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“What everyone got really excited about was, hey, I can publish a paper and people will send me money.” — J. R. Willet, the creator of the first ICO.
This is a fascinating and revolutionary concept: pitch your product idea to the community, and if they like it, they’ll send you money to get your private business or decentralized application off the ground.
But an idea itself is worth very little. How an idea works in practice is of much greater importance. Unfortunately, this evaluation paints a story of scams, incompetence, recklessness, and greed.
On the face of it, an Initial Coin Offering (ICO) sounds very similar to Kickstarter, a popular crowdfunding resource where users can pre-order all kinds of physical products for future delivery. But ICO economies are functionally very different — and while their economic models can vary, there are numerous general differences to crowdfunding.
Kickstarter campaigns sell products, ICOs are selling financial services and investments.
ICOs do not sell physical products but sell financial instruments that allow investors to access products built by the startup — or otherwise engage with its economy in some way. The thinking goes that by applying the concept of ‘decentralization’ to a product and then allowing anybody to participate in, and benefit from the investment process, that they can create the new decentralized economic model of the future.
But there is one small problem with this. You see, apparently just about all countries have laws surrounding this type of thing, and most startup founders don’t think their ideology or business idea is worth being put in a cage.
The solution to this problem for most ICOs was to quickly remove any promise to directly benefit investors, by making them agree to be ‘donors’ instead. The tokens issued to these donors became exclusively for the digital rights to access the startup’s final product, and in no way would these digital rights give donors any claim to equity, profits, or any other benefit from the startup’s activities. I call this the “utility token defense”.
So, these digital ‘rights’ are kind of like vouchers then? — Well, not really.
If the buck stopped there, there likely wouldn’t be much more to this in the way of legal complexity. But the fact is that ICOs are financial instruments masquerading as ‘vouchers’ that have utility the likes of $50 gift cards for Walmart, Amazon, or Costco. But they are not.
ICOs are selling financial instruments that ‘can’ be utilized, not utility tokens that can be financialized.
People that invest in ICOs almost invariably expect a big return on their investment, and that is exactly how most ICOs have sold the opportunity by dishing out bonus tokens and slashing prices for people who participated in earlier rounds of funding. It is not uncommon for investors to purchase hundreds of thousands of dollars of these ‘voucher-esque’ tokens, because the main driver to purchase them is the expectation that they will be openly traded on cryptocurrency exchanges where they could sell for a higher price. These gains would accrue based solely on the efforts of a third party — mostly being the startup’s marketing and listing fee payments to big exchanges. You need just look at the incessant calls by users to get projects to list their shitcoin at ever more and larger exchanges for evidence.
The most rudimentary application of logic breaks the utility token defense, and points to the likely formation of an investment contract that would fall under the U.S. Securities and Exchange Commission’s (SEC) purview. This fact is not lost on the SEC, and after initially targeting only fraudulent scam offerings, the agency has begun charging ICO issuers and exchanges for selling and/or enabling the exchange of unregistered securities.
If any startup truly believed in their utility token defense, there would never be any need to have their coin trade at exchanges — since its purpose is to provide access to software. Investors wouldn’t mind either, since they just want to use the software, right? But this has not happened.
Analyzing ICO issuer and investor actions, along with the spirit that the law was written, reveals a clear intent to skirt securities laws designed to capture this type of scenario. If 2018 was the year of the ICO, 2019 is going to be the year of the ICO lawyer — and none of this spells anything good for confidence in the wider industry.
A story of scams and incompetence
I don’t think I need to spend much time validating the axiom that fast and easy money leads to a never-ending line of scam artists and incompetent developers vying for your money to either run away with or mismanage in their failure to deliver what was promised. It doesn’t particularly matter which, they’re both equally deceitful and investor losses were assured in both cases. These people would have been laughed all the way out the door by anyone in traditional VC.
Unfortunately, the two scenarios described above account for around 96% of all ICO projects to date, and the only reason it isn’t higher is that many of them haven’t failed “yet”. After nearly 30 billion dollars were invested in ICOs to date, not one application outside of new exchanges boast anything more than a trivial number of average daily users — a colossal failure.
The whole thing is based on faulty economics
Quite frankly, the idea that you can get something for nothing is absurd, and so is the idea that printing a ton of new currency won’t affect the value of the existing money supply, absent a commensurate value-add to the economy. ICOs were for people who thought that for every dollar pumped into the system, that two dollars could be extracted without consequences.
This is an interesting predicament, considering that Bitcoin was designed with an algorithmic money-creation process that would limit the loss of value from inflation like central banks cause when they print fiat money ad-infinitum. In modern economies, as new dollars enter circulation, each ‘dollar’ becomes worth less as the price of goods go up — e.g. a US dollar today is only worth 4 cents from 1913.
Functionally, inflation in the cryptocurrency ecosystem works slightly differently, but the end result is much the same. The creation of new ICOs inflate the value of the entire market’s ‘dollar-equivalent’ capitalization, rather than Bitcoin’s. The problem is that Bitcoin remains the only way to get back into dollars — and couched in a few assumptions for the sake of simplicity — for every dollar invested into an ICO, we can expect a minimum of two dollars that the startup and the investors will want to extract.
But how is the creation of non-ICO cryptocurrencies any different?
Now I’m aware of the claim from nocoiners (people that do not own any cryptocurrency) that: “Bitcoin isn’t truly ‘scarce’ because you can create new coins ad-nauseum,” and I imagine a lot of ICO fans would attempt to employ the same logic in defense here, but the mechanics of the two value ‘creation’ models and impact on Bitcoin’s price are very different.
First, new cryptocurrencies achieve their market valuation based on their substance and expected performance, ICOs are generally purely speculative vaporware. Both can raise the market capitalization of the crypto-economy equally, but inflation occurs when there is a rise in the money supply without a corresponding increase in value created in the economy (which doesn’t necessarily apply here).
Second, inflation is felt when new money is ‘spent’ in traditional economies, or ‘liquidated’ from the crypto-economy. Pure cryptocurrencies grow in market capitalization organically based on their substance — and so if $10 million was traded out into Bitcoin, there is no reasonable expectation that this would be liquidated into dollars at a rate any higher than average. In contrast, a large part of an ICOs initial market capitalization is purchased, and if the same $10 million dollars of Bitcoin is swapped in the ICO, we can be sure that most or all of it is going to be liquidated into fiat to pay for development and Lamborghinis — pushing the markets down as they do so.
But why then did the market continue to go up for a while if all these projects have tons of coins to dump?
Well, that’s partially because most startups were liquidating in phases to get the best prices, and they were enjoying a rapid increase in the value of their Bitcoin and Eth holdings as an ever greater number of new and larger ICOs were bringing even more money into the system, which easily offset the liquidations. This worked really well, until it didn’t.
A Ponzi scheme paid for by everyone who didn’t participate
Now this whole system can be very profitable for anyone if you’re good at musical chairs and know where to safely sit when everything turns sour, but the Eth & BTC liquidations by ICO projects into dollars are felt by everyone across the entire crypto economy, and not just their pool of investors.
ICO investors thus make everyone who didn’t participate a proxy financier of their gambles. The system represents a wealth transfer from value-creating investors to speculators and fraudsters who figured out how to steal from the money supply through inflation the same way that governments and banks do, albeit given the quality of most ICOs, I doubt most are cognizant of it.
But now the fun police have turned up to the party, and there are not enough “decentralized version of something that already exists” ICO projects to keep the punch bowl filled. Everyone is now hungover, and not surprisingly, the markets are in turmoil.
So, what is next?
On a more positive note, investors are beginning to smarten up and are doing away with the attitude where they expect ‘something for nothing’. We are also beginning to see some established best practices, and the introduction of new and improved token models that can be anchored to securitized assets like equity that provide intrinsic value within a legally-compliant Token-Generating Event (TGE).
Despite the growing pains and regulatory uncertainty, the concept behind the ICO makes for a phenomenally efficient, and more equitable capital formation system that has the potential to include regular people in early-stage investing and decision-making where they previously couldn’t. But to date the concept has done much more harm than good.