Ethereum unleashed the “initial coin offering” craze, but it can’t handle its insane success

Future of Finance
Future of Finance

The latest craze in the cryptocurrency markets just got crazier. An outfit called the Bancor Foundation raised $153 million worth of ether (the coin of the cryptocurrency ethereum) by selling its digital tokens (the equivalent of shares) for three hours on June 12, making it the largest token sale ever.

Such sales, popularly known as initial coin offerings or ICOs, are a way of financing startups by letting potential users—rather than venture capitalists, as is traditional—buy small stakes in them. They’ve raised $327 million so far this year—more than the $295 million in venture capital that has gone to blockchain tech startups, according to research by industry publication CoinDesk.

The Bancor Foundation says its tokens will do away with the exchanges on which cryptocurrencies are usually traded. Instead of having a middleman that matches buyers and sellers, Bancor tokens will do the matching themselves, using automatically executed rules called smart contracts that are coded into the tokens.

This could pave the way for new investment vehicles, such as a Bancor token that functions like an exchange-traded fund holding a basket of cryptocurrencies, or tokens that are pegged to a particular exchange rate. Investors believe the Bancor token could act like a supra-national currency for cryptocurrencies—indeed, the term “bancor” was coined by John Maynard Keynes and EF Schumacher for just such a currency in the 1940s.

But the Bancor token sale didn’t go smoothly. Hot ICOs have been selling out in seconds, so crypto investors have been feverishly pushing their way in. Some have paid thousands of dollars in transaction fees to get their ether accepted first. Interest in Bancor was so great—boosted by the revelation, just before the sale started, that Tim Draper, a prominent venture capitalist, was involved—that the ethereum network became congested.

A popular wallet provider, MyEtherWallet, reported hours-long delays for transactions to be completed. This was because the Bancor Foundation had recommended buyers use it to participate in the offering. While the ethereum network clogged as users bid ever higher fees to ensure their money was accepted, services like MyEtherWallet struggled to cope with the flood of new users. “With these ICOs you are essentially asking a service to scale from maybe 10% capacity to 1,000% capacity in the course of less than a minute,” says Taylor Monahan, a co-founder of the wallet service. “Every single person presses the send button at the same time.”

This led to another problem. In the past, ICOs have been criticized for selling out quickly to large holders of cryptocurrencies. Mindful of this, and worried that the network congestion would make it even harder than usual for small investors to get a shot, the Bancor Foundation kept the offering open for longer than planned. But as a result it also collected 150,000 ether ($51 million) more in funds than intended. That angered investors who did get in early, and who say they were promised the funds would be capped. “The initial supply was inflated by 58% by changing the rules,” one investor on the Bancor project’s public Slack team, who goes by Kasper23, told Quartz. “And that hurts all investors that got in before the [initial target] was reached.”

More worryingly, the freeze-up of the ethereum network showed that it can’t handle sudden surges in transaction volume. That’s very similar to the problem plaguing its forebear, bitcoin; ethereum was supposed to be more resilient. Ethereum processes about 50% more transactions than bitcoin does every 10 minutes, thanks to its rules that make miners confirm transactions at more frequent intervals. It also side-steps the dispute at the heart of bitcoin—how to increase its “block size” and thus transaction capacity—by allowing the number of transactions processed by each miner to be increased or decreased by a small degree by the miner itself. This means ethereum blocks can grow or shrink dynamically, whereas bitcoin’s blocks are stuck with an arbitrary limit.

Even those clever features haven’t been enough to prevent the ethereum network from seizing up during high-traffic events, like a hot ICO. “This wasn’t the only one, there was at least one other ICO that caused congestion, for at least two to three hours,” says Nick Johnson, a developer at the Ethereum Foundation who works on the protocol. Johnson notes that ethereum has other mechanisms to reduce the effects of traffic jams, such as the ability for ICO issuers to set a maximum price on transactions. This is what Bancor did, and it allows ethereum users not participating in the ICO to get their own transactions confirmed—so long as they pay a price above the limit.

Johnson also points out that unlike bitcoin, which is suffering from prolonged congestion due to its block-size limit, ethereum is being overwhelmed only sporadically, during unusually high periods of activity. Still, he says, the ability of all blockchains to scale remains a fundamental problem for the field. “There is no magic wand,” he says.

The Bancor token sale is a symptom of a wider problem with ICOs. Seasoned observers of the markets say it’s only a matter of time before a crash comes, wiping out the investors who poured funds into the token launches. One such observer is Fabio Federici, who founded a blockchain analytics startup called Skry and later sold it. “Yesterday, we had one ICO and ethereum basically collapses,” he said, speaking to Quartz the day after the Bancor offering. “It just shows me that we are a long way off from a decentralized world computer.”

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