With regulations few and far between, investors hoping to cotton on to the next big cryptocurrency startup are willing to trust almost anything and just about anyone.
Stacey Bennett was angry with herself, but now was not the time for blame, now was the time to start thinking. After graduating summa cum laude from a renowned female-only liberal arts college, Bennett had decided to take a gap year to go “find herself.”
Using the money she had saved up from working part-time at a Dairy Queen and tutoring, her meticulous budgeting had taken her on skin diving tours off the azure blue waters off the Andaman coast, spelunking in Waitomo caves in New Zealand’s North Island and now, on the middle eastern leg of her tour, through exotic spice markets in the ancient city of Ephesus in Turkey, walking on the same cobblestones as the apostle Paul.
Having traveled alone for several months now, Bennett started to let her guard down and tonight was one of the worst nights she could have chosen to do so. Having gone for drinks with a group of Italian students who were living at the same backpacker’s hostel as her, she noticed that after only her first drink, she was starting to lose control of her senses and decided to walk back to the hostel alone while the rest of her party continued drinking at a downtown bar in the ancient city.
Through her drunken haze, she remembers being led down by the arm to what seemed like a narrow and dank alley before she blacked out.
When she came to, she blinked and took in her surroundings. She appeared to lying on a cot in what appeared to be some kind of jail cell. The air was heavy with sweat and stale cigarettes, dank and with the sort of humidity that seems to pervade involuntary incarceration, regardless of ambient conditions.
Bennett looked around when a heavily-accented voice from beyond her field of vision spoke to her,
“Ah, Miss Bennett, good that you are now awake. We were worried about you there for you for a minute.”
“Where am I?”
“You’re in the district police station, not to worry, you’re not under arrest or anything. We put you in the cell because we have no other sleeping quarters available for your use, you’ll see that the cell is not locked. You are very fortunate Miss Bennett, you’ve had quite an evening.”
“Come out and sit down and have a cup of coffee, you don’t remember anything?”
“No, I don’t.”
By now, Bennett was able to make out the face of the police officer who was speaking with her.
Through the fog of cigarette smoke and flickering florescent lighting, Bennett could barely make out the man’s thick mustache and although he was sitting down, she guessed that he was about five-nine, maybe five-ten, about a hundred and sixty pounds.
Gaunt, with weather-worn creases on his face, it was hard for Bennett to tell the officer’s age, but she ballparked it at somewhere in his mid-forties, though in reality, he was far younger.
Bennett sat down at the officer’s desk as he poured a thick dark Turkish coffee into a tiny espresso-sized chalice set before her.
“Please, drink,” he motioned.
Unsteadily, Bennett lifted the steaming cup to her parched lips, thankful more for the comfort of a hot beverage between her hands than for the relief of her dehydration.
“Miss Bennett, you are indeed a very lucky young woman. It’s not advisable to be traveling alone in these parts, especially with strangers one hardly knows.”
“You see, the group of Italian students you thought you had been drinking with last night were not students at all. They had drugged your drinks, which is why you’ve been passed out for the last twelve hours and had my officers not been there, it would be impossible to imagine what would have happened to you.”
“Had my men been there thirty minutes later, we would have had to file an altogether different report.”
Bennett felt sick to her stomach and started to retch. The officer, whose name tag identified him as Ahmet, instinctively reached for a nearby wastepaper basket for Bennett to throw up into, but nothing would come out.
Bennett’s mind raced to try to recall the events of the previous evening, but drew a blank, instinctively she blurted out,
“My passport? My money?”
“Not to worry Miss Bennett, my officers managed to take care of everything. The group you were with are quite well known in these parts, but fortunately for you, they did not get what they wanted last night.”
Bennett sunk into her chair, heaving a heavy sigh of relief of the sort so deep and substantial it seemed to rise up from well within her diaphragm and emanate outwards towards all her extremities.
For now, at least, she felt safe. Within the confines of the police station, she felt as if she could trust this kind-faced officer Ahmet. Noticing the wedding band on his ring finger, she immediately started to feel more secure.
“Now miss Bennett, if you would be so kinds as to just fill out some paperwork, my officer will return your things to you and you can be on your way.”
“I will personally escort you back to your accommodation. For your safety, we’ve checked you out of the backpacker’s hostel which you were originally staying at and have had your things moved to a motel nearby the police station.”
“I don’t know how to thank you, officer Ahmet.”
“Don’t worry, you’re not the first American who’s run into trouble here.”
Bennett immediately sighed an extended sigh of relief. Whatever could have happened didn’t happen. All that mattered now was that she was safe and with people whom she could trust.
She had placed her trust in the wrong people, but now at least, she was with the local police whom she could trust and who would keep her safe until she could make her way out of Ephesus and back to Istanbul.
And while she had been warned by other travelers in Istanbul to be wary of local police, she felt comforted to know that not all police were crooked, as evidenced by the officer sitting in front of her.
Helped to her feet by officer Ahmet, Bennett soon gathered her belongings and her mobile phone as Ahmet and another two colleagues asked her to wait outside while they gathered their things.
Several minutes later, Bennett was ushered into an unmarked police vehicle that started making its way through the by now darkening and narrow streets of the ancient city.
In what felt like no more than a seven-minute drive, Ahmet, who had taken the wheel and who Bennett had only now noticed was no longer wearing his police officer’s uniform (when had he changed?) pulled the car to a stop in front of a low and dingy looking row of apartments.
“We’re here, get out.”
For reasons unknown, Ahmet was decidedly more curt, now that they had left the police station and his two colleagues, who strangely enough were also not in police uniforms stood firmly flanked on either side of her, their grip on her arm unnecessarily firm for some reason.
Ahmet led Bennett towards the second floor of the apartments, slipping a key into the door of one and pushing Bennett roughly through the door, the suddenness and violence of which shocked her.
As Bennett looked around for her things in the room, she started to notice they were not there.
“You’ll get them when we’re done.”
Bennett immediately felt as if a bucket of ice water had been poured on top of her head. As she looked around, she had moved from trusting one unreliable set of individuals into trusting another.
As Ahmet’s eyes combed the landscape of Bennett’s taut body (the work of many hours in the gym and on the treadmill), she could feel him visually undress her as his gaze crawled the expanse of her body to rest at her ample bosom.
Bennett wanted to make a run for it right there and then, but where would she go? These people had her travel documents and all her money.
She couldn’t go back to the backpacker hostel, that wasn’t safe either and the nearest U.S. embassy was over three hundred miles away in Istanbul — she’d never make it.
“Don’t worry Miss Bennett, if you give us what we want, we can all be the better off for this evening.”
Just as Bennett was about to scream, a strong hand, with what smelled like day-old Drakkar Noir clamped firmly over her mouth.
“Now, now, I’d let you scream, but it would only add to the excitement. You see, you can scream all you want and nobody here will hear you. This is my town and I’m the one who gets to say who screams and when.”
“My colleagues and I just want to spend some time to welcome you to the city properly.”
By now, tears were streaming uncontrollably down the sides of Bennett’s eyes as she thought of all the opportunities she had to run, to fight these men, to make a break for it — but that stuff only happens in the movies — reality is far more pedestrian and often, far crueler, you never know who to trust.
A Rose By Any Other Name
Which is why it may come as a surprise that despite the fact so many investors got burned during the initial coin offering (ICO) craze that marked late 2017 and 2018, investors are now clamoring to a new investment vehicle — the initial exchange offering (IEO) with the same reckless abandon with which they had pursued ICOs.
To be sure, the market for ICOs is mostly dead. But the need of entrepreneurs and snake oil salesmen alike to raise funds is still very much alive and kicking, with the honest and the less so, flocking to a new way to ride the digital token fundraising train one more time.
With many ICOs nothing more than business ideas than real business models, most digital tokens today, rightly, trade at prices well below their original issue prices.
Yet somehow, because enterprising cryptocurrency exchanges have now introduced a “trusted intermediary” to vet promising projects — investors have started to pour into IEOs with the same aplomb that went into ICOs against a backdrop of returning interest in digital assets and rising cryptocurrency prices.
Same, But Different
For the most part, IEOs share striking similarities to ICOs, with one subtle but the key difference — digital tokens are sold to investors through a cryptocurrency exchange and not directly from the startup itself and investors must typically hold the exchange’s own digital tokens to participate.
That this ought to create huge conflicts of interest has thus far gone unnoticed as US$518 million has already been raised through 63 IEOs as of May this year, according to TradeBlock, a New York-based data provider of digital currency research.
But those investors looking for a “trusted third party” to verify the quality of these IEOs may be prematurely misplacing their trust by handing over even more power to mostly unregulated cryptocurrency exchanges.
Ignoring the hacks, security lapses and fake trading volumes, it is in the core interest of cryptocurrency exchanges to list projects on their platforms to generate greater trading fees, but with one important caveat — if the cryptocurrency exchange in question is looking towards longevity, then the quality of the project raising the funds matters — in a big way.
Judge, Jury & Executioner
In an IEO, the cryptocurrency exchange plays the role an investment bank would occupy in an initial public offering, researching and analyzing the prospective issuer before deciding whether or not to list it on their exchange.
For instance, Binance, one of the world’s largest cryptocurrency exchanges, produces a report on the new digital token that closely resembles a pared-down prospectus and then later distributes the IEO’s digital tokens to investors.
As the cryptocurrency exchange mounting the IEO, Binance typically takes between 2% and 5% of the sums raised, according to a startup that listed on its platform. And these amounts are on top of the substantial windfall a cryptocurrency exchange stands to make from trading fees of the newly-listed IEO. Not to mention the requirement (in most cases) to hold onto the digital token of the exchange itself — which generates an implied demand for an exchange’s tokens.
There are obvious problems with such a model.
Just like how the U.S. government has separation of powers because of obvious conflicts of interest — power is divided between the President (the Executive Branch), Congress (the Legislative Branch) and the Supreme Court (the Judicial Branch), the world of finance has found a way to separate the conflicts of interest by creating investment banks, exchanges, and rating agencies to be separate.
And the 2008 financial crisis was a clear example of what happens when that separation of entities is more in form than in substance.
Better Is The Enemy of Good
There are of course some arguments in favor of IEOs, with some critics arguing that they are an improvement on ICOs because cryptocurrency exchanges risk reputational damage if they list bad or fraudulent projects.
Mati Greenspan, an analyst at eToro, a brokerage firm that also facilitates cryptocurrency trading suggests,
“People feel that since the exchange does not wish to be associated with a scam, they’re more likely to do their homework before becoming associated with any given project.”
Jeff Dorman, Chief Investment Officer at Arca, an asset management firm that also invests in cryptocurrencies is somewhat less sanguine in his assessment,
“Any investor looking at these IEOs needs to do their own research and not blindly trust the exchange.”
Dorman, a former capital markets banker takes a far more pragmatic view as to why cryptocurrency exchanges would want to launch IEOs,
“Exchanges are making a ton of money. They have every incentive not to kill the golden goose.”
True, but they also have every incentive to lay as many eggs as possible and many of these eggs will never hatch into geese, golden or otherwise.
For obvious regulatory reasons, many IEOs are avoiding U.S. cryptocurrency exchanges. The U.S. Securities and Exchange Commission (SEC) has demonstrated minimal restraint when it comes to taking legal action against cryptocurrency startups, especially when startups attempt to circumvent existing regulations through, ICOs, IEOs and the like.
And the SEC has shown that it is willing to act retrospectively and extraterritorially if needed. Earlier this month, the SEC sued Canadian social media company Kik Interactive, alleging that the firm’s 2017 ICO had evaded U.S. investor protection laws.
The outcome of the Kik Interactive case will have serious repercussions on ICOs which have raised funds from U.S. investors, excluding a significant segment of the investor population from investing in digital assets and perhaps alienating an entire generation of investors from cryptocurrencies in general — which is what happened to the French who shunned paper money soon after the Mississippi bubble of the early 18th century burst, which indirectly led to the French Revolution.
Former SEC lawyer and cybersecurity consultant John Stark, notes in a recent report,
“The stars seem perfectly aligned for the SEC to target IEO purveyors and expel them from U.S. markets.”
Instead, much of the IEO action has occurred beyond American shores, in exchanges such as Binance, OKEx, Huobi, and KuCoin.
In a statement emailed to Forbes, Binance CEO Changpeng Zhao said that his exchange had a full-time team scrutinizing candidate projects for listing on its Launchpad IEO platform, analyzing a project’s personnel, technology, economics as well as strategy.
But for Binance, the buck literally stops there, with the startups themselves bearing the risk of blocking token sales in places where they would pose legal issues, particularly China and the United States and Binance also requires the project owners to obtain legal opinions that their digital tokens are not securities.
The value of such legal opinions is dubious at best. While almost all cryptocurrency exchanges require a project to obtain a legal opinion that their digital tokens are not “securities,” many projects have (despite such legal opinions) been found by regulators in various jurisdictions to have been de facto securities and have had their ICOs stopped, with funds returned to investors.
In other cases, regulators have put pressure on law firms (behind the scenes) to rewrite their legal opinions or to have their clients restructure their ICOs so as not to fall afoul of existing securities regulations.
For the amount of money spent on these legal opinions, they are not law and are a weak shield at best, in the event of regulatory intervention in a startup’s ICO.
Down But Far From Out
Yet ICOs and IEOs proceed undaunted, with funds raised totaling some US$1.2 billion for the first five months of this year, according to data from TokenData, a cryptocurrency data, and research firm. To be sure, the amount raised is down almost 90% from the US$10 billion that was raised during the same period a year ago but demonstrates that the ICO and IEO markets are not completely dry.
Take for instance Harmony Protocol, a San Francisco-based blockchain startup that is attempting to build faster smart contracts, successfully raised US$5 million recently through an IEO on Binance.
According to Harmony Protocol’s co-founder Nick White, Binance representatives were relentless in their scrutiny of the firm’s business model and alleged that the vetting process was far more rigorous that the ICO process, suggesting that the cryptocurrency industry as a whole was maturing.
Given that the previous ICO vetting process was virtually non-existent, there are some who view even some scrutiny as better than none at all.
But not everyone is rushing to trust the cryptocurrency exchange to do the vetting.
Adrian Lai, managing director at BlackHorse Group, a cryptocurrency investment firm based in Hong Kong said that he remains skeptical about the vetting process undertaken by cryptocurrency exchanges,
“It’s a black box basically. You just have to trust these exchanges and that’s really tough.”
But perhaps the vetting process conducted by cryptocurrency exchanges, for better or worse is not dissimilar to the “vetting process” carried out by ratings agencies in the run-up to the 2008 financial crisis, when firms such as Moody’s, Standard and Poor’s and Fitch gave the highest investment-grade ratings to ultimately toxic mortgage-backed securities.
While the role of the rating agencies in the 2008 financial crisis is still a hotly debated topic, in reality, the agencies had not catered for what investment managers and traders refer to as “tail risk” — the possibility that a large number of mortgages turn sour.
In a nutshell, the longstanding belief among the titans of Wall Street was that while some mortgages were expected to go bad, surely not all mortgages would go bad at the same time (a housing slump) and by diversifying and sticking poorer quality mortgages with higher quality mortgages and lumping them all together, the entire risk profile of the security ought to have been less risky thanks to diversification.
The process is known as addressing idiosyncratic risk — the risk profile of an individual mortgage, but could not adequately provide for systematic risk — what happens if the entire mortgage market crashes?
To be sure, while cryptocurrency exchanges should be lauded for trying to take the ICO and IEO market a step forward, extreme vetting (not of the Trumpian variety) of projects and startups can only cater for idiosyncratic risk — risks specific to the startup itself — but is a poor risk management tool for the systematic risk that the ICO or IEO market as a whole faces — global investor risk aversion.
Ultimately it is up to individual investors to diversify their overall portfolio risk to cater for systematic risks as well as to dive deep into any specific project that they invest in to cater for idiosyncratic risks — anything else would be to let one’s guard down, because ultimately, you never know who to trust and when to trust.
About the Author: Patrick Tan
CEO of Novum Global Technologies, a cryptocurrency quantitative trading firm. Trading up to 100,000 times a day the way only an algorithm could.