Instead of speculating on bitcoin, the smart money has figured out that one of the surest way to get rich quickly with cryptocurrencies is to be in early on initial coin offerings.
Hedge funds are proving to be first among equals when it comes to digital token sales by technology startups, receiving preferential discounts and terms and then often cashing out. While legal, the maneuver is drawing comparisons to some of the eyebrow-raising practices that took place during the IPO heyday of the 1990s, when many preferred investors would quickly resell shares for big profits.
“It’s not healthy for the ecosystem, and it’s pretty abusive,” said Kyle Samani, a managing partner at Austin, Texas-based Multicoin Capital, which invests in ICOs. “They are getting a discount because they are a big name, and they think it’s going to draw the retail investor. It’s the greater fools theory –- I’ll buy it if there’s someone who’s more of a fool than me.”
Last week’s ICO by messaging app Kik Interactive Inc. provides a window into how business is being conducted. Even though the Waterloo, Ontario-based company raised around $100 million from more than 10,000 contributors from 117 countries, hedge funds that got in early stand to benefit disproportionately.
Blockchain Capital, Pantera Capital and Polychain Capital, which together contributed $50 million in a Kik presale this summer before the actual ICO, received a 30 percent discount on their kin tokens, which will be used for commerce within Kik. They can sell 50 percent of their holdings at any time -- potentially making a profit even if kin’s price bombs. If the value of the tokens continues to rise, their profits will be higher than regular investors’ when they cash out.
Startups often announce, with much fanfare, that such-and-such funds and big-name investors have participated in the presale. What isn’t as well publicized is that the early investors -- and, possibly, even the startup’s founders -- can often cash out right after the ICO. Recently on Twitter, Samani called the practice of flipping a “bag holder,” where later investors are left holding the proverbial bag.
More than 80 percent of ICOs are doing presales, according to Lex Sokolin, global director of fintech strategy at Autonomous NEXT. For most of the 500 or so tokens launched and listed on exchanges this year, flipping "is very prevalent," said Lucas Nuzzi, senior analyst at Digital Asset Research. “This has been a problem in this industry, and one of the reasons why there is an overwhelming amount of low-grade ICOs being launched.”
Some 148 startups have raised $2.2 billion this year, according to CoinSchedule. And sorting winners from losers is already hard, since most startups are doing ICOs armed only with a white paper outlining their idea and not much else.
That’s raised red flags with authorities trying to figure out how to protect consumers in what’s been an unregulated corner of the markets. In July, the U.S. Securities and Exchange Commission warned investors to beware of fraudulent practices and said any tokens sold as a stake in a company rather than ones tied to an application must abide by securities regulations.
“It would shock me if you don’t see pump-and-dump schemes in the initial coin offering space,” SEC Chairman Jay Clayton said Sept. 28. “This is an area where I’m concerned about what’s going to happen to retail investors.”