The cryptocurrency gold rush
An audacious new system of corporate fundraising known as an ICO has made digital money the wild west of finance
What’s so special about an ICO?
The entirely novel aspect of an ICO – or Initial Coin Offering – is that it enables companies to raise huge sums without having to cede control to venture capital investors, or to endure the rigour and expense of floating shares on the stock market. Instead of offering shares as in a traditional float, an ICO start-up offers investors “tokens” (digital shares, so to speak), which should be paid for with “coins” from one of the new breed of digital cryptocurrencies. The ICO boom this year has raised more than $2.1bn, unleashing a welter of new coins with names like Tezzies, Atoms and Basic Attention Tokens – the majority based on the cryptocurrency known as Ethereum.
What’s so special about Ethereum?
Like hundreds of other cryptocurrencies it relies on a digitised, decentralised public ledger called a blockchain. Far the largest of these is Bitcoin; but Ethereum – the second-largest blockchain network – has the great advantage that unlike Bitcoin and other ‘classic’ cryptocurrencies, you can issue new types of tokens on top of Ethereum with very little technical effort. This makes it an ideal investment currency for ICOS and is why the price of “Ether coins” jumped from $8 to around $400 in early 2017. But it’s very volatile: a summer “flash crash” saw the price plummet 95% to 10 cents when a multimillion-dollar sell order sparked havoc.
What do these cryptocurrencies consist of?
The difference between decentralised digital currencies and traditional “fiat” currencies like the pound or dollar is that they aren’t controlled by a central bank. You can purchase such currencies online with a credit card, the coins you get being essentially entries in an accounting book created and maintained by a network of computers using sophisticated cryptographic protocols. You can then use these to make secure payments, as a store of money or to buy back cash: at no point do you have to divulge your name or go through a bank. Each transaction made with your digital coins becomes part of a larger “block” of interlinked transactions. The interlinking is done by “miners” – teams of crypto-geeks running hugely powerful computers. Miners compete with each other to crunch fiendish mathematical problems that include all pending transactions as inputs. Being the first to find a solution to such a problem gives a miner the right to sign off on the next block in the chain. A miner who successfully creates a new block does everyone a service by committing all pending transactions into the blockchain. As a reward, he can allocate himself some brand new coins in the new block.
Is Bitcoin the market leader?
Yes: it’s what passes as the gold standard in crypto-land. Despite several heart-stopping lurches downward, it has proved an ever-accruing store of “digital gold”. The price has shot from $2 per unit in 2011 to a record high nearing $6,400 this week. Proponents love the system, as it was set up to become progressively harder to mine coins over time; and the total number is limited to 21 million. So there’s no way for a central bank to issue a flood of new coins and devalue those already in circulation. But the system’s limits – it has so little capacity that it can take days to settle transactions – have spurred the creation of a host of alternative cryptocurrencies.
So is digital money in a bubble?
It shows many of the hallmarks. Billed at the start of the year as one of the hottest investment areas, the rush of hard cash into electronic coins in 2017 has sent the notional value of all cryptocurrencies rocketing to over $180bn – or about half the market value of JP Morgan. There is also a huge amount of behind-the-scenes “pump and dump” manipulation (much of it by geeks in China), as speculators cash in on tokens on the way up (pump) and the way down (dump). Meanwhile, the number of currencies competing for attention has mushroomed. In July, around 900 were available online. “Proper excited… I’m in, get involved!” tweeted football manager Harry Redknapp last month when bigging up a “mobile cryptocurrency” called Electroneum.
What’s fuelling the bonanza?
Partly pure greed. Hitching a lift on a vertiginously rising digital currency is an easy get-rich-quick scheme, made more tempting by poor yields in traditional markets like bonds and equities. Deficiencies in the Bitcoin technology have also been a factor in fuelling the rise of faster, more volume-driven, less easily traceable alternatives (see box). Many Bitcoin “whales” (the largest players), trying to reduce their exposure, are shifting into Ether tokens, whose popularity has soared with the boom in ICOS. As a result, Bitcoin’s share of the total market capitalisation of cryptocurrencies has fallen from 90% in late 2016 to closer to 50% today.
What protections are in place for punters in ICOS?
Virtually none. Nothing more is needed to launch a coin offering than a “white paper” in which the start-up’s promoters lay out their grand plans. Indeed, ICOS represent an even bigger risk for the unwary than the dotcom floats of the 1990s, since most lack even basic protection from securities laws. If a traditional firm goes bust, investors and creditors are entitled to claim what they can from the remaining assets. But ICO tokens may not represent a real claim to anything. In the view of JP Morgan boss Jamie Dimon, even Bitcoin, the grand-daddy of digital currencies, is “a fraud”.
What are the authorities doing?
Not a lot. This didn’t matter so much when the world of cryptocurrencies was self-contained. But now that they’re being used to fund mainstream investments – notably high-end property – it certainly does. China has taken fright and banned companies from issuing their own token currencies; and last month, the UK’S Financial Conduct Authority issued its own warning. What’s undeniable is that if the tide turns, it won’t just be the prices of leading digital coins that get whacked – an entire new investment industry would be at risk.