Alternative Investment Alert: Initial Coin Offerings

 In Investing

I have been silent on the FinTech front lately and return with an alternative investment idea that seems to have grown up in the last year: initial coin offerings (ICOs). Bitcoin was the original mainstream digital currency that led to the FinTech revolution thanks to the distributed ledger technology that underpins it, and it has also led to a revolution on the digital currency front with many coins now engaging in fundraising to offset development costs. With the stock market at interesting yet worrisome highs and real estate still illiquid (not to mention tying up a significant portion of your investment pool for an extended period of time), the alternative investment space is limited and ICOs represent a fascinating avenue for those who have a diversified portfolio and can comfortably lose money if luck doesn’t work out in their favor.

Why the ICO is A Different Alternative Investment

I COs (also known as “token sales”) are being fueled by the convergence of distributed ledger technology (DLT, a.k.a. blockchains), new wealth, imaginative entrepreneurs, and investors who believe in the power of DLT. Venture capital firms typically only invest in startups, but the VC industry is beginning to consider ICOs which makes them an interesting alternative investment choice given the ongoing low interest rate environment we’re in. Reasons for the VC industry’s change in heart include profits (some cryptocurrency investors made 2,000% returns on select ICOs in 2016), and liquidity (investors can more easily see gains and pull out profits instead of investing in companies that take a long time to build). The market capitalization of Ether, a cryptocurrency on the Ethereum network, rose more than 500% in value since the beginning of 2017. It’s no surprise that other projects are entertaining the prospect an ICO too.

T oday’s digital currencies (you can think of them as electronic money) are also known as cryptocurrencies due to the cryptographic features that secure many of the coins in use today. Cryptocurrencies don’t actually take long to make – virtually every cryptocurrency on the market today is based on the open source code of Bitcoin or Litecoin which are available on Github, a repository of open source and business code that anyone can access.  Instead of accepting some fund’s money in exchange for equity stakes, cryptocurrency developers decide to issue their own digital currencies, or tokens, that anyone can buy in a crowd sale. Proceeds from the auction of these virtual shares help fund the businesses, and value is arbitrarily determined by the startup team behind the ICO. Price dynamics are then determined by good old fashioned market supply and demand by the network of participants willing to participate in the cryptocurrency scheme.

U nlike other alternative investments (private equity, hedge funds, managed futures, real estate, commodities and derivatives contracts), the winning attribute of ICOs is their liquidity. Yes, mutual funds and ETFs are a liquid alternative investment (and I myself hold about 10% of my portfolio in REIT mutual funds), but you only gain exposure to an alternative investment instead of an ownership stake in the asset. The hybrid model that ICOs embody (liquid ownership) is what makes them compelling, and if you pick an ICO that has a long-run trajectory similar to bitcoin’s since 2009, you will be a happy camper  (a single bitcoin is worth $1,230.15 as of Wednesday night, which is quite a return to have made if you had held on since 2009).

Risks of ICOs

R egulatory uncertainty is a big issue with ICOs as no regulatory agency has issued clear guidelines on how they are likely to treat cryptocurrencies. The IRS notes that you must report capital gains which is clear enough, but other regulatory agencies have not made up their minds regarding legislation they may impose to protect safety and soundness. The tokens, proponents say, are not quite like a security, yet not quite like a currency either.

A side from regulatory uncertainty, the weak governance models in many ICOs should give investors pause. The implosion of the DAO last year underscored why you need real people managing a crisis if/when it occurs. One ICO that is planning to hit the market, Tezos, is working to remediate this problem by building a blockchain where stakeholders can change the underlying technology through an online voting system. Bitcoin itself is at a crossroads with developers split between how best to address the slow speed plaguing its network. With no real governance model, there has been two years of infighting to resolve this situation and no answer lies in sight.

T ezos will sell tokens to anyone wishing to participate in their ICO and token holders will help process and record the transactions. Token holders will have the right to suggest and vote on changes to the network, and the more tokens one has, the more voting power they have. In this way, Tezos aims to be a working democracy.

N ote that if you’re not already computer fluent, it will be almost impossible for you to download the software and participate in the network. What you’ll have to wait for is when the secondary market pops up to re-sell existing coins. Today there are many exchanges that sell bitcoin and ether, two of the most well-known cryptocurrencies to date.

How to Find ICOs

I t’s hard to believe but despite their infancy, there is already a ratings agency for ICOs called ICOrating. The team focuses on both ICOs as well as distributed ledger technology. From the website: “ICORating’s team goal is to to develop clear assessment standards for blockchain startups and assign ratings based on a transparent and standardized scale. It was this approach that turned the Wild West traditional stock market into a civilized platform. After the emergence of rating agencies the risks of fraud will be minimized for both issuers and investors and they will have more unbiassed information to base their decisions on. It will increase the responsibility of the developers of decentralized services before the users.”

T he other (more time-consuming) way to find out about ICOs is to subscribe to FinTech news sources like Finextra, Pymts.com, FinTech Roundup, and CB Insights. While more time-consuming, we are living through an era of unprecedented change in the financial industry, and the time you spend learning about the FinTech developments in the space will make you an informed financial services consumer.

I continue to be amazed and inspired by the innovation that I see in the FinTech field. The alternative investment of yore has generally been staid, so it’s exciting to include FinTech in it. It is my greatest hope that the wave of openness and transparency these startups are bringing into our lives will get the big banks thinking about how to better serve us and our money. Let’s hope these entrepreneurs and inventors can continue to operationalize their grand ideas.

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