ICO Market Makers: When the Market Turns into a Bazaar

‘Market makers’ are fueling the cryptocurrency industry, but their methods of operation may jeopardize the foundations on which it stands

by Roy Keidar, Special Counsel, and Adrian Daniels, Partner, Yigal Arnon & Co

Initial coin offerings (ICO) of cryptographic tokens is a relatively new phenomenon in the global economy. For a little over three years, such ICOs have been challenging rules and norms that were formed over many decades. As in any trend, there are those who skillfully take full advantage of the immature market and reap the largest benefit even in the price of stretching (some would say over-stretching) the legal boundaries. They call themselves ‘market makers’.

The ‘Underwriters’ of the cryptocurrency industryMarket makers are individuals and companies, well immersed in the global cryptocurrencies industry, who offer their services for startup companies in selling their tokens to various potential purchasers at variable commercial terms. The most successful market makers in this field have assisted entrepreneurs raise substantial amounts of money, some raised over $100 million.

Market makers are by no means unique to the ICO industry, and have long existed in traditional capital markets, usually functioning as “underwriters,” with an important role in helping companies that go public, sell their shares to institutional investors. Functioning as underwriters usually entails close familiarity with local capital markets; assisting the company in preparing its IPO documents, notably the prospectus; and most importantly helping the company secure the amounts of money that the company needs for the IPO to meet its goal. Underwriting in capital markets is, however, tightly regulated while crypto market makers have basically no regulatory restrictions.

High remuneration may affect future crypto market priceThis can cause some serious legal issues. Take for example the remuneration model. Some market makers are remunerated through allocation of seller tokens (sometimes in addition to cash, payment in other cryptocurrency such as Bitcoin and Ethereum, or equity in the issuing company). This comes in the form of a bonus for each coin they manage to sell. These bonuses can potentially be extremely high, occasionally 100% over the selling price. If the market maker manages to sell most of the offered tokens, it can end up holding most of the tokens sold. Therein lies the problem; the market makers seek to liquidate their tokens by selling them on the secondary market. In fact, they have a bigger incentive to do so than any other player, because they hold a substantial share of the market. Some of them have direct relationships with exchanges. Sale on secondary markets, especially shortly after the ICO, could cause a significant fluctuation in the value of the coin, and adversely affect other purchasers. Resolute entrepreneurs stipulate a no-sale period for the market makers, which can range between several months and three years, but even so, size matters, and if the market maker has a large share of the market, it can manipulate the value of the currency which might be unfortunate to the current token holders.

Using syndicates to bypass regulationAnother common method market-makers deploy is working with syndicates. These are groups of investors that join forces for the purpose of buying tokens. Their interests are financial. They don’t buy the currency for the underlying service or product, but in order to liquidate it within a relatively short time. Syndicated investors have a threefold advantage: they have better commercial leverage than if working separately; usually, the transaction is entered vis-à-vis a lead investor who, for securities regulations purposes, is considered a qualified (accredited) investor, or is a resident of a jurisdiction that allows investments of this kind; and only the lead investor goes through the KYC procedures required under anti-money laundering laws, while the other syndicate members do not have to be identified (many cryptocurrency investors highly value their anonymity).

The advantage of market makers is their ability to reach such syndicates and close relatively big transactions with investors from different jurisdictions. However, this method leaves the entrepreneurs with little control over the issuance process and in many cases no control over the issue price. In some situations, the market makers offer several currencies as a bundle, and the proceeds are divided among all the offerors, in a manner that does not adequately reflect the actual market interest in each of the bundled currencies. From a legal perspective the most significant concern is that entrepreneurs might find that their tokens had been sold to unauthorized individuals, thus exposing them to sanctions under securities laws.

Losing control of the company’s legal and commercial representationsAnother aspect to consider is the manner in which the issuing company makes its representations. The practice in the last few years has been that instead of a prospectus required pursuant to the securities laws, cryptocurrency issuers would issue a ‘White Paper’ with all the relevant representations. Such representations are needed for the buyer to know exactly what he is buying, and so that the parties have clarity regarding the nature of the product. Representations made on the White Paper are contractually binding against the seller. In other words, in case of a misrepresentation or omission of a material fact, the issuer could be subject to contractual or damage suits. As long as the entrepreneur controls the process, it is likely in his best interest to offer full and accurate disclosure; but when the issuance is managed by a third party, this interest is not so clear. Companies may be exposed to legal action for representations made on their behalf, without their express consent. This concern could be mitigated through legal disclaimers and term & conditions, but cannot be completely removed where the issuer does not control the sale process.

Time for regulators to step inAs the cryptocurrency market continues to develop, we anticipate the further emergence of ‘maker makers’. Already today we see them as probably among the most dominant players in the cryptocurrency industry, second only to exchange platforms managers. The problem is not with the role that they play, but with the methods that some of them have adopted over time. If the regulators intend to step in, protect investors, assure market efficiency and fair trade, they would be well-advised to start with the market makers. In an industry that is gradually moving from the avant-garde to a more mature stage, this is an imperative regulatory move, without which the cryptocurrency market will be less of a market and more of a bazaar.