A salient and largely unbiased view on current ICO madness. Well written by market research director for R3 Tim Swanson.

A high level overview of ICOs
Posted on June 2, 2017
[Note: I neither own nor have any trading position on any cryptocurrency. The views expressed below are solely my own and do not necessarily represent the views of my employer or any organization I advise.]

Just as I did with the COIN ETF proposal last year, I have also written a 50-page paper for internal use diving into the world of ICOs.

I am not sure if or when it will be made public, but here are a few salient points:

ICO stands for “initial coin offering.” Depending on what cryptocurrency group is pitching an ICO, it may be in exchange for company equity, but often times there is no explicit contractual link between control of the coin itself with some kind of equity or financial performance of the company… because there is often no formal contract provided to investors. Not all ICOs are alike and any prospective user or investor should look into the specific operational and funding arrangements.
Since January 1, 2017, more than $200 million has been raised by more than a dozen ICO-related projects and companies, a figure that will likely double by the end of the summer and triple by the end of the year as turn-key platforms such as Prism, Swap, 0x, and Iconomi, are flipped on.

The primary method of raising and funding an ICO is through bitcoin and ether deposits. This has driven (mostly) retail investors to create accounts at cryptocurrency exchanges – most of which have poor track records such as Bitfinex – and acquire BTC and ETH. This demand in turn has been a key driver in the current all-time highs seen by many cryptocurrencies including bitcoin and ether.

There is very little regulatory or independent oversight of any of these coin offerings. Most of the projects attempt to shield themselves from scrutiny from securities, commodities, and money-transmission regulators by setting up a non-profit organization or foundation. These foundations are typically registered in a couple specific countries, each of which is now home to more than a dozen non-profit organizations specifically managing ICOs. In addition, ICO promoters will often use euphemisms such as “tokens” instead of coins, or call their fundraiser a “crowdsale” or “donation” or “contribution” that the non-profit organization will later re-distribute after the ICO is over.

Some of these non-profit entities sign exclusive development contracts with a for-profit entity that is run by the same people who operate the foundation. That is to say, the foundation will hire the for-profit company to develop and advise the project that the ICO fundraiser marketed and advertised, yet often with no independent oversight.

Ignoring accreditation status: very few, only a handful at most, of these ICOs are done in compliance with any KYC, AML, CFT gathering and sharing requirements. This is problematic. For instance, over $1 billion in ransomware was liquidated (largely) through cryptocurrencies last year thus it could be relatively easy for bad actors (hackers) to liquidate their bitcoin and ether holdings into ICOs and not be easily caught due to the inability to link real world identities to specific blockchain activity.
Last week Valerie Szczepanik, the head of the SEC’s distributed ledger group, made several public comments. This included: “Whether or not you are regulated by the SEC, you still have fiduciary duties to your investor. If you want this industry to flourish, protection of investors should be at the forefront.”

As of right now, there are just a handful of ICOs that have explicitly attempted to protect investors by providing full transparency into their organizations. Most do not disclose the principals, directors, and insiders involved within these organizations. Some have private offerings called a pre-sale. A pre-sale allows participants to acquire coins at a discount (e.g., pre-sale investors might receive 2x the amount of coins that the public coin sale will have at the same price). In addition, the participants in a pre-sale are not typically named or made public prior to the public offering of the coins; nor are the conditions by which these participants able to sell their holdings typically disclosed.

Historically companies which file paperwork in order to be listed on a public stock exchange have to submit an S-1 or its equivalent to regulators. The S-1 is important and helpful to the rest of the market because it lays out who the insiders are, who the principals and directors are, how governance is handled, who is responsible, what the business is, what the liabilities are, etc..

In contrast, most ICOs currently have nebulous governance on purpose: because the operators do not want anyone to be held responsible in case the project is unsuccessful or the coin loses its value. Caveat emptor is the name of the game.

Tulip euphoria

In any given month I am provided inside information about ICOs. Complete strangers will send me pitch decks that outline their pre-sale and listing opportunities.

Yes, some exchanges are paid to list these coins, often through a percentage negotiated beforehand with the ICO operator. And there are market makers and underwriters in the form of family offices, high net worth individuals and small hedge funds. There is an entire ecosystem that is completely opaque and opaque on purpose because many of these participants are trying to deflect responsibility in case a coin crashes or a project is unsuccessful or because they are found in non-compliance with a variety of regulations (e.g., not declaring taxes, self-dealing, insider trading, etc.).

One project involved in building a distributed computer recently offered me about $50,000 over the course of 6 months in addition to the native coin they were pitching to the public. All they wanted me to do: act as an advisor and promote their coin on social media.

I said no to all of them but others said yes and that project above raised a couple million in USD.

Last week I attended several events including Consensus and a different private conference held later in the week. I gave a short presentation at one of the events and afterwards I walked to the buffet outside the room to get some food. While gathering some grilled fish, the audio/visual operator for the event came up to me and told me: “Tim, I just put $100 into bitcoin and also ether. How much more should I put into them?”

My presentation wasn’t even about cryptocurrency investing or about ICOs, but this illustrates the exuberance of the current time period. There is a lot of fear of missing out yet few people are actually looking at what these ICO-funded platforms or projects are attempting to do. How can unsophisticated, technically unsavvy people learn more about them?

Media publications? But conflict of interest is rife.

I have mentioned this multiple times over the years: unfortunately many “coin” media sites and magazines are not helping the due diligence situation. Most “coin” reporters, if not all of them, own cryptocurrencies and benefit directly from increased demand of the cryptocurrency, but they often do not disclose it. In fact, many times they report on coins they own and/or that their parent company owns. Several small buy-side analysts and their firms also have published uncritical marketing material for cryptocurrencies and some do not disclose their coin holdings or outline the major risks involved in operating these types of networks, in effect white-washing the risks of anarchic chains.

Others in privileged positions including some of the VCs that are active in this space are now also promoting ICOs but few disclose their active long or short positions. Some of these VCs were entrepreneurs who have pivoted multiple times and this is a last ditch effort to drum up support for their sagging portfolio. 1 2

You just don’t understand the technology!

One common refrain I often hear from ICO promoters is that ICOs are a new form of technology that empowers retail investors like never before and that the traditional world of institutions and laws has no place in the new economy. And that naysayers and critics just don’t understand the transformative power of ICOs and cryptocurrencies.

That may be true but in my case, definitely is not.

In late 2014 I worked with a company called Melotic. Melotic is a tech startup that raised about $1.2 million in the summer of 2014 to build a digital asset exchange: a trading platform that new cryptocurrency projects could be listed on, GDAX before GDAX. For about 9 months I spent the bulk of my time talking to dozens of cryptocurrency projects and operators to find out what unique thing their company did and why they should be listed on Melotic. Nearly all of them were half-baked scams, and others were just impractical (Urea Coin). 3

In May 2015, Melotic announced it was closing its exchange and moving into cross-border payments where it currently operates under the brand, Kleering.

While Melotic deserves its own dedicated post, the takeaways we learned at the time were that traders (who were most of the user base) only cared about two specific things:

(1) Anonymity. Some traders publicly complained when we implemented a set of KYC and AML policies. They said we should snub our noses at the government and banks and provide traders the ability to exchange cryptocurrencies without complying with local or national laws surrounding identity gathering and verification. This is an opinion that is still very prevalent as shown by similar comments on /r/bitcoinmarkets and /r/ethtrader.

(2) Pump and dump. Day traders love volatility and cryptocurrencies often provide that volatile environment. Because new cryptocurrencies such as an ICO are often even more illiquid and thinly traded than say bitcoin (which itself is relatively illiquid), whales and insiders without vesting and lock-up periods can quickly move the market up and down due to the large amounts of coin holdings they have. This creates the booms and busts that many cryptocurrency traders savor. Yet at Melotic, we were apprehensive about listing every single cryptocurrency under the sun, and tried to filter those we thought had unique utility and less volatile. In the end we only listed about 10. Yet empirically the most successful exchanges – as measured in volume – were those that listed every single coin that was launched. Quantity over quality continues to persist today as exchanges compete for volume and liquidity of new coins. This contrasts with regulated exchanges such as NASDAQ (pdf) and NYSE (pdf) which have listing requirements, including transparency into the companies principals. Most cryptocurrency exchanges do not ask for similar requirements and in fact, some take a cut of the coins – similar to payola – in order to be listed.

Over two years ago I wrote a post that looked at around 20 different ICOs and projects that did some kind of public coin distribution. My new paper looks at them in more detail. What were the findings?

While we wait for that paper to be published another key takeaway is that: almost none of the projects lived up to the advertised utility or expectations that their promoters marketed to the community and investors that bought their coins. Yet most of the cryptocurrencies, even ones that lack a real development community, are seeing all-time highs on the cryptocurrency markets.

In other words: utility is completely divorced from market value of the coins; a phenomenon that seems unlikely to change in the short term.

This is compounded by the fact that ICOs are by their nature, not designed for cash flow or optimized to be profitable.

Why is that? Because at its core: the non-profit entities that runs them are by definition, not-for-profit. As a result, these projects largely rely on their token holdings and the price appreciation thereof, in order to be sustainable. Thus the incentive to focus on marketing and create buzz to further increase the price appreciation of the coin holdings.

And ignoring the informational asymmetries above, there are some other interesting wrinkles.

Earlier this week I participated on a fintech panel and during the group discussion one specific ICO was briefly mentioned, the Basic Attention Token (BAT). Brave, the company behind the BAT, had just raised $35 million in a crowdsale (unregistered securities?). Notable to this sale was that over $6,000 in fees to miners were included in the transactions related to the ICO.

How many transactions can you fit into an Ethereum block during high demand times? It depends on the complexity of the contract. For the BAT, it was about 90. 90ish people were able to participate in the first block of the BAT’s ICO. Those 90 ICO seats went to whoever attached the largest transaction fees.

An unsavvy retail investor would need a lot of mempool luck if there is high demand and larger players investing millions are paying $1,000 USD fees just to increase their chance to get one of those scarce seats in the first block. This could mean that in the long run, all the “good” ICOs will be bought up by sophisticated investors aware of this limitation and only sub-par ICOs will run long enough (more than one block) to let unsophisticated retail investors in.4

Conclusions

ICO organizers often exchange coins for explicit support by outside endorsements and lobbying in their favor (e.g., advisors and influential personas are given a cut of coins). Therefore researchers, regulators, developers and potential investors looking at an ICO should look for paper trails to identify investors, users, organizers, insiders, and potential malicious actors.5 This also includes exchange operators and their principals who may learn weeks beforehand when a cryptocurrency will get listed and thus, may have material, asymmetric information they can act on.

Investors should look very hard at what the risks and recourse there is in the event of a hard fork, what happens if their assets end up on a deprecated chain? If it is an ERC20 token, what fork will the developers consider the “legitimate” chain? Ethereum forked multiple times last year and currently, investors of ICOs based on ERC20 have few, if any, protections or recourse in the event an ICO organizer fails to deliver its promises let alone a technical problem occurs. For instance, what happens if the network becomes too top heavy and open to the Hold-Up Problem? Who has legal standing or recourse?

ICOs can be done with existing technology – no blockchains are needed (just ask Beenz and Liberty Reserve) – yet because ICOs are being done on anarchic blockchains where reversibility is economically cumbersome and identification is non-existence, it can create new risks and challenges for investors. Potential investors need to be able to answer: in case a dispute arises, how can recourse take place if key counterparties are not identifiable?

Cryptocurrencies and the coins that piggy back on their network will likely continue to exist so as long as these non-profit entities have enough coins to liquidate to pay for marketing and advertisements. And so as long as there are others willing to buy their coins (e.g., liquidity).

And while it may be too early to distinguish and separate the specific ICOs that are outright scams from poorly run companies, keep in mind that a couple dozen Pyramid schemes failing in 1997 led to massive unrest and a civil war in Albania. We have already witnessed enormous strain and virtual fighting within the cryptocurrency community (e.g., the never ending Bitcoin block size debate and the Ethereum hard fork because of The DAO attack). What would happen to the aggregate cryptocurrency market if the investors and insiders in a couple dozen ICO platforms (Pyramid or not) tried to liquidate their holdings onto an illiquid market?

If you’re looking for dramatic excitement (currently) without many investor protections, the ICO world may have what you’re looking for. But if you’re looking for sustainable operations with repeat revenue and cash flow connected to mainstream utility and accountability – aka a business – then you might want to do a double-take.