June 19, 2017    4 minute read

The Pros and Cons of Cryptocurrencies

The New Kids on the Block    June 19, 2017    4 minute read

The Pros and Cons of Cryptocurrencies

In 1997, at the height of the Dot-Com bubble, technology IPOs were the new craze. An unprecedented amount of capital was pouring into newly incorporated internet startups, and investors who were able to secure a cut of these lucrative equity offerings quickly grew rich off paper gains. Under a climate of speculation fuelled by herd-reinforced sentiment, many wildly unprofitable companies attained absurd market valuations despite suffering severe operating losses and producing little tangible value.

The euphoria of a prolonged super-bull market was never destined to last. When it all came crashing down at the turn of the century, over $1.7trn of market cap was been wiped out, and an entire industry evaporated just as quickly as it had surfaced.

Then and Now

The current cryptocurrency landscape is evolving at a rapid pace, but for those who lived through the Dot-Com boom and bust, the whole ordeal carries with it an uneasy familiarity. As blockchain technology has become more developed, the difficulty of issuing digital currencies has dramatically fallen. This has allowed for new and specialised distributed ledger technologies to enter the market and fill important niches.

One outcome has been the explosive growth of the Initial Coin Offering (ICO) – a new way for Blockchain startups to raise funds for investment. Unlike the IPO of traditional capital markets, coins (or tokens) issued to investors do not represent an equity stake in the business itself, nor do they pay dividends based on periodic cash flows (with a few exceptions such as Etheroll). Rather, the tokens are typically used as payment for goods and services within the company platform, in other words deriving value from potential future network effects.

Speculation over Substance

This forward-looking construction of risk versus delayed reward means that ICOs are inevitably rife with speculation. More importantly, the inability to assign tangible value to an exchange of goods and services, coupled with the lack of estimable cash flows, seriously limits the applicability of conventional valuation metrics in ascertaining fair value and detecting bubble behaviour.

Another problem is that blockchain businesses have been more than eager to capitalise on the “new paradigm” mentality of less experienced investors. While distributed ledger technology is certainly going to be disruptive, this effort is largely spearheaded by a handful of major players such as Bitcoin and Ethereum, but certainly not the companies behind the hundreds of other small-cap currencies coming onto the market.

This situation of asymmetric information creates a classic “lemons in the market” problem for the average under-informed investor. With many ICOs, the only reference material provided is a company website and whitepaper document (which is often more of a marketing piece than the technical brief it is intended to be), making it nearly impossible to distinguish between fundamentally sound businesses and the ones which essentially run attractive marketing campaigns. The unfortunate outcome of this is an over-investment in low-quality businesses and an under-investment in high-quality ones.

Role of the Government

A lack of regulatory oversight surrounding the blockchain space has further complicated the problems faced by ICOs. Although sometimes seen as an advantage of cryptocurrencies over fiat money, the absence of legal frameworks clearly poses certain downsides with regard to lack of due diligence and transparency for investors.

Whether crypto-assets should be considered securities (and therefore be subject to regulation) remains a contentious point. Given the decentralised nature of governance, the actual practicality of enforcement is also a pertinent concern. Until these questions are suitably addressed, it is difficult to envision ICOs gaining traction and receiving widespread approval in mainstream settings.

Proceeding with Caution

The total cryptocurrency market cap recently breached a landmark figure of $100bn. Undoubtedly, a large proportion of this has been fuelled by the ongoing ICO frenzy. In view of the current atmosphere of the ICO space, prospective investors chasing its excess returns should be extremely wary of the risks involved.

That is not to say token sales should be avoided completely. Those looking to diversify their portfolio should conduct thorough research and audits into target investments carefully. Resources dedicated to ICO due diligence (such as Smith and Crown) will be vital in identifying fundamental value to this end and ultimately enable better-informed investment decision making.

It is more than likely that ICOs will remain a part of the investment landscape going into the future. The development trajectory of this nascent yet disruptive industry will be a critical factor in determining the nature of this role. Whether stakeholders learn from past mistakes will very likely decide the outcome of the next boom or bust.

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