ICOs – Fraud, Winning Lottery Ticket or Bad Investment?

Investments in virtual currencies and initial coin offerings or ICOs – a kind of IPO for coins – continue to be a key focus in the investment world. Last week as the Davos World Economic Summit unfolded it was almost lost in comments about investments in coins and tokens. The SEC Chairman, for example, all but lectured market professionals, accounts and lawyers on their professional obligations and issued a not to subtle warning that if those obligations were not honored there would be an SEC investigation and perhaps more. The CFTC Chairman joined in those warnings as his agency filed two more fraud actions centered on virtual currencies.

There is no doubt that the regulatory structure and safeguards which surround an IPO of securities are not in place for coin offerings (here). ICOs may be launched with a so-called “white paper” which talks about the plan for the investment but, as NERA Economic Consulting points out in a recent report, there is no obligation that the investor money be used for the stated purpose – or for anything at all. NERA Economic Consulting, A Look at Initial Coin Offerings (January 2018), available here. That contrasts sharply with an IPO of securities where the issuer is typically required to use the funds for the stated purpose. At the same time there are repeated reports of double and sometimes triple digit gains in the ICO market over very short periods. And, there are reports of huge losses and Government enforcement actions claiming fraud. Through all this, investor frenzy continues at a level which suggests buying a coin in an ICO may be the equivalent of purchasing the winning lottery ticket.

Is the coin the winning lottery ticket? NERA’s report suggests the answer. Through the first eight months of 2017 the report found that about $2 billion was raised through ICOs. Generally those offerings were tied to bitcoin or BTC or ether – ETH. Funds were raised at times to support blockchain projects such as a cloud storage service or a cryptocurreny exchange. Viewed in this context NERA conclude that the ICOs provided an “interesting alternative to IPOs” but “it remains to be seen whether they will provide value to investors.

To consider the question of investor value the report created what may be the most comprehensive list of ICOs available. The list goes through August of 2017. NERA found that over the last two years the number of ICOs has increased significantly. In 2016 there were 48 ICOs. In the first eight months of 2017 the number more than doubled to 131. The largest was Tezos, a ledger with smart contracts similar to Ethereum. It raised an estimated $232 million in BTC and ETH. Clearly ICOs can be profitable for the promoters.

Raising capital through ICOs to profit the promoters is not the question, however. Rather, the real question is how did the retail investor fare in these offering? To assess this question the NERA report attempted to compare the prices paid in the ICO to those in the after market.

Determining whether an investment in an ICO is profitable is not as simple as answering that question for an IPO. For the latter the prices in the after market are readily available so the offering price of the shares can be compared to the post-offering price. No so for ICOs. In many instances NERA was unable to locate a post offering price, suggesting that either the investment was worthless or at least highly illiquid. NERA was able to compute the returns to investment in 97 instances from an initial universe of 174 ICOs (number excludes very recent offerings). In 80% of cases where an investment computation could be made, the ICOs lost value relative to BTC. Many experienced significant declines. At the same time 12 in the group had returns that ranged between 100% and 1,000% while 3 exceeded 1,000%.

The NERA data demonstrates that while there were a few instances of large, and in some instances huge, returns, most investors in ICOs saw their investment decline. Often the decline was significant. In many instances the investment had no readily ascertainable value and appeared to be wholly illiquid and perhaps worthless. This was true even in many instances where there was a listing on an exchange such as CoinMarketCap.

The NERA data underscores the significant risks of ICOs. First, there is no doubt that the number of offerings is increasing dramatically. Second, while the investor may purchase the coin under the assumption that the investment is part of an on-going project, in fact the investment funds may be diverted to another purpose or no purpose at all. Third, there may be large, even spectacular returns from the investment – but the percentage of offerings generating those kind of returns is quite small. In contrast, many ICO investments appear to end with the coin or token being either worthless or at least highly illiquid. Finally, even for those coins or tokens listed on an exchange the post ICO price is most likely lower that the offering price. Overall while ICO promoters are clearly making significant sums, most ICO investors are suffering losses, according to the NERA data.

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