Is the surge of ICOs an innovative funding source or a bubble waiting to burst?

Initial Coin Offerings has suddenly emerged to be a fast growing funding source for technology startups, and by July this year, almost $1,3 billion has been raised through this funding mechanism, where more than half of the amount was raised in June. With this speed of adoption, wither someone has figured out something ingenious to fill a gap in the market, or we are looking at a greed-driven bubble.

For those unfamiliar with the concept of ICOs (Initial Coin Offerings), An ICO has become an alternative mechanism to raise capital where a company instead of issuing shares to investors sells digital tokens or coins such as ether or bitcoin to fund their company. Investors are not given any stake in the company nor any future voting rights in contrast to a stock offering. A comprehensive report published by Autonomous NEXT provide this analogy to explain exactly how an ICO work.

“Imagine there are plans to open a new casino, and for funding, the casino sells its own plastic chips before opening, in anticipation of customers using these chips and creating economic value. “Further, the buyers start trading these chips based on the expected value of the casino, how well attended it will be, and whether other chip holders are trading.”

Just like chips at a casino, the tokens have an inherent functional value, e.g. XRP fuels transactions on the Ripple Protocol and Ether acts as the engine for the smart contracts system of Ethereum. This raises the question whether all the ICOs are offering tokens with an actual functional value, or whether tokens are issued primarily for speculation.

The first question everyone should ask himself or herself in that case is whether the company at hand benefits from using blockchain technology over a traditional database or ledger? Unless you are dependent on inherent functions of the consensus mechanism in the blockchain technology such as immutability, provenance between numerous stakeholders, or could benefit from a smart contract layer, a good old-fashioned database may be sufficient. There are many examples of digital currencies with no need for a blockchain. Take World of Warcraft Gold for instance, a virtual currency that has been traded for real world money for years. Since this currency exists solely in Blizzards closed environment, there is no need for any blockchain to validate or record transactions. There is reason to believe that many ICOs are offering tokens or coins without any real functional value. ICOs like ‘jokecoin’ and ‘uselesscoin’ are still seeing hundreds of thousands of dollars invested, proving that real money is being invested in useless coins

Another cause for concern is the sheer number of ICOs and the amount of capital raised in a very short time. Autonomous calculated that $26m was raised from ICOs in 2014, $14m in 2015 and $222m last year. It found that by the second week of July there had been 56 token sales this year, raising $1.27bn in total. More than half of this year’s proceeds have been raised since the start of June, as the price of leading cryptocurrencies such as bitcoin and ether surged to record highs. We are even starting to see companies reaching unicorn valuations of over 1 billion USD through ICOs.

For existing and potential investors, the number of altcoins being launched should raise some serious concerns regarding liquidity and second-hand market. A unicorn valuation is of little to no value it the underlying token/coin is illiquid.

ICOs are often referred to as a cross-breed between an IPO and a crowdfunding campaign, as supporters sign up for a project similar to a crowdfunding campaign, while at the same time looking for a future return on their investments as the expect token value to rise. To set ICOs as a funding source in context, this year’s total investments are still a tiny fraction of the $34bn raised via crowdfunding platforms back in 2015. Even though Crowdfunding had its number of hopeless investments in its early days, it has proven to be a serious funding option. Time will tell if this also will be the case for ICOs as a funding mechanism.

With the value of popular cryptocurrencies such as btc, ether and XRP rising to record highs this year, it is reasonable to believe that the sudden explosion in number of ICOs are driven by the desire to get on early on what could the next best thing. Opportunistic investors with little to no technical expertise to evaluate whether an ICO is backing tokens with a function value or not hoping to cash in on what they perceive as easy money should prepare for a rude awakening. Both South Korea and China announced this week that they have outlawed ICOs, saying ICOs have “seriously disrupted the economic and financial order”, and SEC has warned against the legality of some ICOs.

Even though the jury is still out on whether we are witnessing a bubble or not, one thing is for certain, there will be losses. After months of unprecedented appreciation, almost every digital currency is seeing double-digit losses over the last 48 hours. Regardless of whether the market is experiencing a correction as it matures and consolidates or whether we are witnessing a market collapse, winter is coming for many hopeful altcoin investors.