The UK’s Financial Conduct Authority has issued a warning to consumers about the risks involved with initial coin offerings, or ICOs.

The financial watchdog has warned that this new crypto trend is a very high-risk, speculative form of investment and that you must be conscious of the risks before getting involved.

Here’s what you need to know about ICOs.

What is an ICO?

ICOs are a new way for startups to raise money.

Instead of pitching their idea to a venture capitalist to fund, entrepreneurs can create their own cryptocurrency on the blockchain, or the ether blockchain known as Etherum, and sell it in order to raise capital for their business.

How does it work?

Instead of normal investment when people buy a stake in the company, ICOs are more like crowdfunding.

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If you support a Kickstarter campaign you will often pay a certain amount of money to receive that product when it is ready.

ICOs work in a similar way. Investors will buy into the ICO and redeem the coins of the new cryptocurrency for future goods and services from the company, like in a normal Kickstarter project, or sell them for a profit if the value goes up.

But investors do not receive any equity in the future success of the startup this way.

Who is doing it?

Loi Luu, co-founder and chief executive of the startup KyberNetwork, an ethereum-based trading platform, has just announced an ICO for his company.

He told Verdict an ICO is the “perfect fit” for the platform.

“We are introducing the token that will be native to our platform called KyberNetworkCrystals (KNC). These tokens will actually perform a function on our trading platform in that they will be required by 3rd parties who will be listing currencies on our network. 

“In every trade, a small fraction of the trade volume will be paid by the reserve to the KyberNetwork platform in KNC. This small fee represents the reserve’s payment to KyberNetwork, in return for the right to operate and earn profits from trading activities in KyberNetwork.”

As well, the digital coin offering is a way for the startup to building up a community of supporters for the new platform.

Luu said:

“We’ve gathered over 50,000 applications to participate in our ICO and we now have the largest Slack and Telegram communities in the world. An ICO allows this community to play a big part in our growth and future success.”

Companies aren’t the only ones using ICOs

Countries are getting involved too; namely: Estonia.

The digitally-focused nation is thinking about creating a digital currency through an ICO, called estcoins.

The new currency would be managed by the republic but accessible to anyone in the world through the country’s e-Residency programme.

According to a Medium post by the managing director of e-Residency, Kaspar Korjus, Estonia’s role as the digital nation makes it well suited for an ICO.

He wrote:

No other framework has come close to developing both the technology and the legal frameworks that would enable them to introduce and securely manage tradeable crypto assets globally.

In terms of “investing in Estonia” through the ICO, the founder of ethereum, Vitalik Buterin, is keen on the idea.

He said:

An ICO within the e-Residency ecosystem would create a strong incentive alignment between e-residents and this fund, and beyond the economic aspect make the e-residents feel like more of a community since there are things they can do together.

The funds raised through and ICO would enable Estonia to invest in new technologies and innovations. As well, it would act as a community-run VC fund to support Estonian companies.

In the UK city of Hull, an initiative named HullCoin is being heralded as a way to use the blockchain to create a cohesive community.

HullCoin’s founder, David Shepherdson, is considering a digital coin offering for the voucher-like currency.

Why should you care?

Due to the nature of ICOs, it means that anyone can invest in a startup.

Sure, the ordinary person missed out on investing in the likes of Airbnb and Uber, but the next unicorn startup could begin with a digital coin sale.

As well, it is becoming a big business for startups. According to financial research firm Autonomous Research, startups have raised over $1.2bn this year through ICOs.

Should you invest?

Like anything when it comes to investment, particularly concerning the internet, there are risks.

Despite the blockchain heralded as a secure and private way to transfer cryptocurrencies, hackers are still finding ways to carry out scams.

The FCA recently issued a warning in the UK, saying that consumers need to be aware of the risks involved with ICOs.

It said that ICOs are unregulated, offer no investment protection, have a high potential for fraud, and it is likely that investors can lose their whole stake in these early-stage projects.

According to research by New York-based firm Chain Analysis, phishing scams pretending to be ICOs on the ethereum blockchain have helped push criminal losses up to around $225m this year.

Chain Analysis believes more than 30,000 people have been hurt by ethereum-related cyber crime, losing on average $7,500 each.

If you are thinking about investing in an ICO, make sure it is legitimate before parting with any money. In addition, if you believe an ICO is a scam, then you can report it to the FCA here.