ICOs – Short Term Bubble, But Perhaps Long Term Innovation

Summary

  • There is a new craze for the issuance by companies of crypto-currencies in the form of Initial Coin Offerings (ICOs).
  • The result is most likely going to be a bubble in the short term, some large investor profits and then losses and regulatory investigation.
  • But this does not mean in the long term some serious and permanent innovation will not emerge from the ICO craze.

Initial coin offerings are offerings of tokens by a company to raise capital in exchange for a crypto-electronic currency. The currency is not strictly equity or debt of the issuer, as would be usual in a capital raise. Instead the currency is just what it says it is – a means of exchange that will be viable depending on demand or supply of the currency. Many of these currencies have no intrinsic value, although they appear to have market value (perhaps no different from say, a gold index position or a spread bet). Some of the ICOs (so-called utility ICOs) are issues of tokens that give you discounts on the products of the issuing company – this means that in one sense the tokens do pay a dividend in kind.

One of the central regulatory issues is that these ICOs are being done outside of the parameters of regulated securities offerings. That is very attractive to issuers, but whether these crypto-currencies are in fact securities or not is now being hotly debated by the SEC, among others. Many ICOs done outside of any regulatory framework, absent of some iron-clad legal opinion protecting the issuer and investor, may find the law comes back to bite them.

Many of the investors in these offerings are also taking highly speculative bets, which is likely to lead (as it is already doing) to a bubble in certain crypto-currencies. This will surely end in a bursting of the bubble and subsequent losses at some future point.

But does this mean the ICO craze is a bad thing? Well not necessarily.

It is important to understand the nature of financial innovation to see what might be happening here. As I argue in my Wiley book “Dinosaur Derivatives and Other Trades” there is no social laboratory for financial innovation. Said innovation must simply be thrown into the public domain and often it initially causes a certain carnage until we understand the socio-economic implications of a given innovation.

There are multiple examples here: junk bonds started as highly speculative instruments resulting in both a credit bubble and fraud. However once that phase passed, junk bonds emerged as a very useful form of mezzanine-type financing in the form of high-yield bonds. CDOs also clearly went into a bubble and created multiple deviant and overly complex forms prior to the 2007 credit crisis. However today asset backed financing is more conservatively implemented, in not overly complex transactions against good collateral. The result is the CDO is today a useful financing tool for non-recourse funding. Internet stocks are another example – they, too, clearly went through a bubble phase leading up to 2000, but today the Internet is a powerful tool for all of us and plenty of viable Internet stocks are active in business.

It would seem we may be seeing a similar phenomenon with ICOs. There is a growing demand for these tokens, and a demand for an asset which in many cases is ephemeral and little understood. Sooner or later the house of cards will come down, the regulators will step in and the game will stop (a number of fraudulent ICOs have already been identified by regulators). However, that does not mean that this is not the beginning of something quite large and sustainable, namely: the emergence of one or more global crypto-currencies which might act as a legitimate means of exchange even absent specific Government backing. Niall’s Ferguson describes currencies merely as “trust inscribed.” If that trust can be achieved ultimately by Bitcoin or one of the other crypto currencies just by collective online trust in exchangeability, well that could at some point (at some future stabilized point) have a lasting impact on the whole global currency system.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.