Why ICOs Are Broken

ICOs, also known as utility tokens, have dominated the cryptocurrency industry for the past three years. They’ve been credited with Ethereum’s growth, a new financing model and a gateway to a decentralized future. But what are utility tokens, really? Economically, what do they do and what value do they add?

This article will show that utility tokens have no real utility and that they’re schemes to extract fees on transactions from a decentralized application. Those applications, in turn, have little to no chance of traction because of the friction introduced by these tokens. In other words, this article will show how ICOs, despite being championed as vehicles of value creation, actually destroy value.

But before we get to all that, we need to define an important concept: rent-seeking.

Defining Rent-Seeking

Rent-seeking is the process of extracting money from a transaction without adding value. The easiest way to describe rent-seeking is taxing some activity without doing anything useful. Think of a typical government bureaucrat who rubber stamps whatever comes through, say in the copyright office. That person doesn’t add anything, but extracts a tax on these transactions by getting a salary.

Rent-seekers make money without doing very much. As every management consultant knows, large corporations have many people who do very little. These are your rent-seekers and they manage to wiggle their way into cozy corners of the market that lack natural competition, such as monopolies, or where their transactions are mandated by regulation.

Why Rent-Seeking is Attractive

Rent-seeking is popular because there’s not much work or risk involved. People like earning in excess of the work they put in. The bigger the gap, the better. This is why so many Ivy League graduates pursue careers in Banking and Finance despite lacking any particular inclination toward those fields. Those fields are rife with rent-seeking opportunities with enormous wealth potential.

The tragedy of rent-seeking is that it’s a net negative to society. Instead of producing goods or services, rent-seekers simply collect taxes that create unneeded friction. That friction is stealing from the productive value creators to fund the unproductive rent-seekers.

Why Rent-Seeking Exists

The existence of rent-seeking is strange, especially in a supposedly market economy. How is it that someone who is a drag on the economy is allowed to exist in an efficient market? Shouldn’t other companies without rent-seekers destroy the companies with rent-seekers in the free market?

This would be correct in a true market economy. Unfortunately, western economies (or any other for that matter) are nowhere near true market economies. A true market economy requires sound money and that’s precisely what these economies lack.

Economies based on fiat money funnel new money to preferred groups, who in turn have an unfair advantage over everyone else. Preferred groups use this advantage to build regulatory moats around their industry and create something akin to a monopoly to essentially force everyone to use them.

This is most obvious in government monopolies such as the public education system and government agencies, but it’s also true of large banks, and through them, large companies. Every large bank gets access to insanely low interest rates which allows them to re-lend those funds on a fractional-reserve basis for a large, no-risk gain. Should those funds get paid back, they make money, and should those funds not get paid back, they get a nice bailout. Those profits, in turn go to the rent-seekers who feast off of the heads-I-win-tails-you-lose situation.

Newly created funds also go to large companies as they’re seen as least risky. This isn’t necessarily because they’re great businesses, but because the likelihood of bailouts is higher when companies are larger. The large companies in turn have a huge advantage over smaller competitors with a much larger war chest. Often, this war chest is used to buy out their competitors.

In essence, fiat money creates a lot of rent-seeking opportunities. The excess money created in fiat money systems finds its way to people that don’t add anything, generating friction in what’s supposed to be an efficient market. This is why government and corporate bureaucracies exist.

ICOs, Democratizing Rent-Seeking!

What ICOs have done is formalized the rent-seeking process. A utility token’s nominal value is the utility value, such as being able to place a bet in a dApp. But due to the dApp being restricted by the token, anyone wanting to use the dApp must go through the holders of the tokens. Instead of using an existing currency, the peddlers of ICOs offer early buyers the “opportunity” to be a gate-keeper for the dApp. In other words, utility token holders are rent-seekers that get to tax people that want to use the dApp.

Of course, adding such friction to an application is bound to dampen the uptake of the application, and that’s exactly what we’ve seen. Utility tokens are almost never used for the dApp and instead used for pure speculation. You can think of this situation as a group being sold rent-seeking positions, only to find that there aren’t enough transactions coming through to justify having paid so much.

Far from making dApps useful, utility tokens almost certainly doom dApps to failure. Utility tokens not only lack utility, but detract from whatever utility a dApp might have by introducing friction. The only people that use the token are the holders whose expected profits from taxing dApp transactions are much lower than they anticipated. The only utility consumption of the token tends to be by these holders, who reason that by using the dApp they can create the perception that the dApp is useful and drive up speculative demand for their tokens.

Taking advantage of the human desire for rent-seeking

This process illuminates the clever way in which ICOs have operated. ICOs use the carrot of potential rent-seeking opportunities as a way to entice buyers. When the application doesn’t end up being popular, the buyers are left holding the bag. Tokens meant to make them rich are the very thing that prevent the dApp from succeeding.

This is sadly how Ponzi/Pyramid schemes work. They promise some easy rent-seeking opportunities to gullible people who in turn expect to make money for doing very little work. Unfortunately, the utility demand for the token is non-existent, so the only demand left is the speculative demand. Speculative demand requires more and more buyers, creating an unsustainable bubble.

In other words, utility tokens, because of their utility-killing nature, require more and more gullible people or the whole scheme falls apart.

Ethereum, Rent-Seeking from ICOs

One might point to Ethereum as an exception to the rent-seeking rule based on the fact that it has been the platform of choice for “successful” ICOs. Ethereum has been successful because it’s taxed every such ICO. Anyone who wants to create an ERC20 token has had to transact in ETH. Every ETH holder is able to rent-seek off of those that want to buy rent-seeking opportunities!

In other words, the Ethereum token has done well precisely because it’s found more greedy and gullible people that want their own rent-seeking opportunities. The prospect of being able to be at the top of a new pyramid of rent-seeking has tempted and suckered them.

ETH has successfully taxed lots of these schemes and ICOs are really new layers of a Pyramid scheme or new suckers in a Ponzi scheme. It’s not a surprise then that so many tokens have tried to compete in this market as being at the top of a Pyramid scheme is enormously profitable. Every dApp “platform” (e.g. EOS, TRON, NEO, etc) is essentially trying to be at the top of a new pyramid so that they don’t have to pay a tax to Ethereum!

Conclusion

Utility tokens are rent-seeking devices. Because access to the application is bound to those tokens, they act as a way to tax anyone that wants to use these “decentralized” applications. Such rent-seeking introduces friction, which is why there have been so few people that have used these applications.

The honest way to build applications would be to use an existing currency like Bitcoin, USD or even ETH. Instead, ICOs are creating their own money and enticing early adopters with rent-seeking potential. This is a Ponzi/Pyramid scheme in a different guise.

Utility tokens are rent-seeking vehicles that doom applications to failure. The sooner people realize their economic purpose, the better off we’ll be.