Today’s article is by our guest writer Sergey Khalil. He’s a third year student at the BSc Economics and Business program at the FEB. Enthusiastic about what new technologies can bring, and trying to take part in the process of shaping the future through investment.

As the title suggests, we live in an era of limitless possibilities… and YES, it does include ‘printing’ your very own ‘currency’ with no legal consequences. At least for now, that is.

Sounds a bit far fetched, but this is essentially what has been happening with the emergence of ICOs, or Initial Coin Offerings—a new way for companies to raise funds.

Anyone can issue their own ‘cryptocurrency’ in a matter of minutes, thanks to a handful of platforms that let you care only about the name of a new coin and how many of them you want to create. This might seem as an easy way to get rich quick, which surely is within the realm of possibilities, but chances are me and you are not the only ones who have thought of it this way. Most new technologies go through a ‘hype’ phase which is clearly indicated by extensive media coverage, huge money inflows and a consequent advent of numerous scam artists wishing to make a quick buck on impatient and uneducated investors.

This article is not about maximising your return-on-investment (ROI), but rather about minimising risk exposure, which is key to any investment strategy. Even if you are not planning to invest in crpyptocurrencies any time soon, getting to know the basics of the ICO economics and more importantly how not to lose money to bad ICOs can prove to be useful in the long-run.

An ICO in a nutshell

ICO, again, stands for Initial Coin Offering, which is a way for a company to raise funds by ‘offering’ investors the opportunity to buy newly issued digital tokens with other cryptocurrency (e.g. BTC) or fiat money (e.g. USD). As a general rule, an ICO is held in an early stage of the project to finance its launch and core product development. In that sense an ICO is quite similar to crowdfunding.

One may also notice an uncanny resemblance of the terms ICO and IPO, or Initial Public Offering. Probably this is one of the main reasons for confusion between the two. “Digital tokens” have nothing to do with ownership of the company, in fact, because of the absence of clear regulation guidelines there might not even be a company behind the project in the first place. Moreover, it is usually done without the friction and restrictions of conventional financial system, since major part of funding for ICOs comes in the form of other cryptocurrencies.

So it is fair to say that an ICO is a way for someone to attract capital at an early stage of the project without the hassle and bureaucracy associated with obtaining a loan from a bank, or seed funding from a venture capital fund.

Why are investors even attracted to ICOs?

Well, they generally have these two ideas in mind before investing:

  1. Buy now for cheap, sell at a higher price later on: This sentence alone pretty much sums up what investing is, however the difference here is the expectation of a disproportionate ROI, that has clearly been the case throughout the last couple of years on cryptocurrency market. Retrospective ‘mental trading’ (how much would I have now, if I invested some money in ETH some time ago) leads many amateur investors to experiencing FOMO (Fear of Missing Out). Considering the Ethereum example, $100 invested during its token sale could go a long way with more than $200,000 in present value. No wonder people want to jump on this bandwagon!
  2. Use tokens to get platform’s services at a discount: For instance, early investors in FileCoin (decentralized file storage platform) could have received more than 90% discount on its service (storing data) as of when the article is published. This approach seems to be very pragmatic and still prone to turning into speculation.

These two ideas originate from two categories of digital tokens: security tokens and utility tokens. First ones behave similarly to stocks and other conventional securities, while the latter are used as integral part of the blockchain platform providing access to its services. It is a good practice to assume all new digital tokens to be securities, unless there is a clear reason why this token is such an important component to the platform it’s being offered by.

How does the a lack of regulation and immature markets come into play with ICOs?

Having the basics of ICOs covered and out of the way, we can now explore the most neglected side of this magical money-making market: risks.

Probably the biggest one is fraud, when founders of a project ‘disappear’ after its ICO is done. Since there is no regulation of such crowdsales, investors give their money based solely on trust. At the same time, it is almost always the case that there are no binding commitments from the team and the company to deliver practically anything, and in the absence of the legal structure they will have no liability either. In some sense, the emergence of numerous ‘exit scams’ and fraudulent projects is economically incentivised. Moreover, significant risk here is in the management of the received funds: Start-ups usually receive funding in stages and every next round is contingent to performance – if a company mismanages first seed money and will not fulfil its commitments, no further funding will be available. Compare that to the ICO situation, where a business idea secures from several to tens of millions USD without even having a minimum viable product.

Who wouldn’t want to get several millions in cryptocurrency with no liability? In fact, many would – including those with good intentions of bringing value and those with selfish intents.

It is important to acknowledge that it is entirely possible that the project will not survive the early adopter phase. Like in traditional markets, betting on innovative technology can yield high returns but it also means that most of the projects are likely to fail, since nobody knows what will work and what won’t. It is really hard to anticipate what native ‘killer feature’ a new technology will have and when a successful company that brings it into reality will come about. Remember, Facebook didn’t exist until 2003, and just like Uber, Airbnb and Tinder it has not been part of the internet boom of the 90s. Also, it is useful to keep in mind that cryptocurrency markets are subject to price manipulation in large due to lack of liquidity, which may make investments made during a hype phase of the project look rather disappointing with major negative ROI for long periods of time.

This eventually leads to the market risk. The market is still in its early stages of development and prone to panic sells during periods of FUD (Fear, Uncertainty and Doubt) as well as moments of euphoric price spikes, hence the enormous volatility. The scenario when global community would ban all the cryptocurrencies altogether seems highly unlikely, especially with existence of a few cryptocurrency ‘safe heavens’ (e.g. Belarus) and the creation of the self-regulating associations in Japan; however, prices still seem to be very dependent on the investors’ sentiment. This situation is likely to continue until ICO regulation comes around as a part of the broader set of laws that would outline the legal status of cryptocurrencies, thus eliminating a significant element of uncertainty in that sense.

What to look out for before participating in ICO?

Investing in the early-stage projects involves putting trust in the team and founders, in their competence, diligence, and commitment. So, background and reputation of team members behind the project are utterly important. A lot of the criteria converge to the ultimate question: Will this team be able to succeed in what they have set out to do?

There is a slow, but clear move towards more rational valuation methods comparable to that of VCs. For example, such a simple thing as funding through an escrow can vastly reduce the unnecessary risk of project failing in the short-term by conditional capital release by a third party (the escrow), and it also decreases the incentive for the team to just take the money and leave, since relatively not that much money is available at any given moment. And yet it is not so common, but with an increasing number of fraudulent projects it is easy to imagine for it to become general practice on the market.

ICOs that have something to show are much more likely to raise capital. In contrast, many VCs wouldn’t even consider investing in a start-up without MVP, since it shows team’s competence and determination to make the project a reality.

A careful study of the associated whitepaper (the document outlining how the project and the cryptocurrency/token is supposed to function), agreements, and other supporting documents that should be easily available really can’t be stressed enough. Doing so will help to surface some peculiar details that organisers of the ICO may have decided to conceal, like that the project might not be incorporated. Relatively speaking, the chance for deliberate fraud should be less than that of a project that is not incorporated. So by extensively informing yourself ahead of time, you can make better investment decisions. By the way, in the IPO world it is not even possible to not be incorporated, which again signals how young this market really is.

Instead of a conclusion…

The complexity of it all makes the barriers to entry seem high, when in fact they are lowering by the minute as companies start to realise that the one who is closer to the consumer wins. In the context of the blockchain infrastructure, it means the emergence of more accessible and intuitive interfaces for the end users.

Maybe you haven’t learned today how to print your own money per se, but at least you are much less likely to fall victim to scam-ICOs and hopefully not as likely to take uncalculated risks with cryptocurrency investments in general.

Investing is not as easy as it seems and requires a lot, let me repeat again, A LOT of research and I mean hours of scrupulous reading and fact-checking. With the current stage of the market framed as ‘building the infrastructure,’ most projects are quite technical in nature,

…but hey,

when it is all easy and clear, there simply won’t be as many high-risk high-return opportunities.