The risks of the ICO: why Ethereum suffered the flash crash

Written by on June 30, 2017 in Guest Blog with 0 Comments

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The cryptocurrency space has been gripped by the ICO (Initial Coin Offering) craze, with many offerings raising tens of millions of dollars in minutes. But the success of ICOs has little to do with advancing the cause of cryptocurrencies as a decentralized key to freedom from central bank tyranny, and more to do with good old-fashioned casino capitalism. And it’s one reason why we’ve been seeing recent massive flash crashes in the price of Ethereum and Bitcoin.

Here’s how the vast majority of ICOs work:

Someone with an idea deploys a smart contract on Ethereum, usually a lightly modified copy-paste of the ERC20 standard token example, then opens a window of time for people to buy the tokens. Buyers send Ethereum an address to claim their place in the queue for the new tokens. Usually a small amount of tokens will be reserved on a first-come first-served basis, with the rest being distributed through a standard bidding war. The smart contract will issue the tokens to the winners automatically, and issue refunds to those who did not get any.

In an ideal world, this would not be a problem. In the real world, this leads to a whole list of problems on multiple levels.

Breaking point

Firstly, as most ICOs need Ethereum to bid for the tokens, that means people need to buy Ethereum at amounts that stress the markets and cause the price of Ethereum to skyrocket.

Secondly, the Ethereum network has been pushed to breaking point because of the load from the ICOs. It simply cannot cope or scale gracefully. We see Ethereum being deposited to ICO smart contracts hours after the window has closed because they were stuck in some miner’s memory pool waiting to be mined into the Ethereum blockchain. Of course, that also means that they have to be refunded, leading to even more congestion.

Ethereum users have taken to social media warning each other when the next big ICO will happen, as they know that the network will be jammed for a period of time around the ICO. Exchanges and mining pools freezing Ethereum withdrawals during busy periods are now the norm.

What’s even worse is that once the companies that issued the ICO have all that Ethereum, they will usually convert it into US dollars straightaway, which causes the price to crash. There is simply not enough liquidity in the markets to absorb the hundreds of millions of dollars in ICOs that need to be converted back and forth, hence the constant market booms and busts. It is probable that the lack of Ethereum-to-US-dollar liquidity led many to convert Ethereum to Bitcoin first, leading to a crash fir Bitcoin as well.

On most markets, Ethereum fell from $350 to around $250, wiping $4 billion off its market cap. On highly leveraged market GDAX, it fell to 10 cents, causing many long positions to be liquidated, and resulting in the market offering to refund its investors.

This past weekend, TenX launched its ICO. One hour after the window closed, over 7,000 deposits to the TenX smart contract were still pending. That is how bad things have become in terms of network congestion.

Some blamed the Ethereum crash on a fake news story that Ethereum founder Vitalik Buterin had died in a car crash. Buterin himself refuted the news in a tweet with handwriting showing a recent Ethereum block and its hash. Since the hash would not be known until the block is mined, that proved he was alive at the time of that block. (Proof of life, as it were.)

Vanilla capitalism

Apart from the stress on networks and exchanges, the other key problem with ICOs is that – weirdly – nobody seems to quite know what they are. The vast majority are based on Ethereum, and thus depend on the Ethereum network for their tokens to continue to move around and be immutable (if they want). But unlike Ethereum – or indeed Bitcoin – ICO tokens are not platforms in and of themselves. They are more like shares in a company (hence the play on the term IPO), except that as far as the SEC is concerned, tokens don’t legally confer ownership in a company.

Block.one – who held its own ICO this week with EOS – probably took all this in, and issued their ICO on terms that almost seem to be taking the mickey. The EOS token window is 341 days (to avoid clogging up the network with a flash sale), and the smart contract clearly states that EOS tokens have no rights, uses or attributes, and that buyers may lose all their money. At least they are being honest about it.

The Bancor ICO – staged two weeks ago and the biggest ICO as of this writing – issued an Ethereum smart contract that states the publishers retain full control over all the tokens and can freeze and seize tokens at will, which totally defeats the point of a decentralized cryptocurrency in the first place. If that’s all you want, why not just use PayPal or a DB2 database?

The fact that they do not care about immutability or decentralization, or even believe in Ethereum as a store of value, makes you wonder what is going on.

On the plus side, it indicates that normal users (as opposed to techies or anti-establishment anarchists who fear central bank tyranny) have fully embraced cryptocurrencies  – Ethereum in particular – as a simple tool to make money in a plain, vanilla capitalist way. Or as some prefer to call it, pump-and-dump.

However, the ICO craze has distracted people from two major events that are coming up on August 1.

First, Bitcoin may experience a hard fork (a split in the network) when the battle between Western developers backing SegWit through BIP-148 and Chinese miners backing a fudge called Segwit2x (which comes bundled with up to 8MB blocks) come to a head.

And second, a mysterious page on litecoin.mit.edu is promising something on the same day. No one – not even Litecoin creator Charlie Lee – knows what the boffins at MIT are up to. Many have speculated that it will be commercial Litecoin Lightning instantaneous payment networks.

Perhaps given the potential drama coming soon to Bitcoin and Litecoin, Ethereum’s turmoil might seem like a safe haven in comparison.

This article was written by Don Sambandaraksa, a regular contributor to our sister publication Disruptive.Asia.

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