Explaining the new cryptocurrency bubble
You're going to hear a lot about initial coin offerings (ICOs) in the coming months. As investors have poured more and more money into newly created virtual currencies, they have created a gold-rush mentality. In recent months, some ICOs have raised tens of millions of dollars, and in early October the cryptocurrency market as a whole was worth about $140 billion.
Some ICOs have been for serious projects trying to solve hard technical problems. Others seemed like little more than cynical attempts to cash in on the speculative boom. Celebrities like Paris Hilton, Floyd Mayweather, and Ghostface Killah have endorsed ICOs The launch video for the cryptocurrency Hilton endorsed, called LydianCoin, consisted entirely of cliches: "Purpose isn't defined by what you want to achieve but what you want to live for to achieve happiness." (Hilton has since deleted her tweet endorsing LydianCoin.)
But throughout 2016 and 2017, ICOs of all shapes and sizes have repeatedly set new fundraising records as existing cryptocurrencies like Bitcoin and ether simultaneously soared in value. Experts we talked to—like Peter Van Valkenburgh, an expert at a blockchain advocacy group called Coin Center—didn't think that was a coincidence.
"We're probably in a bubble," Van Valkenburgh told Ars in an early September interview. But even if the current boom does turn out to be a bubble, Van Valkenburgh argues that this isn't necessarily a bad thing.
"You can look at bubbles as being socially productive," he told Ars. Bubbles "allocate capital to long shot, paradigm-shifting innovation" instead of incremental improvements to existing technologies. The dotcom bubble created a lot of failed companies—but it also created Amazon, eBay, and Google.
The ICO boom is a classic speculative bubble
Paul Graham is a well-known Silicon Valley investor who co-founded one of the first e-commerce companies and then sold it to Yahoo in 1998. From there, he became a Yahoo employee, which gave him an inside look at the dynamics of the dotcom boom, which Graham described in a 2010 essay as a "de facto Ponzi scheme":
Investors were excited about the Internet. One reason they were excited was Yahoo's revenue growth. So they invested in new Internet startups. The startups then used the money to buy ads on Yahoo to get traffic. Which caused yet more revenue growth for Yahoo, and further convinced investors the Internet was worth investing in. When I realized this one day, sitting in my cubicle, I jumped up like Archimedes in his bathtub, except instead of "Eureka!" I was shouting "Sell!"
Something very similar has been happening in the Blockchain world, and this story begins with Ethereum. Today, it's the second most popular cryptocurrency after Bitcoin. Ethereum's cryptocurrency, called ether, was offered for sale months before the launch of the Ethereum network. The presale concluded in August 2014, and it turned out to be a phenomenal deal for buyers. Since the July 2015 launch of the Ethereum network, the value of ether has risen more than 200-fold.
Seeing this success, a lot of other cryptocurrency founders have followed this approach in the last two years. The strategy has come to be known as an initial coin offering.
ICO founders tend to come from within the cryptocurrency world. Blockchain investors are more likely to take a project seriously if it's led by veterans of previous projects. Founders usually follow the template set by Ethereum: the project's vision is laid out in a white paper that describes how the new network protocol will operate. They set up a website with instructions for registering for the ICO and sending money—usually in the form of Bitcoins or Ethereum—to the company. ICOs generally run for a few days, but some of the most popular ones have been halted within hours or minutes as they became over-subscribed and quickly reached their fundraising target.
People buy into new ICOs in the hopes of getting in at the ground floor of the next Bitcoin or Ethereum, just as investors in the IPOs of the late 1990s hoped they were buying shares in the next Yahoo. But the parallels to the dotcom boom don't stop there.
Legal and technical obstacles make it tricky to directly sell a new cryptocurrency for dollars, euros, or other conventional currencies. So ICOs almost always use bitcoins or ether as a medium of exchange. People first convert their dollars into bitcoins, then use the bitcoins to buy the new cryptocurrency. That creates demand for bitcoins, pushing up their value.
And that's not all. The Ethereum blockchain is a general-purpose computing platform, and a lot of the new tokens being offered for sale are actually built on top of the Ethereum blockchain. It takes ether to run software on the Ethereum network, so the more projects are built on top of Ethereum, the higher the demand for ether.
The result is a powerful feedback loop. Token creators point to the success of the Ethereum presale as evidence that token presales are a good investment—much as startup investors in the 1990s pointed to Yahoo's success to justify their own fundraising. At the same time, growing ICO activity boosts demand for ether (and Bitcoin), creating an even greater sense of momentum in the blockchain world as a whole.
This feedback loop is likely one of the reasons the price of bitcoins and ether soared over the last year. At one recent point, the price of Bitcoin had risen six-fold from a year earlier, while the price of ether had risen by a factor of 20 in one year.
The rising price of Bitcoin and Ethereum also means that early investors in these currencies have a lot of paper profits they can throw at new projects—just as dotcom millionaires often became investors in subsequent ventures. "There's a lot of new wealth," blockchain investor William Mougayar told Ars. "Everyone who's gaining from it is being very generous, they're re-circulating the gains into these ICOs."
Some blockchains seem more promising than others
Over the last year, hundreds of coin offerings have been announced. Many of them raised barely any money, but there have been dozens of ICOs that have raised millions of dollars for their creators. Some have even raised tens of millions; a handful have topped $100 million. I asked experts which projects showed promise—and how they differed from ICOs that seemed to be little more than hot air.
A lot of the "hot air" ICOs involve startups that try to use cryptocurrency tokens to represent conventional assets. One project, called Bananacoin, for example, uses a cryptocurrency token to represent the sale of bananas. There are several projects to use blockchains to disrupt the real estate business. There are multiple projects for selling event tickets using a blockchain to fight fraud and scalping. There's a blockchain for selling groceries, a blockchain for luxury travel bookings, and a blockchain for transportation services.
Most of the experts I talked to were skeptical of this kind of project because the power of the blockchain comes from its trustless model. Transactions can be verified mathematically, avoiding the need for intermediaries to clear transactions and combat fraud.
"When you try to interface with the physical world, there's trust injected into that relationship," Van Valkenburgh told Ars.
That can cause problems. If you buy a token representing a banana harvest, for example, there's a risk that the guy harvesting the bananas won't deliver. If you buy a token representing a house, the guy living in the house might not move out. In this kind of situation, a blockchain doesn't help you avoid the hassle and expense of using old-fashioned enforcement mechanisms like contracts, title insurance, lawsuits, and so forth.
"Just tokenizing existing real estate doesn't create a liquid market," venture capitalist Albert Wenger told Ars. "My instinct is that tokens only make sense when the tokens play an actual role in the protocol."
Alternatively, as Wenger hints, the most promising blockchain projects were ones where the token was tightly integrated into the network's functionality. For example, there are several projects working to build decentralized file-storage networks. Three of the leading projects in this area are Filecoin (which raised around $200 million in a recent ICO), Storj (which raised $30 million), and Sia (which did not do a presale before launching its network).
The creators of these networks have developed (or are developing) ways for storage contracts to be verified automatically on the blockchain. On the Sia network, for example, storage providers post collateral using the Sia network's currency, siacoin. Providers are required to periodically furnish cryptographic proof they're storing the files they promised to store. If a storage provider fails to supply this proof in a timely manner, it automatically loses its collateral for that contract. Customers never have to appeal to external legal authorities to enforce these deals—it's handled automatically by the blockchain itself, with minimal cost.
Another major category of blockchain-based projects uses cryptocurrency to reward creation of content. Steemit, for example, is a reddit-like social network that stores all site content—posts, comments, even upvotes—on the Steem blockchain. As on Reddit, users vote on the best posts and comments. The difference is that on Steemit, the authors of the most-upvoted content get rewarded with cryptocurrency that can be redeemed for cash. Right now, Steemit has one of the most active blockchains, with thousands of people adding content to the network on a daily basis.
Some of the biggest ICOs have been for projects that aim to replace Ethereum itself. For example, Tezos is an Ethereum competitor that uses formal verification techniques to ensure that Ethereum-based programs do what they're expected to do. Bugs in a poorly verified Ethereum project called the DAO cost investors tens of millions of dollars last year, so Tezos wants to make it a lot easier for people to write bug-free blockchain software. The project raised $232 million in a July ICO.
ICOs are an easy way to raise cash
Legal experts in the blockchain world draw a distinction between selling blockchain tokens as investments—analogous to selling stock in a startup—and selling tokens for their intrinsic utility. If you sell an investment token to the general public, there's a risk that regulators will likely treat that as an illegal stock offering. On the other hand, you're on firmer legal ground if you sell a token with practical applications. Bitcoins, for example, are primarily a way for people to make online payments, so selling them likely doesn't run afoul of securities law.
Of course, this distinction isn't always so clear in practice. This is especially true of projects that sell tokens for a network they haven't started building yet. Ether eventually became useful once the Ethereum network was created, but buying ether before the Ethereum network existed wasn't all that different from buying shares in a startup that doesn't yet have a shipping product.
Meanwhile, startups are noticing that token sales are an easy way to raise funds. In August we talked to Brendan Eich, the former Mozilla CTO who founded Brave Software, the company behind the Brave browser. The company built a Bitcoin-based micropayments system into Brave for funding online content. But the company ultimately decided to rebuild the system around a new cryptocurrency invented by Brave called the Basic Attention Token (BAT).
Eich told Ars there were several reasons for switching from bitcoin to the BAT. For one thing, the Bitcoin network has been suffering from congestion lately, leading to high transaction fees. But the possibility of getting millions of dollars of essentially free money was also a powerful draw.
"There was no Richie Rich who was going to endow our user growth tool with a bunch of bitcoins to give to users as a way of priming the pump," Eich told Ars. Instead, Brave launched a token sale that generated $35 million in 30 seconds.
Brave's ability to raise money so quickly was partly a reflection of Brave and Eich's strong reputation, but it also reflected a broader hunger for new investment opportunities among cryptocurrency enthusiasts—many of whom were flush with cash from the rising value of bitcoins and ether. In recent months, it has seemed that anyone who can write a halfway plausible white paper describing a new blockchain-based network can raise millions of dollars to build it.
We expect Eich to deliver on the technology underlying the BAT, but there's a danger that entrepreneurs less conscientious than Eich will raise money with half-baked proposals that they never implement—either because the original idea didn't make sense or because they simply don't bother to follow through.
Indeed, some projects have avoided doing an ICO due to this kind of ethical concern. Sia, for example, didn't hold an ICO and holds fewer than 1 percent of outstanding siacoins. Sia founder David Vorick told Ars that having developers hold and sell coins "creates a very perverse incentive on the network where the development team's whole goal is to push the price of the coin. You might be motivated to lie so you can fund yourself."
Instead, the Sia network is designed so that the company gets 3.9 percent of the value of each file storage contract made on the Sia network. That means Sia only makes money if the Sia network becomes widely used. Vorick argues that this better aligns Sia's interests with those of its users.
If ICO sponsors fail to deliver on their promises, people who participated in pre-sales will suddenly find they're holding tokens that are worthless or close to it. That could create an atmosphere a lot like the one Silicon Valley suffered through between 2000 to 2002—when a ton of previously hot technology startups floundered. That created an atmosphere of broad skepticism about technology startups. For several years, it was difficult for anyone to raise capital for a new venture.
But companies like Google and Amazon survived and ultimately thrived. And while the excesses of the late 1990s had some obvious downsides, the euphoric atmosphere may also have accelerated progress in Internet technology by providing plentiful cash to the most promising startups. Whatever cryptocurrencies find longterm stability in today's crowded market, chances are they'll be similarly worth watching.
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