ICOs, Rigged Games & Frontier Justice

I want to spend a few moments ruminating on a timeless truth of finance and investing: smart money loves a rigged game.

In the aftermath of the 2008 financial crisis nothing better exemplified this than a hedge fund called Magnetar. While other investors were content to bet that toxic mortgage-backed securities and their issuers would fail, Magnetar helped structure and issue toxic securities and then bet those same securities would fail. You see the advantage? In the first instance you hope a security will go to $0. In the second instance you know it will go to $0, because you designed it that way.

Fast forward to today and Bloomberg is reporting on “hedge funds” flipping ICOs:

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.”

Here is the scam game. There is nothing dumb retail money likes to buy more than lottery ticket type assets. You saw it with tech stocks in the ’90s and you see it with ICOs now. It’s the reason unsophisticated investors trade small cap biotechs and penny marijuana stocks.

The smart money knows this. However, the smart money prefers not to play the lottery. Playing the ICO lottery would do nothing but put smart money on a level playing field with dumb retail money, which is self-defeating. Hence a great deal (but certainly not all) of the smart money has absolutely zero interest in holding any digital asset for the long term.

But what if the smart money could be the lottery? After all, it is much better to be in the business of selling lottery tickets than the business of buying them. ICO flipping gets you pretty close without actually requiring you to commit fraud.

This is The Greater Fool Trade. The fundamentals of the asset as an investment are irrelevant. You are scalping tickets and for an investor of modest sophistication that is an attractive position. You are arbitraging the greed and stupidity of others. Add 2-3x leverage and you’ve got yourself a “hedge fund.”

Frontier Justice

Before you despair of capital markets, consider that if the majority of ICOs are as fundamentally worthless as they seem, The Greater Fool Trade will eventually end in a catastrophic blowup (see also: tulips; pets.com). One day we will wake from a fitful slumber and there will simply be no one willing to bid any higher. The whole ICO complex will collapse. This is the logical end to any investment strategy that trades on the first derivative of greed. Many of the ICO flipping “hedge funds” will be destroyed in this cataclysm, precisely because they will have gotten too greedy themselves. They will stay in the trade for too long and with too much leverage.

Thinking on this symmetry I am reminded of these lines from late in the movie Unforgiven:

Will Munny: Hell of a thing, killin’ a man. You take away all he’s got and all he’s ever gonna have.

The Schofield Kid: Yeah, well, I guess he had it comin’.

Will Munny: We all got it comin’, kid.

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