Initial coin offerings promise to disrupt the venture capital industry for technology projects, raising almost $13 billion to date. This may seem like a relatively small number, but the valuation of these tokens has already multiplied several times. As of May 31 2018, the entire cryptocurrency space has a market cap of roughly $333 billion after hitting close to a trillion at its high in December 2017. A subset of the space are tokens that can represent basically any asset that is fungible and tradeable, from commodities to loyalty points to even other cryptocurrencies. How sustainable is this nascent token ecosystem?

Data source: https://www.coinschedule.com/stats.html?year=2018

The short history of ICOs

Let’s first revisit the short history of initial coin offerings. The first ICO was Mastercoin in July 2013, and Ethereum raised several millions of dollars by selling its token in 2014. ICOs and token sales became popular in 2017. Initially selling at $0.31 per token, Ethereum has traded as high as $1,400 in January 2018, a handsome 451,612% gain. In just a few short years, the industry has mushroomed into a multi-billion dollar behemoth rich with froth and speculation. ICOs allow firms to raise money by selling digital tokens, cryptoassets that promise to go up in value as the company develops its services on the blockchain. Ninety percent of them build on the Ethereum blockchain, but there are other blockchains, such as NEO, Waves, or NEM. At the time of this writing, over 81,000 tokens existed on the Ethereum blockchain, many of which are ICOs. Some of them have a market cap that beats the GDP of a small country, such as EOS, the leader of the pack, with a valuation of over $15 billion.

It’s perhaps important to understand that most tokens that trade on public exchanges already appreciated a great deal before retail investors can buy them. Even though ICOs directly compete with VC funding, ironically, large ICOs, such as the Filecoin ICO, also received investment from top venture capitalists in Silicon Valley, including Y Combinator and Andreessen Horowitz. Professional investors are already crowding out everybody else, especially in high-profile ICOs with the greatest potential for a multiplication of the investment. After raising $1.7 billion from professional investors in its pre-sale, the messenger app Telegram canceled its public ICO. In the pre-ICO world, this would mean the company raised enough capital from private equity investors and didn’t need to list on a public exchange. So much for democratization of access to investments in the token economy. Are the well-known tokens that trade on public exchanges still worth their money, and are those that professional investors passed on even worth looking at? Some ideas to “tokenize everything” may turn out to be useful, but in many cases, they may complicate business models unnecessarily.

The value proposition of token economics

Token economics promise to reduce inefficiencies in business processes and more mundane things of our lives. The idea is to give people incentives to do things activate resources that otherwise would lie dormant. For instance, do you have empty hard disk space on your laptop? FileCoin promises you to rent your excess disk space to others and monetize a resource that you own but that is currently unproductive. Instead of relying on traditional venture capital, FileCoin sold its tokens in an ICO directly to the public to raise $257 million. ICOs promise to democratize access to capital by selling tokens directly to the public and private investors. Changpeng Zhang, the CEO of Binance, is a fan of ICOs. “Raising money through ICOs is about 100 times easier than through traditional VCs, if not more,” he writes in a Medium article. With the ease of raising money increased, logic says there may be 100 times more startups, well-funded startups, where ICOs are allowed.” While this logic is not necessarily sound — this might be a long tail game with a skewed distribution of funding — it will certainly benefit investment gateways into ICOs that operate on a commission basis. Binance is the world’s biggest trading platform for cryptocurrencies and tokens, and its quarterly profit eclipsed that of Deutsche Bank in Q1 2018.

Much of the traditional world is woefully inefficient, and tokens promise to fix that by giving incentives to network participants. However, having a token in a business model can make it harder to gain adoption and build a network of users, because now, they have to go and buy a company’s token to use its services.

Capturing alpha in the token ecosystem

The blockchain as a distributed ledger that is permissionless, trustless, and censorship-resistant is at the heart of token economics. If it succeeds, the blockchain might be one of the major growth stories of our time. The next question is how to take part in that growth story without overpaying or falling prey to outright scams. “Once you have identified a use case where you need a blockchain,” says Fabio Federici, Founder and CEO of Base58 Capital, “the question becomes how to design the system in a way that the value of this network will accrue at the level of the token. If this succeeds, you have a new asset that can generate a lot of value for investors.”

Excess returns come with understanding the design of a token ecoystem, and this needs deep knowledge and insider connections in the space. We’re still a long way from full transparency in the ICO space. As an only half-joking start, there is the [Useless Ethereum Token(https://uetoken.com) (UET), which brands itself as “the world’s first 100% honest Ethereum ICO with no value, no security, and no product.” Is this a scam? “Neither,” proclaims the website of the developer. “This is real and 100% transparent. You’re literally giving your money to someone on the internet and getting completely useless tokens in return.” Despite numerous disclaimers on the website of the developer not to invest, the crowdsale netted $300,000. There sure is “dumb” crypto money sloshing around in the cryptoasset ecosystem, but the success of UET is still a surprise. It shows how much room this industry still has to grow.