HERE is the deal. You can buy an entry in a computer ledger issued by a startup company on the basis of an unregulated prospectus. It is called an “initial coin offering” or ICO. But though the ledger entry is called a coin, you cannot spend it in any shop. And whereas the use of the term ICO makes it sound like an IPO (initial public offering), the process whereby a firm lists on a stockmarket, coin ownership does not necessarily get you equity in the company concerned.

This sounds like the kind of bargain that would appeal only to people who reply to e-mails from Nigerian princes offering to transfer millions to their accounts. But ICOs may well be the most popular investment craze since the dotcom boom of 1999-2000; even Paris Hilton, a celebrity heiress, has jumped on the bandwagon. The list of active, upcoming and recent ICOs on the website “ICO alert” covers 31 pages of A4 paper and includes around 600 companies. More than $2bn has been raised in total.

There is a serious side to the craze, just as there was with the dotcom boom. The technology that underpins digital currencies—the blockchain—is an important development. This is a secure, decentralised ledger that everyone can inspect but that no single user controls. It seems likely to be adapted for use across the financial system—to record property transactions, for example.

Many ICOs are designed to finance applications that will make use of the blockchain—for trading currencies, lending money or searching for jobs. In some cases, the “coins” can be exchanged for services on the site. In a way, this is like selling air miles in a startup airline; investors can either use the miles for flights or hope they can trade them at a profit. For the business, it is also a way of creating demand for the product they are selling.

But in plenty of cases, an ICO is just a way of raising capital without all the hassle of meeting regulatory requirements, or the burden of paying interest to a bank. Businesses are able to achieve this feat because investors hope that the coins will rise rapidly in value, as has been the case with bitcoin or ethereum, the best-known digital currencies, which have seen stellar gains in the past year. Nothing makes individuals more willing to take risks than the sight of other people getting rich.

But bitcoin is also different from ICOs. Its appeal is as a digital currency that can be used in a broad range of transactions. And the supply of bitcoin is designed to be limited, meaning some people regard it as an electronic version of gold.

So there is a chance that bitcoin or ethereum will come into widespread use, although their function as a means of exchange is undermined by the volatility of their price. Currencies must be stores of value, at least in the short term. If you think a digital currency is going to rise 20% tomorrow, you won’t want to swap it for goods and services; if you think it is going to fall 20% you won’t want to accept it.

It is also worth remembering that governments set the rules regarding the nature of legal tender within their borders. They will always have the whip-hand when it comes to issuing currency. If they believe that a digital currency is being used for widespread tax evasion, or is distorting the financial system, they will crack down hard.

As far as business-related ICOs are concerned, a few may succeed. Investors may well be taking the “lottery ticket” approach, hoping that one big winner will offset a large number of losses. In a sense investors are acting like venture capitalists. But the sultans of Silicon Valley’s VC industry insist on a wide range of rights before they invest their capital, including protection against dilution of their stakes and (sometimes) the right to nominate board members. Investors in ICOs have nothing like that level of protection.

In the circumstances, it is hardly surprising that regulators are getting involved. In America, the Securities and Exchange Commission has ruled that these coins may, in some cases, be securities and thus subject to regulation. A British regulator, the Financial Conduct Authority, this week warned investors about the risks involved. The Chinese authorities have gone a lot further, declaring that ICOs are simply illegal.

It is not easy to draw a line between financial innovation and reckless speculation. Perhaps an ICO will finance some breakthrough that boosts economic efficiency. If you work in the tech sector, you may be able to spot the occasional grain of wheat among the pile of chaff. Everyone else should assume that ICO stands for “It’s Completely Off-limits”.

Source: economist
ICO stands for Investor Caution Obligatory