For anyone that has been following crypto in 2017, hearing about the next hot ICOs has been par for the course. Having a phonetic similarity to IPO and only having 3 syllables when each character is sounded out, has definitely played to its “cool” factor. And, for folks that want to play up their hipness in the space, saying “īkō” as a 2-syllable word can sound even catchier.
Regardless of your stance on ICOs are, they are a novel fundraising phenomenon. Having largely been popularized by the founding of Ethereum in July 2015, ICOs standing for Initial Coin Offerings have taken the early stage technology market by storm.
What is an ICO?
But what exactly is an ICO? In short, ICOs are a global fundraising mechanism for blockchain-based technology companies. These companies issue a new cryptographic digital asset in exchange for more established cryptocurrencies such as Bitcoin and Ethereum. These companies typically use the raised funds for the launch of a brand-new company, and, in some cases, a new service or capability within an established company. The ICO mechanism has served as a launch point to make that possible. In return, ICO investors receive tokens at some predefined crypto exchange rate.
Generally, these tokens are expected to have platform utility and secondary market liquidity. This investment vehicle is highly speculative and risky. In a worst case scenario, any investor should be prepared to lose ALL of their investment.
The Speculative Why
Those unfamiliar with ICOs might be asking, “Why would anyone invest in such a thing?” Simply put, while the traditional investment world looks for ROI in terms of “%,” ICO investors are looking for returns in terms of “x.” Extreme ICO performance has yielded results in excess of 90x. Now, the possibility of a 9000% return in many cases is well worth the associated risk. While 90x is exceptional, a return of 200–400% in a matter of weeks or months has by no stretch of the imagination, been outside the realm of possibility.
And while all of this may seem like high stakes gambling, keep in mind that the highest payout when playing roulette, a popular casino game, is 35-to-1. And the lowest roulette payout is a matching 1-to-1. For those investing in the stock market, “beating the market” tends to mean beating a 6–8% year over year yield. When looking at speculative investment, there are few steroid-like options such as these, short of trading with leverage and buying up derivatives, such as options and futures contracts.
Typically No Equity
With rare exception, most ICOs to date have not issued any equity in their respective companies. This essentially means that they have in many cases raised millions of dollars without giving up ownership in their respective companies. (Note that this primarily holds true at the retail investor level. There are likely to have been equity terms provided to institutional investors that make larger investments in these companies, similar to what you would expect from traditional early stage capital markets. Also, I expect crypto token equity offerings are due to increase in the years to come.)
The Regulated Security Predicament
To make the ICO even more vexing of a subject, many of these ICOs have been executed under the pretense that their token offering is not a regulated security. While the Securities and Exchange Commission (SEC) in the United States has begun voicing their stance and taking action against companies who are clearly in violation of the certain terms that would qualify any investment as a security, many technology companies pursuing this funding mechanism have gone to great lengths to protect their tokens from being considered a security.
To date the SEC has:
- Released Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, №81207 on July 25, 2017,
- Provided a Statement on Cryptocurrencies and Initial Coin Offerings by the SEC Chairman James Clayton
- Issued its first cease and desist order against an in-progress ICO by Munchee, Inc., ADMINISTRATIVE PROCEEDING File №3–18304, SECURITIES ACT OF 1933 Release №10445, December 11, 2017.
Now if you were a company and you could raise millions of dollars without giving up equity, why wouldn’t you take advantage of this opportunity? While most would not say “no” to this type of funding opportunity, ICOs are not easy to launch, nor are they guaranteed to be successful. And the consequences of launching a failed ICO can be devastating.
Early Stage Capital and the ICO Market
In the age of startups, the early stage capital market has consisted of Seed and Angels investors, Venture Capital Funds, accelerators and incubators, specialized banking services, and various crowdfunding platforms. The crown jewels of these investment methods has typically been access to equity, future revenues, and in some cases control over the direction of the candidate company.
While I am confident that the early stage capital market is still alive and well, a shot over the bow was fired this June 2017. June was the first month where ICO fundraising took in over $500 million in equivalent crypto capital priced in US Dollars, whereas Angel, & Seed VC Funding in the Internet/Tech space was approximately $300 million. To put it bluntly, ICO fundraising on a per dollar basis was more than early stage capital in its equivalent category.
While this June ICO fundraising compared with traditional Early Stage Capital could have been an anomaly, July reinforced this market phenomenon. July ICOs were just over $300 million, while angel and early VC funding was just over $200 million. If you are an internet-based early stage investor, this recent trend is a troubling turn of events and has most likely made you reconsider your investment strategy and terms for getting into blockchain-based internet tech deals.
Red Flags, Controversy, and Bubble Rhetoric
Since ICOs issue a cryptocurrency and cryptocurrency is largely attributed to Bitcoin in mainstream media, the word “Bubble” is frequently thrown around. And for those who have been following additional cryptocurrencies that have also appreciated substantially in value the Bubble argument becomes even stronger.
So are we in a Bubble? This is a complicated topic and my personal belief is that the answer is both Yes and No.
Token price. If by bubble, you mean that some investors from the institutional to retail level are bidding up the price of newly issued tokens as speculative opportunities, then the answer is in some cases yes.
Token Supply. If by bubble, you mean that some of these companies executing ICOs are not effectively managing the supply of their tokens from ICO launch or through the maturation of the business, then in some cases the answer is yes.
Overcapitalization. If by bubble, you mean that some of these companies executing ICOs are receiving excessive amounts of capital, essentially overcapitalizing them, then the answer in some cases is yes.
Pre-product Ventures. If by bubble, you mean that some of these companies launching ICOs do not have an actual product and will eventually fail at building, deploying, or even growing a meaningful userbase, then the answer in some cases is yes.
Lack of Regulation and Investor Protection. If by bubble, you mean that there are little or no investor protections in place and that some investors will be outright defrauded and have no recourse for their losses, then this is a resounding yes.
Marginal Price Phenomenon and Asset Fragility. Crypto assets are trading in highly fragmented markets and the prices by which assets are trading generally do not reflect the true value of the underlying asset, but rather the marginal price of the last exchange of that asset. This is supply and demand economics at its best. Notionally, all of the circulating supply of those tokens inherently have the value of the last traded price, but varying degrees of asset liquidity combined with fragile market dynamics make these assets’ prices anything but stable and at high risk of crashing in the event of market sell-offs.
While there is much more to consider than just token price, token supply, overcapitalization, product risk, and general lack of regulation, the intent is not to painstakingly examine the bubble argument in gross detail, but to provide you with the traditional business case answer to the complex bubble question and tell you that — “It depends…”
Despite all of these bubble-oriented risks — there are positive trends emerging in this sizzling hot investment arena.
The Case for the Crash
As much as the blockchain and crypto community does not want to see a market crash, we may very well be heading for one. Millions of dollars in crypto are being sloshed around as if it is business as usual. The propagation of higher crypto values make it even easier for new ICOs to get funded.
Take for example someone who invested $10,000 in crypto. Let’s assume that over a period of 6–12 months they 10x’d their investment and now they are sitting on $100,000 of crypto. It is now possible for this individual to invest that newfound money. Let’s say this person wants to diversify in 10 ICOs each at $10,000 a piece. Previously, this individual would not have had this money available to invest, but now 10 new projects are getting $10,000 of new money being invested in them. No big deal, right?
Now let’s assume that the entire market 10x’d their investments over a comparable period of time and they also feel as if investing in ICOs is a sound investment vehicle. Now let’s say that there are 5 million people in the world that are holding $10,000 in crypto. At the onset this represents $50 billion of money in the system. After their holdings 10x, now their collective investable capital available is $500 billion… You get the idea. And with today’s market cap sitting just over $700 billion. These figures are comparable to reality.
This base case with retail investors having a uniform distribution of capital available to them is one way to look at this asset space, but this is not the case. The distribution is highly skewed with crypto whales and institutions wielding large amounts of crypto capital, and retail investors holding much smaller amounts. This market cannot cash out to fiat money and still remain intact. While there are an endless amount of hypotheticals that can be considered to sustain the current market environment in a relative homeostasis, I would like to highlight the following as critical requirements:
- New money needs to continue to be invested in the crypto market
- Existing crypto holders need to minimize cashing out and converting back to fiat
- Existing cryptocurrencies and ICOs need to merit their crypto market capitalizations by delivering real value
This drunk money phenomena combined with central governments’ need to maintain control over flows of capital and tax collections is precarious at best. Layer on the threat of the criminal underworld and terrorist financiers taking advantage of crypto’s unique capabilities and there may be harsh policies put in place for ICOs, crypto trading, general legality, and the ability for the traditional banking sector to interact with crypto customers and businesses alike.
The Case for Optimism
There are in fact positive market trends that present a case for real optimism, shoring up some of the risks and associated concerns mentioned above.
Blockchain technology is rapidly improving
- Increases in transactions per second
- Improvements to consensus algorithms
- Security protocols are advancing (consider Quantum Resistance initiatives)
- Protocols are becoming more interoperable
Smart Contract capabilities are advancing
- Code libraries are in development that will facilitate the automation and integration of efficient and reusable smart contracts
- Poorly designed smart contracts will be replaced with stronger code
Investors are getting smarter
- As the volume of blockchain-based projects ICOing increase, investors are forced to conduct stronger due diligence
- Terms such as overall supply, discount rates, lockup periods and governance models are just some of the many considerations investors are more closely looking at
Bad projects will fail
- As ICOs fail, the market will become even more efficient. Few things force markets efficiency than sudden losses of capital.
- The post-mortems on these companies will serve as lessons to the ICO investing community as to the indicators, timelines, and triggers related to the failure of blockchain-based companies.
Good projects will succeed
- Conversely, the indicators, timelines and core contributing factors that enable good companies to survive in their respective industries, markets, and technology stacks will serve as comparable points of reference for future investors.
Bitcoin correlation and market dominance decreasing
- The crypto market is slowly decoupling from Bitcoin. For sometime Bitcoin served as the bellwether of all things crypto. With each new project that comes online, the crypto market capitalization will become more distributed, slowly reducing the market cap percentage of Bitcoin
- While Bitcoin can spike in price offsetting the growth and market dominance of other cryptocurrencies, I am confident that the net effect of the price of Bitcoin will matter less and less over time.
- Decoupling is important so that ICOs and the market altogether do not react as harshly as it has to the rampant volatility that most Bitcoin holders are frequently subject to.
ICO Standards will continue to develop
There have already been attempts at creating ICO standards. These will likely become more robust in time. See the following links for some of the latest developments:
- Vitalik Buterin’s Decentralized Autonomous ICO (DAICO) where participants contribute ETH to a smart contract, and get tokens in exchange after the terms and requirements of the contract are met.
- Growth of self-regulatory initiatives such as Hong Kong-based Financial Commission on ICO Certification and the ICO Governance Foundation
- Russia Developing Global ICO Ratings Standard With 30 Countries
- Waves and leading market players are founding a new self-regulatory body to set standards for ICOs
- NEO-based ICO standards.
Government authorities will continue to implement guidance and enforcement actions
As there is an indisputable linkage between investor regulatory issues and the need for organizations such as the Securities and Exchange Commission (SEC) to deliver guidance on ICOs. Other regulatory bodies will also get involved.
Growth of Cryptocurrency
- Both institutions and retail investors are more widely adopting cryptocurrency. Data out of South Korea, a country representing one of the most active cryptocurrency markets, show that approximately one-third of its countries workers are crypto investors. And while there are ongoing efforts to regulate trading activity in South Korea, protecting the population from the associated risks of investing in crypto, the overall growth is staggering.
- The net effect of more market participants will likely be increased market liquidity and while many hope for market stabilization, I project that more liquid markets are resilient and that even in the wake of volatility, they will more quickly rebound than markets that are not.
Onset of Asset-backed Cryptocurrency, Putting Real-world Assets on Blockchains
- There are a number of ventures that are tokenizing real work assets. Some of the projects in this space include:
- Gold Tokenization. Digix Global and GoldMint
- Real Estate. ATLANT and Velocity Ledger
- Artwork. Maecenas and CryptoKitties
- Futures Contracts. Evermarkets
- Issuance of company equity. As tokens have the capacity to represent real shares within a company, the issuance of such tokens are on the horizon
Advancements in Blockchain interoperability
- While blockchain itself unlocks powerful capabilities through decentralization and newly deployed technology-based trust mechanics, advancements in blockchain interoperability will likewise unlock those “would-be” platform- based siloed features and capabilities with compounding effects.
- These advancements will flourish as we gain more integrations for protocols and solutions. Some highlights include:
- Interledger Protocol, sending payments across different ledgers
- ARK’s Smartbridge technology,
- Loopring’s Decentralized Exchange and Open Protocol
- Airswap’s Peer-to-Peer trading network
- Atomic Swap capabilities such as the cross-chain interaction between Decred (DCR) and Litecoin (LTC)
- Onchain’s Distributed Network Architecture (DNA). Onchain, the company behind NEO (the blockchain, commonly referred to as the Ethereum of China), has its eyes set on a well-developed inter-blockchain network.
The 2018 Outlook
Confused? Fearful? Optimistic? Welcome the club. We are in highly unstable and formative times as it relates to the overall health of the crypto markets. This market can be sent into a tailspin by the smallest of events or by many events occurring over a period of time.
The market continues to be shocked by news designed to spread FUD — Fear, Uncertainty and Doubt, the advent of derivatives markets, and seemingly excessive sovereign regulatory measures (e.g. outright bans on ICO investing and cryptocurrency trading) to name a few.
Antifragility. People have commented on Bitcoin as being an antifragile asset and that this may apply to a host of other crypto assets. But even if a number of crypto assets gain strength and resilience from market instability, that does not mean that it applies to the entire market landscape.
Blockchain Resilience. We do know now that blockchain tech is resilient, powerful and here to stay, but that does not guarantee that the crypto markets can continue to resist a crash. The boom bust cycle is all too familiar to those who have lived through the Dot-com bubble in the 1990s, the financial crisis of 2008, and the follow-on Euro-debt crisis through 2012.
I do predict that there will be a market crash (one that can be recovered from), but I do not believe that 2018 will be the year. This market is too promising, too new, and gaining too much media attention for their to be a mass exodus. I believe 2018 will be a year of unprecedented market growth whereby we reach a market capitalization of $1.5 trillion to $2.5 trillion globally.
Past that, we will need to continually assess the market environment and determine whether sustainable fundamentals are developing and shoring up major risk factors. Today, I am not a believer that the necessary fundamentals are there. Even despite this, I am quite optimistic about future market growth.
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