An ICO is a way for companies – usually start-ups – to obtain funding. With an ICO, the provider issues digital tokens by means of blockchain technology. ICOs have a cross-border nature: in principle, anyone with Internet access and a digital wallet can buy these tokens.
ICO funds are usually received in Bitcoins (BTC) or Ether (ETH). All token sales request cryptocurrencies – primarily either Ether or Bitcoin – in payment for the tokens. Fiat currency is generally not accepted. Given that most token sales are for Ethereum based Dapp tokens using the ERC-20 standard, Ether is the most common method of payment.
In explaining how an ICO functions, the paper analyses the steps taken by the company or project raising through an ICO. The project creates a Bitcoin or Ethereum address for receiving funds and displays it on a web page. This is like opening a bank account, and displaying it on a web page for people to send money to. Investors send BTC or ETH to the published address, in return for the new tokens. The project uses the BTC or ETH to pay staff or sell the cryptocurrency for fiat currency on a cryptocurrency exchange to fund the project.
Types of Tokens
Since tokens are essential for ICOs, the paper looks at tokens and the different types of tokens involved. Startups and mature companies have taken advantage of Ethereum’s smart contract functionality by building decentralized applications (Dapps) on top of Ethereum and creating their own unique tokens. Over time, a token standard called ERC-20 has been adopted which enables interoperability of tokens on the Ethereum network. The token standard governs a set of functions for each token, which in essence creates a template by which other ERC-20 compliant tokens can be cloned in a relatively simple manner. Companies that create tokens using the ERC-20 standard benefit by being able to interface easily with other tokens (for example, exchanging one token for another). In turn, this network effect increases the value of individual Dapp tokens. The majority of ICOs in the market today are the sale of tokens per the ERC-20 token standard for an Ethereum based Dapp.
Tokens vary widely in their design and function. Usually they represent a (prepaid) entitlement to the service to be developed, which may be a reward, or even have no value whatsoever. It may also be that they give entitlement to a share in a project or a portion of the expected returns.
The first token reviewed in the paper are work tokens. Work tokens give owners permission to contribute, govern, and/or “do work” on a blockchain. An example would be Maker (MKR), which gives owners the ability to govern an organisation that manages the stability of an underlying coin (DAI). Utility tokens are rights to services or units of services that can be purchased. These tokens can be compared to API keys, used to access the service. Asset-back token represent a claim on an underlying asset, and to claim the underlying one sends the blockchain asset (i.e. the token) to the issuer. Revenue tokens are tokens issued under the promise of participation in future revenues, even though there typically is no legal obligation for companies to honour such promises. Participation percentages and timing are almost always left undefined. Equity tokens represent equity in the issuing company, giving token holders votes as shareholders, participation in future dividends, and supposedly ownership of the company as well.
Initial Coin Offerings are crowdfunding and resource pooling mechanisms for projects, start-ups and ventures. Practically, token sales are fundraising events that can happen (1) before a company launches, (2) while a product is being built, or (3) after a product has been in the market for a while. Tokens which are issued as a result can represent almost anything depending on the structure and product. In fact, blockchains and the issuance of tokens are so flexible that they can almost be adopted to execute any structure, contract or product. As seen from the above literature, tokens can represent different things, give different rights and access to different utilities. Only after screening a token can a specific Shariah opinion be offered on the product.
When discussing the Shariah technicalities of tokens, the paper unravels what each token can represent from a Shariah perspective. If the tokens entitle one to a service, use of something or utility on a protocol, then the utility tokens would be classified as al-Huqūq al-‘Urfiyyah (customary rights). According to the classical Maliki, Shafi’i and Hanbali jurists, such tokens would be classified as Māl (property). Equity tokens represent a share in a company that has completed a token sale. This will be similar to trading in shares and investing in IPOs. From a Shariah perspective, the same rulings which apply to shares will apply to equity tokens. A business activity screening and a financial screening will be required before investing in such an ICO or network. When trading asset-backed tokens, the Shariah principles of buying and selling must be considered before trading such tokens.
ICOs have become a synonym for hype, unjustified valuations and excessive risk. On the other hand, blockchain can increase project transparency, decrease investor risk and develop into an effective financing tool for quality blockchain projects. The inherent nature, structure and use of ICOs must be analysed separately from fraudsters who use ICOs to usurp wealth of people to amateur investors speculating on tokens. The behaviours of such people are an extrinsic matter which would have separate rulings. Likewise, there could be certain activities of token issuers which may not be Shariah compliant. As the industry develops and more knowledge is gained, the Shariah principles regarding the industry will equally develop.