Manias, panics and Initial Coin Offerings

Crypto-coin mania illustrates the crazy and not-so-crazy sides of bubbles

EVERY market mania reaches a point when pitches to would-be investors enter the realm of the surreal. So it goes for “initial coin offerings”, or ICOs. A new one by a firm called POW invites Facebook users to claim tokens for nothing; when they later become convertible into other tokens, the first to take advantage of the offer could “become worth $124bn…making them the richest person on Earth”, the blurb says. Not a bad return for no money invested and no risk borne. However bizarre, bubbles are hard to resist: no one wants to be the only one of their friends left out. They can also be financially ruinous. But gambling on a craze, even a highly dubious one, can be about more than blind greed.

The ICO boom is an outgrowth of the emerging, occasionally inscrutable world of cryptocurrencies. These are a form of money (bitcoin and ether are examples) used in transactions which are recorded on a distributed public ledger called a blockchain. An ICO is a scheme to raise funds for an enterprise written into a contract on a blockchain. To buy in, punters use cryptocurrency to pay for tokens. Those tokens become the working currency within the new enterprise. A new social network, for instance, might fund itself through an ICO, then allow users to spend their tokens on goods or services on the network once it is up and running. In successful projects, demand for tokens should rise and early investors should profit. ICOs resemble both a new form of crowdfunding, and a technological leapfrog over the regulations that hem in more orthodox funding strategies. They are also all the rage. Ether, the currency used on the ethereum blockchain, is up by more than 2,400% against the dollar over the past year and boasts a market capitalisation of nearly $28bn. ICOs have so far raised nearly $2bn in 2017.

This looks like irrationality in action, bound to end in tears. Why, then, should the party continue? Manias are as old as finance, and economists have devoted plenty of time to studying them. Though often blamed on easy credit, human nature alone can goad a raging bull. As Charles Kindleberger explained in his book “Manias, Panics and Crashes”, enthusiasm for new markets or technologies frequently results in excessive optimism, which ultimately collides with reality in a spectacular crash.

That seems at odds with the idea of an efficient market, in which asset prices reflect the discounted value of expected future profits, and in which easy, risk-free money is a rarity. But economists have learned that efficiency is a somewhat loose constraint on markets. The discounted value of dividends, for instance, varies by much less over time than stockmarket indices, meaning that people’s views of the state of the world gyrate more than history suggests they should. Markets are better at setting prices for individual stocks than in aggregate—in Paul Samuelson’s words, they are “micro-efficient and macro-inefficient”. Yet that may be because individual stocks are more likely to provide well-informed investors with opportunities for a quick no-risk profit.

The ICO craze certainly appears to entail a departure from reasonable values. Such deviations can happen when taking the pessimistic side of a bet is difficult—shorting stocks, for instance (ie, selling securities the investor does not own in the hope the price will fall). In some accounts of the tech boom of the 1990s, the small float of many new tech stocks made shorting them nearly impossible; as issuance increased, however, bears could have their say, and markets tanked. Housing, too, is famously hard to short; in the global crisis those few financiers who found vehicles to bet against mortgage-backed securities eventually made a fortune. There are some opportunities to short cryptocurrencies, but essentially none for ICO tokens (something those intending to buy might reflect on, if reflection is their thing).

Human quirks also play a role. Robert Shiller, who helped create the subfield now known as behavioural finance (and won a Nobel prize), reckons that ideas about markets spread like an epidemic. At any point in time, multiple stories about the future are potentially true, and have evidence supporting or undermining them. Sometimes, particular stories become infectious. Investors under their sway hear good news and are deaf to the bad—and spread the bullish bug to others. This pushes up prices, bolstering the bulls. An ICO may be a consequential innovation, so early entrants will make a mint. But it may be that regulators will prevent them becoming more than a curiosity (both China and South Korea have banned them). Worsening news for ICOs could make pessimistic stories the next virus.

Cryptos through the tulips

Viral optimism may be especially common in the winner-takes-all contests so frequent within digital markets. Platform-based firms (which aim to provide a digital space within which other enterprises can do business) or social networks grow more valuable as they gain users. People want to be where everyone else is. In such cases, one of many contenders eventually dominates, and those with a stake in its success, whether shares or tokens, reap vast rewards. But because investors lack perfect foresight, the levels at which markets value nearly all contending firms will, in hindsight, appear to have been obviously bubbly. In the same way, the value of the winning firm, which looked laughably high during the bubble, will later look reasonable. One or two of the ICOs—and cryptocurrencies themselves—stand to follow such a path, if they come into wide use. Think a crypto version of Google (and pity those holding tokens for crypto-AltaVista).

Bursts of investor enthusiasm sometimes (if not always) spur experimentation and investment, laying a foundation for future growth. Caution is needed, however. Markets are not perfectly efficient. But they are usually efficient enough to punish those who mistake a bet on one version of the future for a sure thing.