ICO Market Makers: When the market turns into a bazaar
Market makers power the cryptocurrency industry, but their methods of operation can jeopardize the foundations on which it rests
Initial coin offerings (ICOs) of crypto tokens are a relatively new phenomenon in the global economy. For just over three years, these ICOs have been defying the rules and norms that have formed over decades. As with any trend, there are those who skillfully take full advantage of the immature market and reap the greatest profit, even at the cost of stretching (some would say exceeding) legal limits. They call themselves “market makers”.
The ‘Subscribers’ of the Cryptocurrency Industry
Market makers are individuals and companies, well-immersed in the global cryptocurrency industry, who offer their services to start-ups by selling their tokens to various potential buyers on varying trading terms. The most successful market makers in this space have helped entrepreneurs raise substantial sums, with some having raised over $100 million.
Market makers are by no means unique to the ICO industry and have existed for a long time in traditional capital markets, typically operating as “firm guarantors”, with an important role in helping companies that go public sell. their shares to institutional investors. Operating as underwriters generally involves in-depth knowledge of local capital markets; assist the company in the preparation of its IPO documents, in particular the prospectus; and most importantly, helping the company get the money it needs to make the IPO successful. Capital markets underwriting is tightly regulated, however, while crypto market makers have virtually no regulatory restrictions.
High compensation can affect the future price of the crypto market
This can lead to serious legal issues. Take for example the compensation model. Some market makers are compensated by the allocation of seller tokens (sometimes in addition to cash, payment in other cryptocurrencies such as Bitcoin and Ethereum, or shares in the issuing company). This comes in the form of a bonus for every coin they manage to sell. These bonuses can potentially be extremely high, sometimes 100% above the sale price. If the market maker manages to sell most of the tokens offered, they may end up holding most of the tokens sold. Therein lies the problem; market makers seek to liquidate their tokens by reselling them in the secondary market. In fact, they have more incentive to do so than any other player, as they hold a substantial share of the market. Some of them have direct relations with the exchanges. Selling on secondary markets, especially soon after the ICO, could cause the coin’s value to fluctuate significantly and hurt other buyers. Resolute entrepreneurs stipulate a no-sell period for market makers, which can range from several months to three years, but even so, size matters, and if the market maker has a large share of the market, they can manipulate the value of the coin which could be unfortunate for current token holders.
Using unions to circumvent regulations
Another common method deployed by market makers is to work with syndicates. These are groups of investors who join forces for the purpose of buying tokens. Their interests are financial. They do not buy the currency for the underlying service or product, but to liquidate it in a relatively short period of time. Syndicated investors have a triple advantage: they have better trading leverage than if they worked separately; generally, the transaction is entered into with a principal investor who, for the purposes of securities regulations, is considered to be an accredited (accredited) investor or is a resident of a jurisdiction which authorizes investments of this type; and only the lead investor goes through the KYC procedures required by anti-money laundering laws, while other syndicate members do not have to be identified (many cryptocurrency investors place great importance on their anonymity).
The advantage of market makers is their ability to reach such syndicates and conclude relatively large transactions with investors from different jurisdictions. However, this method leaves entrepreneurs with little control over the issuance process and, in many cases, no control over the issuance price. In some situations, market makers offer multiple currencies as a bundle, and the proceeds are allocated among all bidders, in a manner that does not adequately reflect the true market interest in each of the bundled currencies. From a legal point of view, the most important concern is that entrepreneurs could discover that their tokens have been sold to unauthorized persons, thus exposing them to penalties under securities laws.
Loss of control of legal and commercial representations of the company
Another aspect to consider is how the issuing company makes its representations. The practice over the past few years has been that instead of a prospectus required under securities laws, cryptocurrency issuers would publish a “white paper” with all relevant statements. Such representations are necessary so that the buyer knows exactly what he is buying and so that the parties have a clear idea of the nature of the product. The declarations made on the White Paper contractually commit the seller. In other words, in the event of misrepresentation or omission of a material fact, the issuer could be the subject of contractual proceedings or for damages. As long as the contractor controls the process, it is probably in their interest to provide full and accurate disclosure; but when the program is managed by a third party, this interest is not so clear. Businesses may be subject to legal action for representations made on their behalf, without their express consent. This concern could be mitigated by disclaimers and terms and conditions, but cannot be completely removed when the issuer does not control the sales process.
It’s time for regulators to step in
As the cryptocurrency market continues to grow, we anticipate the emergence of “makers of makers”. Already today, we consider them probably among the most dominant players in the cryptocurrency industry, second only to exchange managers. The problem is not in the role they play, but in the methods some of them have adopted over time. If regulators intend to intervene, protect investors, ensure market efficiency and fair trading, they would be well advised to start with market makers. In an industry that is gradually moving from the cutting edge 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.
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