ICOs, Dumb Money and Ethereum's (Eth)ical Dilemma

Matt Prusak is a Schwarzman Scholar at Tsinghua University in Beijing City, China; the business development manager of Jupiter, an Internet of Things startup; and an investment strategist at Tano Capital.

In this opinion piece, Prusak speaks to the hype surrounding ethereum and the tokens being created on the platform, ultimately issuing a stern warning to new investors.

"Double, treble, quadruple bubble, watch the stock market get into trouble…" – Garth Nix

Is the bubble about to pop?

The popularity of trading cryptocurrencies, especially ether (ethereum's ether coin), has spread like wildfire in the past few months. With ether returning roughly 3,000% since January, it comes as little surprise many are interested in cashing in on the "next bitcoin."

However, market prices are looking increasingly worrisome for several reasons, ranging from the influx of naïve investors to the onslaught of initial coin offerings (ICOs). As such, now may be a good time to consider taking profits off the table and waiting for a correction before entering.

Blockchain and ethereum have great long-term potential, but face short-term hurdles. Why wait and try to time the dips, when you can sell now and buy the crash?

The lake and the streams

To analogize, think of the ethereum ecosystem (ethereum, plus all the alternative coins on top of it, such as Augur, Golem or Gnosis) as a lake.

Since January, an enormous amount of fiat currency has flown into this lake, rapidly raising the price of ether in expectation of future value being realized, and pushing the lake to a high-water mark. The reality was that there simply were not enough credible places for the lake to flow into; people preferred to keep their capital in ether, because the returns on ether have historically been better than any of the initial altcoins it spawned.

Enter the ICOs.

These ICOs provided a raft of new investment opportunities for ether holders to take advantage of. Similar to IPOs in the dot-com boom, ethereum investors were eager to funnel ether into the ICOs of startups building companies on top of ethereum. In exchange for their ether, investors received tradeable tokens. Once the tokens hit the exchanges for open trading, early investors could either cash in on the expected trading "pop" or continue to speculate on the future rise of these tokens as the companies develop.

These altcoins are "streams" where all the pent-up capital held in ether will flow into.

While ether itself is the base, capital is now being increasingly siphoned off into these coins. Without a continuous large influx of capital from fiat investors into the ethereum ecosystem, the value of ether will stabilize or fall.
lake, ICOs

Meanwhile, investors who continue to hold ether itself cheer on the "Flippening"  –  the moment when ethereum's market cap will exceed bitcoin's, and thereby dethrone bitcoin as the dominant cryptocurrency. What these investors don’t realize is that the Flippening is essentially already upon us. They should not be comparing the market cap of bitcoin (which largely stands in isolation) to the market cap of ether.

Instead, they should be comparing the market cap of the ethereum ecosystem to bitcoin, ie the aggregate market cap of ether along with all its altcoins.

If you look at cryptocurrency market caps, seven of the top 10 are already based on ethereum. For those expecting another rapid doubling in price, they may be left waiting as value continues to diffuse across various ethereum-based tokens.

Dumb money follows smart money

The rise in ether prices in the last few months has unsurprisingly resulted in an enormous amount of press on the future of the technology.

This has invited speculation from investors who are fairly ill-informed on the space, and intend not to miss out on the "next bitcoin." Enormous investor pile-on has driven the price sky high, with capital coming from (psychologically fragile) speculators who are not particularly versed in the technology.

It's similar to what Fred Schwed, Jr, the author of "Where Are the Customers' Yachts?", said:

"There are certain things that cannot be adequately explained to a virgin by either words or pictures. Nor can any description I might offer here even approximate what it feels like to lose a real chunk of money that you used to own."

Any security dominated by retail investors is going to have a massive amount of volatility driven by sentiment. Even a veteran of the stock market is unlikely to have the stomach for consistent 25% price swings in a given week. The only reason most speculators in cryptocurrency can bear this volatility is because of enormous confidence in future return. That means if this confidence is shattered and the market corrects, it is likely going to correct quickly and with force.

This is not helped by the fact that inflowing investors have no idea what this technology does.

For proof of that, all you have to do is look at the rise in price of ethereum classic, up from $5.86 on April 30 to $21.53 today. Ethereum classic, a product of a schism in its blockchain community last year, is not interchangeable with the main ethereum blockchain. In fact, market commentators have predicted that ethereum classic will more or less die off.

While it has the same fundamental technology, ethereum classic has essentially nothing to do with the mass adoption of ethereum by recent projects (and the formation of the Enterprise Ethereum Alliance) – yet the price continues to rise.

While there are some obscure investment cases to be made for ethereum classic, it strikes me as highly likely the price has been driven significantly higher by uninformed investors simply not understanding the difference between the two – similar to how adding ".com" to a company’s name in 1999 sent stock prices up on average 74%.Ethereum Classic, graph

Further compounding the issue is that there has been a rise in retail investors with a limited grasp of how finance works. When Coinbase's GDAX exchange briefly crashed to $0.10 per ether on 21st June (from its current range of around roughly $300) as a result of a massive sell order, hundreds of margin traders were liquidated.

While the exchange requires traders to confirm they are accredited investors with at least $5m in assets, all investors had to do to gain access to triple-leverage on their capital was click a button saying they were accredited. No KYC needed.

Needless to say, chatter on the internet following this crash and the resulting liquidations made it clear that many of these "accredited investors" were nothing of the sort. Instead, they were speculators who took risks well outside their means in expectation of high future returns.

Pleas for Coinbase to "undo" the trades and threats of a class-action lawsuit initially fell on deaf ears, but then the company announced it would both honor the trades and make up the losses for investors. Deus ex machina aside, this invites further reckless investing.

A flagship exchange has now demonstrated it will bail out margin traders who had willingly taken outsized risks. In doing so, Coinbase has effectively offered a bungee cord to daredevil investors, creating a severe moral hazard issue.

Naïve investors will continue to flow in, only making things worse.

Who hasn't bought into ethereum?

A quick glance around the internet shows public interest in ethereum has far surpassed its original, niche crowd.

While mainstream adoption of the technology is great, interest in getting rich is driving the most recent mania.

The father of Vitalik Buterin, ethereum’s 23-year-old creator, tweeted on 13th June that he overheard a friend's 71-year-old aunt being pitched a no-lose investment in ethereum by a coffee shop manager:Dmitry Buterin, Twitter

The Wall Street Journal quoted a grooming-products business owner, Zachary Mallard recently for his perspective on ethereum versus bitcoin:

"A lot of my friends are selling their bitcoin and buying ethereum."

BroBible, a website targeted at college fraternity brothers, posted a piece last week entitled "What Is The Etherum Cyrptocurrency And How Will It Make You Rich AF?" First, the site probably should have spelled "Ethereum" correctly before recommending it as an investment product. Second, on a more editorial note, "AF," ie "as fuck", seems a bit dubious as a projected level of valuation.

This level of ridiculous bullishness is everywhere.

Subreddits focused on ethereum are plastered with memes about buying Lamborghinis, and technical analysis (TA) plotting how quickly ether will reach $1,000 a coin. An investor pool guided by TA might as well be relying on astrology.

Newcomers bemoan their lack of instant return on an investment that has grown 90%-plus in the past month alone. Bullishness is now so high that the default when there is no news is a downward trend in price, implying that as soon as hot air from optimistic press stops being pumped in, ethereum will deflate.

This is not an atmosphere that indicates rational investing.

As Bernard Baruch wrote about the 1929 stock boom:

"Taxi drivers told you what to buy. The shoeshine boy could give you a summary of the day's financial news as he worked with rag and polish. An old beggar who regularly patrolled the street in front of my office now gave me tips and, I suppose, spent the money I and others gave him in the market. My cook had a brokerage account and followed the ticker closely. Her paper profits were quickly blown away in the gale of 1929."

Last week an Uber driver was telling me about his investments in cryptocurrency. History doesn't repeat itself, but it does rhyme.

Will institutional traders save the day? Sadly for the bulls, the entrance of mainstream institutional players seems unlikely in the short term.

Goldman Sachs's most recent coverage (only written after investors begged them to cover bitcoin) stated that cryptocurrencies are in a bubble. The ICOs (detailed below) pretty clearly confirm this hypothesis.

Once government regulation improves (which is antithetical to the decentralized, anarchic nature of the technology in the first place), institutional interest will undoubtedly turn into action, but for now, investment banks directly trading the coins seems unlikely.

ICOs = 'idiots constantly overbuying'

ICO valuations are insane. Ethereum has basically just become an "ICO machine."

These are companies getting Series C level funding for seed-level products  –  we're talking tens of millions in valuations for white papers and teams with no track record. Many of these will fail.

Ethereum itself only raised $18m during its crowd sale.

Last year, a company that ICO'd took the investor's money and went on a vacation in Spain. At this time, the SEC wouldn't care even if they just burned it in front of your eyes. This is the Wild West of capitalism.

Just to take the pulse of the current market, here are two recent ICOs that would have had more red flags than the Beijing Olympics if assessed by the professional venture capital community, yet had astronomically successful ICOs.

Exhibit 1: Bancor ,  a market-making startup that failed to properly make its own market

Bancor raised about $153m in roughly three hours. Even they did not anticipate this: the funding campaign overshot the initial target by $51m, and thereby inflated the supply of Bancor’s tokens over 50% of the intended amount, while simultaneously congesting the entire ethereum network.

This is fairly ironic, given network congestion is a critique more commonly leveled at bitcoin.

Shortly after the ICO, a piece entitled "Bancor is Flawed" skewered the overall concept of the (not yet existing) Bancor system on numerous levels. While Bancor issued a lengthy response, the sheer number of issues raised by the critique calls into question whether investors really knew what they were getting into.

My guess: most investors have no clue what Bancor really does.

Exhibit 2: Patientory,  a healthcare records startup with no track record of its own

Patientory recently ICO'd at $7.2m, and currently, less than a month later, has a market cap north of $20m (after peaking at $60m in-between). Its CEO has less than four years of professional work experience and a non-technical background (she has an MA in business management and dual BAs in Africana studies/Spanish), and is running a company whose market cap went from $7.2m to $60m in a single month, despite not having a finished product or revenue, much less profit.

For those keen on more details, a scathing, seven-point critique of Patientory’s business plan is online. The fact that patient data could possibly be leaked into the public blockchain, and be permanently recorded is only one concern among many.

While there are only two examples, they're fairly representative of the overall market. While other companies have much more credible plans (Brave's BAT and Mysterium are two I find compelling), the valuations of all of these firms are intrinsically linked. Once a few major blockchain startups fail, investor confidence across the ecosystem will be shattered as people rush to sell their tokens before they become worthless.

Even assuming failing startups do not induce a short-term correction, the ICOs in general have led to concentration of ether in the hands of these overvalued startups. CEOs cannot pay employees and development costs in ether –  they're going to need to transfer this back to fiat in order to do so.

Once they all start liquidating, the other firms are going to be similarly incentivized to sell their holdings in order to get as much fiat money as possible. While startups are incentivized to hold ether in order to keep the price stable, they have to weigh that against market prices falling and crippling their non-fiat reserves.

The bottom line

I am bullish on blockchain, and very bullish on ethereum.

However, I would not buy in at this price. If you bought in well-below the current price and continue to hold, great. But the potential upside compared to risk seems askew at today's price. The smart money got in far beneath the current figure (and potentially may soon be out). If you first heard about ethereum from The New York Times, you're not the smart money.

Perhaps I’m totally wrong. Perhaps the endless influx of investor dollars overcomes the inevitable failure of most of these ICO'd companies. Or perhaps you can time the horizon of this crunch. If so, more power to you. But what if the drop happens when you're asleep? The 24/7 markets do have that issue.

Or what if a crash blows through the entire order book, and your stop-loss gets filled far beneath its placement amount? That happened this past week to many investors.

If you are keen to squeeze out some additional profit, these are the risks you will have to take.

To summarize:

The price of ethereum has rocketed upwards in the past few months, indicative of blockchain’s potential.
Dumb money has now followed the smart money.
Ether's price may have leveled off due to ICOs now providing an outlet for capital outflow.
Many of these ICOs will fail, punishing the dumb money and inducing a correction.
My prediction is ethereum will take a big hit in the next six months. Take the easy gains and wait for the correction.