A new and hip way to invest is becoming real via advances in blockchain tech.
On 19th April, the ethereum banking app Humaniq became the latest blockchain startup to make a mark by using a fundraising process called an initial coin offering (ICO), securing $3.9m in pre-seed funding by creating provably unique cryptographic tokens and selling them to the public.
A week later, Gnosis would go on to raise eyebrows in the industry for the $12m it secured in less than 15 minutes – all for offering 5% of the tokens that will power its decentralized prediction market application in a digital auction.
But, these aren’t the only projects seeking to test the model.
CoinDesk data shows that the total funds raised by ICOs in 2016 reached nearly 50% of what startups received through traditional venture firms that year. But, with more than 75% of participants reporting they were investing for financial or speculative reasons, this growth in interest has raised concerns.
While the idea of a high-risk, high-return investment seems to make sense to those eager to be on the ground floor of the next big thing, the lack of structure, the relative novelty of the industry and the opaqueness of many ICOs are all contributing to an environment that has some uneasy over the potential risks.
The next hot currency
One of the most significant problems surrounding speculation is the dumping of funds into projects that have little to differentiate themselves or, worse, may be poorly designed or considered.
Thinking of a blockchain application in terms of infrastructure helps to explain the danger of this speculation.
Unlike Web 1.0 and Web 2.0 applications – such as Facebook, Pinterest or Google – that are ‘fat’ deployments on the application layer set on a ‘thin’ HTTP or TCP/IP protocol layer, blockchain applications are built on a ‘fat’ or feature-robust blockchain layer and a relatively ‘thin’ application layer.
This means that, with the infrastructure being disrupted by innovators, apps may migrate to another blockchain should it become successful. Already, some applications have made the move to ethereum, citing its superior traction as compared to other alternatives.
But, for others, it’s the sheer number of applications launching that is dubious.
“The proliferation of ICOs can be likened to the app explosion of early 2010s,” said Brad Hines, startup advisor and founder of e-commerce website NerdPlaythings.com. “The problem is that we are now wading through hundreds of cryptocurrencies, many of which are poorly differentiated.”
Hines went on to note that not all ICO tokens are successful, and many are delisted from exchanges due to irrelevance.
Proper understanding of the investment vehicle is essential in this environment. Yet, the difficulty in this lies in the fact there are no real requirements for entrepreneurs to report the risk factors connected to their ICOs. As a failed project called The DAO proved, the team itself may not even be aware of everything that could go wrong.
This makes the vetting of claims difficult by those that are not cryptocurrency professionals, and a challenge to those that are.
“As anecdotes like, ‘The bitcoin I bought in 2012 is worth thousands now!’ have been told, so has greed developed for getting into the next hot currency,” Hines added. “With so many trading in incremental amounts that are mere clones of the other, expecting them to ‘hockey stick’ is misguided at best.”
Fear of missing out
Still, there is an argument the ICO model is simply in a stage of rapid iteration, and a belief the process will become more standardized – and less risky – over time.
“There are no generally accepted best practices for conducting these sales,” said William Mougayar, founder of Startup Management and author of “The Business Blockchain”.
“No one knows the right formula. We are seeing iterations and wide degrees of variations in these implementations.”
But still, a major advantage of ICOs is the speed and access to capital. An ICO can secure seed funding for a blockchain company in, sometimes, minutes.
As a result, the speed of delivery and the hype surrounding the larger ICOs, has created a fear of missing out among cryptocurrency entrepreneurs.
“Entrepreneurs are seeing that they can raise money as a one-shot deal and swing for the fences,” Mougayar added.
This type of asset structuring makes speculation particularly dangerous, as confusion between actual and hypothetical market valuations can hide telltale signs to an asset’s true health and future positioning.
Still, some write this off as the product of a growing and developing market.
“The higher the rise, the harder the fall if these projects don’t deliver,” Mougayar said. “There are high expectations everywhere.”
Liquidity is king
With all this, it is both too simple and too simplistic to call all speculation bad.
Speculation is important for improving the liquidity of an asset. For assets that would otherwise suffer from a lack of public visibility, this is important. Speculation drives the trading volume of an asset, which is essential for maintaining the liquidity – or access to sell or purchase without an immediate effect to demand or share pricing – of the commodity.
Let’s say, for example, a person had an eye for a classic used car for $30,000.
The potential buyer only has $12,000 on hand, but also has a comic book collection worth $20,000 available. The collection – as it is right now – is illiquid, as it cannot be used immediately for the purchase of the car.
The buyer will have to find someone willing to purchase the collection – likely at a discount and at a marked disadvantage to the potential car buyer – and will have to wait until the comic book transaction is concluded before he can buy the car.
There may be a market for the comic books and it may be robust, but it is not currently accessible to the buyer.
Now, say there has been speculation on comic book futures due to hype from the upcoming blockbuster season. Our would-be buyer could sell to a speculator at a price close to what he expected and purchase his dream car.
In an intermingled marketplace, such as cryptocurrency marketplaces, liquidity in one asset directly affects the trading volume of another.
For example, speculation in a newly minted bitcoin blockchain-based project could cause a spike in bitcoin prices, as the project’s tokens would be immediately tradable for bitcoin (which is more widely traded). Improving liquidity in the project improves the pricing position in other more available tokens, which increases trading volume throughout the entire market.
Speculation and opaqueness
Speculators also serve as a control valve against price manipulation.
Take, for example, Yasuo ‘Mr Copper’ Hamanaka. Mr Copper controlled – at one point – 5% of the world’s copper supply as the chief copper trader at Sumitomo Corporation. He was responsible for $1.8bn (with losses rumored to exceed $4bn) in unauthorized copper trading.
Sumitomo had no copper mines of his own. Hamanaka successfully manipulated the copper market by buying copper futures low, taking a large percentage of the cache off-market and creating an artificial shortage that kept prices inflated.
By working through intermediaries, Hamanaka was able to keep his trading strategy opaque. Hamanaka’s fraud was revealed following pressure from speculators – such as George Soros – who suspected artificial supply manipulation, and a refusal by Hamanaka to accept a loss when the copper market collapsed.
And this is the control valve in commodity markets.
And there are worries such practices could be taking place in the market. Entrepreneur Charlie Shrem, for example, is offering a bounty to anyone who can prove that some ICOs have cheated in reporting their funding.
“I have a bounty out for someone to check the top 50 crowdsales and see if any of the money from the exit address went back into the smart contract,” he said.
Quality not quantity
Over time, all hope the industry will evolve.
This transitioning of the conversation away from the evangelists, fanatics and idealists toward the common fold is needed if a trust of this technology – and a greater embracing of its potential – is ever to be cultivated by the public.
“Not all ICOs are good for the industry, but quality ones are,” Alan Friedland, founder of Compcoin and the Fintech Investment Group, said, adding:
“Anytime you can bring new people and new investors together toward teaching about our new commodity money, that’s a good thing.”
Friedland expressed his desire that the industry would create a flywheel effect in which more high-quality companies attract more high-quality entrepreneurs.
Yet, he cautioned that the responsibility of those who have used the model must now be tested.
Friedland concluded:
“Investors must be cognizant of what involvement in these projects brings.”
Typewriter dollar sign image via Shutterstock