Capitalising on confusion – or what the hell is an ICO?

Ok.. what the hell is a cryptocurrency?

In order to answer this, you have to know what a decentralised application is.

So, what is a decentralised application then?

Simply put, it’s a new form of organisation and software.

They can create, operate and finance any type of software service, that is wholly decentralised.  It’s a service that no single entity operates.

Important – that doesn’t necessarily make them better or worse than existing software models or the corporate entities that create them – it’s just a different way of doing things.

Right.. so what the hell is a cryptocurrency?

To understand this, it’s best to lose any concept that a Bitcoin, or any other coin or token issued in connection with an ICO, is anything other than a new type of asset which enables a decentralised application.  For example, Bitcoin is a specific type of crypto asset issued to support one organisation.

Like every other asset class, a cryptocurrency, or crypto asset exists as a mechanism to allocate resources to a specific form of organisation. Despite the obsession with trading crypto assets recently, they don’t exist solely to be traded. That is, in principle at least, they don’t exist for their own sake.

It is a mechanism that enables resources to be allocated to an organisation.  Bitcoin is the same as mortgages, bonds and shares in as much as they serve the issuer.

Do you know what PayPal is?

Bitcoin was a paper published, outlining a method for making electronic payments without a central party like PayPal.  See… It’s decentralised.

Without a central party like PayPal, who manages payments?  Determines balances?  Validates transactions?

Using PayPal, you announce a payment.  The amount you want to spend and you use a key that lets everyone know the funds are yours.    In order to ensure that you don’t spend the same funds twice (i.e. by issuing two competing announcements) you need someone to validate the first payment.  You use an intermediary like PayPal.

Bitcoin disposes of this single intermediary and uses a peer-to-peer network, entities that compete to validate the payment.   Like any competition, you need a reward for winning.  An asset.  A BITCOIN!

Hi Ho

This is what Bitcoin mining is, you are competing, using computing power, for the right to timestamp the latest batch of announced transactions.  Anyone can join this contest at any time as the code and network is open.  All you have to do is find a random number generated by a network.  This isn’t easy so you need a lot of processing power and electricity, you will incur a financial cost for mining, meaning you will value the reward.

A BITCOIN!

In other words, miners follow the rules because it is in their economic self-interest to do the right thing.

And since these miners have debts to pay (mostly huge electricity and resourcing bills), they will likely sell their newly earned Bitcoins on the open market in exchange for whatever real currency they need to satisfy their liabilities. Anything left is profit. The Bitcoin is now in circulation. People who need it can buy it. And so can people who just want to speculate on it.

To summarise, in just the last few years the world has invented a way to create software services that have no central operator. These services are called decentralised applications and they are enabled with crypto assets that incentivise entities on the internet to contribute resources — processing, storage, computing — necessary for the service to function.

Is any of this useful?

It’s not at all clear yet that decentralised applications are actually useful to most people relative to traditional software.  They are slower, expensive and not as scalable and almost inevitably offer terrible user experiences.  That’s before we even consider the utter lack of regulation and sheer number of people looking to scam the current enthusiasm for ICOs.

What’s more, this is unlikely to change anytime soon.   What they do offer is openness and a lack of regulatory control.  They are not subject to third-party oversight and to that end, are unstoppable.   You can send a crypto asset to anyone, free of regulation and accountability.  You can do what you want.

However, in reality, these applications have very few ‘mainstream’ users and it is traditional software that dominates and drives online activities like payments.  So, at the moment people are using crypto assets for another purpose, to store value.  It is not being used for its real purposes.  Property is only a good store of value in the long run if people live and work in buildings. The same is true of decentralized applications.

Where’s the value?

As such, as with any form of capital raise, the long-term value only exists by reference to the value of the decentralised application it enables.  In the mania for ICOs, we should not conflate investors with early users. 

The overlap between people who buy your crypto asset and people who actually want to use the service you are building is likely very, very small, especially during market manias. Yes, people are buying crypto assets. But that’s because the “market” are people who want to get rich and the “product” you are selling is a “way to get rich.”

In the long-run, the value of a crypto asset will rise and fall in proportion to the use of the decentralised application it enables.  In the short-run, there will be extreme volatility, confusion reigns and greed pushes rationale thought out of the door.

To ICO or not?

In the current mania, seeing the value in any decentralised asset is critical.  Many issuers of new crypto assets aren’t actually building decentralised applications but are instead shoe-horning an ICO into their service because of the investor appetite.  This doesn’t mean ICOs are bad, just that people are capitalising on confusion.

Remember Bitcoin is nearly 10 years old and the concept of crypto assets and decentralised applications clearly isn’t going anywhere.  In the long run, ICOs are likely, not to destroy all other forms of raising capital, but to find a place alongside them.