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Funding on blockchain: a new bubble

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By Lewis McLellan
25 Jul 2017

Initial Coin Offerings (ICOs) are the hot new way to raise capital — $1.2bn has been raised in 57 launches this year (according to a report by Autonomous) — and the appeal for start-ups is obvious. However, with investors piling in with no regard for long-term value, it’s a bubble waiting to burst.

For start-ups, it’s a no-brainer. It’s not stock, so you don’t have to dilute your holdings, or cede any control to pesky shareholders and their votes (although there are other ways to get around that).

It’s also not a debt. You aren’t borrowing the money so you never have to give it back.

All that’s required is that you invent money and get people to buy it. Bitcoin was the first. A currency tracked on a public distributed ledger (or blockchain), allowing parties to perform transactions without the need for a mediating entity.

Now all sorts of start-ups are following where Bitcoin led. Companies design a run of ‘tokens’ registered on a blockchain that will keep track of every transaction, then auction off the units to investors. So far, investors are jumping at every opportunity, allowing the Brave ICO (from Mozilla founder Brendan Eich) to raise $35m in 30 seconds while Tim Draper’s Bancor launch broke $150m.

The pace is accelerating, too. About 50% of this year’s total came in 30 days of June and early July, according to Autonomous’s report. 

The start-ups are able to pocket some cash without making use of the traditional routes of borrowing money or selling equity.

What’s it worth?

In an ideal world, the token is supposed to have some utility, some relationship to the product being funded by the ICO. Bitcoin was supposed to be a decentralised payments system (although the eye-watering transaction costs have put paid to any idea that it could have much real utility for transactions); Ether is required to use the Ethereum computing platform.

If you buy a token, helping to fund the development of a decentralised application, you would hope that the token would be of some use when the project is launched.

This is true for some ICOs — holding Filecoin grants you storage space on its network when (if) it’s launched — but others are quite open that you shouldn’t expect anything.

The documentation of EOS’s ICO (which has raised more than $200m) is comically explicit (to the extent of making liberal use of block capitals) about its token’s utter purposelessness. The docs acknowledge that even if the platform is launched, the tokens will not have any “functionality or rights”, not even guaranteeing that the holder will be able to use the platform.

One ICO, begun on July 22, 2017, is raising money to build the world’s largest aquarium. While PAquarium’s ICO offers a profit share from the aquarium to token holders, an aquarium is not a decentralised application. There is no reason for it to raise funds using a cryptocurrency.

To value a cryptocurrency as an investor, one has to look at the expected utility of the decentralised application it enables. If a blockchain-enabled application provides a service that people genuinely need, then its associated cryptocurrency has long-term value.

Trusting together

The problem is that the selling point of most blockchain applications is the removal of oversight, of a trusted intermediary. There are some highly specialised occasions in which trust, guaranteed by code, might be preferable to the established system of trust, guaranteed by the mix of hard regulation and soft incentives that we have been using (with mixed, but mostly acceptable results) for hundreds of years. But most of these highly specialised alternative purposes are illegal.

If you launch a blockchain-based service as a competitor to an established industry, either you have to provide a better service, or you have to appeal to whatever subset of the population is primarily concerned with avoiding third-party interference. So far, few blockchain systems appear to provide quicker, safer or cheaper equivalents to non-blockchain equivalents. They must live or die by the value placed on decentralisation.

While a decentralised application might provide a better user experience than its equivalent centralised competitor, the improvement must be a property of the blockchain, or it could be replicated without one.

Crypto-fans will bang on about removing the need for trust thanks to the guarantees provided by the code, but really this applies only in a small area of operations. If you are ordering a product online, the blockchain offers no guarantee that what you buy will actually be sent to you and, without some kind of trusted intermediary, disappointed customers have no recourse.

Hope against hackers

Even for situations where removing an intermediary might be more efficient and cut costs, crypto-based organisations have run into tremendous difficulties. The lack of an intermediary leaves a rather obvious vulnerability.

The Decentralised Autonomous Organisation was created to remove the wasteful and inefficient human component from fund management, instead relying on individuals’ votes to decide whether or not funds should be disbursed to particular projects. In short, it was an investor-directed automated venture capital fund.

It was launched on April 30, 2016, and attracted hundreds of millions of dollars’ worth of Ether (its cryptocurrency of choice) within a couple of weeks.

A scant six weeks later, the DAO was attacked and a hacker stole a third of the fund — about $50m of Ether.

When a group gets together and decides that “the code is the law”, a certain type of person views that as a challenge.

Given the pace of advances in cryptography, code can fall out of date even more rapidly than regulation. After all, you can regulate against that which seems impossible. It’s harder to make something impossible when it doesn’t exist yet and, without a regulatory authority to back them up, victims don’t get their money back.

One response to a bubble is to say: “Look, if investors are happy to give a company their money and receive no stock or debt in return, buying the digital equivalent of a colonialist’s glass bead, then that’s up to them.”

That has not been the SEC’s response — it announced on Tuesday night that it would treat DAO tokens as securities, meaning these offerings would be regulated (see separate story), which has sent shockwaves through the market.

Until the SEC’s announcement, at least, cryptocurrency was one of the frothiest markets around. It has been growing at an alarming rate, capturing the imagination of a certain type of social-media-influenced, tech-savvy investor, so buyers are often coming out ahead (unless they get robbed, which happens quite a lot).

As a model for sustainable investment, this breaks pretty much every rule ever conceived. It relies on the same logic as a Ponzi scheme. Benjamin Graham is no doubt spinning in his grave over the very notion.

But such crytocurrency tokens are tradeable assets. Investors can speculate on whether people will pay more to hold it in future (shorting is trickier). Even if there’s no underlying value, what does that matter?

A new role for crypto?

Part of the problem is that cryptocurrencies have often been treated as investment assets to speculate on, rather than having a real purpose.

The crowd-funding model has been gathering speed. Kickstarter and its peers have allowed founders to raise billions of dollars to bring a product to market, or at least to spend a lot of money trying to bring a product to market.

If investors looked at the market the way fans look at Kickstarter — as a service allowing them to sacrifice some capital to see a project come to fruition — then the sector would be in less imminent danger.

Despite — or perhaps because of — the increasing popularity of passive fund-management, investors seem to care more and more about where their money is going. The rise of green bonds and other socially responsible investments is testament to the arrival of a world where people seem to care what their money funds.

Perhaps ICOs as a means of crowdfunding is simply the next stage in this trend. It would certainly be a safer role for ICOs to adopt.

But the shine must come off crypto-investment. The market is indisputably still picking up steam and as long as speculators are piling into the sector with no regard for long-term value, the crypto-bubble will continue to grow.

Until it doesn’t.

By Lewis McLellan
25 Jul 2017