ICO Ethics, Filecoin, Short-term Fear & Long-term Greed

This is a hybrid post about what I think we need to see in order to avoid a hard landing for the ICO ecosystem (once the market inevitably corrects) and why I backed Filecoin in the advisor round (my first ICO).

[Spoiler alert: they are related.]

It’s also one of the longest I’ve written, probably too long, because it’s been a bear to edit. I’ll get back to short and sweet posts next week.

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“Be fearful when others are greedy, and greedy when others are fearful.”
-Some idiot that missed the late ’90s tech boom

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I’ve spent a lot of time recently thinking about the crypto bubble, and I’m convinced the best chance of a soft landing post-correction hinges on the willingness of today’s professional investors to show some courage, temperance, and long-termism, and commit to decisions that could prove costly in the short-term.

A soft landing for ICOs depends on a combination of:

1) Timing. How long do we have before a major correction? We have no control over this. The party could continue to rage, and we could see another order of magnitude pop in crypto-asset prices. On the other hand, if the music stops tomorrow, a long, dark winter will probably follow because there’s no…

2) Regulated infrastructure. Will new tools get built (and used) which help token issuers and early investors comply with existing securities law? Some teams are starting to work on projects in this area, but it will take time for anything fully functional that can pass regulatory muster. Infrastructure generally refers to new tech platforms and legal constructs, but I’d also put voluntary self-regulation in a similar bucket, which requires…

3) Investor courage. Will the leading crypto funds voluntarily disclose their initial ICO positions and selling patterns, and agree to lock-ups? Self-regulation is 100% within the control of investors, and maybe investors alone, for reasons I’ll expound upon later. It’s technically possible already to lock tokens for defined periods of time, and if you take VCs at face value (that they are long-term supporters of these projects), it isn’t a big ask.

Let’s take this one step at a time.

Timing

This first element is most obvious and most outside of our control.

There’s a black cloud on the horizon, but it’s unclear how fast the storm is moving in or how violent it will be when it hits. We’re in a race against the clock to fortify our little crypto village now that the SEC has given official notice regarding ICOs.

The things that could freeze the frothy quasi-securities market overnight are well-known: (a) the SEC shuts down some of the major exchanges, vaporizing liquidity, (b) investors suddenly realize “assets” like Dogecoin shouldn’t have $5mm of daily trading volume and $200mm market caps and start to dump, setting off a rapid and vicious cycle downwards, (c) new ICOs stop popping 2–10x between pre-sale and on-exchange listing, and investors decide the risk-reward on ICO “flips” has gotten out of whack, with anticipated risks (a) and (b) outweighing potential spoils.

Any of these factors could set off a chain reaction that makes the other two more likely, creating a vicious cycle.

While a near-term SEC crackdown is the most obvious catalyst for a system collapse, it’s just as plausible, for instance, that an innocent cyclical correction is the catalyst that then spurs the SEC to act. Once retail investors start losing their shirts, the SEC has less cover to sit quietly on the sidelines and watch chaos unfold.

Likewise, cooling ICO returns are scary because gains don’t get recycled into new projects or sop up the inflation existing projects are generating. That makes it difficult to bet on net new capital inflows that will offset the rapid dilution baked into new tokens’ supply schedules. (I touched on this concept of “fully diluted network value” last week.)

The bubble could pop tomorrow or a year from now. That’s the bad news. But we all already knew that, so instead we need to focus on what we can work on now in order to mitigate disaster:

Build regulated infrastructure and commit to voluntary self-regulation.

Regulated Infrastructure

During the last major crypto bubble, we actually did pretty well with this, and it may have saved the industry.

In the fall of 2013, right before bitcoin first touched $1,000, you could have fit all the investor-backed executives around the same large dinner table. Coinbase, BitPay, Circle, Xapo, and Blockchain had fewer than 25 full-time employees combined.

Mt. Gox was still the world’s top exchange despite a history of hacks and shoddy management, but at least some adults had walked into the room talking seriously about foreign concepts like “security” and “compliance.” The regulated infrastructure needed to buy, sell, spend, and custody bitcoin would get built because long-term funding had been secured.

In early 2014, many people paid dearly for the weak state of affairs after Mt. Gox collapsed and lost 650,000 customer bitcoins. Bitcoin began a slow, painful decline that didn’t bottom out until January 2015 — after an 85% correction.

Today, many people seem to have bought into the false narrative that “honey badger don’t give a sh*t” and the industry would have been just fine, thank you, regardless of whether newcomers had entered the market in the nick of time.

That’s silly survivorship bias.

Had the Gox collapse happened six months earlier, without newly funded infrastructure developers, the whole ecosystem could have collapsed.

An 85% drop was painful, and some of today’s high-flying companies were near death for a while because of it. How much worse would it have been had the other OGs not raised capital when they did?

The parallels with today’s ethereum ecosystem are uncanny.

Look at ether’s price chart now vs. bitcoin’s in 2013. (Via Chris Burniske.) Consider that bitcoin took off thanks to permission-less P2P payments, and ether is now taking off thanks to permission-less P2P fundraising — ICOs. The crypto community seems to have found its second, “illegal, but ethical” killer app.

But there’s one incredible, alarming difference.

This time around, well over a billion dollars of funding has been raised by token projects, yet there have been exactly zero platforms built to facilitate compliant fundraising and token reselling.

No one has allocated a dime to regulator-compatible infrastructure, instead focusing all energy on new decentralized apps that route around regulatory regimes, and/or on paying lawyers to write up investment contracts that, of course, aren’t actually called investment contracts.

The whole apparatus seems Gox-ish, and the typical current processes should raise red flags:

Investors — many of them anonymous — send ETH to ICO contract addresses, get their token distributions, and then quickly flip them on unregulated exchanges with the expectation of profit.

The truly terrifying thing is that while the adults have entered the room once again, this time they aren’t demanding regulated infrastructure get built. Instead, they are getting in on the action, and hiring their own lawyers to ensure they properly route around regulations.

VC’s that would have barfed at these same projects’ asset valuations when they were an order of magnitude lower six months ago, are fighting for allocations today because they know liquid 10x returns are possible if they hold ever so briefly.

This isn’t nefarious or unethical per se, but let’s at least be honest about the dynamic the process creates: fiduciaries are pouring gasoline on a raging fire and getting preferential allocations and/or upfront discounts on ICOs in return for their embrace of the process and signaling to retail investors.

Me, every day.

The biggest ICO innovations are happening at the law firm level, not the protocol or infrastructure level, which is also alarming. (Although perhaps it shouldn’t be: paper contract innovations are keeping up with white paper innovations.) And while I love me some Cooley-Coie Kool-aid, I’d prefer to see tech infrastructure that keeps the token / crypto-security industry humming once the excesses get reined in.

Where’s the Coinbase of token issuance?

Enter CoinList.

I participated in the Filecoin advisor sale for a few reasons.

Of course, I buy in to the hype that IPFS and Filecoin have a chance to be the backbone for Web 3.0, and that Filecoin is a rare cryptocurrency with actual network utility. Others have written more cogently about its technical merits, so I won’t here.

In addition, I wanted to support Juan and the Protocol Labs team (the creator of IPFS, Filecoin and CoinList) because they are among maybe a handful of teams that fit in the center of the “fiduciary/compliance understanding” — “personal ethics” — “technical genius” venn diagram. I’ve gotten to know them over several years now, and I believe they are committed to this project for the very long term.

Mostly, though, I wanted to back the project because of the tool they built to run the sale, CoinList. It looks like an important initial piece of infrastructure for today’s utility tokens and tomorrow’s crypto-securities, and I backed the project on pure principle because of it.

If we take the SEC’s notice earlier this month at face value, (which seems wise), then at least *some* ICOs will be deemed securities. That is problematic for the issuers that sell them, the exchanges that list them, and the initial investors that buy the ICO and resell once tokens are distributed.

Protocol Labs solved their own issuer problems with CoinList as a platform and the SAFT as a new form of investment contract.

The result is a fledgling marketplace which resolves some universal issuer challenges. The collaboration with AngelList streamlines the accreditation process for investors and ensures issuers stays within the bounds of securities law and KYC/AML regulations. And the SAFT likely punts most securities liabilities to token resellers (investors and exchanges), instead.

While that opens up new challenges for investors-cum-resellers (secondary markets infrastructure for tokens = fodder for another post!), and it sucks Protocol Labs had to restrict some investors from the Filecoin sale at all, the CoinList/SAFT approach was a smart one.

We need more professional teams investing in similar compliance-focused investor platforms.

At worst, Protocol Labs took the least bad option among nightmare scenarios in which the company could later get taken to task by regulators and bogged down with legal distractions post-network launch.

At best, it’s the first tool we can point a journalist or regulator or newb to, and say “See, we’re at least trying to be legit. The industry is growing up.”

Oh, don’t worry. I hear you howling.

“[Screw] you, TBI, you total bush-league [sell-out]. Easy for you to say. I cannot believe you invested at a preferential rate, in a sale that restricted most investors, and in a project where the company is keeping 2x the rewards that will be distributed to investors. And you have the f*cking gall to write a post titled ‘ICO ethics.’”

Fair enough, but I haven’t gotten to my last point on voluntary self-regulation.

Investor Courage

If I were to make a bold guess as to what will happen in the next 6–12 months in the ICO market it would be something like this: all the major token exchanges will face SEC enforcement actions for their role in facilitating the secondary trading of tokens, which are almost universally acting like securities.

In the bull case, the exchanges don’t get shutdown, but most have to delist tokens, even ones they otherwise hoped would be innocent until proven guilty. In the bear case, the exchanges actually get shut down entirely and have to work with regulators in order to reopen.

[Note: Indeed, most of the major exchanges have reacted to the news already, with varying approaches: Shapeshift and Poloniex — commitment to token by token delisting; Bitfinex — restricting access by US users.]

The bear case is probably extreme. It’s hard to imagine the SEC inflicting harm on retail investors by freezing their on-exchange assets. Perhaps trading and deposits get frozen, but investors are able to withdraw tokens. This would be chaotic, liquidity sapping, and awful for crypto UX, but it wouldn’t be armageddon.

[Another note: it would also be insanely lucrative for the decentralized exchange projects, but again, more fodder for another post…so much to write about.]

No one wants to hear that exchange freezes are a possibility, because it seems like an unsubstantiated bit of FUD. FUD. FUD.

But the truth is I can afford to bang the FUD drum here because a) it seems like a logical end to the boom once the market starts to correct, and b) I simply do not care what happens to most of my token investments in the short term. (Bitcoin, on the other hand, I care deeply about in the short-term. #No2x)

With all of my personal investments, I try to be short-term fearful, long-term greedy. I’m a low-volume, high-conviction investor (also: often wrong), because I don’t like trading and, honestly, I suck at it.

As such, I took the maximum vesting period for the Filecoin advisor sale — three years plus however long it takes to launch the network. I am locked in for the long-term — another reason I backed the project on principle.

But with Filecoin’s set-up, I’m no virtue-signaling martyr — the three year lock-in also provides me with the steepest available discount on the tokens, so I’m being long-term greedy.

It’s important, I think, for long-term investors who are signaling support for a project and getting special pre-sale treatment to contractually restrict how much they can sell, and when they can sell it.

To illustrate why, I’ll be honest. Right now, I’m up ~10x on paper in less than a month. If that seems like bullsh*t to you, I totally understand.

But the reality is that while you may think I look like this:

Pump and dump, baby.

I think I actually look like this:

Freeeedom!

And, *importantly*, I expect that if the project doesn’t pan out, asset prices correct, exchanges freeze up, or inflation hammers the post-distribution price, I’ll look like this while other investors are boarding the life boats:

Going down with the ship.

Even at the most highly discounted rate, advisor investments will be under water unless Filecoin trades for over a billion dollars on a “fully-diluted network value” basis several years from now.

That leaves a lot of room to the upside, but also a ton of time for the numerous risks I’ve highlighted to materialize and send my investment crashing below break-even or even to zero. It’s a fair risk-reward tradeoff.

My only complaint is that the Protocol Labs guys didn’t force long-term lock-ups from advisors and lock them all in for the full three years, minimum.

The stunning thing is that this still looks like the very best long-term investor alignment of any pre-sale to date!

Most other projects simply haven’t taken the same steps Protocol Labs took to prevent day 1 sales from pre-sale advisors.

Instead, the status quo is for VC’s, who have built their reputations for high-quality long-term investing, to get the opportunity to invest with steep initial discounts, preferential allocations, and short illiquidity durations.

In the process, they effectively offload entirely the “exchange freeze / market correction” risks to retail investors, and can recoup their principal investments via partial sales when the ICO “pops”, letting the rest ride.

This is near risk-free investing. And it doesn’t smell right.

It won’t smell right to the SEC either.

If the adults won’t make tough choices to signal long-term support for their preferred projects, and there isn’t better self-policing through reasonable and publicly disclosed lock-ups, I predict some fierce blowback.

The good news is, I think there’s willingness to submit to lock-ups! Most of the funds are true long-term believers in their investments, and I don’t think any are guilty of pumping and dumping.

Even in the case of their biggest ICO wins, I’d wager most are taking only partial liquidity because they still want to participate in the even larger long-term upside. As fiduciaries, they probably need to take partial gains once their investments pop if they are able to.

So this is really a design issue: do you believe pre-sale investors should have minimum holding periods post token issuance? How about a responsibility to disclose when they exit (common for material public stock investors)?

I think they do.

The Filecoin token distribution changed the game a bit, forcing investors to vest over a minimum of one year and up to three years. I know many others like me opted voluntarily for three year vesting. That’s not perfect investor alignment, but it’s a great start.

I hope more projects follow the Filecoin lead.

If not, I hope the major crypto funds have the stones to commit to some minor self-regulation and voluntary lock-ups, anyway.

Shouldn’t one-year minimum commitments be the new “long-term” in crypto?

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Miscellaneous Notes:

Why pick on funds?

1. The funds do little of the real actual work. They have the flexibility to trade off of their brand names — invest in friends and family pre-sales and send positive signals to other retail investors, but then retain the right to hold with the conviction of a mere day trader once the tokens float publicly.
2. There’s nothing inherently wrong with the quid pro quo of “I’ll attach my name and attention to this in return for a cut,” but the line from helpful advisor to “pump-and-dumper” would get fuzzy in the case where an investor recoups principal before capital gains rates would even kick in. Call me old-fashioned, but funds need some skin in the game. It would be helpful to see them publicly commit to one year holding periods post-network launches (at least) as a rule rather than exception.
3. Something just doesn’t sit right with a crypto fund that invests heavily in the pre-sale for IdiotCoin, and is then able to flip that investment 30 days later thanks in part to the FOMO created by the very signal that they were investing in the first place — with no disclosure of the sale! I’m not calling out any projects or firms in particular because I don’t think any of them operate in bad faith like this, but the mere fact that it’s possible should give people pause. Because the “possible” will turn to “likely” when the market turns. These funds are fiduciaries, after all.
4. Some investors have claimed that they have no intention of selling their token stakes in certain projects, but what happens if a project founder breaks some bad news to the investors, and they decide to trade on that information? Seems like insider trading, but these aren’t securities! Still, almost all tokens certainly look and act like securities when you look at the investment cycle. Even if they are loath to admit it, the pros on the buy side know this.
5. Who else can you really pick on?

A) Entrepreneurs/Developers? Maybe, but remember, this group is the one doing the work and taking the career risks. There are some scammers out there to be sure, but most are raising because it’s a non-dilutive tool that can be used to pay founders, and bootstrap networks with new developers, partners, and users. Many believe these raises are a one shot deal, where the initial public sale will need to fund the projects in perpetuity.

Even if the market misses some overt scammers, it’s hard to imagine regulators will be kind to token issuers who shamelessly follow Cartman’s infamous startup advice and exploit the process.

B) Retail investors. The democratic mob of speculators who pile in to new projects because they think prices can only go up, or they are getting in early on the next big thing is the most at risk because they are the least sophisticated. I know we should all be free-market extremists, and that the government is bad, bad, bad, but protecting this group is why the SEC exists. Retail investors’ power is extremely limited. Capital is not a scarce resource in the current environment, and the retail community writ large is likely to hand most of their gains to the pros when the tide goes out and the novices are left swimming naked.

C) Existing token exchanges. Bittrex, Poloniex, et al are the ones facilitating the bonanza, so are an obvious place to point the finger for self-regulation. But since they are also squarely in the crosshairs of regulators already, it doesn’t make much sense to tacitly admit guilt by “self-regulating” now. Hundreds of millions of dollars have been made by these companies and they are probably gearing up for defense: “Three years ago, we were selling digital beanie babies and never touching the banking system. Yet we still do KYC on customers, invest in security and customer protection, and make it possible for people to trade tokens that are used for decentralized applications. F you, these are not securities.”

4) The lawyers. As a wise man once told me, “lawyers gonna lawyer.” Self-regulation is impossible for a class of people who get paid for “quantum thought” and are representing clients who operate in the legal gray area. Their job is to defend their clients, not choose a side.

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There is an exciting possibility that CoinList and others to go beyond issuer tools and build private, regulated secondary trading markets for bona fide crypto-securities. Some smart people are starting to look at crypto-securities much more closely. This is an area I’m spending a lot of time thinking about. Ping me if you are, too.

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Since you were wondering, but too polite to ask: the only other pre-sales I’ve really ever considered were Ethereum, Cosmos, Civic, and 0x.

• I met Vitalik the day he announced the Ethereum project in Miami, and I was with Anthony Di Iorio in SF the very hour they launched the ETH crowdsale. I think my reaction to the lack of cap or valuation on the “software license” sale was “lol, nope.” Oops.
• I’m fascinated by what Jae Kwon and his team are working on, but found it tough to invest in Cosmos when I was still running a media business and inviting ICO issuers to speak at Consensus. Kind of a conflict of interest and bad for the CoinDesk brand if it ever got out. F*ck me, right? I want Atoms at the crowdsale rate.
• I love Vinny. One of my favorite people in the space. I love Civic, and hope they succeed in helping people more securely manage their personal information. I’m a user. I loved the democratic structure of the CVC token sale. It was a masterful way to incentivize allies to rally around Civic’s product. But I knew I was going to flip a large percentage of the tokens I bought within ~30 days. Flipping didn’t sit right with me, so I passed. (See above — I prefer highly illiquid, expensive tokens that I might never actually sell like Filecoin.)
• 0x. I bought in because a) I thought the sale process was well designed and democratic, b) I didn’t get special treatment in a pre-sale, nor did anyone else save for their seed investors from the spring, and c) decentralized exchange is a big hedged bet of mine in anticipation of the music stopping for most centralized exchanges in the next 12 months.

I’m sure there will be other interesting ICOs to participate in going forward. Best practices are slowly developing, and I’m eager to back the good guys.