The market in Initial Coin Offerings risks becoming a bubble

WOULD you care to invest in Gnosis, a prediction market where users can bet on outcomes of events such as elections? Or in ZrCoin, a project to produce zirconium dioxide, used to make heat-resistant alloys? How about an “immersive reality experience” called “Back to Earth”?

These are just three of a new wave of what are called Initial Coin Offerings (ICOs). Nearly $250m has already been invested in such offerings, of which $107m alone has flowed in this year, according to Smith+Crown, a research firm. But it was in April that ICOs, or “token sales”, as insiders prefer to call them, really took off. On April 24th Gnosis collected more than $12m in under 15 minutes, valuing the project, in theory, at nearly $300m.

ICO “coins” are essentially digital coupons, tokens issued on an indelible distributed ledger, or blockchain, of the kind that underpins bitcoin, a crypto-currency. That means they can easily be traded, although unlike shares they do not confer ownership rights. Instead, they often serve as the currency for the project they finance: to pay users for a correct prediction, as does Gnosis; or for the content users contribute. Investors hope that successful projects will cause tokens’ value to rise.

In a way, bitcoin was the first ICO—except that instead of putting money in directly, investors had to buy computing gear to “mine” (ie, mint cryptographically) the tokens. Bitcoin inspired hundreds of variations—“alt-coins”. But these involved the tricky business of creating a new blockchain. Today most issuers simply write a “smart contract” on Ethereum, a rival blockchain. This piece of code then automatically creates tokens when it receives “ether”, the coin of the Ethereum realm. Issuers typically publish a “white paper” (a prospectus of sorts) and market their undertaking on social media.

As Gnosis shows, such offerings can sell out quickly. The crypto-currency cognoscenti made a lot of money investing in bitcoin and other tokens and have cash to invest (as The Economist went to press, the value of all ether in circulation was nearly $5bn). Less popular projects offer incentives for buying early or a lot. “Back to Earth”, whose ICO launched on April 26th, wants to raise 750 bitcoin (almost $1m) by selling StarCredits. Investors who buy coins worth 0.75 bitcoin or more get a special “Golden Ticket”, entitling them to special content and, later on, free StarCredits.

But the claims in white papers are mostly unaudited. ZrCoin plans to build a factory in Russia to extract zirconium from industrial waste; cameras on the site are supposed to let investors monitor progress. ZrCoins are backed by the zirconium to be produced. But as in many ICOs, it is unclear why the funds are not raised in conventional ways. And since most ICOs have no link to any particular jurisdiction, it is hard to see what investors could do if issuers abscond with their money. Often they have immediate access to the funds raised.

Even ICO fans fret that an offering will blow up, as did Mt. Gox, an early bitcoin exchange, in 2014. But the market is showing signs of maturing, says Matt Chwierut of Smith+Crown. More ICOs now use escrow accounts, which makes it harder to take the money and run. Blockchain Capital, a venture-capital firm, has just raised $10m, but it sold its coins in America only to “accredited” investors. On May 1st Adel, an incubator for blockchain projects, will launch one of the first ICOs to comply with anti-money-laundering and know-your-customer rules. Otonomos, which helps firms incorporate, is planning to offer a service giving ICOs a legal home.

Regulators will have to decide how to deal with ICOs. Peter Van Valkenburgh of Coin Centre, a think-tank, argues that if the tokens are mainly used as currencies, they should not be classified as securities. But in March the Ontario Securities Commission warned that issuers may need to meet legal requirements, such as registration and filing an official prospectus. This may be hard to enforce: blockchains know no borders and some ICOs, including Gnosis’s, are created expressly to avoid regulations.

America’s Securities and Exchange Commission has not said anything yet. Insiders worry it will come down too hard on ICOs, stymying innovation. Albert Wenger of Union Square Ventures, another venture-capital firm, argues that ICOs help finance projects that today remain unfunded, in particular “protocols”—code enabling computer systems to work together. One example is Storj, a service for decentralised file storage, which has issued tokens on bitcoin’s blockchain. Subscribers use the currency to pay for file storage, but can also earn it by contributing storage to the network. They hope such services might one day replace the big centralised ones that dominate the internet. Imagine Facebook had issued a token, says Olaf Carlson-Wee of Polychain Capital, a hedge fund that invests in ICOs. Users could be paid for their posts and thereby share in the firm’s wealth.

Forever blowing

Still, before ICOs fulfil this promise, they may well have to endure a cycle of boom and bust. Some liken the ICO craze to the South Sea bubble in the early 18th century in Britain, when promoters raised funds for companies promising the “transmutation of quicksilver into a malleable fine metal” or a “wheel for perpetual motion”. Prices soon fell, in particular after Parliament in 1720 passed the “Bubble Act” to rein in “undertakings of great advantage”. But the sorry episode was a step toward some rather useful innovations: the modern joint-stock company, for example.