ICOs: a History of Building Castles in the Air
This article explores three investment bubbles: the South Sea company bubble, the tronics boom, and the ICO bubble. While these “castles in the air” span different eras and have completely different companies and technologies involved, the underpinnings for the speculation remains the same. Investors get swept up in the madness of crowds and follow the herd in an effort to strike it rich. From analysing these bubbles we can learn important investment lessons.
This article does not constitute legal, investment, or any other professional advice and is not intended to be relied upon as such.
A Short History of Bubbles and Lessons Learned
Bubbles in investment products are a feature, not a bug of financial markets. Every so often we come across a new trend in the market that everyone wants to get into. From potential riches in the south seas, growth companies in the electronics sector, to new revolutionary technologies in crypto and blockchain, our history of bubbles or building castles in the air is rich with history.
As we proceed along this journey into the history of bubbles, we will take note of the lessons we learn so that we can identify when a new bubble or castle in the air may be forming. Although the focal point of the bubble may differ across time and era, as we will find out, the characteristics and fundamentals do not. Analysis of three bubbles — the South Sea company, the tronics bubble, and the crypto/blockchain Initial Coin Offerings (“ICO”) bubble — show that key themes and lessons do in fact exist. What we ultimately can take away from all of this is that human investment behavior has not changed from over 300 years ago. In fact, history tends to repeat itself.
Building Castles in the Air
All bubbles share the same common feature: investors do not respect the firm foundation theory and instead get swept up in the craze of building castles in the air. Investors let their emotions drive their investment process rather than analysing an asset in terms of its true intrinsic value. They embark on the task of entering the castle at the bottom floor in hopes of exiting and cashing out at the top. They forego fundamental analysis and abide by the logic that if an asset continues to rise in price then they will be able to sell it to someone for a higher price. Sometimes it pays off and other times it ends in disastrous losses and pierced egos.
No matter what the outcome, equipped with hindsight and knowledge of the castle and the air theory, we can understand the lessons that come from the craze of crowds. Such a theory explains how many of the bubbles in the past formed: from the tulip bulb craze to that of our recent sub-prime mortgage crisis. Without a doubt, if we can learn anything from the past it’s that history tends to repeat itself and that we are all humans prone to making decisions based on emotions. With one bubble popping it’s only a matter of time before we start building another castle in the air.
Two bubbles in particular, the South Sea bubble and the tronics boom of the 1960’s, represent interesting moments in investor history in which we can derive important lessons. Using these lessons we can readily see how the ICO bubble of 2017 formed and quickly popped.
The South Sea Bubble[1]
During the 18th century, Britain found itself in the middle of the Spanish Succession in which Spain controlled most of the seas and trading routes into South America. The indebted British nation sought to incorporate the South Sea Company in 1717 to takeover Britain’s national debt and reduce costs. In return, the British government granted the company an exclusive monopoly right to trade and operate in the “South Seas”, hence the name of the company. The public viewed the company favourably as they perceived that such a monopoly right would lead to exclusive profit opportunities. The directors of the company however had no knowledge or experience in trade in the South Seas.
From the incorporation of the company, profit opportunities arose not from business opportunities but solely from trading in the company’s stock. Investors that had knowledge of the forthcoming incorporation of the company bought government securities with the knowledge that they would be able to convert those securities into the stock of the company at a higher price. Again in 1720, the company offered to fund the entire national debt of Britain which would be effected by a statute of parliament. Those who backed the law were awarded with free stock grants that they could exercise and sell back to the company when the stock increased. Upon the passing of the statute, the stock of the company was worth considerably more and the public who witnessed the constant increase in price of the company’s stock wanted in on the action.
To meet investor demand, the company issued new stock to the public at £300 per share which they could purchase with a £60 down payment and pay off the rest in eight installments. The company made two subsequent stock offers to the public as public demand for the stock increased along with its price. At this point in time, the stock hit £1000, a ten times increase in price from its original price per share of £100. The crowd mentality had officially caught on and the public had started to construct an enormous castle in the air despite the fact the company had little to no revenue. As a consequence, they inflated a company in name only with nothing behind it.
Attracted by the idea of riches, investors went on the lookout for other favourable castle building opportunities. The market delivered. Company promoters started selling shares of companies that had no place to be sold other than the fact that investors were in the mood to throw their money at anything. They created companies with the most exaggerated business objectives such as the trading in human hair, building hospitals for bastard children, extracting silver from lead, and extracting sunlight from cucumbers. One promoter even offered shares in a company for the purposes of “carrying on a great advantage, but nobody to know what it is”. That issue sold out immediately with the promoter quickly vanishing off to the continent never to be heard of again.
As the law of gravity states: what goes up must come down. The same was true for stocks during this era that had outlandish valuations. Realising the price of stock in the South Sea company did not coincide with its intrinsic price, the directors in the company sold their shares, the news of which leaked and entered the public domain. This sparked a tremendous sell off in the company’s stock. At last the stock that had almost no revenue or profits finally collapsed. The tremendous castle in the air that had been built disappeared into thin air along with all the other castles that were built off hopes and dreams of riches. The crash that had accrued was so bad that the British parliament had to pass a statute that forbid companies from issuing stock, which was not repealed until 1825.
The Tronics Boom of the 1960s[2]
The tronics boom of the 1960s had a lot of similarities to that of the South Sea company bubble. Although they occur roughly 250 years apart, the underpinnings of the boom and bust remain the same: Investors in search for the latest trend in the market got sucked into the madness of crowds in the hopes of getting in early and cashing out late at a higher price.
The 1960s represented a time of “growth stocks” such as IBM and Texas Instruments. Anything to do with electronics was all the rage on Wall Street. Like the South Sea company bubble before, investors gravitated towards stocks that promised high returns from speculative business ventures. Newly formed companies started trading with some combination of the word “electronics” in their name in hopes that investors would invest in their company on the basis of association with the new trend. Previously incorporated companies also strived to take advantage of the trend and started changing their trading names to include electronics.
Hence the name of the “tronics” bubble of the 1960’s whereby companies rushed to incorporate some form of electronics into their name to attract new investment even if their company had nothing to do with electronics. For instance, the company American Music Guild sold record players door to door and changed its name to Space Tone before listing on the stock exchange. Its stock rose from $2 to $14 in a matter of weeks simply because its name reflected something to do with the electronics industry. Investors simply did not care whether the price reflected its true price, all that mattered was that the price of the stock continued to rise.
Like any fad and castle created in the clouds the air came out of this bubble violently taking down with it the majority of these companies’ stock prices. Those that timed the market perfectly, who entered in on the bottom floor and exited at the top, were few and far between. Many investors learned the hard lesson that foregoing fundamental analysis and getting swept up in the crowd often results in poor returns. But as history again shows, investor behaviour little changes from generation to generation, as the tronics boom had similar bubble features to that of the south sea bubble. If only they had paid attention to the past maybe things would have been different this time around.
However, a major difference between the South Sea company bubble and the tronics bubble was the sphere of investor protection enforced by the Securities Exchange Commission (“SEC”). The SEC has the responsibility to protect investors from fraud, misrepresentations, and market manipulation, but it does not have the power to prevent investors from entering into purely speculative positions. The stocks that listed during the tronics boom complied with securities laws and issued prospectuses that had sufficient warnings and risks of purchasing shares in their company. Many prospectuses at this time contained a disclaimer that the company had no assets or earnings, could not pay a dividend, and that the stock was very risky. Despite those explicit warnings, investors cared less and decided to try their luck at building castles in the air in an attempt to sell the stock to another sucker. Of course like the South Sea company before it, once the castle was built, investors rushed to the exit, leaving many to feel the pain of their poor investment decision.
ICO Boom:
57 years later from the tronics boom and over 300 years later from the South Sea company bubble, the ICO bubble started to inflate. The ICO bubble of the 2017’s shares all the hallmark features of a bubble and has very similar characteristics to the preceding incidents of castle building. Overall, it reinforces the proposition that history tends to repeat itself.
The ride up to the ICO boom saw an increasing interest from the public in crypto and blockchain. Many heralded blockchain and crypto as the panacea that would change banking, trust, finance, payments, remittances, equality, and wealth for the better. Influencers, bloggers, and the media pumped out hundreds of articles, books, and podcasts about the technology and touted its revolutionary features. The public slowly got hooked into the idea that crypto and blockchain were the next big thing that would be even bigger than the Internet. The thought of riches from this new craze had officially began.
Similar to the tronics boom where investors appropriated the word “electronics or tronics” to make money, promoters during the ICO bubble started leveraging the words blockchain and crypto. They sprinkled those terms into their whitepapers and released ERC-20 tokens to the public to meet the crazed public who awaited any opportunity to invest in this space. Hundreds if not thousands of ICO were launched during this time all of which had some connection to crypto or blockchain. Investors did not care that the ICOs and ideas behind any of the projects were speculative, all that mattered was that these ICO tokens had the potential to skyrocket in price and make them rich. The castle building was in full motion with investors flocking to any crypto or blockchain token just like investors during the tronics boom gravitated towards stock with the name tronics in them.
Linked to this idea of investing in anything connected with crypto and blockchain was the sheer exaggerated and bizarre ideas backing these tokens. Like the South Sea bubble where investors looked for the next South Sea company and invested in companies with frivolous ideas, so too did investors partake in this behavior during the ICO boom. For example, the ICO PAquarium, had the idea to build the largest aquarium in the world where investors could use their tokens to decide where the aquarium was to be built and granted them a share of the aquarium’s profits. Other ICO ventures included XmasCoin, a fund raising effort to build a “mystery project”, Lust Coin, a blockchain marketplace to help people find their sexual partner anonymously, and my favourite ASTRCoin, a cryptocurrency and blockchain that aims to become the currency and investment vehicle of space.
At the height of the ICO castle building exercise, the sector had $200 billion tied into it, which outpaced angel and seed venture capital investing in Internet companies in June 2017.[3] Shortly thereafter the bubble burst and along with it the median ICO returned -87% to investors[4]. Safe to say the vast majority of ICO investors got severely burnt.
Unlike the tronics and South Sea bubbles before, the SEC made significant interjections in the space and meted out hefty penalties to promoters of ICOs that failed to abide by securities laws. In fact, to this day, the SEC continues to mop up the mess of the ICO bubble. At least every month there is news of the SEC bringing a new enforcement action against an uncompliant ICO or of the SEC reaching a settlement agreement. The grandiose scale of the bubble and the number of ICO issues means that the SEC will undoubtedly be cleaning up this space for the forthcoming future: A telltale sign that this bubble exhibited very poor promotor and investor behaviour.
Lessons Learned
We can learn a lot from the foregoing bubbles. For starters, in the aftermath of any bubble we have winners and losers. The winners include the promoters of the companies and ICOs that pitched ludicrous business plans to the public. The promoters of the South Sea company and ICO bubbles stand out particularly as many of them were able to make gains and strive off to the continent or into the abyss of the Internet as the case may be. Meanwhile the losers include all those overconfident investors that thought they could win a game of out smarting the psychology of the market by timing their entrance and exit impeccably. They failed to realise however that trying to outperform the behavior of the madness of the crowds has no rhyme or rhythm to it. In the end, you get lucky or you get stacked.
All three bubbles described above feature hallmark signals of building castles in the air. We learned from the tronics and ICO bubbles that one should be wary about companies that simply tack on a trending word or sector into their business trading name. A plethora of incorporating companies that employ a particular name for gain or those companies that change their name to reflect the latest fad may be using that name for no other purpose than to make money off the growing public sentiment in that sector. The rampant increase in companies using “tronics”, “crypto”, and “blockchain” respectively signaled that the market may have been a little too excited about the potential that these sectors actually had.
We also learned from all three bubbles that fundamentals — profitability, revenue, growth — get pushed aside in the madness of crowds and replaced with psychic value. The potential for gain — the action of getting in early and selling out profitability — spurs investment rather than core investment factors. We saw investors gravitate towards companies with grandiose and unrealistic business plans with no potential for revenue or profitability, despite in some cases blatant warnings in the company’s prospectus. In other words, all that mattered to investors was the potential to sell the stock or token higher to another investor. The fact that the price of the stock or token had no basis in reality did not matter. Building castles in the air trumped any other valuation method.
Lastly, we have witnessed the rise and enforcement of securities regulation. While no regulatory agency existed during the era of the South Sea company bubble, by the time of the tronics and ICO bubbles, the regulatory environment had changed drastically. Even though the SEC did not intervene in the sale of securities during the tronics boom we know from the ICO bubble that the SEC has taken on an important role in protecting investors. Enforcement action after enforcement action the SEC targeted ICO promoters for issuing unregistered securities and other fraudulent practices. We can take from this that while the same trends in building castles in the air stay the same from bubble to bubble, the SEC’s response to these activities do in fact change, often with increased scrutiny. The SEC may not be able to protect investors from making poor investment decisions but they surely will crack down on issues that transgress securities laws.
These lessons all point toward the reality that human behavior does not change only the object of the crowd does. From South Sea companies, tronic enterprises, and ICO madness, the sector changes but the underpinning foundations of castle building do not. Hot trends in the market tend to proliferate and suck investors in as they cannot resist the temptation of making riches off the latest market fad. But beware, such trends often come with dire consequences. As some say, “you may lose your shirt”. With all that said, remember these lessons so that you can decide whether the next trend is a repeat of history, as often is the case.
[1] Burton G. Malkiel, A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing (Kindle Edition, 2019) 40–46.
[2] Burton G. Malkiel, A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing (Kindle Edition, 2019) 56–59.
[3] Arjun Kharpal, ‘Initial coin offerings have raised $1.2 billion and now surpass early stage VC funding’ (CNBC, 9 August 2017) <https://www.cnbc.com/2017/08/09/initial-coin-offerings-surpass-early-stage-venture-capital-funding.html>.
[4] Larry Cermak, ‘A post-mortem on the ICO bubble: at least 89% of ICOs are in the red’ (The Block, 7 August 2019) <https://www.theblockcrypto.com/genesis/35090/a-post-mortem-on-the-ico-bubble-at-least-89-of-icos-are-in-the-red>.
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