As 2018 has now ended, there is a plethora of both prediction and “year in review” commentaries. Across these articles, there is a lot being written about the wreckage left by the crypto tsunami, where crypto surged to meteoric heights in 2017, followed by a brutal bear market in 2018. In 2017 we witnessed tales of incredible wealth and forecasts of world changing technologies. In 2018, we saw both positive and negative stories. On the positive side, adoption continues to increase and many household names have announced plans to enter the market. At the same time, there have been many reports about regulatory actions, cases of fraud, and, of course, the disastrous results of imprudent investments made by investors.
One of the most important lessons the industry should learn is that there are reasons behind many of the negative stories, including the excessive greed, fraud and organized market manipulation that occurred. The non-financial background of many participants helped create a culture where “caveat emptor” was considered acceptable, while, at the same time, those running most crypto markets had little experience with financial market principles such as best execution or fair and orderly markets. With that backdrop the crypto market developed rapidly as the allure of a new technology sparked the imaginations of investors, with an accelerated cycle of greed and fear as a result.
2017–2018 was, in many ways, quite similar to the 1990s dotcom bubble. In addition to a new technology that promised disruption of many industries, it featured rapid price appreciation of the major assets and even larger price moves among smaller assets. In fact, much of the behavior in the ICO market closely resembled stories from the over the counter (OTC) equity market, such as those chronicled in the movie “The Wolf of Wall Street”. (This similarity is important to understand for regulators; being securities didn’t protect investors in thousands of cases in the 1990s, so it would be foolish to assume it would have prevented a thing in the ICO craze. Fraud is a crime and needs to be punished, but there is little reason to strangle a nascent industry when doing so)
To put all of this in perspective, I would like to highlight 4 important lessons learned last year, along with our perspective:
- There is enormous investment demand from the global public for early stage technologies
- For investors, easy money is a siren song
- $$$s attract opportunists, which, in turn, will attract a regulatory response
- Basic principles of financial markets should not be ignored
Let’s examine each of these in turn:
There is massive public demand to invest in early stage technology: As SEC Chairman Clayton has observed, the capital markets have a major problem with attracting new public companies. The number of listed companies have fallen by half since 1997, while the amount of capital injected into private companies from venture capital and private equity funds has increased significantly. This combination has effectively prevented individual investors from being able to participate in early stage investments in the equity markets. Thus, it is not surprising that, presented with what appeared to be the ability to invest in potentially valuable blockchain projects, many investors jumped at the chance. Despite little more than basic descriptions of ideas, often without real business plans or operational products, companies were able to raise billions of dollars.
The global nature of these offerings, meanwhile, presents a double-edged sword for capital markets in the U.S. On the one hand, the market structure of digital assets promises significant efficiencies to better connect investors and entrepreneurs worldwide. The flip side is that the U.S. could be left behind if our regulators are overly aggressive. Rather than, once again, render early stage investing in the U.S. to the exclusive province of venture capitalists, regulators and the industry should work towards better disclosures and rules that guarantee investor rights.
Investors should be wary of easy money: As the old saying goes, if something seems too good to be true, it probably is… The siren song of the ICO market attracted both investors interested in making long-term, potential life-changing investments as well as those looking for a quick buck. There were two major differences, however, between the VCs, who had cornered the market on early stage investing, and the ICO phenomenon. First, and most important, the individual investors targeted by ICOs couldn’t perform due diligence or request the type of investor protections granted VC firms. (This, in part, explains why ICOs were so popular among founders for raising money). Those founders were able to get away with this, however, due to the second difference: many projects were able to promise immediate liquidity by virtue of crypto “exchanges” listing and trading the tokens. This added substantially to the allure of these assets and helped high pressure sales tactics succeed. I said earlier that this was reminiscent of the internet bubble, since ICO sales were quite similar to the tactics of “boiler room” OTC stock salespeople. Those assets also had instant liquidity and displayed prices on the pink sheets that often-showed meteoric price rises. The ability to demonstrate that early investors made fortunes was a major component of the appeal of these assets. Unfortunately, when the music stopped, most investors lost money.
The lesson here is that early stage investments (i.e., without actual products and revenue) should be treated the same, whether “securities” or not. Rather than outdated rules that fail to stop the problem, the companies who control such assets and those who sell them should disclose everything material to the sale, be held to strict guidelines of customer suitability and there should be strict enforcement of rules against fraud.
When a lot of money is involved, fraud will follow: This is pretty obvious, considering human nature, but it is important to keep in mind. The only reason I identified this as a separate lesson is to remind us that we should not dismiss an entire technology due to the fact that it attracted fraudsters. Every time there is a technology that looks like it could be transformational, whether the internet, genetic biotechnology, energy breakthroughs or blockchain, it attracts a mix of legitimate firms and scam artists. It is a shame that this happens, and tarnishes the entire industry for a while, but it also seems to be inevitable.
When fraud becomes rampant, regulators will react: As sure as day follows night, when people are defrauded, regulators will try to do something to prevent it from happening in the future. Sometimes the rules make sense, and sometimes they don’t, so the key for legitimate industries is to work with regulators rather than object & complain. While not a panacea, the best step is usually some form of industry cooperation and self-regulation. The good news is that seems to be what is happening with crypto.
Financial markets have evolved for important reasons, and crypto markets should embrace them: All of the negative stories occurred as most of the early adopters and technologists that drove crypto innovation had little knowledge of how financial markets operate AND have core beliefs which conflict with key established principles of investor protection, price discovery, and best execution.
Investor protection — Modern financial markets have evolved with rules that attempt to ensure that markets are fair and that investors are protected against unscrupulous attempts to take advantage of them. These range from customer suitability rules to mandatory financial disclosures, to market structure rules that guarantee fair access. In crypto, however, there are many issuers and market models that, on purpose, ignore these principles. Issuers and their advisors who pursue “non-dilutive capital” epitomize this, but the concept of caveat emptor goes further. There are exchanges that are willfully ignorant of manipulation taking place on their market, and others whose employees have been accused of being complicit in such activities. Others have made public statements that manipulation is not their concern. As an aside, the SEC has made it clear that rectifying this situation and establishing a culture of compliance is a necessary precondition for them approving a Bitcoin ETF. All of that said, institutions typically avoid markets they feel are rigged against them, and the only way to convince them markets are fair is a clear rulebook being followed.
Price Discovery/Best Execution — Modern financial markets are based on the premise that all participants know the price of assets and that such prices are determined fairly in a transparent manner. As a result, price discovery is a primary goal of markets, while the concept of best execution (meaning clients should have a realistic expectation of receiving the best price when they trade) is essential for investors to have confidence in markets. In order for price discovery to be maximized, however, there is a need for client orders to interact or, at a minimum, have information about prices on other markets. Yet, the crypto markets are fragmented on purpose. The dominant exchanges ignore prices available elsewhere while peer-to-peer markets are being built without consolidated pricing. Meanwhile popular crypto websites are often consistently wrong in the prices they report due to averaging together prices from jurisdictions that trade at a premium or prices based on different funding currencies. What is needed, therefore, are consolidated price feeds, such as CoinRoutes provides, becoming ubiquitous and authoritative.
In conclusion, the excesses of the crypto markets over the past two years should be a wake-up call to the industry and the regulators attempting to reform it. Understanding how financial markets operate and incorporating the types of technologies and rules which protect investors while improving market integrity is exactly what the crypto markets require. Considering the potential for digital assets to improve the banking system and capital markets allowing entrepreneurs worldwide to connect with capital, this should be a vital step forward.