In the burgeoning world of cryptofinance it is entirely possible to be seduced by the barrage of stories of the latest and greatest, to be lured to the potential of the shiny, new and disruptive, and in the process overlook fundamental technological factors that often can provide valuable insights into the future viability of a technology, it’s ability to attract a relevant developer community and then address the uses cases the project’s are intended to serve. While readers may have caught on to this notion, it often goes deeper than one thinks. In this first article we start by exploring some of the less frequently discussed aspects of the cryptofinance ecosystem that can send mixed messaging and contribute to confusion.
Initial Coin Offerings
Even with the recent bear market in cryptocurrencies, one of the first thoughts anyone has when getting in to digital currency is “Which token is going to be the next Bitcoin? I don’t want to miss out.”
With perceived fortunes to be made, it can be tempting to invest in a project that promises to disintermediate well entrenched companies or industries, has a compelling white paper, or appears to have a good team – even without necessarily understanding much about the underlying technology nor completely contemplating potential use cases. Here are some attributes of the marketplace that might help.
Unique technology? Many ICOs have no unique technology developed, but are actually piggybacking off of the Ethereum platform for fundraising. Their developers simply move investor money into their accounts and, in exchange, provide people with an Ethereum contract that distributes new coins created for a project that may not have anything substantive to offer.
Early stage investing. When investing in such ICOs you become an early investor in a project at the ‘idea’ stage - which is the most speculative and uncertain phase of any company. While the story may be tempting, investors are still investing in an unregulated market, often on the wrong fundamental basis, with incomplete information. It can be tempting for anyone with fear of missing out to inflate the slim probabilities of success.
Market price. Even if ICOs are backed up by legitimate technology and have a sincere purpose, it is not necessarily the case that the value one might see on an exchange is what the currency is actually worth in the marketplace. Applying traditional notions of value to ICOs does not always make sense. Teams running ICO projects can inflate earnings by buying up their own offerings with company and developer money - diluting investor returns while boosting their valuation. Exchanges may act in less ambiguous ways to achieve the same goal. ICOs can and do change the rules of their launch without notice. They may, for example, claim to have plans to hold a public ICO and then collect money in a private pre-sale, only to cancel the scheduled public ICO launch.
Where is our compliance officer? ICOs have this leeway because they have very little legal or reputational accountability. Part of the reason for the lack of accountability is because it is difficult to tell who owns what. Most projects are semi-anonymous and not properly contextualized. While a light-touch may in-part be a philosophical approach for regulators facing an emerging industry, it is just as much a capacity issue: tools helping distinguish legitimate projects from outright scams are hard to come by and the space still seems to be growing exponentially.
Exchange listing. ICOs were a comparatively easy place to begin, but the same operating environment applies to exchanges and, as you will see below, trading. Cryptocurrency exchanges are charging up to $1 million to list ICOs on their platforms. While IPOs can cost $1 million, that includes the whole basket of services to get companies ready for a launch. Not just the cost of walking through the door. Crypto exchanges often times have their own agenda beyond obtaining these listing fees. They inflate initial trade volumes, buy new digital currencies before they are officially listed on an exchange, and try to attract new customers by listing more coins regardless of the legitimacy of the asset.
Trading
Boiler Room. Pump and dump schemes are well known in cryptofinance by now. Sophisticated social media campaigns have turned into double digit percent gains in altcoin markets, but more interestingly, popular cryptofinance specific news websites are often affiliated with creators of digital currencies or exchanges. We have noticed unusual levels of mentions of certain digital currency projects even in well established crypto-news outlets. Some outlets disclose potential conflicts of interest in their article disclaimers, others can be less forthcoming about their connections to developers of certain projects.
Developer activity. Majority coin holders can also easily fork the assets they hold purely for profit. They can capitalize on their stakes in the original project and then dump their holdings once the forked coin is traded on exchanges - exchanges they often own or control. As most digital currencies are open, however, analyzing developer activity around digital currency projects can be a useful metric to discern which ones have promise and which are near death.
Digital currency traders face this challenging backdrop before confronting real-time indicators on exchanges. These cannot be trusted at face value, either. Traders can, and often do, manipulate markets by driving prices up or down on illiquid exchanges by holding high concentrations of the digital currencies they trade. Order books cannot be trusted as exchanges allow zero fee trading and hidden orders. Occasionally, exchanges intentionally inflate their trade volumes simply by moving their own digital currency holdings from from one asset to another.
Conclusion
The point of this article is not to evoke pessimism, but to properly frame digital currency as an investment class. It is not enough to simply apply traditional financial concepts to the digital currency market. While indicators and overlap certainly exist, digital currency is a class unto itself - especially without a regulatory scheme in place. Incentives for developers, exchanges, and index websites may not align with those of investors and traders. Understanding all of this requires a new form of analysis which we are calling crypto-fundamentals.
Even when a more tangible regulatory regime is established, it behooves current and prospective investors and traders to source consumer side intelligence and the right types of analytics based on these crypto-fundamentals. The arc of the internet is bending towards decentralization, and over time the space will mature. In the meantime, crypto-fundamentals can provide the industry with a useful analytical framework. We shall be speaking more about in the future.