Cryptocurrency capital comes with a caveat

Initial coin offerings are the latest craze to hit both the cryptocurrency (bitcoin, ethereum etc) and the startup worlds. In a nutshell, they use cryptocurrency technology to crowdfund seed capital for startups.

There’s more to it, obviously, and like anything to do with the blockchain, the underlying tech is tricky to understand. The business process, however, is simple.

When a new cryptocurrency starts, it generates new coins (or tokens). These new tokens are tradeable right from the start. An ICO is the sale of these first tokens in a new cryptocurrency venture. However, the mechanism has spread to other non-currency uses of the blockchain. Startups are funding themselves using an ICO to generate interest and funding.

Investors in an ICO receive tokens in the new blockchain. These tokens represent voting rights, equity, or pre-orders, depending on the business model. They are very share-like in operation, while having the advantage of being totally unregulated.

Tokens are not shares in the business and do not actually confer ownership, but they may confer financial benefits from the actual activity of the business. They can also be traded like shares.

ICOs are also using the ethereum blockchain’s capability to create ‘smart contracts’ to do away with the need for a new cryptocurrency. The business creates ethereum contracts as its token system. This means it doesn’t need to provide any of the infrastructure of a new blockchain.

It also gets ‘hard’ ethereum currency immediately to fund the new venture. The smart contracts implement the token rights from the ICO tokens. So the ICO founders don’t need to do anything except code-up a watertight smart contract. This has become the ‘killer app for ethereum’s smart contracts.

The primary market for ICO tokens is the huge pool of cryptocurrency speculators. They’re comfortable with the technology, aware of the risks, and know the markets. Speculators are responsible for the vast majority of token purchases in ICOs. The speculator frenzy around bitcoin and ethereum has fuelled a huge appetite for this sort of risk.

Steemit, while not technically an ICO, is an example of the new blockchain businesses. It uses a complicated model to reward authors of content by charging readers. It has its own cryptocurrency (steem) that underpins the business model. New content generates new tokens, which are paid to the authors and miners. Steem tokens can be held to increase ‘reputation’, or converted to US dollars.

New users of the system buy in with USD, which is the inflow of funds that the whole system relies on.

There’s something familiar about this – a system funded by new arrivals, whose primary market is speculators, which avoids regulations designed to protect investors.

I’m sure that not every ICO is like this. I’m sure there are valid new business models using this funding method. I just haven’t found one yet.

The problem with this sort of speculative bubble, of course, is when it pops. When the bitcoin bubble popped (as it has done repeatedly), the losers were speculators. That comes with the territory. With an ICO, the losers may well be the employees of the startups involved. If the price of tokens crashes, the startup won’t be able to raise new funding. In some cases, they may not be able to raise new revenue. Until employees can pay their rent in tokens, there’s inherent vulnerability.

It is hard to find someone who approves of ICOs among those in the developer community. Developers divide neatly into two camps – those who want to profit from others’ ignorance, and those who disapprove. It’s all very scammy.

Almost none of it uses blockchain in any meaningful way. You could achieve the same effect using a database in almost all cases, but that wouldn’t have the magic blockchain dust that makes it worth money to speculators – some of whom don’t understand blockchain or understand that adding a blockchain to a thing doesn’t make it bitcoin.

Anyone who lived through the dotcom era can see where this is heading – utterly illogical valuations on pipe-dream ideas with no basis in reality.

However, while the dotcom era was 20 per cent real and 80 per cent speculation, this is 100 per cent speculation. There’s nothing of value underlying any of this; it’s a house of cards built on sand in a hurricane.

Buyer beware, go long at your peril.