ICO stands for Investor Caution Obligatory

 

HERE is the deal. You can buy an entry in a computer ledger issued by  a startup company on the basis of an unregulated prospectus. It is  called an “initial coin offering” or ICO. But though the ledger entry is  called a coin, you cannot spend it in any shop. And whereas the use of  the term ICO makes it sound like an IPO (initial public offering), the  process whereby a firm lists on a stockmarket, coin ownership does not  necessarily get you equity in the company concerned.

This sounds  like the kind of bargain that would appeal only to people who reply to  e-mails from Nigerian princes offering to transfer millions to their  accounts. But ICOs may well be the most popular investment craze since  the dotcom boom of 1999-2000; even Paris Hilton, a celebrity heiress,  has jumped on the bandwagon. The list of active, upcoming and recent  ICOs on the website “ICO alert” covers 31 pages of A4 paper and includes  around 600 companies. More than $2bn has been raised in total. 

 There is a serious side to the craze, just as there was with the dotcom  boom. The technology that underpins digital currencies—the blockchain—is  an important development. This is a secure, decentralised ledger that  everyone can inspect but that no single user controls. It seems likely  to be adapted for use across the financial system—to record property  transactions, for example 

 Many ICOs are designed to finance applications that will make use of the  blockchain—for trading currencies, lending money or searching for jobs.  In some cases, the “coins” can be exchanged for services on the site.  In a way, this is like selling air miles in a startup airline; investors  can either use the miles for flights or hope they can trade them at a  profit. For the business, it is also a way of creating demand for the  product they are selling 

 But in plenty of cases, an ICO is just a way of raising capital without  all the hassle of meeting regulatory requirements, or the burden of  paying interest to a bank. Businesses are able to achieve this feat  because investors hope that the coins will rise rapidly in value, as has  been the case with bitcoin or ethereum, the best-known digital  currencies, which have seen stellar gains in the past year. Nothing  makes individuals more willing to take risks than the sight of other  people getting rich. 

 But bitcoin is also different from ICOs. Its appeal is as a digital  currency that can be used in a broad range of transactions. And the  supply of bitcoin is designed to be limited, meaning some people regard  it as an electronic version of gold. 

 So there is a chance that bitcoin or ethereum will come into widespread  use, although their function as a means of exchange is undermined by the  volatility of their price. Currencies must be stores of value, at least  in the short term. If you think a digital currency is going to rise 20%  tomorrow, you won’t want to swap it for goods and services; if you  think it is going to fall 20% you won’t want to accept it. 

 It is also worth remembering that governments set the rules regarding  the nature of legal tender within their borders. They will always have  the whip-hand when it comes to issuing currency. If they believe that a  digital currency is being used for widespread tax evasion, or is  distorting the financial system, they will crack down hard. 

 As far as business-related ICOs are concerned, a few may succeed.  Investors may well be taking the “lottery ticket” approach, hoping that  one big winner will offset a large number of losses. In a sense  investors are acting like venture capitalists. But the sultans of  Silicon Valley’s VC industry insist on a wide range of rights before  they invest their capital, including protection against dilution of  their stakes and (sometimes) the right to nominate board members.  Investors in ICOs have nothing like that level of protection. 

 In the circumstances, it is hardly surprising that regulators are  getting involved. In America, the Securities and Exchange Commission has  ruled that these coins may, in some cases, be securities and thus  subject to regulation. A British regulator, the Financial Conduct  Authority, this week warned investors about the risks involved. The  Chinese authorities have gone a lot further, declaring that ICOs are  simply illegal. 

 It is not easy to draw a line between financial innovation and reckless  speculation. Perhaps an ICO will finance some breakthrough that boosts  economic efficiency. If you work in the tech sector, you may be able to  spot the occasional grain of wheat among the pile of chaff. Everyone  else should assume that ICO stands for “It’s Completely Off-limits”.