A man looks at monitors displaying the prices of cryptocurrencies at a Bithumb exchange office in Seoul, South Korea. (Photographer: Jean Chung/Bloomberg)

Initial Coin Offerings Are Getting a Bad Rap


(Bloomberg Opinion) -- Initial coin offerings are a hot topic, but the focus tends to miss the most important innovation. Attention naturally is on the 81 percent that are frauds, but the honest ones raised $7 billion for cryptocurrency initiatives in 2017. Those were predominately for double-blockchain ideas, which is blockchain funding to support a blockchain project.

Frauds permeate crypto projects because they’re hard to understand or verify. But the majority of non-fraudulent ICOs by number (not dollars) are for ordinary business projects. This latter group may be as transformative as cryptocurrencies themselves. Moreover, they’re easy to understand.

Suppose a promoter wants to put on a touring music festival along the lines of the original Lollapalooza. She needs $8 million to sign bands, rent venues, advertise and pay other expenses. She could, for example, create 100,000 shares and sell 80,000 at $100 each for expenses and keep 20,000 as her compensation. Another strategy is to presell the product, perhaps 200,000 tickets at $40 each. Instead of owning 20 percent of the equity, her compensation consists of any additional ticket sales and other revenue that are generated after the presale.

An ICO can be regarded as a hybrid. The promoter creates 50,000 tokens and sells 40,000 for $200 each, keeping 10,000 tokens as her compensation. She pledges that festival tickets will only be sold for tokens. Unlike equity, the tokens are not promised a share of profits in the venture, and unlike pre-sold tickets, the promoter does not specify how many tickets one token will be able to buy.

If the festival doesn’t click and total demand is for only 50,000 tickets, then one token buys one ticket and the ICO investors paid $200 for a ticket. But suppose total demand is 500,000 tickets and people are willing to pay $50 each for them. Now one token buys 10 tickets and can be sold for $500. Our ICO investor can take a 150 percent profit, or go to the festival with nine friends, or go himself and sell the remaining 0.9 token for $450 — a net cost of negative $250 to see the show.

Investor, customer and manager interests are exactly aligned. All of them only care about the total quality delivered — total revenue, not profit. This changes the fundamental purpose of the enterprise. If bands and other vendors accept token payment, there is even more alignment. There is less risk as well. An ICO buyer who paid $200 for a ticket gets to see a festival he desired, and in more intimate setting with only fellow fans rather than a gigantic venue with a general audience. ICO funding could make many useful ventures possible that cannot be funded today with either equity or presales; and in other cases it might deliver a better product.

But this is only half the ICO idea. The promoter could implement token financing with a centralized database or physical tokens. Nobel laureate Friedrich Hayek suggested this in 1976, but pointed out token users would have to maintain separate accounts at every company using token financing, making the tokens illiquid and inconvenient.  A potential customer would have to search for a token holder willing to sell, and negotiate a price.

Putting the tokens on a public blockchain solves the problem. Applications are already available that would allow any customer to click on a price in some reference cryptocurrency (say Bitcoin or a Stablecoin) and have the exchange for the required token and transmittal to the vendor handled seamlessly. Plenty of intermediaries exist to keep the markets liquid.

All the advantages — and I’ve only touched the surface here — are theoretical. Legal, financial, technical and regulatory infrastructure will need to be created, and expensive lessons learned by trial and error, before ICOs for non-crypto projects are ready for prime time. But ICOs have the potential to create a new type of economic entity that could be as transformative as the for-profit public corporation. So it pays to look beyond the fraud and big dollars of ICOs to the honest little ones that may grow into black swans.

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

Aaron Brown is a former Managing Director and Head of Financial Market Research at AQR Capital Management. He is the author of "The Poker Face of Wall Street." He may have a stake in the areas he writes about.

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