A large part of Ethereum's appeal is the ability for users around to world to create decentralized financial apps, or DApps, on the Ethereum blockchain. Software programmers worldwide band together to form decentralized autonomous organizations (DAOs) to develop new financial services. DAOs can create applications with their own assets on-chain, which can be stored and transferred like ether.
These assets are called tokens, and they must follow strict technical standards set by ERC-20. To start many DeFi projects, the DAOs raise money using an ICO to hire and pay for development expenses. When new tokens are created, many are sold to the public through initial coin offerings. For example, EOS raised $4 billion in a year-long ICO in 2019!
In an attempt to protect our money, regulators enforced new laws requiring descriptions for these tokens. Now a token can be either a utility token or a security token.
Many DAOs categorize their coin offerings as utility tokens because it allows them to bypass regulations.
However, utility tokens are inherently riskier because scammers often use ICOs to take our money and disappear. Additionally, utility tokens' value is speculative and entirely based on supply and demand.
As lawmakers are starting to put the screws to these offerings, very few utility tokens pass the Howey Test - more on that below.
When a company issues security tokens in an ICO, they grant the investor ownership rights and dividends.
From a legal standpoint, security tokens are identical to shares in the company. However, these tokens are less risky since they need to adhere to a set of compliance laws, and the value of these tokens is tied back to the value of the company/organization.
Tokens that pass the Howey Test are categorized as security tokens, while those that fail are classified as utility tokens.
As ICOs are becoming more regulated, helping boost confidence if you are interested in participating. However, this doesn't mean you are safe to let your guards down.
To help avoid ICO scams, you can go through the following checklist:
Make sure that project developers can clearly define what their goals are. Successful ICOs typically have understandable whitepapers with clear and concise goals.
Know the developers. You should strive for 100% transparency from a company launching an ICO.
Look for legal terms and conditions set for the ICO. Because outside regulators generally do not oversee this space, it's up to you to ensure any ICO is legitimate.
Make sure that ICO funds are stored in an escrow wallet. This is a wallet that requires multiple keys to be accessed. This provides valuable protection against scams because a neutral third party holds one of the keys.