This week Tim Bennett looks at the explosion of cryptocurrency Initial Coin Offerings (ICOs) and explains why regulators are watching them closely.

Bitcoin basics: What are Initial Coin Offerings (ICOs)?

A few years ago, barely anyone had heard of cryptocurrencies such as Bitcoin and Ether. Now they are fuelling the latest investment craze, the likes of which we have not seen since the Dotcom mania of the late 1990’s. Hot on the heels of Bitcoin (the best-known cryptocurrency) have come a small army of rival offerings. These are typically brought to market by way of the Initial Coin Offering (ICO). So this week I take a quick look at what these are and whether you should get involved. Be warned before we start: this is a guide written for curious investors, not technology boffins!

A basic definition

The ICO has become the latest hot topic in the cryptocurrency world and in the process has attracted attention not just from excited investors but also of a rather different sort from both the Chinese government and the US regulator. So what are ICOs? A working definition would be this;

In a nutshell, these are Initial Public Offerings (IPOs) combined with crowdsourcing, for the cryptocurrency markets. But first, a word or two about the currencies themselves.

Bitcoin basics

I will leave the technicalities of Blockchain technology, of which Bitcoins are the most widely-known but not the only, manifestation, to the many good books, articles and blogsites devoted to the subject.

For a budding investor, the basic mechanics of dealing in cryptocurrencies are pretty simple to describe, if a little harder to execute in practice than some of the marketing hype would have you believe.

Fans of Bitcoins (and their many rival currencies) claim that this cheap, transparent, web-based currency, that operates completely independently of central banks (so it is free from central controls and the vagaries of monetary policy), will one day perhaps replace existing currencies altogether. Combine that ambitious belief with, what its original authors say is, a finite supply of Bitcoins and you have most of the reason the price has rocketed many thousands of percent since it launched. In any market, a compelling story, coupled with limited supply, tends to create huge demand.

Bitcoin holders can, in theory at least, do all of the things that you can do with a conventional currency, only cheaper and more securely (claim its fans) thanks to the permanent and immutable transaction trail created by Blockchain within the virtual community in which it sits. Having bought Bitcoins and stored them in a virtual wallet, you can choose to hold onto them, spend them or swap them for another cryptocurrency or “tokens” (see below). This is where the ICO comes in, about which more shortly.

A no-brainer or a crazy scam?

Few new asset-classes have divided opinion like cryptocurrencies. To some the underlying Blockchain technology is so transformative that it justifies sky-high prices for its most visible products such as Bitcoin. To others, the whole thing is smoke and mirrors – yes, the technology may have value but that cannot explain the misplaced euphoria around Bitcoin and its rivals. Here are just a few viewpoints;

Blink, and it’s expanded

One thing is for sure, this is a fast-growing market. The estimated value of Bitcoin alone (at the time of writing – by the time you read this, it will have changed!) is around double that of the market capitalisation of some of America’s biggest investment banks;

What is notable is that much of the recent money that has poured into this area has done so by way of the relatively new, Initial Coin Offering (ICO). So what does this latest buzz-phrase mean and why are ICOs all the rage?

“An IPO within the Blockchain environment” (techcrunch.com)

The ICO has become the latest manifestation of the current craze for cryptocurrencies. Here is a short description of how they work. Like an Initial Public Offering (IPO) in the shares market, these bring together two parties, here called promotors (developers basically) and investors;

However, whilst the basic structure of a deal looks similar (below) there are some quite big differences between IPOs and ICOs, which are summarised here too;

The biggest one is that whereas issues of new shares in the IPO market are quite tightly regulated, the issue of new currencies, or tokens, in the crypto-market is not. At least, not yet.

The basic process

In an attempt to lend credibility to what can be a fairly fast-and-loose funding environment, ICO promoters have devised a process built around the biggest ICO in recent times that was used to launch a Bitcoin rival called the Ether. Whilst not every ICO follows this process (remember, there is no regulation in this market) nonetheless quite a few chart a course that looks something like this;

A key stage for aspiring investors is number two above – the White Paper. These can be relatively short, or lengthy and quite technical. They are vital, because often you will have little else on which to base a decision to invest. It really is “caveat emptor” in terms of the need to do due diligence on the promotors, their stated aims and whether you think they can deliver.

Into the Ether

Perhaps the biggest success story in the ICO space was the launch of Ethereum in 2014 whereby investors could swap Bitcoin for a new currency, Ether. Many then enjoyed its meteoric subsequent price rise. Many recent ICOs have often raised crypto-funding for new projects via the issuance of tokens instead. These can be seen as a type of electronic right over a future development project; post-ICO, a token holder may have some influence over how a project subsequently evolves. Think of it as a way for a developer to raise funds by giving away rights a bit like a firm involved in an IPO gives away shares.  It is these rights that have caught the attention of the SEC, amongst others, as it tries to decide how and whether to regulate the ICO market. Much turns on how tokens are classified: as currencies, securities (like shares) or even perhaps commodities of some type. Watch this space, as should the SEC decide on the securities label it could have massive ramifications for the regulation of the whole market.

With huge “paper” profits seemingly available post-ICO, many investors are joining the market simply to reduce FOMO – fear of missing out – even if many don’t really understand what they are buying, let alone what it is really worth. However, anyone thinking of doing so, either to acquire cryptocurrencies themselves, or to exchange them for tokens, should be very careful.

Weighing up ICOs

There are two sets of risks that potential investors should be aware of, relating to the currencies themselves and specifically to the ICO mechanism, should you get to participate in one (see chart below).

The currencies themselves (such as Bitcoin and Ether) are next to impossible to value and can be highly volatile and illiquid when it comes to turning them into assets or “hard” currency such as US dollars. The lack of consumer protection (cryptocurrency transactions cannot be reversed nor is there any compensation if a promotor goes bust or fails to deliver) and the possibility of huge regulatory intervention (ICOs are already banned in China for example) are also big risks. Further, the fact that Bitcoin is hard to short (so that participants can bet on falling, as well as rising, prices) makes the market, for now, very unstable and immature compared to say the equity market. Yes, there are plans to launch a futures exchange and some nascent exchange traded funds have been developed by nonetheless this remains a heavily “long-only” market.

Meanwhile, with the market for currencies and tokens proliferating faster than perhaps any market in recent history, it is hard for investors to distinguish the wheat from the chaff or to spot and avoid a fraud. Although the Ethereum ICO was a success, most ICOs are a leap of faith unless you are savvy enough to fully understand what a promoter is offering and how they plan to execute on their White Paper promises.

Conclusions

Whatever the technological potential of the underlying Blockchain technology, the fact is that the valuation of cryptocurrencies such as Bitcoin has long since parted company with any “intrinsic” value-link between the two. In effect the price of Bitcoin is now being driven by speculative demand alone since its claimed utility as, say, a currency is still very small and the lack of a liquid, widely used shorting mechanism makes it “one way”.

Worse, ICOs have become a mishmash of some genuine development projects mixed with many pretty bogus ones. This is a market ripe for the “pump and dump” by experienced players and one where inexperienced smaller investors can be lured in on the promise of development projects that may never get finished, or work before they are overtaken or rendered obsolete.

Should you get involved?

If fear of missing out will keep you awake at night then by all means buy a small amount of cryptocurrency (the obvious one being Bitcoin) via an established broker that you will not miss if the price crashes. As for ICOs, I would steer clear until the regulatory landscape is much clearer and the issuance process more visible and controlled, in terms of who can promote a project. Joe Kennedy, a famous investor, once said he exited the stock market when his shoe shine boy started giving him tips. When taxi drivers started asking me how to open Bitcoin wallets some time ago, I started to get pretty nervous about cryptocurrencies and ICOs in particular, which in many cases smack of what US mega-investor, Warren Buffett, would call a “rising tide floating all boats”. Until the tide goes out and this space is properly regulated, it remains for me one designed for gamblers, rather than investors.