Somewhere on the way to a financial revolution, this unregulated, wildcat mass of decentralized digital commerce became a lame, late 1970s situation comedy.
Try explaining cryptocurrency to anyone not vested, not formally associated with the space.
It’s impossible to make sense of what’s been wrought. Close to a decade-on, and we still don’t even know who created protocols setting the whole thing off. Satoshi Nakamoto, one dude, a group of dudes, pseudonymously quickened a digital form of cash, trustless, permissionless, borderless—all the best lesses. Bitcoin wasn’t hatched by a foundation. There’s not a corporate structure claiming its origin, no hotshot venture capitalist behind it, no government backing.
All that’s missing is a mouthy, ethnic child with carefully choreographed catchphrases to round out the given scenario and, boom, Bob’s your uncle: genuine 20th century entertainment mastered. So maybe cryptocurrency is that sassy Tween, and then the ecosystem’s main contribution to modern finance, the initial coin offering (ICO), is its hipper older brother.
Technically a breathable half of cryptocurrency’s lifespan, the ICO phenomenon arrives a variation on initial public offerings (IPO). The formal bringing of an incorporated set of actors to market has been around, similar in its present IPO arrangement, since the 1800s in the United States. Scholars can place its ultimate history as far back as ancient Rome. It would seem the need for capital is hardly new.
Traditionally, there’ve been but a few ways to grab dough for business expansion. Loans are popular, either through the banking system or friends and family. Whale investors can at times plop down mounds if the climate is right. The IPO in the modern age seemed to have thread all the right needles. No odious interest payments to ultimately disinterested parties in your business’s future. No bugging mom and pop. Waiting for a moneybags that never showed, and if he did make an offer it was at outrageous terms, seldom was a good idea.
Instead, IPOs are a skin in the game process. There’s more to them of course, but essentially a company sells itself out in the open. A kind a financial democracy can take place where a great many more people wet their beaks in the hope of eventual profit taking.
That’s the theory, anyway. What happened is part victim of its success and the tired, fucked-out notion of government’s strangling such markets through do-goodery regulation. What might have been the every man’s way to wealth, leveling a financial playingfield, has morphed into “accredited investors,” gaggles of lawyers, oceans of regulations to navigate. Whatever IPOs were, they’re now reserved, gate kept, decidedly closed to the type of people they, again at some point, were designed to empower.
Coin offerings introduced five years ago, debuted with an unstated business model. Literally without gatekeepers, a business could tokenize an idea, a service. Rather than shares proper, the investor at nearly any size would be allotted proprietary coins. They could be used on other open markets as they were being created, for speculation, or even within a particular ecosystem created by the originating business.
After fits and starts, the power of an ICO became obvious to anyone paying attention. As organic, voluntary associations are wont, markets within markets grew to serve all aspects of onboarding and offboarding within the ICO universe. Exponential growth during the halcyon year of 2017 led to a blossoming of offerings, and with them billions and billions of dollars in valuations. The Ethereum blockchain had become the choice of investors and entrepreneurs, ushering in 40 times the ICO growth of just the previous year.
Arthur Herbert Fonzarelli
With such insane amounts of liquidity came requisite subpoenas. Accusation of scams. About one scam for every dozen ICOs was the formula for a great deal of 2017. For as much money was made, what began as anecdotes, tales almost, turned into regular nightmares for investors, many very new to the game, being robbed without a gun as ICO proponents ghosted with gobs of cash.
Initial coin offerings could be said to have reached peak everything when no less than the U.S. Securities and Exchange Commission (SEC) trolled the industry. The once radical, hotshot way to raise capital had so lamely devolved by Q2 of the present year, the SEC published a masterstroke of scam education.
Masturbatory ICO industry vocabulary spread over a bulky Wix-inspired template, along with a countdown ticker for driving urgency, showed the initial coin offering community to itself. May 16, 2018 is the exact day ICOs as a favorited new way to do things ended. Once an industry is so easily, formulaically parodied (SEC isn’t known for its creativity or humor), trolled by government regulators, it’s pretty much over.
They’d indeed fell prey to the Fonzarelli Axiom. ICOs really were a bad sitcom straight out of 1977. That’s the year Happy Days was mid-way into its magnificent run. The first episode of season five aired to some 30 million as Arthur Herbert Fonzarelli iconically played on national panic, accepting a bravery challenge to waterski jump over an artificially lagooned, very Jaws-looking man eater.
History hasn’t been kind to Season 5, Episode 1. Jumping the Shark, many years later, became a battle cry aimed at mediocrity, cynicism by projects lazy enough to strike at low hanging fruit of any sort. Favorite bands bending to fads, unjustifiable movie sequels—when something has been so bloody obviously wrong, it’s placed on those skis, pulled by a boat, heading for a ramp. ICOs are now adorned in leather jackets atop their swimming trunks, pasty legs in all their glory, giving a hardy Fonzie thumbs up to worrisome and adoring crowds.
Can anything be done to both better protect ICO participants while not killing this relatively gatekeeper-less form of investment?
Coin-Operated Capitalism from the University of Pennsylvania Law School proposes answers (Cohney, Shaanan and Hoffman, David A. and Sklaroff, Jeremy and Wishnick, David A., July 17, 2). Available online through the Social Science Research Network, is an interdisciplinary, legal academic first.
Four Penn Law researchers, guided by Professor David Hoffman, recently presented their deep dive working paper on the subjects of ICOs and smart contracts. At well over 20,000 words, more than 100 pages, meticulous footnoting, and a 10,000 word collection of appendices, Coin-Operated Capitalism is a muscular working paper.
Fifty of the most successful ICOs from 2017 were examined. The premise, Do ICOs match expectations given investors?, is the main filter. Running through that filter were every white paper, prospectus, terms and conditions, along with scouring relevant social media posts of all 50 projects.
The working paper developed a basic theme, mainly how “inquiry reveals that many ICOs failed even to promise that they would protect investors against insider self-dealing. Fewer still manifested such contracts in code,” Penn Law researchers noted.
Eighty percent of their study samples didn’t code for vesting. A quarter of those promising token supply restriction left out relevant code to that end. Of the 17 projects to tout burning as a way to limit inflation, over a third of those had no reference to such code, no proof. Sixty percent of 10 modifiable tokens, such as Bancor, didn’t even bother to disclose their modifiability.
Code is a priestly language
“Surprisingly,” Coin-Operated Capitalism’s abstract muses, “in a community known for espousing a technolibertarian belief in the power of ‘trustless trust’ built with carefully designed code, a significant fraction of issuers retained centralized control through previously undisclosed code permitting modification of the entities’ governing structures.”
Smart contracts on which most ICOs depend seem to increasingly be enshrined in a kind of priestly language. To illustrate, researchers in one example rely on Polybuis. The Estonian outfit gobbled over $30 million during their ICO, summer of last year, making “several claims that would lead us to expect certain features directly coded into tokens or other smart contracts,” the paper explained.
Yet beyond standard token compliance “and the presence of a modification feature, we did not verify that any of these features are present, largely because Polybius’s coded governance exists in bytecode,” which is thought to be more of machine language rather than a legal arrangement. “Without spending a large sum of money purchasing the time and know-how of a very motivated and talented reverse engineer, an investor would be restricted to relying on vernacular promises.”
A member of the research team told CoinGeek, “On a practical level, blockchain seems only to exacerbate the problem of the priesthood—ordinary individuals are far more able to read [analog] contracts than they are to read code. The level of training one needs to read blockchain code and think about effectively extends beyond the generalist skills your average CS grad may have.”
Even scammy, ICOs are still a mostly unique investment opportunity
The above results show how “lawyers, bankers and investors being dependent on a highly select cadre of individuals, the ranks of which are filled with people overselling their skills. This leads to a second problem—how do you know your expert is really an expert? Academia has ways of filtering for cranks, but the blockchain community is still a while away from solving that problem,” the Penn Law team continued to explain to CoinGeek.
Despite all researchers have outlined as problematic, and the obvious scammy Jump the Shark properties of ICOs so well known even the SEC can seem savvy, such flawed arrangements continue to be one of the most unconventional transfers of wealth in human history. There is a lot to be optimistic about.
Mangrove Capital Partners studied initial coin offering markets prior to the Penn Law effort, and concluded, even with fraud and scams baked-in since the industry’s beginnings and through 2017, plunking down blind amounts of cash across every single ICO, investors would’ve earned more than 13x.
More recently, former Wall Street turned blockchain evangelist Caitlin Long took to her Forbes column, cheering on the embattled ICO path toward capital formation so maligned in the Penn Law working paper. ICOs, which she professionalizes into a nice turn of phrase, “Cryptocurrency capital markets,” markets not even three years old, are challenging “the supremacy of traditional investment banks for raising new capital, as they raised 45% of the amount raised by traditional IPOs during Q2 2018. Incumbent investment banks remain absent from nascent cryptocurrency capital markets and may increasingly lose customers to them.”
Lack of definition
Maybe it’s unfair to point out an almost eye rolling truism: Ivy League institutions, such as Penn Law, are predisposed to favor establishment assumptions. Among those givens is something known as “regulation,” always in the hands of bureaus headed and staffed by other Ivy Leaguers. It is they who ultimately claim protection of the hoi polloi. Should Ivy Leaguers not take their role seriously as benefactors, that simply means beefing up “regulation” and employing more Ivy League bureaucrats. New and more “regulation” is forever the answer.
The Penn Law team described to CoinGeek tensions between offerings and contracts as essentially coming down to how “ICO style capital raising definitely lowers barriers to entry,” which the working paper’s authors mostly laud. Penn Law researchers understand how ICOs “can make capital raising easier from a functional perspective. However, the lack of regulatory enforcement and investor protection is a heavy price to pay.”
CoinGeek frankly asked about incentives for Penn Law researchers to tackle this issue. “This study was not funded by any organization outside the University of Pennsylvania. [Researchers] owe thanks to the Department of Engineering, Penn Law and the Penn Center for Technology, Innovation and Competition, with whom [researchers] are affiliated,” the team insisted.
Still, and rather immediately, Coin-Operated Capitalism suffers from a lack of definition, real failure at clearly setting terms. Capitalism is used exactly one time, and in passing, early in the paper (page 5). The wistful line concludes, “an understanding of the ongoing ICO experience can also inform debates about the digital future of capitalism.” No debate, now or in the future, is possible if readers cannot be sure what it is precisely under consideration.
Assumptions, assumptions, assumptions
Their footnote getting close to a definition refers to Julie E. Cohen’s 2016 paper, The Regulatory State in the Information Age. The Georgetown Law Mark Claster Mamolen Professor of Law and Technology employs the word capitalism only nine times in 46 pages, and even then it’s met with qualifiers, informational capitalism as contrasted against industrial capitalism.
The closest Professor Cohen, and therefore the Penn Law working paper, gets to a definition is how “it is important not to confuse the demands of informational capitalism, understood as a distinct system of political economy requiring effective oversight and guidance, with the demands of information capitalists.” That hardly settles things.
Neither is a distinction made by the Penn Law team between government, coercive means of regulation, versus guilds or cartel notions of voluntary, industry-derived regulation. In fact, to Penn Law, only government regulation seems to exist, and so it is, again, assumed the magic escape hatch of “regulation” can be appealed to because readers for whom the working paper is meant share such assumptions. It is as if 2008’s Great Recession never happened, nor flash crashes, nor countless other anecdotes about mainstream finance’s failures despite being heavily regulated.
It’s safe to assume innovation taking place in the many billions of dollars around the world due to ICOs, opening up mostly permissionless speculation to unaccredited investors, would never have gotten off the ground if the likes of Penn Law had any say.
It is also ironic lawyers in the study are worried about lack of clear contractual language, code or no code, employed by ICO proponents. If ever there was a group who should be castigated for purposefully muddying waters, it is the legal community. There is probably an argument to be made about contractual language being so regularly opaque and impenetrable in real life that average folks don’t bat an eye at having to read them.
“One of the biggest takeaways,” the Penn Law paper notes, “is that many ICOs did not promise that investors will be protected from insider self-dealing. In other words, there was no guarantee that the tokens won’t be subject to pumps and dumps by ‘whale’ traders, insider trading, and other market manipulations.”
The working paper’s basic finding “is that ICO code and ICO contracts rarely match. In a financial ecosystem built around the proposition that regulation is unnecessary because code is the final guarantee of performance, the absence of coded governance protections is troubling. We also show that at least some popular ICOs have retained the power to modify their tokens’ rights, but have failed to disclose that ability in plain English.”
To put it the entirety of Coin-Operated Capitalism in plain language: no one reads smart contracts, and it almost doesn’t matter. The watchwords are “be careful out there.” Crackdowns, courts, cops, and bureaus staffed with regulatory enforcers, new laws will indeed kill the greatly innovative aspects of ICOs. They’ll become a digital version of IPOs, and no one should want that.
C. Edward Kelso is a financial technology journalist based in Southern California. Follow him on Twitter.
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