By Sergejs Tjazelovs and Dans Staermans
If you at least sometimes experienced some pieces of enthusiasm over the crypto world, you probably have heard about an Initial Coin Offering, which made a huge bang a few years ago.
In layman’s terms, an Initial Coin Offering (ICO) is something very similar to an IPO, but in the world of cryptocurrency. Despite unbelievable popularity in 2017, with 875 ICOs and around 6 USD billion raised according to ICOdata, the process of raising capital by providing investors with tokens, which are then listed on cryptocurrency exchanges, has some undeniable flaws and minuses. Arguably, the main imperfection of an ICO is the absence of sufficient procedures and eligibility standards which would prevent scammers from funding their empty and fake projects. No one being of sound mind would prove the trustworthiness of an ICO in its initial form today.
In an attempt to fix credibility issues towards the blockchain approach for raising capital, cryptocurrency exchanges, such as Binance, decided to take responsibility for scrutinizing the projects before they are listed. That was the beginning of an Initial Exchange Offering, which happened in the last months of 2017.
The first and foremost advantage of an IEO, which is basically a form of an ICO, is that it almost completely eliminates the risk of scam projects’ coins being listed, as says Benjamin Vitaris, a crypto journalist for the Crypto Potato. This step seems to have restored the trust to the blockchain approach towards raising funds. Another big benefit of an IEO is, as known from the same source, that large cryptocurrency exchanges have a lot of marketing resources to promote companies going public. Moreover, investors usually have to undergo KYC procedures before being able to participate. In this article, we will look at some examples of IEO and argue on what risks are still there even after all the improvements and whether an IEO is a long-term investing model.
Investment Times Ten
Among the companies that have undergone an IEO, the most well-known one is probably a San-Francisco based BitTorrent Inc. BitTorrent develops a torrent management software of the same name and has about 100 million monthly active users. Their IEO, held on January 28, 2019, was a huge success: 7.2 million US dollars (USD) were raised within 15 minutes, as reported by Binance exchange which facilitated the offering. According to CryptoRank data, all-time-high price (ATH) is about 15 times higher than the IEO BitTorrent token (BTT) price, which was 0.00012 USD. For instance, 100 USD investment turned into 1542 USD. At the moment of writing this article, BTT is still in the green zone with impressive ROI of 3.83. Another good example of mind-blowing figures is the IEO of blockchain platform Harmony, also held on Binance. The project raised 5 million USD with ATH of 9.59 and current ROI of 1.62.
Binance, however, is not the only IEO platform on the market. OKEx, the Malta-based exchange, can be proud of Wirex coin (WXT) listing. Wirex is a British company that launched Visa card linked to the Bitcoin wallet. Wirex raised 2 million USD with ATH of 7.03 and current ROI equal to 2.75 within 14 minutes.
Looking at the figures and keeping in mind that IEO is designed to be safe and definitely safer than ICO, one may ask a question: have I finally found a way around one of the most upsetting golden rules of investing – “high profit means high risk”? We shall find out.
Direct Risk 1: Lottery Will Not Let You Enter the Game
Initially, participation in an IEO was organized as a first-come-first-served system: a live row of people willing to buy tokens. This method caused at least two significant problems: the dependence on external factors (internet connection quality, CAPTCHA procedures) and disadvantageous situation for big investors (as their significant demand was not prioritized over tiny demands of small individuals). Therefore, the lottery method was introduced.
The main idea of the lottery method is to determine a certain allocation of coins per one winning ticket and create a rule that chooses winning tickets. The more money a person holds on an exchange, the more tickets she gets.
In the case of Binance, each ticket is assigned a number (e.g., 18843 or 15944), and, during the lottery, numbers are generated. Generated numbers are matched against the tail digits of all tickets and winners are determined. The number of winning tickets is previously set (as both the total supply and the allocation per ticket are known), so there are multiple draws until this number is reached (e.g., winning tail number 5, 12, 37, 27, 89, 67, 632, 8942, 5332 – probability of winning ticket decreases with each following draw).
The share of winning tickets is driven by the total demand and is not known before the draws. In the case of Harmony, it was 30.82%. The general trend and, therefore, a problem for small investors is that the share of winning tickets is decreasing (see note 1). An IEO of Perlin, proof of stake smart contract platform, that was held on August 25, 2019, also on Binance, featured a lottery with 5.46% of winning tickets. Even having a maximum allowed number of tickets, 10 (500 BNB, around 13000 USD at the moment of the lottery), would have given around 50% probability of getting the winning ticket.
The two latest IEOs on Binance, Band Protocol and Kava, had a similar share of winning tickets: 9.43% and 9.01% respectively. The fact that it becomes hardly possible to win with only one ticket (something relatively many small investors may be able to afford) may, from our point of view, push an IEO away from the community’s sympathy.
Direct Risk 2: Say Hello to Volatility
Before dealing with the problem, it is necessary to acknowledge one difference between an IEO and an IPO. This difference is known as the lock-up period. This is the predetermined amount of time after the IPO wherein shareholders are prohibited to resell newly bought stocks. There are many variations of the conditions and rules for this period depending on various factors. The thing is that, in terms of an IEO, such a measure as the lock-up period is not really a practice. As a result of such omission and a great willingness to cash out recently acquired tokens, investors apply themselves to resale soon after the deal.
Even though it may seem attractive at the beginning that no lock-up period usually exists in IEOs, it turns out that there is another “lack of freedom” period. Cryptocurrency exchanges would typically ask potential investors to hold their coin (BNB for Binance, KCS for KuCoin, etc.) for a few weeks before IEO takes place.
For the Harmony’s IEO, a person had to hold at least an average of 50 BNB (at that point of time, 1450 USD) during a 7 day period prior to the lottery draw. A snapshot of the balance was recorded each of the 7 days. For Wirex IEO, it was a 15 day period and 500 OKB (835 USD). For the latest Binance IEO, Kava, the threshold has not changed, but the holding period was 30 days.
Cryptocurrency exchanges are, in fact, interested in prolonging this period, because it ensures the demand for their coins. The more people are interested in IEOs, the better it is for the price and liquidity of the coins. If there is at least one IEO a month with the holding period of 30 days, it would be reasonable for an investor to always have sufficient amount of coins on the balance and be able to participate in all the offerings.
However, some empirical data shows that the price can change dramatically during the holding period, and these changes are not always positive for investors. Price of 1 BNB had grown from 4.5 USD (December 8) to 39 USD (June 22) – extremely positive for BNB holders, but then plunged back to around 15-16 USD (first days of October) during the last year. For instance, if an investor had made a decision to invest 5000 USD in BNB on August 12, his/her coins would have been worth only 2/3 of the initial value after a month (see the chart for better understanding). Bearing in mind that the proportion of winning tickets on Binance may be expected at around 10%, the chances are that the investor would have not participated in an IEO on September 12 (the one did not happen on the date, it is just a matter of example) and would have lost a sufficient amount of the investment.
The price of KCS has been fluctuating between 1 and 2 USD since April 2019, which is also a very broad range. Same comments can be made about almost all major cryptocurrency exchange coins.
It is clear that high volatility is a general characteristic of the crypto-market at the moment, but the most important note is that it should never be forgotten when analyzing potential benefits from participating in an IEO. Incredibly high ROIs of many offerings seem attractive, but the truth is that it is easily possible to not be lucky enough to have a winning ticket and lose money because of price fluctuations. Having understood the two direct risks, it is now worth taking a look at some deeper issues.
Indirect Risks: Possible Complications
Even though the credibility and the reputation of an IEO is better than that of its previous version, an ICO, sometimes things develop not for the sake of investors. There are sufficiently many exchanges for an IEO today. The biggest exchanges with the most solid reputation, such as Binance, are the main targets for big companies aimed at raising capital in this way, in accordance to Larry Cermak, the director of research for The Block. He also notes that there is an increasing amount of small exchanges which selling point is reduced requirements of acceptance criteria for projects before being listed. Hence, not all exchanges should be considered as a risk-free platforms for long-term investing.
Secondly, as found by Cermak, the prices of tokens are very volatile. According to him, the price of tokens is never sustainable due to the initial goal of traders to resell them. As stated in the same source, 75% of projects have lost 50% of their value since ATH, while 39% of projects shrunk more than by 75% of ATH. Larry Cermak draws the conclusion that there is a positive correlation between the fall in value since ATH and the number of days after an IEO.
Finally, no state protection for the IEO investments can be expected. The only powerful institution between an investor and a company is an exchange. However, even the prominent exchanges can be hacked. For instance, as reported by The Next Web, hackers were able to transfer 7,000 Bitcoin (around 40 USD million at the time of the event) in one transaction from Binance’s hot wallet in May 2019. Luckily, users’ losses were covered by the “Secure Asset Fund”, but, once again, this the case of Binance. Users of some smaller exchanges may be not that convinced of the safety of their funds.
We have found out that the incredible ROI are real, but hardly accessible. There are two direct problems everyone faces when participating in an IEO: the lottery system and the high volatility of cryptocurrency exchange coins. The lottery system makes the participation in an IEO a matter of luck even for relatively big investors, while high volatility of coins puts an investor’s capital at significant risk even without her participating in an IEO.
Some deeper analysis of the situation reveals that there are another two factors making investors’ choice even more complicated: a big number of exchanges facilitating IEOs of doubtful quality and the lack of safety for the invested funds. Negative correlation between the days since an IEO and the value of listed tokens infers that there is a lack of long-term interest in listed companies. Therefore, it is too early to proclaim that the current form of an IEO is designed for long-term investing.
Based on the facts stated above, one general conclusion we can make is that now the optimal strategy is to stick to the IEOs by large exchanges and consider it as a short-term investment opportunity. We acknowledge that such a conclusion can sound too mercantile, but this seems to be the reality of today.
This article does not contain investment advice or recommendations. Every investment involves risk.
1. It should be noted that for losing tickets so-called “airdrop pool” mechanism was introduced, so that all ticket holders get at least some of IEO coins. We ignore this fact consciously as these “airdrops” are too insignificant and, as a result, do not change the whole picture for investors.
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Charts and graphs
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The Block. (2019, July). ATH return vs days since IEO. Retrieved November 2, 2019, from https://pbs.twimg.com/media/EAzOgPDX4AEe3qF?format=jpg&name=large