Are Ethereum Initial Coin Offerings Dangerous?

Ethereum Initial Coin OfferingsPeople Misunderstand Blockchain

On a recent episode of the Slate Money podcast, columnist Jordan Weissmann said half-jokingly, “Friends don’t let friends invest in ICOs.” It was an offhand comment, but it got me thinking. Is that what people think about Ethereum initial coin offerings?

What a horrible thought…

ARE initial coin offerings a scam, though? This is a tough question to answer. We may look for a simple answer, but we won’t find one. ICOs are simply too new.

It is fresh from the idea factory and we’re learning about it in real time. Even regulators don’t fully understand what’s going on.

The United States Securities and Exchange Commission (SEC), for instance, is investigating whether ICOs fall under their jurisdiction. Read that again.

The SEC—America’s most important financial watchdog—is “investigating” initial coin offerings…which means they don’t understand ICOs either.

After all, the only reason to “investigate” something is to learn more about it.

Also ReadEthereum Crashing: Is Ethereum a Good Investment?

I don’t get to say this often, but I feel at a slight advantage to the SEC. I’ve been writing about cryptocurrencies for a while now. So let’s break down these funky new technologies.

What Is an Initial Coin Offering (ICO)?

An initial coin offering is a claim on future goods and services produced by a company.

You’ll often hear people compare ICOs to IPOs (initial public offerings), but they are not exactly the same.

When a company goes public through the IPO process, it issues common stock or other forms of equity. This gives shareholders a small piece of the company; an ownership stake.

ICOs do not do that. If you buy coins in a token sale, you do not own any part of the company.

What you get in a token sale is the right to use those tokens at a future date. So when the company builds what it promised to build, you can use its service with your tokens.

Now there is a speculative component to all this. If a company is incredibly successful, it follows that its token value will skyrocket. So it’s possible for you to participate in an ICO without the intention of ever using those coins.

In this way, a token sale can be similar to derivatives trading. You can go long as a matter of speculation, not because you intend to exercise the actual instrument.

What Does Ethereum Have to Do with ICOs?

The majority of initial coin offerings take place on Ethereum’s platform. It is the New York Stock Exchange of cryptocurrencies (although, as said before, ICOs aren’t IPOs), which naturally raises demand for ETH tokens.

Ethereum price history

But how did this happen? Why Ethereum instead of Monero or Dogecoin?

Because unlike most other cryptocurrencies, Ethereum wasn’t formed as an offshoot of Bitcoin. It wasn’t even an offshoot of Litecoin (which is to Bitcoin as silver is to gold).

Also ReadICO Basics: Everything You Need to Know About Initial Coin Offerings

Ethereum was a genuinely unique platform released by a prodigy named Vitalik Buterin.

Buterin is a bona fide genius. At the age of 17, he came across Bitcoin; it captured his imagination. Two years later, he wrote a white paper outlining a successor to Bitcoin.

He called it Ethereum.

Buterin expanded the best ideas of Bitcoin beyond money and payments. He envisioned a world wrapped in blockchain, where any power structure or intermediary could be removed. All you needed was the right code to replace them.

This is partly why I like Ethereum more than Bitcoin; it is more flexible and creative.

Plus, Ethereum has “smart contracts.” These are essentially agreements or actions translated into code. They can be activated by entering a command, after which no one can stop them.

I know this doesn’t sound all that interesting, but it’s a HUGE deal.

Think about all the stupid things that require a middleman. If you buy a house, for example, you need a lawyer to manage the paperwork. But suppose there were a standard “smart” contract that could replace the lawyer.

You fulfill all the requirements on your end, the seller does the same on theirs, and the transaction executes itself. Both of you save on lawyer fees. That’s just one example among hundreds.

I often hear the criticism that cryptocurrencies aren’t practical, but what is more practical than disintermediating markets? Seriously, does anyone like paying lawyer fees?

Are Ethereum ICOs Dangerous?

But I digress. Let’s get back to the original question of risk.

In a way, Weissmann is right that ICOs are dangerous. They are, at the moment, unregulated methods of funding a company. If I were a con man, there’s no business I’d rather be in. All you need is a website and a white paper to get started.

Granted, you also need a good idea to sell, but you don’t have to build the thing you promised to build. There is no one holding your feet to the fire; no one looking over your shoulder.

It would be perfectly legal to raise money in an ICO, pay yourself an enormous salary, “fail” to build the product, and walk away. There is no mandatory audit system, disclosure form, or deliverable that keeps ICOs honest.

But that is just for now

I hesitate to speak ill of ICOs because there is so much potential for them to become useful. If the ICO market can act like a giant Kickstarter, we could actually see it circumvent traditional venture capital.

It’s already starting to happen. This year, cryptographic companies raised more money through ICOs than through VC funding. So while it’s true that Ethereum initial coin offerings are risky, I am hopeful they can mature into a legitimate channel of startup capital.