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Initial coin offerings are getting a bad rap
[NEW YORK] Initial coin offerings (ICO) are a hot topic, but the focus tends to miss the most important innovation. Attention naturally is on the 81 per cent that are frauds, but the honest ones raised US$7 billion for cryptocurrency initiatives in 2017. Those were predominately for double-blockchain ideas, which is blockchain funding to support a blockchain project.
Frauds permeate crypto projects because they're hard to understand or verify. But the majority of non-fraudulent ICOs by number (not dollars) are for ordinary business projects. This latter group may be as transformative as cryptocurrencies themselves. Moreover, they're easy to understand.
Suppose a promoter wants to put on a touring music festival along the lines of the original Lollapalooza. She needs US$8 million to sign bands, rent venues, advertise and pay other expenses. She could, for example, create 100,000 shares and sell 80,000 at US$100 each for expenses and keep 20,000 as her compensation.
Another strategy is to presell the product, perhaps 200,000 tickets at US$40 each. Instead of owning 20 per cent of the equity, her compensation consists of any additional ticket sales and other revenue that are generated after the presale.
An ICO can be regarded as a hybrid. The promoter creates 50,000 tokens and sells 40,000 for US$200 each, keeping 10,000 tokens as her compensation. She pledges that festival tickets will only be sold for tokens. Unlike equity, the tokens are not promised a share of profits in the venture, and unlike pre-sold tickets, the promoter does not specify how many tickets one token will be able to buy.
If the festival doesn't click and total demand is for only 50,000 tickets, then one token buys one ticket and the ICO investors paid US$200 for a ticket. But suppose total demand is 500,000 tickets and people are willing to pay US$50 each for them. Now one token buys 10 tickets and can be sold for US$500. Our ICO investor can take a 150 per cent profit, or go to the festival with nine friends, or go himself and sell the remaining 0.9 token for US$450 — a net cost of negative US$250 to see the show.
Investor, customer and manager interests are exactly aligned. All of them only care about the total quality delivered — total revenue, not profit. This changes the fundamental purpose of the enterprise. If bands and other vendors accept token payment, there is even more alignment.
There is less risk as well. An ICO buyer who paid US$200 for a ticket gets to see a festival he desired, and in more intimate setting with only fellow fans rather than a gigantic venue with a general audience. ICO funding could make many useful ventures possible that cannot be funded today with either equity or presales; and in other cases it might deliver a better product.
But this is only half the ICO idea. The promoter could implement token financing with a centralised database or physical tokens. Nobel laureate Friedrich Hayek suggested this in 1976, but pointed out token users would have to maintain separate accounts at every company using token financing, making the tokens illiquid and inconvenient. A potential customer would have to search for a token holder willing to sell, and negotiate a price.
Putting the tokens on a public blockchain solves the problem. Applications are already available that would allow any customer to click on a price in some reference cryptocurrency (say Bitcoin or a Stablecoin) and have the exchange for the required token and transmittal to the vendor handled seamlessly. Plenty of intermediaries exist to keep the markets liquid.
All the advantages — and I've only touched the surface here — are theoretical. Legal, financial, technical and regulatory infrastructure will need to be created, and expensive lessons learned by trial and error, before ICOs for non-crypto projects are ready for prime time.
But ICOs have the potential to create a new type of economic entity that could be as transformative as the for-profit public corporation. So it pays to look beyond the fraud and big dollars of ICOs to the honest little ones that may grow into black swans.
This is by my rough observation. It's hard to track all the small ICOs and to tell which ones are frauds A good analogy is stocks. Many companies allow direct stock purchases, where investors can buy stock directly from the issuer without fees or market impact, and in any dollar amount.
But these are not popular because the investor must set up an account at each portfolio company; and selling one stock to buy another requires a series of transactions. Almost all investors prefer to maintain a single brokerage account to hold all their shares, and to execute transactions on public exchanges rather than dealing with the issuers directly.
While in theory we could set up brokerages and public exchanges for company tokens, that's hugely expensive. Crypto does the same thing better, faster and cheaper. Another example is the frequent flyer miles and reward points given out by many businesses - they remain fringe economic inducements except for a few heavy users — due to inconvertibility and other inconveniences. In contrast, the "trading stamps" popular from 1910 to 1975 functioned as real alternative currency.