It’s an IPO, It’s an ICPO. No, Wait, it’s an ICO!
What Happens When Venture Capital meets Cryptocurrencies (approximate reading time: 10–20 mins)
Idea in Brief
From barter to Bitcoin, finance can be viewed as a perennial search for the highest possible risk adjusted returns. The field of finance today is undergoing a technology renaissance with Bitcoin and its ilk converting paper currency into a digital variant. What is ingenious is the use of cryptocurrencies for crowdfunding. This article explores Initial Coin Offerings (ICO) as a form of Venture Capital.
Let’s begin with some basics.
A blockchain is a distributed ledger(database) that records transactions in a growing list of blocks. These blocks are free from tampering and revision and are timestamped.
Using a peer to peer network, and a distributed server, blockchain is managed autonomously.
The entire transaction history is booked in the distributed ledger and is visible to everyone on the network but everybody can tamper the transactions.
Blockchain can be used for a variety of purposes e.g. For peer to peer payments.
If Sally pays Henry $10, Sally’s account in the Blockchain ledger will be debited and Sally’s account will be credited with $10. This transaction will be visible. Also, if Henry then pays John $10, the entire circulation of the $10 will be recorded in subsequent blocks.
Bitcoin & Other Cryptocurrencies
Bitcoin was the first and now relatively stable cryptocurrency that was built using the blockchain platform. The entire movement of the currency is recorded in the distributed ledger. Supporters of Bitcoin think that Bitcoin will soon be a stable store of value just like Fiat currencies. Bitcoins can be mined by essentially using your computer to be part of a distributed network or you can buy Bitcoins on Bitcoin exchanges. Other currencies include Litecoins, Altcoins etc.
The first Bitcoin was launched by Satoshi Nakamoto in 2009 after conceptualizing the currency in 2008.
Ether & Ethereum
First, Ethereum is not a crypto currency like Bitcoin is. It is a Blockchain based decentralized platform that issues tokens called ‘Ether’. Ethereum is used to create smart contracts. Developers can use the platform to create a plethora of applications that are tamper proof.
Like Bitcoin(BTC), Ether (ETH) is mined. So, you can mine cryptocurrency by essentially loaning your computer to global decentralized network. Unlike Bitcoin which has a finite supply (21 million) there are no limits on the supply of Ether. As supply goes up, the price declines unless users decide to hold Ether
Smart contracts are Turing complete (AI equivalent of parties to a contract agreeing to execute the terms of the contract) programs that execute a clause in a normal contract if certain conditions are met. Eg if you pay a Bitcoin using a mobile wallet, the parking meter allows you to park for one hour. The trust between your mobile wallet and the chip in the parking meter is established using a Blockchain.
Initial Coin Offering (ICO)
Having understood the terms, imagine that you have a Blockchain based project that utilizes the Ethereum smart contract platform so that cars can automatically pay parking at the parking meters without human intervention. IoT combined with smart contracts using the Blockchain
Incidentally, a subsidiary of RWE, one of Germany’s biggest energy and gas provider with 30 million customers and billions of revenue, has launched 100s of electronic vehicles (EV) charging stations all over Germany, connected to ethereum’s public blockchain.
“Describing the vision of a new enthralling future, RWE’s representative detailed how blockcharge would work. By using a computer chip in the charging station, a smartphone app to communicate with the interface, and a blockchain to manage and record all of the payment and charging data, a fully automated, worldwide authentication, charging and billing solution with no middleman is created. The app used is called Share & Charge.
Now imagine, you want to launch a similar project on the Ethereum platform and you want to use crowdfunding to do so. You resort to what’s called a ‘Initial Public Coin Offering’ or ‘Initial Coin Offering’ which is accepting money from investors in the form of Fiat currency or cryptocurrency and providing the investors with tokens (similar to a equity) in the project. Thus, this is venture capital using crowdfunding and cryptocurrencies. Ingenious and borderline ‘purely speculative’
An exchange provides liquidity to investors to buy and sell the tokens which could be Ether (ETH)
Relatively Riskier Investment
As an individual, you can buy Bitcoin or Ether using a Bitcoin/cryptocurrency wallet such as Coinbase. The beauty of digital wallets is that you have a fairly liquid exchange to buy and sell Bitcoin, Ether and Litecoin. At the inception, you couldn’t trade in Bitcoin; you could just redeem it at vendors that accepted Bitcoin as a form of payment which were few to begin with.
However, since cryptocurrencies are not subject to stringent regulations and they exist in a digital realm, there is always a risk that you can lose your money.
If you want to understand why people across the world and primarily Chinese investors are attracted to Cryptocurrencies, look at the charts below:
Performance of Bitcoin
Performance of Ether
Performance of Litecoin
Legal and Regulatory Challenges
In an environment where high yielding financial options are limited, It is not hard to see why investors and speculators alike flock to provide liquidity and enjoy stupendous price appreciation for the risk taken.
The value of a typical token is based on the value of the project. If a token is similar in function to an equity share, then it’s a matter of distributing the profits as dividends and the growth comes from increase in the market value of the project.
But, the underlying technology behind the project is a Blockchain. Because the Blockchain is a distributed ledger with self authentication built in, a token cannot be classified as a financial derivative contract but if you peel the onion and understand that the holder of a token has no voting rights, there is some resemblance to financial derivatives.
Since a Bitcoin or Ether is essentially a rent paid for loaning out your computer or a currency bought by using your actual money on an exchange, it can create challenges in classifying and accounting in conventional books of account. Do you Mark to Market?, hold it as cash or investment? etc.
The Securities and Exchange (SEC) is yet to comprehensively regulate Initial Coin Offerings (ICO’s), there is very little doubt that human nature will propel speculation and fraud making it necessary for regulators to start regulating such forms of crowdfunding/venture capital.
The Mt. Gox Hack
Mt Gox was a Bitcoin exchange based out of Tokyo that at one point handled 70% of Bitcoins issued. In February 2014, the exchange filed for bankruptcy and started liquidation proceedings.Most of the Bitcoins are assumed to be stolen. Although, Bitcoin appears to have stabilized but incidents such as these are not out of the ordinary.
The DAO Hack
Bitcoin itself is a Decentralized Autonomous Organization (DAO). However, The most recent DAO is the example of an ICO:
- Programmers wrote smart contracts to create the organization on the Ethereum platform.
- To fund its initiatives, the founders of the DAO sought crowdfunding and issued tokens to the contributors. Tokens had no voting rights.
- The DAO launched on 30th April, 2016, with a 28-day funding window. For whatever reason, The DAO was popular, raising over $100m by 15th May, and by the end of the funding period, The DAO was the largest crowdfunding in history, having raised over $150m from more than 11,000 enthusiastic members. The DAO raised far more money than its creators expected (source:coindesk)
However, a programming flaw allowed an unknown attacker to siphon off 3.6 m ether which resulted in a fall in the price of Ether from $20 to $13. In other words, DAO was vulnerable to breaches which should serve as a cautionary tale to investors.
As the search for yield continues, utilization of the Blockchain will proliferate. Blockchain is already part of mainstream business with banks and other institutions developing applications using Blockchain.
As for Bitcoin, Litecoin, Ether and other Cryptocurrencies, its hard to say whether either will end up becoming a very stable store of value. Cash has not been replaced yet even though many predicted its demise.
Regulators across the world are watching and so are speculators and investors with a very high risk appetite. Till then, it’s an interesting saga in a financial renaissance.
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