Initial Coin Offerings: The Next Dot-Com

On March 10th, 2000, the NASDAQ Composite hit a peak of just over 5,130, a new high at the time. Over the next 30 or so months, the Composite would drop by 78%. Many people familiar with this will know it resulted from the dot-com bubble. The period leading up to this peak was characterized by huge jumps in internet usage, effortless financing through venture capital and initial public offerings (IPOs), and rapid growth for companies with little-to-no viable products or business models, among other things.

It would be 15 years before the NASDAQ Composite reached this high again. While industry bubbles are far from uncommon, the dot-com bubble was one that had a lasting effect on information technology companies and venture capital/startup investing. Nowadays, the tech sector continues to grow with financial technology (fintech), artificial intelligence (AI), machine learning, and other areas making huge leaps in popularity.

For one, the cryptocurrency sector has seen billions of dollars flowing into the ecosystem. In fact, just recently, the digital currency space saw its first unicorn startup appear when Coinbase announced a recent funding round that attached an over $1 billion valuation to the company.

Beyond Coinbase, numerous cryptocurrency and blockchain-related projects have raised tens of millions, and some hundreds of millions, of dollars. Most notably, many projects are utilizing a relatively newer method of fundraising: Initial Coin Offerings (ICOs).

Initial Coin Offerings

ICOs involve a project creating a decentralized application (DApp) in which the tokens being used by the network/project are sold to supporters in return for other cryptocurrencies like Bitcoin and Ethereum. ICOs began to be heavily employed as a method for facilitating an easier way for individual investors to invest in a project at their leisure while also allowing the companies creating the DApps to circumnavigate strict venture capital and financing regulations. Some examples of some of the more heavily invested ICOs include:

  • Tezos, a governance and consensus protocol for blockchains, raised over $220 million
  • EOS, a project aimed at creating commercial and business-scale blockchain solutions, raised over $180 million
  • Bancor, a decentralized exchange ecosystem for smart tokens, raised over $150 million

These are just a few of the larger ICOs to date, but the majority of such DApp projects raise millions of dollars in cryptocurrencies. Recently, the Securities and Exchange Commission of the United States passed down a decision declaring some tokens issued through ICOs would be classified as securities and thus past sales were technically breaking U.S. securities law. While no charges were pursued, this effectively barred U.S. residents from participating in many ICOs moving forward. Still, many projects continue to raise millions of dollars in short periods of time.

The Issue with ICOs

Of course, initial coin offerings can be seen as a good thing as it allows financing where such money would not normally be found or easily acquirable. More often than not, though, these ICOs are funneling money into projects that don’t meet implied standards of raising such money. Such issues include:

  • No working product or prototype
  • Unverified and unreputable developers behind the projects
  • Vague or downright incomprehensive whitepaper describing how the DApp will work
  • Providing blockchain solutions to ideas that don’t need such solutions and are simply better as a traditional centralized service

One would think with the money being thrown at these projects that investors would perform necessary due diligence. Even so, projects are getting receving millions simply for having a halfway decent idea with an accompanying visually pleasing website and nothing else to validate the money they bring in.

This is not to say that many projects don’t meet standards with regards to detailing project roadmaps and milestones, detailed use of funds, and similar. But far too often, investors are too quick to invest their cryptocurrency into projects with nothing to show: no proof of concept, no technical description of how it will work, or anything else to show for why they deserve your money.

Further, far too often a project creates a token that has no inherent value and is just used as a method to raise funds for the project more than anything else. Namely, building a centralized platform that utilizes tokens primarily as a way to pay for the product, as many projects do, is not innovative or interesting -- all it does is create a barrier to entry for people potentially wanting to use your product. That is, users are deterred when they have to purchase an obscure, illiquid token just to use a platform. In the end, these tokens whose purpose and use can be equally, if not better, achieved by other, more popular and liquid coins like Bitcoin or Ethereum fail to demonstrate any real value proposition.

The Bubble

One of the key indicators of economic or industry bubbles is these rapid investments like the ones described above and the ability for companies to receive financing extremely easily. Specifically, players in the cryptocurrency space suffer from extreme cases of FoMo — fearing of missing out. With this, people feel as though they must invest in projects due to a fear, whether conscious or subconscious, of missing out out on the ‘next big thing.’

Further, another indicator of a bubble appears when large amounts hype builds up around an industry or specific projects. This is illustrated by excessive use of buzzwords, baseless claims, and the inability of projects to live up to expectations no matter how successful they are. Investors are chasing gains seen on other tokens in hopes that their token or projects of choice will see this same support.

With everything written here up to this point, and to anyone involved in the space who has dealt with ICOs, it is clear that we are in a bubble (and arguably, the cryptocurrency scene as a whole is in a bubble too). Excessive hype, extreme FoMo, and undeserved fundraising can only last for so long.

When the Bubble Pops

So, if we are in a bubble, what happens when it pops? For one, the projects described before that don’t meet implied quality standards will pop with it (note that this is not necessarily including the projects specifically mentioned before — Tezos, EOS, and Bancor). With so much money being thrown into the space, it is only a matter of time before projects fail to provide what they promised and investors realize that their money is being put toward things that don’t deserve it.

As seen with every other bubble, reality will kick in sooner or later. Companies and projects will flop, tokens will decrease in value significantly, and investors will become far more cautious in how they use their funds. It is essential for one to understand the risks of dealing with ICOs and emerging markets and technology. The hype can only go on for so long, and while cryptocurrency and blockchain technology may very well go mainstream, it will have its bumps along the way.

Protecting Oneself

Now, you may be asking yourself: “How do I invest safely in cryptocurrency and blockchain ICOs?” Of course, with any investment you make, whether it be in a cryptocurrency, your first house, or any other number of things, there will always be some amount of risk involved. That said, especially with cryptocurrencies and the high volatility seen with them, extreme precaution and risk avoidance should always be taken to best prevent any unfortunate significant losses of money.

When it comes to due diligence of a project and its ICO, you may find yourself asking what to be on the lookout for in terms of both good signs and red flags. When deciding on whether to invest in an ICO, the following questions should be considered:

  1. Who are the developers? A project cannot be successful if the required human capital is not there. An idea and concept can be revolutionary, but it won’t actually be unless there is a qualified, experienced, and educated team backing it up.
  2. What is the goal of the project? When it comes down to it, there has to be a viable and realistic aim for the project as far as what they want their technology to do. Further, the token it uses has to have a defined purpose that by nature calls for the use of a token.
  3. Are there any other projects attempting to accomplish the same thing? And if so, how does the one you are interested in differ from others and how are they similar?
  4. Does using blockchain technology as platform enhance the idea in anyway? That is, what improvements does blockchain technology provide over more traditional channels?
  5. Does the whitepaper provide explanations about reaching their goal, or just make claims? One essential thing a whitepaper must have is technical details. Anybody can make claims as to what they want their technology to do, but only worthwhile projects are able to provide their reasoning, methods, and in-depth details as to how it will all work.
  6. Does the project provide a plan for the use of funds?
  7. How are the ICO funds going to be spent? As in, do they have a legitimate plan, or is it just a payday for developers?
  8. Who is to say that the team won’t take in funds and just run off with them or not attempt to build the technology?
  9. Does the project provide a timeline or roadmap? Every project, whether it utilizes an ICO or not, should provide some idea of what they are aiming to get done when. Without those deadlines, development tends to stagnate and fall behind.
  10. Does the token utility match its valuation? Based on the other criteria in this list, different tokens will have different inherent values (and is many times subjective).

While the above list is not at all comprehensive, they are key things to look for in projects and should aid in shielding oneself should the cryptocurrency market go through a huge correction. The above also does not mean that one can’t see large gains in the short-term, but it is the ones with continual development, a reputable team, a viable idea, and other such characteristics that will be around to stay in the long-term. At the end of the day, it really comes down to one’s own opinion of if a project is worthy of and deserves investment.

To reiterate, every emerging market goes through its hype phase. After this initial buildup reaches its peak, markets will always correct and the bubble will pop. It is essential to always be prepared for something like this and to do due diligence when it comes to investing your money. Finally, as always, if something seems too good to be true, it probably is.

“The four most dangerous words in investing are: ‘this time it’s different.’”

Sir John Templeton

Happy trading!