The ICO bubble is not necessarily a bad thing

You have probably heard a lot recently about initial coin offerings (ICOs) and if you have not, you most certainly will in the coming months. This year alone, firms have raised $1.3 billion from ICOs, a type of blockchain crowdfunding for start-ups, and they have done so with blinding speed. Depending on who you ask, it is either a revolutionary shift in the investment paradigm that will shape the future of fundraising and create new business models, or it is a bubble-creating phenomenon the like of which the world has not seen since the dotcom bubble.

So, what exactly is happening here? What is an ICO? And, is this a bubble?


The circumstances that created the phenomenon of ICOs

Bitcoin burst onto the scene in 2009, following the release of a now-legendary whitepaper wrote by a mysterious coder with the pseudonym of Satoshi Nakamoto. He produced the theoretical model behind this new kind of distributed digital currency (which he called Bitcoin) that relies on a network of computers to process, authenticate and copy transactions in a “blockchain ledger”, based on the consensus of the system. This decentralized and theoretically tamper-proof mechanism, thus promises lower transaction fees and convinced millions of people to trade and use bitcoins for making online payments, transferring money abroad, and in some cases, even illegal activities. Its application for commercial transaction created a gold-rush mentality that led to Bitcoin's price to rise 640% since the start of the year, to an all-time high of $7,454.04.

While Bitcoin opened the world to the possibilities of shared ledgers, Ethereum expanded on that potential and created an open-source platform upon which next-generation applications that need a distributed blockchain can be built and developed on. Ethereum's cryptocurrency, called “ether”, can be “spent” as a way of leveraging the platform and was offered for sale in August 2014, months before the actual launch of the Ethereum network. Today, Ethereum is driving a revolution in financial transactions, eclipsing its predecessor in terms of future promise. All this led to the value of ether to rise more than 300-fold since 2015.

Ethereum’s success, in turn, determined many other cryptocurrency founders to follow this approach and, in the last two years, hundreds of new platforms like Ethereum promised to put the blockchain technology to a much broader use, such as for smart contracting, automated governance, regulatory compliance, tokenization, etc. Any one of these new uses of a shared ledger comes with a new set of coins that are offered for sale through an Initial Coin Offering (ICO). Due to legal and technical obstacles, the new “coins” are bought almost always using bitcoins or ether as a medium of exchange and, as they are built on top of the Ethereum blockchain, it takes ether to run the software on the network. These two forces result in a powerful feedback loop that boosts demand for bitcoins and ether, pushing up their value to soaring levels and creating and even greater sense of momentum in the blockchain world.

How do ICOs work?

ICO founders tend to follow the same strategy: 1) create a company and build it to an early stage; 2) announce their intention to launch a token sale; 3) publish a whitepaper about what they plan to create, how they wish to do it, how much money they need to raise and instructions for registering and sending the money to the company; and finally, 4) launch their new cryptocurrency by running an ICO for a few days (or even hours or minutes if they become over-subscribed) until their fundraising target is reached. For example, Tezos raised $220 million in four days,, a messaging app, raised $100 million in under three hours, while Brave, a browser startup, raised $35 million in under 30 seconds. It all seems like ridiculously easy money and when a company raises millions in a matter of seconds, solely with a whitepaper, you know something is definitely wrong!

Although ICOs raise funds, the “coins” are not currency, but code that forms contracts. They can be thought of as tokens that can be used to store or transfer value within the new coin’s ecosystem, to other cryptocurrencies, or to standard government-backed currencies.

There is a distinction to be made between selling blockchain tokens as investments (the coins for sale are tied to some external financial instrument) and selling them for their intrinsic utility. If a token that resembles a security is to be sold to the general public, then it should be regulated as one, while a token with practical applications (e.g. decentralized file-storage networks, rewarding online content creation) is more easily marketable. However, this distinction is not always so clear in practice and most ICOs emphasise prior to their campaigns that the native tokens do not have any intrinsic value. For instance, the Token Purchase Agreement of EOS mentioned that its “tokens do not have any rights, uses, purpose, attributes, functionalities or features, expressed or implied. Although EOS Tokens may be tradable, they are not an investment, currency, security, commodity, a swap on a currency, security, or commodity or any kind of financial instrument.”

Why do individuals choose to invest in ICOs?

There are two main reasons: 1) because they believe that the tokens will have value of themselves as currency (e.g. Bitcoin) or 2) because the tokens will have value on the platform to be created (e.g. Ethereum). However, quite evidently, investors purchase tokens simply as a means of speculative investment, hoping for a jump in the price of the new currency and a position at the ground floor of the next Bitcoin or Ethereum. Moreover, the early investors in the two established players now sit on millions of paper profits and they are generously re-circulating the gains into these new ICOs (also as a way of diversifying), feeding back the loop.

Despite the bubble-like nature of the ICO market, with the massive pace of ICOs launches, over-tokenisation, ideas on paper and arbitrary balances on ledgers, investors continue to focus on blockchain because of its potential to transform the world the same way the Internet did.

We probably are in a bubble. But is this necessarily a bad thing?

If we look back at period between 1997 and 2001, we can observe that what is currently happening in the blockchain world is extremely similar to the dynamics of the dotcom boom. Back then, investors were excited about the Internet and Yahoo’s rapid revenue growth, so they invested in new Internet start-ups which used that money to buy ads on Yahoo to get traffic, which in turn, caused yet more growth for Yahoo and reinforced the idea that the Internet was worth investing in.

The problem with bubbles, of course, is that they burst, as they did during the dotcom boom and more recently, during the mortgage crisis. In the process, companies were wiped-out, jobs were destroyed and hundreds of thousands of investors lost massive sums of money. But one could also see the dotcom bubble (and arguably, the ICO bubble) as a socially productive phenomenon that allocates capital to paradigm-shifting innovation instead of incremental improvements to existing technologies. It is true that the “dotcom bubble created lot of failed companies – but it also created Amazon, eBay, and Google.”

There is no doubt that many of the ICOs receiving investments now will not succeed, either because they are scams or because other legitimate companies are starting to come down the pipeline. Furthermore, as government agencies, such as the US Securities and Exchange Commission (SEC), are stepping up to provide more regulatory clarity around ICOs, the market will start seeing the light about real values and the bubble will pop. This will probably happen sooner rather than later. However, cryptocurrency enthusiasts argue that Bitcoin and Ethereum are here to stay and so are those blockchain projects that offer an inherent utility and a token that is tightly integrated into the network's functionality.