met

These are just a few red flags out there, so always be on the lookout before investing.

There are risks, but there are also rewards

Indeed, fraudulent initial coin offerings aren’t uncommon, but that doesn’t mean that all ICOs should be avoided. There are still great projects out there, and you’ll just have to do your research and find out whether or not the ICO is credible or not. If you’re able to find a decent one, then you could have the chance to enter a market from the very beginning—if it turns out to be successful, you could be seeing some big profits!

Try to identify the red flags as soon as possible to stay safe. Remember, in this space, knowledge is power and the more you know, the safer you’ll be.

*The content of this article is for informational purposes only. You should not construe any such information or other material as legal, tax, investment, financial, or other advice.