Ever since my friends and I set up a Digicash server to sell music and artwork with a digital currency called eCash representing real gold, back in the ’90s, I’ve been waiting for the day when cryptocurrencies—digital currencies that operate independently of central banks by using encryption to generate units and verify transfers of funds—would transform the world. Cryptocurrencies are finally here, but not exactly in the way that I envisioned.
And so since last year, I’ve found myself issuing warnings instead of accolades about the latest trend in the frothy world of cryptocurrencies: ICOs, or initial coin offerings. The initial idea was a pretty good one—blockchain technology could be used to issue new cryptographically secure “tokens” or “coins” that are easy to transmit peer-to-peer. The coins could be sold to fund open-source software projects and other services that people find useful but are hard to finance with traditional structures. They could even function as shares and thus allow startups to finance themselves far more efficiently, from a broader range of people, and without the intermediaries that take fees and require a drawn-out process. Or the “coins” could represent some unit of utility, such as a gigabyte of storage or access to a network.
My concern with today’s ICOs is that they’re being fueled by the gold-rush mentality around cryptocurrencies, and so are deployed in irresponsible ways that are causing harm to individuals and damaging the ecosystem of developers and organizations. We haven’t set up the legal, technical, or normative controls yet, and many people are taking advantage of this.
Thus, ICOs are to cryptocurrencies what Trump is to American democracy: not what the founders of the institution envisioned.
It doesn’t have to be that way.
Think of an ICO as a means of creating digital certificates that have signatures, rules, programs, and other attributes controlled cryptographically. You could create a digital version of a check, a stock certificate, an IOU, or a gift card for a hamburger or a barrel of oil. That makes these certificates equivalent to a security, a commodity, or even just a simple financial transaction.
In their traditional forms, each of these elements have different risks and different regulatory bodies governing them. The Securities and Exchange Commission, the Treasury Department, and so on play a role in reducing financial risks and preventing financial crimes. In other words, some of the rules and regulations—the friction—in the existing system is there to protect investors, customers, and society.
But those regulators haven’t caught up with ICOs quite yet. Issuers are getting rich and unwitting investors are buying tokens of questionable value.
On July 25, 2017, the SEC announced that if a token looks like a security, it will regulate and treat the token as a security. It subsequently set up a task force to go after ICOs that are scamming investors and exploiting gray areas in securities laws. But many of the tokens issued through ICOs today are not shares in a company. Rather, they are “tokenized” versions of some sort of product, service, or asset, or a promise to invest funds in research or infrastructure. Issuers are calling the sale of such tokens a “crowd sale” instead of a “funding” to make it clear that people are buying a product rather than a security—and, intentionally or not, avoiding regulatory scrutiny.
A Swiss platform for posting jobs, for instance, used a crowd sale to sell what it calls Global Jobcoin, which buyers can use to pay for employment services. Meanwhile, someone—it is almost impossible to figure out who—is using a crowd sale to peddle Jesus Coins, which promise to forgive sins and fight corruption in “the church,” among other things.
I’m not saying all ICOs are sketchy. Some have legitimate uses, such as Filecoin, which aims to allow a token holder access to storage online and rewards people for hosting files.
The problem is that many of these tokens are traded on exchanges, and are thus viewed by investors as commodities or currencies to trade in and out of. Most tokens aren’t “pegged” to anything in the real world, and their exchange rates fluctuate. Most tokens are currently going up in value, which has attracted a large number of speculators who aren’t looking for workers or forgiveness of sin. They don't really care about the underlying asset linked to tokens, and are investing on the Greater Fools Theory—the idea that someone dumber than them will buy their tokens for more than they paid. This is a pretty good bet … until it isn’t.
Requiring companies to sell tokens only to accredited investors won’t solve the problem, because those investors will later sell them to speculators or, worse, to people who have seen the ads online promising to provide the secret of making a bundle on cryptocurrencies. And Wall Street has never been willing to end a rip-roaring party once the keg is tapped.
The regulatory intervention that has just begun will need to be much more sophisticated and technically informed, and in the meantime there’s a long line of people who’ve read about the skyrocketing price of Bitcoin (or Jesus Coin) and are waiting for a chance to buy into one of the myriad ICOs coming down the pipeline.
And volatility adds to the burdens of young companies issuing tokens, which will need functions similar to a central bank and corporate-style investor relations in addition to just trying to run their core businesses. If these companies fail, investors will get some benefit in a fire sale or liquidation, but token holders will end up with something akin to the Zimbabwean dollar in my scrapbook.
But a coin without volatility would be of little interest to such speculators, and it would be quite easy to design. We could start by simply pegging the value of tokens to something, say $1 or the price of one hamburger. A pegged token would fluctuate in “value” only to the extent that the underlying asset fluctuated. If the subscription price is fixed or you only eat hamburgers, there would be much less fluctuation or volatility.
For people hoping to make a fast buck, that linkage would remove potential upside value, narrowing the market of the coins to mostly just those people who would use the service. Having said that, even with a value pegged to some underlying asset, it’s possible that the current irrational market would still make prices go crazy. If the issuer didn’t own or have the ability to produce the underlying asset, the owners of its coins might be in peril of holding a valueless proxy. For example, concerns have escalated recently that Tether, a cryptocurrency pegged to the dollar, may or may not have actual dollars to back its tokens. If it doesn’t, then it’s sort of like an uninsured bank printing its own version of dollar bills without anything in its vaults. People have been buying Tether as a proxy for dollars on cryptocurrency exchanges, and so its failure might cause the price of Bitcoin to plummet and, more broadly, do substantial damage to the market.
A lot of otherwise productive developers are devoting their expertise and attention to working on shallow, quick money ICOs rather than working to sort out the underlying infrastructure and protocols in academic and more open deliberative settings not fueled by warped financial interest.
It reminds me of the late-’90s dot-com bubble, when the now-defunct Pets.com was spending investor money buying Super Bowl ads to sell products at 30 percent of what they cost the company itself to buy. I understand the desire of venture capital to use blockchain and other technologies underpinning ICOs, and for new companies to take this nearly “free money” to build their businesses. But there is, I feel, an ethical issue in such knowing exploitation. I’ve pleaded my case with entrepreneurs, investors, and developers, but it’s like trying to stand in front of a buffalo stampede.
ICO mania will no doubt run its course, as all such financial manias do. But in the meantime, people will be hurt and there will be a painful correction. The one upside is this: As in the wake of the dot-com implosion, serious developers and investors will continue to work to build what will be a more robust network and foundation for the future of the blockchain and cryptocurrencies.
My friend Bill Schoenfeld, along with a small number of investors, made a lot of money when the real estate bubble in Japan popped. At some point, the Japanese real estate bubble got going so fast that almost no one was assessing the underlying value, but Bill insisted on pricing real estate doing just that. When the bubble popped and the prices went into free-fall, he bought a lot of property at a rational price. Bubbles make pricing irrational going up as well as going down. Maybe the clever thing to do right now is for people to assess the real underlying value of these tokens and be prepared to buy the ones that are actually valuable when the bubble pops.
Amara’s law famously states that “We tend to overestimate the effect of a technology in the short run and underestimate the effect in the long run.” The largest and most successful companies on the internet were built after the first bubble, when the protocols and the technologies became mature. I’m holding my nose, squinting my eyes, and imagining—and running for the mountains beyond the dust storm around the ICO stampede.
Note on conflict of interests: When I helped found the MIT Media Lab Digital Currency Initiative, I sold my shares in all blockchain and bitcoin related companies and have not invested in any companies engaging in cryptocurrencies as their primary activity. I do not hold any material amount of any cryptocurrency. I believe that in the current phase of our work, it is important for me to be clear of any conflicts of interest. You can see a more complete conflict of interest disclosure on my website.