Are ICOs Like Ethereum The Next Big Financial Scandal?

Written by Adam English
Posted September 5, 2017 at 8:17PM

Following the latest news out of China, there are a slew of stories about a new type of investment that is seeing an explosion of popularity, but may be far riskier than investors may know.

BBC News even went as far as to ask "Is this the next financial scandal waiting to happen?" in its headline.

I’m going to just flat out say they are all wrong.

However, I am also going to say that you should probably avoid this latest fad like the plague.

Does it seem like I’m conflicted here?

If so, you probably should keep reading to see what an ICO is, and what it is and isn't good for.

Before you get anywhere near one of these, you really need to know what you're getting in to.

Caveat Emptor

Let’s start with the news out of China. A “working committee” that oversees risk in the country’s internet finance sector stated in a notice that new projects raising cash or other virtual currencies through cryptocurrencies will be banned.

In addition, authorities will crack down on related fraudulent practices, and investigate 60 major initial coin offering (ICO) platforms.

In short, an ICO is a new type of funding for startup companies. In lieu of issuing shares, the company uses blockchain technology to issue a digital currency, which investors hope will appreciate in value as more investors come in, the project it funds succeeds, or both.

The positives and negatives of an ICO are closely related.

Startups are able to completely circumvent the regulations and requirements of initial public offerings and the strict, sometimes nearly extortionate demands of private and venture capital funds.

Companies raise funds by going straight to the public on their own terms. Early small investors don’t need to worry about privileged stakeholders, bizarre share structures, cheap warrants for insiders, or institutional investors or underwriters capturing all of the early returns.

At the same time, the complete lack of oversight and regulation, and often any look at all into the books and business plans of the company, creates a massive risk for investors. There is no requirement to tell people what is happening, or verification that any information is correct.

For investors who go into ICOs with their eyes open to these facts, they'll know they're taking on greater risk for a potentially greater reward.

For investors who don’t know, well, they should have and they didn’t. There are very real penalties in all aspects of life in that regard.

So this cannot possibly be a scandal. This is a pure caveat emptor situation.

The Good and The Bad

However, that doesn’t mean that investing in an ICO is a good idea, and it certainly doesn’t eliminate the potential for outright fraud.

The rapid growth of ICOs has attracted a whole lot of smart money, and a whole lot of smart people looking for any kind of money.

Take Ethereum for example. It started with an ICO, and has done exceedingly well by just about any measure.

In just a few short years it has amassed a $28 billion capitalization, and the underlying project holds incredible promise.

It is like Bitcoin, but instead of being a pure digital currency, the volunteers who are rewarded with Ethereum for processing the blockchain data are also part of a massive, decentralized platform that can handle data and financial transactions.

The implications can range from hack-proof voting systems, to applications that cannot be blocked by third parties, to decentralized crop insurance programs. That last one is actually already being used by farmers to cut out big banks and insurance companies.

Then there are far less promising ventures. Their founders are either delusional about their ability to deliver, or they outright know it will fail, and both types roll out glitzy promotional campaigns that lack any meaningful information to draw in investors.

Investors have no real way of distinguishing the great, from the well-intentioned, to the possibly fraudulent.

And the only reason they can invest in the first place is the reason why that is the case: a complete lack of verifiable information.

With nearly $1 billion in ICOs this year alone, you can bet the good investments are far outnumbered.

Information Asymmetry

To sum it up, this can’t possibly be a financial scandal because it is blatantly obvious that there are no protections. A one minute scan of Google search results would teach anyone that much.

And at the same time, the vast majority of investors should avoid these things like the plague. They carry a lot of risk, and it is hard to even figure out how much risk is involved.

The reason that both of these statements can easily coexist is the age-old idea of information asymmetry in the markets.

There would hardly be any money to be made if the market was truly efficient. Everything would be fairly valued, and every stock would depend on sector and broad economic growth alone.

It isn't though. The amount of expertise, time, and connections it takes to properly determine if a company is worth more or less is daunting.

And for small, speculative investments, it is all but impossible for retail investors. Winners and losers tend to be sorted by how much they know about what they're buying.

I can’t blame companies for pursuing ICOs. The advantages for them are pretty obvious.

But for investors, there is a far better way to get in on the early growth of promising companies. One that doesn’t put blind faith in what the company does and does not choose to tell you.

Nick Hodge has been specializing in this approach to private investments for some time.

Not only will you be able to take advantage of his expertise and full-time research. You’ll also be tapping into connections he has spent years cultivating.

The results speak for themselves. I’ll let him tell you about it. Fair warning though, it isn’t for everyone.

Take care,

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Adam English

follow basic @AdamEnglishOC on Twitter

Adam's editorial talents and analysis drew the attention of senior editors at Outsider Club, which he joined in mid-2012. While he has acquired years of hands-on experience in the editorial room by working side by side with ex-brokers, options floor traders, and financial advisors, he is acutely aware of the challenges faced by retail investors after starting at the ground floor in the financial publishing field. For more on Adam, check out his editor's page

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