When people think about financial market bubbles, a few infamous examples instantly come to mind. Financial economists often name history’s first speculative bubble as tulip-mania. This event occurred in Holland during a 3-year period between 1634 and 1637, where the price of tulips rose to incredible heights due to attention surrounding their quality. During the peak of the bubble, a tulip could command a higher selling price than a house. However, when people eventually realized their tulip investments held no intrinsic value, a massive sell-off ensued, which sent the tulip-market in a precipitous crash. Alternatively, we can look at the dotcom bubble, which occurred between 1997 and 2001. Equity markets ballooned due to massive speculation around internet companies, with the Nasdaq increasing five-fold. Once again, when investors realized that most of these companies did not have a profitable business model, a sell-off ensued and the stock market crashed. Today, another market trend seems to display many of the symptoms of an economic bubble: Initial Coin Offerings (ICOs).
ICOs are a fund-raising method for new business ventures that doesn’t require issuance of equity or venture capitalists. During an ICO, the programmers leading the offering sell various types of crypto-currencies to potential investors. The crypto-currencies issued in an ICO can only be used as tokens to transact within the business. For example, the creators of Filecoin, responsible for the biggest ICO to date at $257 million raised, designed the crypto-currency to pay for storage on a global cloud storage network that they plan to create in the future.
People often point out parallels between ICO’s and the bubbles of the past. For example, a common theme between economic bubbles is a meteoric rise in an asset class. During the dotcom bubble, the over-valued equity of internet companies caused the Nasdaq to rapidly swell, not doubling, nor tripling, but quintupling in just a few years. In the case of ICOs, we observe a similar phenomenon. Indeed, in what financial media are calling a financial craze, upwards of $1.8 billion has been raised by ICOs in 2017.
Furthermore, speculative bubbles are generally characterized by an intriguing concept or “story line,” carrying much uncertainty. In the dotcom bubble, market uncertainty resulted from the rise of the newly- commercialized internet and the incredible potential for innovation. However, despite the uncertainty, the market created excessive hype around it. Numerous internet start-up companies profited from this hype, attracting steady capital inflows despite showing no signs of a profitable business model.
With ICOs, we see a similar case. Many of the ventures issuing crypto-currencies to self-fund promise incredible future innovation on the premise of block-chain technology, which has the potential to revolutionize decentralized peer-to-peer transactions. These start-ups’ promises are rewarded with massive inflows of money. Like the dotcom bubble, investors are uncertain if their investment will in fact yield a tech giant disruptor such as Amazon, who emerged successful from the dotcom bubble, or a worthless company who fades out with the thousands of internet companies that died in 2001. Finally, ICOs fall outside the realm of securities law and regulation. Seeing as crypto-currencies are not legally classified as securities, they do not grant their investors any sort of legal protection, which represents high risk. This lack of legal protection further increases the riskiness of ICOs, since they are left exposed to internet fraud, such as the case with “the DAO,” an ICO where hackers stole most of the crypto-currencies issued within it. Because of the volatility of fund flows, the uncertainty regarding the future value of blockchain and the riskiness of crypto-currencies, ICOs demonstrate some of the symptoms present in classic speculative bubbles.
While the ICO market has not yet crashed, it does present signs of significant over-heating, which demands caution on the part of investors. Furthermore, important players in the international community have positioned themselves against ICOs and crypto-currencies. Namely, China has issued a ban on ICOs and crypto-currency exchanges. However, a discussion on ICOs would not be complete without mentioning their benefits. ICOs display some utility as crowdfunding tools for innovative blockchain start-ups to raise capital without being limited by traditional venture capital and equity financing. This allows for increased start-up capital market efficiency, which means that true innovation will have more opportunities to find the capital it needs.
By: Kristian Nedelchev