cats in a bag

Bring on the ICOs

A rash of cryptocoin offerings will help determine which are viable and which will fail.
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Photographer: Matt Stroshane/Getty Images

Initial Coin Offering.

It's a term deliciously similar to those three letters guaranteed to make bankers, investors and founders salivate: IPO.

For the most part, bankers have been cut out of the ICO equation -- almost by design -- but founders are loving the notion that you can launch your own cryptocoin, and a growing number of investors are excited about the prospects for huge windfalls.

ICOs are so similar to penny stocks that the investing strategy looks almost the same: Throw a few dollars at a low-value security and hope that a bit of hype will see its price go up by astronomical multiples.

Here's how it works. A founder comes up with a new cryptocoin and pre-sells an amount to investors prior to launch. They may swap these digital tokens for fiat money, such as U.S. dollars, but are more likely to do so for an established cryptocurrency like bitcoin or ethereum. This early investment not only funds development but helps kick-start the coin's circulation, because a currency isn't very useful if it all sits in the wallets of just a few people.

In many cases, founders are developing a real service that's usually linked to the crypto ecosystem, such as a new decentralized exchange, and the coin will become the transactional currency for that product. Others are little more than a lottery. The actual project is spelled out in a white paper, similar to a prospectus.

As with penny stocks, investors in ICOs are betting on one of two things: that the underlying company or project becomes a sustainable venture, thus making the coin it uses a sought-after commodity. Alternatively, enough hype is created around the future prospects of the venture, or its coin, that others want to buy in, bidding up the price and allowing earlier investors to exit at a profit. If the project fails, or no one really believes that anyone else will want the coin, then it could quickly become worthless.

But ICOs aren't selling securities: Investors are getting neither equity in the venture, nor a promise of some future cashflow (i.e., debt). This fact has helped the crypto community dodge financial regulators.

Working in the ICOs' favor is the fact that the phenomenon has so far been the domain of crypto geeks, libertarians and sophisticated investors. While counter-intuitive, I would argue that keeping this circle tight is in the crypto community's best interests, for now.

ridiculous number of speculative new coins have hit the market -- including at least 67 in the past month -- and the vast majority will fail, which means losses for investors. But this try-and-fail process needs to happen in order to shake out the wheat from the chaff so that we can truly understand which blockchain models work, and which don't.

Within the safety of this sandbox we'll be able to test whether the world really needs a blockchain lottery, whether a decentralized exchange provides enough value to justify the transaction fees, or whether cryptocoin truly is the future of in-game currency.

Let there be no doubt that these are the Wild West days of crypto -- a domain that's unsuitable for mom and pop investors. But when the dust settles this new economy may be more robust than ever.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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