The uncomfortable parallels between ICOs and the “penny stock” underworld

On the prowl.
On the prowl.
Image: Photo by Diane Bondareff/Invision for Paramount Pictures/AP Images
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Jordan Belfort, of The Wolf of Wall Street fame, made his name dealing in “penny stocks,” the thousands of securities that don’t trade on a big stock exchange. Today, this lightly regulated, often times questionable, market isn’t nearly as prominent as it was back in Belfort’s heyday. Still, there are lessons from the rowdy world of penny stocks that resonate for investors in initial coin offerings (ICOs), a sexy newcomer to the financial world.

More than $3 billion has been raised via ICOs so far this year, according to CoinSchedule. The offerings typically blend aspects of cryptocurrencies like bitcoin and ethereum with crowdfunding; whether and when they should be regulated as securities is still being debated. Sometimes the tokens that are issued correspond to a product—one digital unit might confer the right to send e-mail on a new system, for example. If the service proves popular, the token should increase in value.

ICOs seem shiny and new—blockchains are involved, after all—but they are susceptible to many of the same old problems that have plagued penny stocks. 

Pump and dump schemes

The practice that made Belfort infamous in the off-exchange stock market entails a small group of investors quietly buying up an asset and then driving prices higher via relentless promotion through e-mails or cold-calling boiler rooms. After pumping up the price and convincing others to buy, the group dumps the asset and leaves duped investors holding typically worthless securities.

The chairman of the US Securities and Exchange Commission recently said pump-and-dump schemes are easier to pull off for ICOs than penny stocks, because trading in tokens is all electronic and anonymous, making it “harder to catch the bad guys,” according to Coindesk. Belfort himself told the Financial Times (paywall) that while most people involved in ICOs probably aren’t fraudsters, the offerings are still “the biggest scam ever,” worse than anything he ever did.

Launching an ICO scam is particularly easy now because the media excitement about cryptocurrencies is palpable. (To be a journalist these days is to drown in a sea of ICO pitches.) A penny-stock purveyor must fight for attention, but ICO founders garner airtime on high-profile media outlets thanks to novelty value and, in some cases, celebrity endorsements. Twitter and Telegram channels have largely replaced the boiler room, but the idea is the same.

Thin disclosures

Another parallel between some ICOs and penny stocks is a lack of financial information published by issuers. Instead of a regulated prospectus, an ICO white paper “might be unbalanced, incomplete or misleading,” according to the UK’s Financial Conduct Authority.

On markets where penny stocks are quoted, some tiers have hardly any registration or reporting requirements. To sum up an SEC analysis of that market, just about everything seems to get worse as companies disclose less information: liquidity (the ease of trading) declines, and the likelihood of a stock keeping its value sinks. The only thing that seems to increase is the risk of manipulation.

Put another way, the SEC’s research suggests that markets with few standards for disclosure may attract people with fraudulent or manipulative intentions. Stocks that are “promoted,” or heavily advertised, also perform badly.

As for ICOs, some issuers provide a lot of information, but not necessarily what investors need to perform traditional financial analysis. MBA students are taught to rely on things like an audited set of financial statements with a projection of future cash flows, according to Joshua White, assistant professor of finance at Vanderbilt University and author of the SEC’s penny-stock analysis.

ICO white papers, on the other hand, aren’t necessarily financial statements. Instead, they usually contain technical specifications for how a product or computer network would work once it’s built. Instead of a creating a traditional business, as Bloomberg’s Matt Levine puts it, ICOs can be used to make “an unowned system for everyone to use.”

If investors are trying to make money from an ICO, it’s hard to say how tokens should be valued. But at a minimum, the SEC says investors should know basic things like what the money will be used for, and the issuer should have a clear business plan available to buyers. Potential investors should also ask if they can get their money back, and if there are any limits on reselling tokens.

For now, many ICO white papers are relatively light on details. For example, Shake Shack’s S-1 filing for its initial public offering ran to more than 600 pages, providing years of revenue and expense data. The burger chain raised about $100 million in its IPO in 2015. Tezos, a self-amending crypto ledger project, published things like a 17-page white paper (pdf) that described technical protocols and a 20-slide presentation (pdf). It raised more than $230 million earlier this year.

Hot money

The investors who flock to the wilder corners of the financial world aren’t always rubes—plenty of penny stock traders know very well that the companies they are investing in are dicey and prices may be manipulated. They wait for the buzz to mount, driving prices higher, and then try to get in and out before the mania dies down (pdf).

Studies suggest that these traders treat penny stocks as a sort of lottery, systematically miscalculating the odds of making a return. Some people who participate in ICOs are probably doing the same.

Deja vu all over again

Comparing penny stocks to ICOs is “a little bit aggressive,” according to Emma Channing, general counsel of the Argon Group. The company is part of a joint venture called tZERO with The alternative trading system is compliant with US securities regulations, unlike other venues tailored for cryptoassets. The venture is working on a set of screening questions for admission to the platform.

“We certainly anticipate getting people to up their game,” said Overstock CEO Patrick Byrne. “We don’t want the scammy types.”

In the meantime, regulators around the world are taking a closer look at the burgeoning ICO market. After all, finding ways to make financing easier would be a good thing—risky ventures need money, and small companies often find it hard to raise funds. Tech companies are staying private longer than before, raising money from a select few funds and moneyed investors instead of via stock markets, drawing criticism that the rewards of innovation are going to people who are already rich.

But if penny stocks have taught us anything, it’s that a market with little transparency and lots of hype tends to be bad for investors. The uncomfortable parallels with the swindles and scams in the penny-stock world casts a cloud over the newfangled ICO market, even for those with the best intentions.