Why Are ICOs Dangerous?

June 17, 2017

Initial coin offerings (ICOs) have upended the crypto-currency markets in recent weeks.  So why are ICOs so dangerous to investors like you and me?

Because the only thing propping them up is that they are unregulated.  Start-ups are able to bypass rigorous and regulated capital-raising processes typically required as part of initial public offerings (IPOs). Furthermore, the value behind the ICO is arbitrarily determined by the start-up team based on what they think the network is worth at its current stage.  This leads to high valuations and often over-capitalisation.

Given the large number of ICOs that have occurred in the past few weeks, the simple law of supply and demand has dictated that the price of ether has shot up to unsustainable levels, with consistent 10%+ days.  Ethers in particular, the crypto-currency of choice for ICO token exchanges, have been removed from the market, falling into the hands of start-ups and thereby restricting supply.

Ether has been the popular choice given the strong fundamentals backing the crypto-currency.  It follows that start-ups can rely on ether as a suitable form of financing.  However, there is an incentive problem.  As the price of ether continues to rise, there is no sense of urgency for start-ups to sell their ether positions in order to finance their business plans or accountability given that these start-ups have been able to raise funds without offering equity to its stakeholders.  This props up the price of ether as more and more ICOs are launched.

If there were anything that causes a bubble in ether, this would be it.  There must come a time when credible start-ups begin to convert their ether positions into fiat currency to cover their costs.  This puts pressure on the price of ether, which in turn causes more start-ups to liquidate their ether positions based on the fear that the price of ether will go even further down and they would no longer meet their minimum fiat equivalent required.

Another problem with regards to ICOs is the influence of cryptocurrency whales.  These whales are finding ways to reduce their exposure in bitcoin and ether without having to go into fiat currency, which is taxable.  A perfect way to do this is to participate in token sales that allow them to diversify their portfolios while pumping and dumping these new tokens.  These whales ultimately make or break ICOs.

Whales often do not care about the start-up’s business plan or value proposition and end up preventing those who do care from participating in the ICO altogether.  They often pay 1,000 times what a normal project supporter like you and me would in ether fees, in order to have their trades come in ahead of the other orders.  This is how the Bancor Foundation managed to raise $146 million worth of ether (396,720 ETH) in less than three hours on the 12th June, and how Civic sold out eight days before the official offering was to take place.

Ultimately, ICOs have amplified the tug-of-war between speculators who misuse ether and investors who believe in Ethereum’s long-term fundamentals to the point where ether becomes victim to ‘pumps and dumps’.  ICOs have raised over $327 million so far this year.  No doubt, this number will continue to rise exponentially so long as there are no regulations.

ICOs have caused mass congestion in the Ethereum network, which is concerning given that Ethereum is expected to be more resilient by being able to process about 50% more transactions than bitcoin can every 10 minutes.  This reflects the scale of the problem as exchanges worldwide have been unable to meet the demand.

Ether is a sensible investment but the ICO phenomenon has favoured the few, not the many.  Once again, small investors like you and me are best placed to protect themselves from unnecessary market volatility by simply buying and holding, and ignoring all the noise.

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