Entrepreneurial start-ups, most often those focused on developing software programs and apps in niche markets, may issue virtual tokens to raise capital. These offerings, called Initial Coin Offerings, or ICOs (even though virtual tokens, not tangible coins, are offered) have become an increasingly popular fund-raising vehicle. Purchasers of these tokens include venture capitalists and hedge funds, as well as individual investors.

The initial sale of these tokens is similar to an initial public offering (IPO) of stocks.  Typically, the issuing firm sets the value of the token, which then fluctuates, depending on market demand, or what investors are willing to pay for them. Investors anticipate that the tokens will increase in value if the company’s product is a success. Investors also hope to share in the company’s earnings.

How Cryptocurrencies Are Valued

While the value of a virtual currency may, in fact, increase, it may also decrease or fluctuate widely, as Bitcoin has done since it was first introduced. The value is determined by the demand—or lack of demand—which may be influenced by the fortunes of the particular cryptocurrency, or the market interest in virtual currencies in general.

Since the market for cryptocurrencies is still comparatively small and trading is light, even seemingly minor market events or anticipated events can have an immediate and dramatic effect on their prices. So, if you were to buy Bitcoin or any other currency when the price was peaking, you could suffer a sizable loss if it suddenly plummeted, especially if you try to sell when the price is declining and the demand has softened.

Despite their volatility, virtual currencies are making inroads in traditional markets. One example is the BCGI Index that tracks the performance of the largest cryptocurrencies traded in U.S. dollars.

Security or Currency?

One of the issues facing regulators and legislators is how to characterize virtual currencies. The SEC, for example, argues that the tokens sold in an ICO are securities, and therefore subject to the same rules and regulations as stocks. That would mean, for example, that individuals and entities selling cryptocurrency-related offerings, such as ICOs, would need to be licensed and provide required disclosure information. They would not be permitted to use misleading information to market their offerings.

However, some groups have lobbied Congress and regulators to make digital currencies exempt from regulation. They maintain that certain cryptocurrencies—Bitcoin and Ether being two examples — function as “utility tokens” in commercial transactions and are not primarily bought and sold like securities. As such, they argue, these cryptocurrencies should be considered the equivalent of actual currencies and therefore not subject to regulation.

Next up: Cryptocurrency offerings can be extraordinarily risky.

                                                                                                                                              

The Investor's Guide to Cryptocurrency Offerings was funded by a grant from the Investor Protection Trust and written in collaboration with Lightbulb Press