By Gertrude Chavez-Dreyfuss
NEW YORK (Reuters) - A small, but rapidly growing number of digital technology start-ups is raising cash by creating and selling their own currencies in offerings that bypass banks or venture capital firms as intermediaries and are outside the reach of financial regulators.
Investors are being drawn in on hopes that such "initial coin offerings" will match or exceed the performance of the first digital currency, bitcoin.
For the sellers, the appeal of selling their own currencies, or tokens, to raise cash is enormous. There is no paperwork as would be required for a public securities sale.
But the lack of regulatory oversight is raising red flags among some market experts and financial technology lawyers, some of whom even question the legality of the tokens.
Joe Zhou says he needed just 58 seconds to sell enough tokens to meet the roughly $5.5 million fund-raising target for FirstBlood, the online gaming website he co-founded.
"We had expected the sale to run for a month and we even gave the people who participated early-bird discounts because we were not sure how it would go," Zhou said.
The tokens sold by FirstBlood, like those sold by other companies, are the currency required to play games on the platform, for instance, or claim rewards for referrals.
For FirstBlood, a distinct advantage to having its own currency was to give gamers complete control over their funds, with no intermediaries such as banks involved, and with encryption features protecting against hacks.
The transactions are accounted for using blockchain, a ledger of transactions that first emerged as the software underpinning bitcoin and is maintained by a network of computers on the internet. Blockchain has gained traction on both Wall Street and Main Street, encouraged by the technology's ability to record and track the movement of assets.
Companies raising capital through the sale of tokens are all operating in the blockchain space.
The market is still tiny, but it has been growing at breakneck pace. About $225 million has been raised so far this year in 40 initial coin offerings (ICOs), compared with just $9.8 million in 2015, data from crypto-currency research firm Smith + Crown showed.
ARE ICOS LEGAL?
With such rapid growth comes wild swings in currency prices traded on digital asset exchanges such as Bittrex, and investors have no recourse or means to retrieve lost capital.
"What people are actually selling are just internet tokens that have no value, no legal meaning and represent no asset," said Preston Byrne, chief operating officer and general counsel at Monax Industries, a tech company that has developed a platform based on self-executing transactions called smart contracts.
Some market participants say ICOs could be illegal because the companies are selling tokens that can be considered securities, which fall under the Securities and Exchange Commission's jurisdiction.
The SEC declined to comment.
"Offering coins to retail investors as an investment, and then operating the scheme without registration, is probably against the law," Byrne said.
First Blood's Zhou does not want to call the company's coin offering an ICO, but prefers to call it a "pre-sale or crowd sale."
Lewis Cohen, a partner at law firm Hogan Lovells in New York, said if the issuer of the token intended to raise money from others for investment purposes, the coins being sold could be considered a security.
Cohen believes the SEC can investigate ICOs on its own, but he said that until there is concern that substantial money has been lost by any investor it seems to be taking a hands-off approach.
In deciding whether a coin sale is legal, Peter Van Valkenburgh, director of research at crypto-currency advocacy group Coin Center in Washington, said it is important to determine whether the token has a useful application, other than for investment.
"The SEC has a long-standing policy of not regulating securities that people buy and sell to use," said Van Valkenburgh.
He cited shares in real estate co-ops in New York City which are bought by people who plan to live in the apartment that the shares represent. The sale of shares in co-ops is not regulated by the SEC.
"So co-ops may be similar to the decentralized computing context," said Van Valkenburgh. "You may be buying the token because the price may go up, but you're also buying it because it has utility."
These tokens, whose sales are advertised in different cyrpto-currency forums and chat pages, are primarily bought by technology enthusiasts, software developers, as well as institutional and retail investors.
"Trust is the biggest factor in ICOs," said Jani Valjavec, director of technology and trading, at ICONOMI, which raised more than $10 million in a coin sale this year.
"People will always wonder: Are those guys for real? Are they going to run away?"
STEEP PRICE SWINGS
There are also concerns about the volatility of the tokens issued.
Smith + Crown data showed that the bulk of new currencies, launched this year typically dropped after trading on an exchange following their ICO.
Of the 28 start-ups that issued tokens in 2016, about two-thirds have seen the value of their currencies fall below their initial price at the coin sale, said Matt Chwierut, Smith + Crown's research director.
Crypto-currency markets are notoriously volatile, with big price swings over the course of days, Chwierut said. "It's not a market for the faint-hearted."
Jake Brukhman, a partner at U.S.-based CoinFund, which invests in these currencies, said the number of currencies that have useful applications is fairly small.
"There's a long tail of coins in the market that for the most part don't really add that much new technology," said Brukhman.
(Reporting by Gertrude Chavez-Dreyfuss; Editing by Megan Davies, Tomasz Janowski and Leslie Adler)