Capitalisn’t: Mo Crypto Mo Problems

May 01, 2018

Sections Finance

In the brave new world of cryptocurrency, the latest frenzy involves initial coin offerings (ICOs), which make Bitcoin look tame by comparison. On this episode of the Capitalisn’t podcast, hosts Luigi Zingales and Kate Waldock explore this volatile, largely unregulated market and consider creating their own ICO.

Speaker 1: Bitcoin crossing the $14,000 mark.

Speaker 2: Cryptocurrency passing $15,000 for the first time ever.

Speaker 3: Now it looks like we may hit the $17,000 mark.

Kate: Hi, I’m Kate Waldock from Georgetown University.

Luigi: And this is Luigi Zingales at the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And most importantly, what isn’t.

Speaker 6: If you think the DOW had a bad day, Bitcoin’s was worse. The price is now hovering around $7,000.

Speaker 7: What do you think of the volatility of Bitcoin and the chance that it could lose all serious value?

Speaker 8: How do you regulate the cryptocurrency market?

Speaker 9: It’s a fair question.

Speaker 10: In terms of cryptocurrencies, generally, I can say almost with certainty that they will come to a bad ending.

Luigi: Everybody’s talking about Bitcoin these days, but a phenomenon which is related to Bitcoin but is actually broader and quite important is this new phenomenon called initial coin offerings. What we’re going to try to do today is try to understand what is this phenomenon and to what extent this is a fraud, to what extent it is for real, and what you should be aware of.

Kate: You’ve probably heard about Bitcoin, and maybe you’ve also heard about Ethereum or Ripple, even. But there are certain types of cryptocurrencies called tokens that you probably haven’t heard of.

Luigi: My favorite one is Bananacoin. A token whose value is linked to the price of a kilo of bananas. This is actually a ICO, initial coin offering, that took place last month and raised a significant amount of money to actually finance an investment in a plantation of bananas in Laos to export bananas into China.

Kate: My favorites are a little more salacious. I’m not sure, but maybe you’ve heard of Groincoin or Tittycoin or Lust. There’s a whole bunch of them out there.

Luigi: Sorry, I sound like a dork, but what are all those coins?

Kate: As you can imagine, they are linked to online porn.

Luigi: I think it’s important that our listeners understand that ultimately what money is is simply a trusted ledger. I know that most people have in mind money as gold because historically, that was the way the trust in the ledger was created. But even today with the US dollar, there is no relation between the US dollar and gold or silver or any other valuable metal. The ultimate ledger is kept by the central bank, which is the Federal Reserve Bank.

To make this point, I think in a very clear way, I want to tell a story that is described by Milton Friedman in a paper in the early ’90s. He talks about a group living in Micronesia, the Yapese, living on the island of Yap. One characteristic of this group is that in order to transact among themselves, since they didn’t have any precious metal on the island, they used pieces of stone, gigantic pieces of stone that could not be actually transferred from one guy to the other, but could be reallocated in property from one side to the next. If I want to buy some milk from Kate, I simply reallocate one stone or piece of that stone to Kate in exchange for milk. Kate and I agree that that’s a transaction, and we write on the piece of stone this transaction, and everybody on this small island knows each other and they trust that this is the actual transaction.

The irony that makes this point very clear is that they were trying to mine for this stone on a far away island, and as they were bringing back one of these gigantic pieces of stone, the stone ended up falling at the bottom of the ocean. But everybody in the Yapese community knew that this stone existed at the bottom of the ocean. They used this piece of stone that nobody could see as a means of exchange without even seeing the piece of stone. This makes it very clear that what money is doing is simply keeping track of transactions in a way that everybody trusts.

Now in a small community like the Yapese community, the trust is given by the social network of social pressure. Once you start to have exchange at a distance, you either give a bond in this transaction, and that bond is the value of the metal associated, or you have a superior authority that maintains this record in a trustworthy way. That’s what the dollar is about. Or, and this is the innovation, you have a currency that keeps track of all the transactions without a central authority in a way that it cannot be modified by anybody—that’s what Bitcoin is about, it’s a currency based on the decentralized ledger that is not mutable because of a combination of cryptography and the distribution component of this ledger.

Kate: The history of Bitcoin, every single transaction that’s ever taken place, sits on everyone’s computer who’s mining Bitcoin. Everyone has the same exact copy of this ledger that accounts for all transactions. If you want to change a particular transaction, if I want to say, “Oh, I paid Luigi 10 bitcoin,” and then take that 10 bitcoin back and give it to myself again, I would have to find the block that contained that transaction and alter it. But if I alter the transaction in the ledger, that then changes the link to all of the other blocks in the chain. That makes it really hard for people to go in and hack or alter the ledger.

Why do I use dollars? I mean, yeah, sometimes I have actual, physical dollars and I use them to buy stuff. But for the most part now, I use my debit card or a credit card to purchase stuff. I trust that Bank of America, when I buy something, it’s going to keep track of the transaction that I’ve made. And then it’s going to deduct the amount of what I bought from my bank account and it’ll give it to whoever I purchased that thing from. Likewise, if money is transferred into my account, I trust that Bank of America is keeping track of that money and that Bank of America isn’t going to be hacked—or American Express or whatever credit card you use. I trust that they’re not going to be hacked to the point where they no longer have any track of who’s purchasing what. That’s the idea and the importance of a secure ledger.

By the way, there’s a TV show, a socialist dystopia TV show, called Mr. Robot, which I highly recommend. The whole premise of the show is that they hack credit card companies and therefore destroy all credit because people can’t keep track of who owes who.

Luigi: Yes, but given that something is not hackable and so potentially could be a currency doesn’t necessarily mean it will be a currency because what determines the success of a currency in part is driven by how many people are willing to use it. The irony of the Bitcoin in this moment is that people who invest in Bitcoin, invest in Bitcoin in the expectation that this will become a standard currency for exchange. However, the more they demand this currency for speculatory reasons, the higher is the value of this currency and the more it will appreciate. And the more it will appreciate the less people are tempted to use the Bitcoin for transactions because whether I want to buy a pizza or sell a pizza, if the price of the bitcoins in dollars fluctuates wildly, I don’t want to use that for transaction purposes. In fact, at the last Bitcoin conference, they did not accept Bitcoin as payment. They did not accept it as payment because it was very volatile.

Kate: We’ve talked a little bit about what cryptocurrency is and what currency is in general. But we started this episode by saying that we want to talk about tokens and initial coin offerings. What distinguishes a token from a cryptocurrency? I like to think of this example of going into a video game arcade. You take your dollars and you purchase the currency of that particular arcade. These days it’s like a card that has some tokens on it and you use those tokens to play games. One game may be three tokens and the really good games may be six tokens. That’s kind of the same idea behind the coins that are being issued in these ICOs. They are a virtual means of exchange that are linked to a particular company. This idea of a token has become super popular.

Luigi: I don’t have a lot of experience on video game arcades, but when I was a kid in Italy, in order to make a phone call you had to use a token. Let’s say that the token was worth 25 cents. Instead of using a quarter, you would use the token. Now, because that token was so widespread, people will take it in exchange for a quarter because the telephone company was selling tokens for a quarter, was accepting tokens for a quarter, so it was basically providing a liquidity for having a token worth a quarter. People started to accept the token as money. The difference between the two is not that big as you make it to be.

Kate: I’m not saying that there couldn’t exist some bizarre state of the world where tokens are so popular that they actually end up being used as currency themselves. But I don’t think that it was the initial purpose of the phone company or the telecom utilities in Italy that these tokens were then going to replace currency. It was just that they happened to be that popular.

Luigi: I agree. That was not the intention of the telephone company in Italy. But I think it is the intention of many of these cryptocurrencies to become a substitute for money. When you look at Ethereum, Ethereum is a cryptocurrency like Bitcoin and was created to enable a set of transactions. We use it as currency within the universe of Ethereum, but ideally they want this universe to be the entire universe.

Kate: Yeah. This is, I think, a little bit of a confusing point. But you’re absolutely right. But it doesn’t need to be a currency company that ICOs. For example, you could have Bananacoin that’s intended to be used for purchasing and supplying bananas. I don’t think whoever ICO’d Bananacoin was intending for Bananacoin to become like the world’s premier virtual currency. They intended it to be used within a certain, more limited context. The point that I’m trying to make is, yes, even though cryptocurrency companies can ICO, non-cryptocurrency companies like any regular company can try and raise money through an ICO, and that’s what becomes dangerous.

Luigi: Disney could raise money by selling Disney Dollars. Those are tokens accepted in Disneyland and they could raise money this way. Now, they don’t need to raise money. But if they needed, they could. However, I think that part of the confusion is exactly this is the reason why so many companies now are raising funds this way is because people are very excited about the increasing value of Bitcoin and they want to jump on the new Bitcoin wagon. They are buying Bananacoin because, I don’t think they’re speculating on the price of bananas, they are hoping that this coin will become more accepted and will be more valuable. That’s, in my view, the reason why so many people buy these tokens from unknown companies with unknown track records and with very vague projects.

Kate: What blows my mind is that these tokens are actually really easy to create. Luigi, if we were to start a company what would it be?

Luigi: It would be the Capitalisn’tcoin.

Kate: OK. This is our podcast coin, and you need these coins to be able to listen to our podcast. If I wanted to actually issue some of these coins to raise money to, let’s say, invest more in our podcast, I could do that relatively easily. Let’s say I’m going to start with Ethereum, which is another popular cryptocurrency. I’m going to link it to that. First I need some Ethereum. I need an Ethereum account and I need a virtual wallet that has my Ethereum in it. And then I need to be able to code just a tiny bit. I just need to be able to edit some code.

What I do is I go online, I download what’s called a smart contract, which was written by this person named Bokky Poobah. I edit a couple lines of the code that say, “All right, this is owned by Luigi and Kate. It’s called Luigi-and-Katecoin. This is the amount that I want issued.” I just hit enter. And then within a few minutes, we would have our own tokens that would potentially be linked to our podcast. And then all we would need to do is create a website, write up a 12-page paper that says this is what we’re going to use these coins for, and then give it to some exchange, some other website that’s selling these coins off to the public, and we would probably raise millions of dollars doing that. That’s exactly what these companies are.

Luigi: But the crucial part to understand is why people are willing to pay millions. Certainly if we produce a piece of paper with, let’s say, Katedollar—I think that sounds better than Luigidollar, Katedollar, a big picture of you in the middle—I’m not so sure people are buying that for a huge amount of value. But in many situations they do. Why? Because the companies promise to use those tokens in the future for some valuable purpose. For example, I have a student who actually is in the process of doing an ICO as we speak who invented a new way to store your cryptocurrency in a digital wallet that is very secure, and is trying to finance the production of this through some tokens. He promises that people can use these tokens to buy this crypto wallet or to pay for transactions in the exchange he will establish.

That’s what is interesting with ICOs because it’s in between some kind of crowdfunding. We know that people have raised money in crowdfunding by promising to give at a discounted price, or at zero, a product to the people who contribute to their endeavor. Here, instead of promising necessarily the product, you give immediately some tokens that can be used to buy the good or can be used for something else.

Kate: I’m sure there’s some completely legitimate businesses out there that have good business ideas and a team put together to actually use the money that they’ve raised to create good products. But what’s concerning about ICOs right now is just that a lot of investors think that this is an easy way to make a quick buck. They’re so interested in trying to double their money or make 1000 percent ROI right away that they’re not really doing much research into what these startups are.

For example, there is a token called UE Token. You can look at it at uetoken.com. When you go to the webpage, it says immediately, “You’re going to give some random person on the internet money. And they’re going to take it and go buy stuff, probably electronics to be honest, maybe even a big screen television. Seriously, don’t buy these tokens.” They raised $40,000. I mean, yeah, $40,000 isn’t a whole lot. But there are still people who are not paying attention to the extent that they didn’t even read it. They just gave that person money. Hey, I would like $40,000 if I could. That was like a hack. That was obviously not real. But there are a lot of people across the world, like in Russia for example, who are trying to make websites and descriptions of companies that look very real that are raising hundreds of thousands, if not millions, of dollars from American investors through these tokens which will never be put to good use.

Luigi: If you’re saying that there is a speculative frenzy and things are out of whack, I completely agree. But this is not limited to the ICOs. We are of the view that we’re not there to regulate stupidity. To some extent, people can take a gamble as long as they are aware that they are taking a gamble.

Kate: Whoa, whoa. The US government is absolutely in the business of regulating stupidity. That’s why we don’t have casinos everywhere. And that’s why most forms of online gambling are illegal. That’s why even sports betting is probably going to be highly regulated soon. That’s why the Consumer Financial Protection Bureau exists. The government doesn’t want people who have worked really hard to earn $15 an hour and put away $3,000 in savings, the government doesn’t want that person to try and go triple their money by investing in cryptocurrencies in the same way they don’t want them betting on a horse. I think that the risks in cryptocurrencies, particularly in ICOs, are a lot worse. There’s a lot more potential for just outright fraud.

Luigi: I agree. But I don’t agree with the strong position that, for example, China or South Korea took to say every ICO is illegal. Some ICOs can be legitimate. We want, with the proper amount of protection, but we want people to experiment. I think that in some situations, the ICO could be a very effective way to raise money. Why do we allow crowdfunding of products by financing the purchase of future products and we don’t want to allow ICOs?

Kate: Here I think it’s important to talk about what exactly the SEC did. A few months ago the SEC took the position that they’re going to start regulating ICOs and tokens that are created by them. And the way they’re going to start regulating is that they’re going to distinguish between tokens that are utility tokens versus tokens that are security tokens. A utility token might be something like, OK, Luigi and I want to raise money for our podcast. We create a token. We issue it to people who want to purchase them. And if you buy a token then you can listen to one of our special podcasts because that token is linked specifically to a good that you’re going to get in the future.

But some startups are also creating tokens that are linked to, say, cash flows of the start up. A company might say, “Oh, we’re going to raise tokens. And if we make money in the future, you’re going to get like one tenth of one percent of the cash that we make each year.” That looks an awful lot like just a regular stock that people could purchase except the way that the stock was issued was behind the back of the government. Most companies when they issue stock, they have to comply with a bunch of regulations. And issuing security tokens is a way of doing this without government oversight. The SEC is saying you can issue these utility tokens, but you can’t issue security tokens.

Luigi: The problem is that this is a world market. The United States can prohibit the ICO. You can do the ICO in other countries. My student has organized the ICO in Singapore. We know that you can pay with bitcoins for an ICO, bypassing the banking sector. You’re an American investor. You can buy an ICO with bitcoins in Singapore. There’s very little you can do in the United States unless you ban Bitcoin and you put in jail everybody that even touches one.

Kate: You think that we shouldn’t try and regulate anything on the internet?

Luigi: No. But I think that there are some things that are easier to regulate than others. I think that the problem we have here is the fact that the internet is creating a world market for securities. Up to now the market for securities has been quite segmented. It’s been segmented by regulation. It’s also being segmented by the difficulties in subscribing across the border without using the traditional banking network. And the traditional banking network is supervised by the US authorities because this network works in dollars.

Now, with Bitcoin, this banking network can be bypassed. And that opens really a new world in terms of regulation because the power of the United States is dramatically reduced as a result of that. The power of the United States to nudge regulation all over the world has been reduced. And now we are in a world of more competitive regulation that will probably tend to go to the so-called race to the bottom because competition will lead to regulation to be lower and lower everywhere.

Kate: If anything, I think that regulation of ICOs right now is leading a race to the top. A lot of countries are trying to protect their citizens by enacting really strict regulations on ICOs. I think that the US should be part of that. I think that our citizens are only going to keep being hurt until we do that. But I also think that there is a point to be made about protecting people’s faith in well-established capital markets particularly in the US. The SEC regulates securities that are being issued by companies, and as you pointed out one of the problems with ICOs is that start-ups can make tokens that don’t really look like securities even though they may be securities. That will lead to an explosion of companies raising money through these ICOs and dodging the regulation of the SEC. That’ll be cheaper. It’s cheaper for companies to issue not under regulation than it is to issue securities while being regulated.

Right now we have faith that if you invest in a stock, you’re not going to be ripped off. There’s a sound system of corporate governance. And there is no guarantee with these start-ups that are issuing tokens through ICOs.

Luigi: I agree with most of what you said. I am, however, worried about throwing away the baby with the bathwater. Is there a lot of bathwater in ICOs? Absolutely. Is it all to be thrown away? No. It is an innovative way to raise money. I think it is possible—of course there will be litigation, but there is litigation in everything in the United States—it is possible to try to mark some boundaries of what is a security and what is not a security. And I envision that this method could be useful to launch new platforms, in the sense that we know that in a world of winner-take-all markets the rents tend to accrue to the creator of the platform and to some extent in a disproportionate way.

Let me make a concrete example. Suppose that now I want to compete against Uber or Lyft in the market for basically passenger services. The way I want to compete is by asking a lower percentage fee from the drivers and offering the same price to customers. Now, the drivers will come to me, but the customers will not see a lot of the benefits of coming to me, so without customers there will be no drivers and my platform will disappear. However, if I can incentivize customers to start using this platform by giving them some tokens and saying, “If my new platform will be very successful, these tokens are redeemable in free rides at some point,” then I have a very easy way to market it. That facilitates entry, facilitates competition, keeps lower the prices of Uber and Lyft. I think that overall it’s a great thing.

Kate: I acknowledge that tokens and ICOs represent an innovative way of raising money. But we don’t need some new-fangled cryptocurrency. We already have crowdfunding platforms that allow companies to easily raise money for a future product. Yeah, we would be putting a bit of a damper on companies that are legitimate that are raising money this way. I just think that the benefits of regulating it out of existence outweigh the costs. Also, by the way, I want to make an important distinction here. I think Bitcoin and blockchain technology is incredibly important. I think once the volatility that is in large part driven by ICOs dies down that it will be continually used as a medium for exchange. And I also think that blockchain technology and cryptography to secure ledgers and secure transactions, I think that that will start being used more and more by private institutions as well as potentially the government to make things more secure. We do need to worry a lot about cybersecurity. I think there’s a lot of value in blockchain. I just think that ICOs are too dangerous.

Luigi: Kate, we should rush to sell our Katecoin before you succeed in blocking all ICOs.

Kate: If you want to make Katecoin, be my guest. But I’m not endorsing this sort of activity.