ICO: How a Flawed Model Raised Over $20 Billion And How It Can Be Fixed
“There are specific identifiers that are entirely recognizable during the bubble’s inflation. One hallmark of mania is the rapid rise in the incidence and complexity of fraud….”
- Michael Lewis, ‘The Big Short’
In 2017, Robert Shiller, economist and author of the book ‘Irrational Exuberance’, predicted Bitcoin to be a bubble. For someone who won a Nobel prize for his work on financial bubbles, he was spot on yet again. Similarly, the ICO mania during this period witnessed such irrational investor behavior that it was a bubble of its own. Repeated instances of fraud and failed ICOs did not deter investors, as they continued to pour billions into concepts on a white paper. ‘Irrational Exuberance’ had gripped the space.
The concept of ICO was born in July 2013 when Mastercoin made an attempt at this new way of fundraising. Ethereum followed suit in 2014 raising $18 million to build its ‘World Computer’. Once, Ethereum’s ERC-20 token standard came into existence in 2015, literally, anyone could create their own token. Blockchain-based projects immediately began adopting this revolutionary model, raising modest capital that, barring a few exceptions, was in sync with early-stage rounds of venture capital. Then came the breakthrough year of 2017 that saw multiple projects raise tens and even hundreds of millions of dollars while still in their concept stage. By the end of the year, 343 ICOs raised over $5.4 billion, while the price of 1 Bitcoin, the ‘Alpha’ that started it all, hit $20,000.
This movement was stopped in its tracks in early 2018 with a bear run wiping off over 70% of the total crypto market capitalization. Despite this, ICOs have already raised $14 billion in only 7 months of 2018. My previous article addresses the reasons behind this irregular investment activity. However, the fundamental issue with the ICO fundraising mechanism is what I term as the ‘Investor-User Paradox’.
A paradox is a seemingly absurd or contradictory proposition. And the ICO fundraising model is a perfect example. To understand this, one would have to look into the core purpose of doing an ICO.
In the short term, an ICO is a means to raise capital for a project in exchange for coins or tokens also known broadly as crypto assets or simply crypto. These are cryptographically secured digital assets whose attributes like supply and inflation can be programmed. These coins and tokens derive their value because of their necessity in the functioning of the project itself. So if the project fails to launch or go live, these crypto assets end up being worthless. But, the incentive for investing at this stage of infancy is a potential return that could be many times over.
So how do these crypto assets appreciate in value? The idea is if the project goes live and is successful in attracting users, there will be demand for its crypto asset. With the coin or token being critical to the functioning of the project or even accessing its products and services, a surge in demand would mean an increase in the price of its crypto. Besides, tactically induced scarcity means a spike in demand would allow investors to sell their crypto on exchanges for huge profits.
Here lies the paradox as these projects operate with the assumption that their products and services are inelastic. Inelastic products or services are those that will retain user demand despite changes in price. Inelasticity is hardly true for blockchain based products and services. In fact, their centralized counterparts offer more stable alternatives to users. On instinct, users seek products or services whose price is predictable in nature. So, when investors seek exponential returns on their crypto through rapid price appreciation, this repels users.
Hence, we end up with a proposition rife with misalignment. Investors want price appreciation for their crypto, which occurs with demand from users. But this leads to extreme volatility, in turn reducing demand from the same users.
An inability to address this basic flaw has snowballed into what I unimaginatively call the ‘Identity Crisis’.
Any value-producing asset requires an identity. For instance, USD is a currency, the stock of Exxon Mobil (XOM) is equity, and oil is a commodity. Exxon is an entity that produces oil and transacts in USD. Yet, it would be absurd to use Exxon’s financial performance to explain the value of USD or a barrel of oil. Rather, these metrics of Exxon act as an indicator of its stock price. Hence, having this identity of an asset class is essential to ascribe value to these instruments in a logical way.
There have been instances when public companies have lowered the price of their product or service to increase revenues and capture a larger market share. Hence, a lowering of the product or service’s price could still result in stock value appreciation. This level of sophistication seen in capital markets is yet to be replicated in crypto markets. This is primarily because crypto assets issued through an ICO face a constant struggle with duality.
Initially, they are the instrument that brings in investment, and later, metamorphosize into the instrument that a user purchases. This lack of clarity behind crypto assets means further research is needed in developing valuation models. What we’ve seen so far are approaches that focus on pseudo-metrics that have forced speculators to turn to arbitrary indicators such as the likelihood of a token getting listed on an exchange. It is important to note that trading a coin or token back and forth a gazillion times does not make it inherently more valuable. The only value created here is revenues for the exchanges.
It’s ironic that centralized businesses like Coinbase and Binance are the ones to emerge with $1B revenues from a technological revolution that sought to disempower centralization.
It’s soon going to be a decade since the first ever Bitcoin transaction. But the fact that neither Bitcoin nor its multitude of successors are yet to achieve mainstream adoption is rather disappointing.
The argument behind the technology still being in its infancy is understandable. The trade-off between scale and decentralization is an issue making crypto unfeasible for several use cases. Yet, the biggest factor affecting crypto adoption is price volatility. Volatility is not a direct result of the technology’s shortcomings but it is a product of a flawed ICO fundraising model and an amateurish ecosystem behind it.
Buying a product on Amazon.com with Amazon Stock (AMZN) is not a possibility today and nor should it be. Speculative instruments like stock have never been the best candidates for a store of value so attempting the same with crypto is bound to fail. Instead, an instrument such as an Amazon Gift Card is a better medium of exchange and store of value for users.
Besides, the only answer to volatility is stability. For this, we have an immediate solution in the form of stablecoins. A stablecoin is a cryptocurrency pegged to an acceptable stable asset, such as USD or gold. Hence, these have greater odds to receive widespread user adoption than ‘moon’ coins. But how can stablecoins that are pegged create value for an investor seeking returns? Well, here is where the investor mindset must go through a radical shift. Cryptocurrencies should be treated as the name suggests — like currencies.
In the real world, sometimes we do not gain value from owning $1 and expecting it to moon. Instead, we gain value by accumulating more dollars.
Hence, investors must turn to the good old way of crypto value creation — by participating in the system, through mining and/or governance that propagates adoption. While on the other side of the table, the onus is on projects to develop crypto models, protocols, and algorithms that incentivize such investor participation and behavior.