How ICOs inflate the cryptocurrency market cap

in ico •  9 months ago

As I was writing my piece on cryptocurrency pricing, I realized that ICOs have a surprising and peculiar effect on the market capitalization of cryptocurrencies. Let's say Alice has 1 Ether, and Bob has a magical idea and needs to raise money to develop it. Bob decides to run an ICO to raise the money. This means he'll do some work, create a smart contract in Ethereum (or some other platform), and voilà, he's running an ICO.

Alice, savvy investor that she is, likes Bob's idea and decides to contribute to the ICO. This means she'll send her 1 Ether to Bob's ICO contract, and Bob's contract will send 1 token over to Alice. Let's call Bob's token MAGIC. So here's the picture:

Graphics.004.png
Alice participates in Bob's ICO by sending him 1 ETH. Bob sends back 1 MAGIC as thanks for the contribution.

So what just happened? Bob issued a brand-spanking-new token to Alice. What's that shiny new MAGIC token worth? Well, Alice paid 1 ETH for it, so we know it's worth.... yep, 1 ETH. That is, Alice's economic situation hasn't changed; as far as her accounting is concerned, she still has 1 ETH worth of value in her wallet. But Bob's situation is far better! Now he has 1 ETH, where before he had none! Here's the picture:

Graphics.005.png
By engaging in an ICO (as contributor and creator), Alice and Bob magically doubled the value of Alice's original ETH token.

Bam! Value magically created!

How should we think about this?

At first thought, it feels nefarious when you go from having less value to having more value. But in a good world, the doubling of value above is totally legitimate. Here's one way to think of it: Before the ICO transaction, Bob's idea was valuable. The doubling of the value of Alice's ETH token is the result of Alice putting her capital to work, which takes Bob's actual valuable idea and starts to put some cash behind it. That is, the value was there all along -- it was just in Bob's mind and needed Alice's cash to unlock it.

But the world isn't always as rosy as you'd hope. In reality, Alice's estimate of the value of Bob's idea will never be perfect. Sometimes she'll overestimate, sometimes underestimate -- and she'll take losses and profits accordingly.

Worse, Alice could be contributing because she's taken up in ICO mania. In that case, she doesn't really think Bob's idea is all that great, but she knows that in today's world, ICOs return ludicrous profits instantly. If that's the case, then we can't really take Alice's contribution as a vote of confidence about Bob's idea; her contribution is merely a statement of the wild ride that the crypto markets have taken us on lately.

Worst, Bob could deliberately mislead Alice about the value of his idea. This is called a scam. He knows that there is ICO mania, and that it won't take much convincing to get Alice to contribute -- so he runs a fancy ICO and then absconds with the proceeds once it's done. When he eventually sells his ETH, that pushes down the price of ETH -- and since he's gone, Alice's MAGIC tokens lose all their value. When scammers run ICOs, they reduce the value in cryptocurrencies rather than increasing it -- they hurt all of us.

But I digress somewhat. The point is, every single ICO, whether good, stupid, or fraudulent, instantly increases the total market capitalization of cryptocurrencies. This is a powerful economic tool, but I suspect it can also mislead us into thinking that the crypto-economy is more healthy than it really is.

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Very nice article ! There Are so many ico going on it is like playing the lottery now !

Just like POCKET (as an ICO) instantly inflated the value of the STEEM accounts that received them :)

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i see what you did there ^^
POCKET was a giveaway, not an ICO though ;) cheers

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by the way, what happened to them? am i rich yet?

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I know you can trade them on the DEX... but I keep my hodl hands strong ;)

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realy? how much are they worth? (not that i want to sell or anything)
what dex? + i'll follow you now :)

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The BitShares DEX! Check out @pocketexchange for details!

A Genesis stake is worth somewhere around $50, I believe.

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nice! good to know and congratulations on your successful ICG ;)

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pocketsend:501@fips, might as well give more away :)

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Successful Send of 501
Sending Account: biophil
Receiving Account: fips
New sending account balance: 829374
New receiving account balance: 1000500
Fee: 1
Steem trxid: 7b01c3ca3e85ff680d4b9ee16392aece6d257ffa
Thanks for using POCKET! I am running this confirmer code.

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wow thx! :) your right! if its not moving, it will die maybe... i'm going to start sending these to nice people too ;)
(btw. just noticed... @kata uses the same symbol as Gateless Gate. is their a connection?)

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probably more like a ICG - Initial Coin Giveaway ^^

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pocketsend:1001@jeffjagoe

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Hey, biophil.
I tried to send some pockets yesterday, but no luck.
I've double checked my syntax and I should certainly have enough to cover it.
Edit: never mind. I worked it out.

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What did you figure out? Pocket did have some issues in the past couple days.

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My mistake. My phone auto capitalised the P.

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Ah good.

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pocketsend:1001@jeffjagoe

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Successful Send of 1001
Sending Account: mattclarke
Receiving Account: jeffjagoe
New sending account balance: 1189045
New receiving account balance: 2002562
Fee: 1
Steem trxid: fbe2f1ed04f3409c2e357976d7aff713a023bb6b
Thanks for using POCKET! I am small bot and right now I am running this code.

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Successful Send of 1001
Sending Account: mattclarke
Receiving Account: jeffjagoe
New sending account balance: 1189045
New receiving account balance: 2002562
Fee: 1
Steem trxid: fbe2f1ed04f3409c2e357976d7aff713a023bb6b
Thanks for using POCKET! I am running this confirmer code.

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Successful Send of 1001
Sending Account: biophil
Receiving Account: jeffjagoe
New sending account balance: 829875
New receiving account balance: 2001562
Fee: 1
Steem trxid: c879d680c0a5cc329733655bfd670af5ad1d924a
Thanks for using POCKET! I am running this confirmer code.

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Thanks for filling my POCKETs :)

i couldn't agree more. especially because there are idk 500 different tokens with all those bright ideas running on the ethereum blockchain. let's say only 10% realy succeed and deliver their product (dex, storagesolution, and whatnot...). all of them will be using this very limited ether-blockchain to have their product running... and it only needs one cryptokitties to block the whole network for days. it's going to be a disaster

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Yeah, I'm tinkering with Lunyr right now and it makes me hate Ethereum so much. Cool project, but it costs $20 in gas to submit a review of an article. Just crazy.

Fantastic outline of how and why ICOs have a big effect on total market cap. The idea of value not being realised until after transaction is always difficult to grasp, but you got it in very simple terms, which is what is needed as I find it is always over complicated.

I agree that it leads to a false confidence if how healthy the market is - as essentially all assets circulate internally, the value is never lost but will increase based on the speculative value Of The new coin. Thanks for the great overview!

One again @biophil writes a spectacular article! I have a question on one point. You state that you believe that even the worst ICO's increase the total market capitalization. I see a situation where this may not be true.

Although mostly an academic point, if Alice and the rest of the ICO participants buy Magic with Ether they already own the price does not double unless more people enter the market with new USD and purchase ether.

Until the further purchase of ether occurs everyone's Magic coins are essentially worthless. That, or the price of ether must decrease in an amount equal to the rise in the price of Magic. In this situation, the market cap does not change.

Thoughts?

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Right, the prices do not double, but the total amount that's accounted for does due to the newly-minted ICO tokens. We know the magiccoins aren't worthless because people just traded valuable Ether for them.

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Correct, but what I am saying is that if we have a million ether worth a million dollars to every one magic coin at the release of the ICO, and we take that one ether and trade it for the magic coin the magic coin is now worth 1 dollar, but the total value of ether takes a hit and the one million ether are worth $999,999. or 99.9 cents each. So although it appears to have created two new coins, in reality we have just lowered the price of ether a miniscule amount which is essentially invisible. Once people buy more Ether using USD the price of ether re-normalizes to a dollar and then and only then does the market cap increase.

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But why would contributing that Ether to the ICO reduce the market cap of Ether?

Just because the Ether is momentarily out of circulation doesn't mean it's not counted in the market cap. Or am I misunderstanding something about what you're saying?

It is only a matter of time until many of those ICOs will lose all their value because they won't deliver a product. Within 2 years a start-up (here ICO) should deliver some sort of value or I consider it failed, and we are getting closer and closer to that 2 year mark for some ICOs and many of them are still in very early development phase! But as with start-ups 95+ % will fail, so that should come as expected... Bad part is, like you said, that will have a bad effect on the whole market! In my opinions ICOs should be conducted when they at least already developed some kind of code, not with a whitepaper only, which happens way too often lately.

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From concept to actually producing something of value I would say 3-5 years is actually pretty normal. But that takes into account that ICO's are like venture capital. To make that long term worthwhile massive profit potential needs to be there as you have an opportunity cost to each ETH you put towards an ICO.

Lately that opportunity cost has been very high. Any coin that hasn't increased in value as fast as ETH shows this opportunity cost. You had the opportunity to just hold ETH and profit from it's run up.

Hi @biophil! Thanks, its been a few weeks that I am around Steemit but I have not yet dared to write a post, so I'll start with a comment at least. I've been going through your posts and I am enjoying quite a lot the way you think.

For example I liked a previous post where you made a point I haven't read before about why, these days, there seems to be a bit more of economy behind cryptocurrency ecosystem because of the ICOs, which at least aim to add value to the system. Whereas in 2013-14 there were barely any ICO, so the majority of money flowing in was about speculation (nowadays it's still similar, but at least there is so many ideas that I bet some will be the next Amazon).

But in this post, I am not sure I've properly followed your reasoning. I understand that a new ICO creates new tokens, which are not really money as of now (although there are some ICO's whose idea is already quite implemented and profitable, so somehow you invest in a "real" asset/security and not just in a promising future, i.e. FriendZ -highly recommended btw). But that's slightly different from:

Alice paid 1 ETH for it, so we know it's worth.... yep, 1 ETH

Actually since Alice paid 1 ETH, now it's actually worth nothing (well, the token). It's virtually the same as if she just used USD to buy the ETH and then the ETH to buy the token. So yes we have incorporated extra USD to the crypto market cap, but ETH supply has not changed.

Am I right? I am quite new in the crypto space so sorry in advance if I am wrong.

Thanks again!

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Hi, glad you're finding my stuff useful!

Actually since Alice paid 1 ETH, now it's actually worth nothing (well, the token).

My reasoning is that the act of paying 1 ETH is what makes the token valuable. I mean "valuable" here in the sense of "having a market value." The market value of something is the only thing that impacts its market cap, and understanding the massive market caps of cryptocurrencies was the main goal of my article.

ETH supply has not changed.

Correct, but the new ICO token that Alice bought now exists, whereas before she bought it it didn't exist. So the market cap of ETH is still exactly the same, but the market cap of whatever this ICO token is has grown.

I wonder if you're mixing up different notions of value. The ICO token that Alice bought might be for a crappy project, but the token can obviously have a market value that's independent of the project's value. We see this in Ponzi schemes like the old Bitconnect. The project was vapor (and this was known by a lot of people), but the token had a huge market cap.

Clear anything up?

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Yes! I guess it was about semantics. As you said, new tokens inflate the market cap, totally agree. I guess my point was more towards the fact that this inflation is the same that happens with the actual mining of one BTC for example; or even less, since at least some of these new tokens will actually end up having a utility.

I think it can boost it until the crypto market becomes strong enough through the widespread adoption of blockchain and alternative, transparent financing/money.

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Hopefully true!

Very well said, when scammers run ICOs, they hurt the entire market. I was a victim and became resentful of cryptocurrencies while things got rosy last year.

Very good.

This is an interesting point and perspective. I have been thinking about how to rationalize market caps recently and one thing that strikes me is the potential double counting when looking at the market cap of a basket of tokens.

Ethereum or Bitcoin or any coin have value because they have a utility that will in some way be utilised in the future and may generate income. In Ethereums case it will be a supercomputer running smart contracts tokens or whatever. You may consider the value of Ethereum as reflecting the value of its network of applications, those that will use the platform. I think of it more akin to an economy where it's applications are it's goods and services that give the currency value.

When you view coins like this it means that by counting the value of a token issued on the Ethereum blockchain and Ethereum we are double counting the value of the network and the value of the network that is already baked in to the Ethereum valuation.

My two cents. Still haven't gotten it quite figured out.

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Yeah, I wonder if that would be a good way to approximate the value of a platform like Ethereum. It becomes difficult partially because the price of Ether reflects the market's perceived value of the basic platform itself, given the fact that all of the tokens issued on Ethereum are valued what they are; that is, in principle, the possibility of double-counting has already been accounted for and the market caps actually reflect the reality.

Of course things are always more complicated than the basic principles would have you believe.

Great insight. A similar thing happens elsewhere in the economy. Alice wants to work, but has a baby. If she get a job, she has to hire a baby sitter, and a maid to clean her house. Suddenly, GDP of the economy grows by 2x. (When Sally cleans here own house this is not economic production.) Some world event happens and the price of gas goes from $2 for $4 a gallon. Suddenly, the sales of every gas station goes up. Demand for houses in California rises because of low interest rates, now every house is suddenly "worth" twice as much.

where the incident, there are casualties, really impress ya 😱😱

I think we are talking about this briefly. A system that grows as you share.
I think it's the best kids do.
images-112.jpg

Late to the party on this, but I agree. How much “real” moolah is in there, who knows? I’ll leave that to those much smarter than me to calculate.

Another good post @biophil. I do remember when BCH was born, billions of bucks suddenly appear out of thin air. I would say that was like magic. LOL

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Yeah, that was a particularly weird one. I didn't expect it to go the way it did -- I thought we'd see a drop in BTC's price that corresponded to the new market cap of BCH, but BTC kept going like it didn't even care.

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pocketsend:101@mountrock

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Successful Send of 101
Sending Account: biophil
Receiving Account: mountrock
New sending account balance: 829273
New receiving account balance: 1001507
Fee: 1
Steem trxid: 06155bd68568c60cee3fe13edeb8932e4adcfdc1
Thanks for using POCKET! I am running this confirmer code.

where the incident, there are casualties, really impress ya 😱😱

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Checked, but did not find documentation on a daily basis.
I meant if there is something that documents ICOs like coinmarketcap.com documents tradable currencies.

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Yeah, makes sense. I bet there is such a thing, but I don't know where.

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