Why the VC community should be skeptical of cryptocurrency

You know a financial trend is hot when late-night comics start doing riffs on it. That’s certainly true for the more than 1,700 cryptocurrencies like Bitcoin that are out there. (Among the wilder ones: the Jesus coin, the Deep Onion coin and the Dogecoin, which began life as a parody of an internet meme and is now worth more than $1 billion.) In one recent sketch on Late Night with Seth Meyers, a coffee klatch of moms discusses Bitcoin. “It’s so simple to use,” one deadpans. “Transactions take place through cryptography and are verified and recorded in an immutable public ledger called a blockchain. What could be simpler than that?” Last Week Tonight with John Oliver recently dubbed it “everything you don’t understand about money combined with everything you don’t understand about currencies.” The reality is, we don’t know if cryptocurrencies will be revolutionary or go the way of the Pet Rock, Cabbage Patch Kids, and Beanie Babies.

So far, the attitude of venture capitalists has been a bit binary when it comes to cryptocurrencies — either euphoric or scoffing. Some firms have gone deep into the brave new world of Bitcoin, Ether, and other cryptocurrencies and so-called initial coin offerings (ICOs). Few are more evangelistic about crypto than Tim Draper, founder and Managing Director of Draper Fisher Jurvetson. “This is bigger than the internet. It’s bigger than the Iron Age, the Renaissance. It’s bigger than the Industrial Revolution,” Draper said at a debate in Manhattan in April. He went on to predict that Bitcoin would reach $250,000 by 2022. (It’s now hovering just below $7,900.) “This affects the entire world, and it’s going to be affected in a faster and more prevalent way than you ever imagined.”

At the Upfront Ventures Summit earlier this year in Los Angeles, Mark Suster, Managing Partner of Upfront Ventures, surveyed the VC-heavy audience of the conference, which featured quite a few cryptocurrency boosters on panels. Even so, the findings were mixed — illuminating the sometimes Manichean views of cryptocurrencies in the VC world. On one hand, almost 80 percent of those who took the survey were either “skeptical” of ICOs as fundraising mechanisms or considered them a flat-out “scam.” When it comes to the granddaddy of crypto, Bitcoin, 57 percent thought there would be a significant correction ahead or its value would go to zero, while at the same time 62 percent said it would be a significant store of value in the long run. Eighty-three percent of respondents didn’t have a partner focused on blockchain, but more than 90 percent were moderately or highly optimistic about its long-term impact.

If you drive down Sand Hill Road, you’ll find some firms have jumped in with more enthusiasm than others. Some big-name venture investors are putting up large stakes in cryptocurrency. No wonder money seems to pour into crypto startups almost every week. For instance, in mid-April, Intangible Labs, creator of a new cryptocurrency called Basis (meant to be less volatile than others), picked up $133 million from investors including Bain Capital Ventures, GV (Google’s venture arm), Lightspeed, and Foundation Capital. Hedge funds are getting in on the act, too, as a small share of their assets, and VC firms are putting money into their funds. Some VC firms are even trying to rewrite their charters to allow them to get in on more of the crypto action.

But there are plenty of skeptics. In early May, before the annual meeting of Berkshire Hathaway, Warren Buffett told CNBC that Bitcoin was “probably rat poison squared.” Berkshire Hathaway Vice Chairman Charlie Munger was even more blunt. “I like cryptocurrencies a lot less than you do,” he told Buffett. “To me, it’s just dementia. It’s like somebody else is trading turds and you decide you can’t be left out.”

After working in Silicon Valley startups for decades, I think there are lots of reasons to be wary of crypto and ICOs. The first is that they’re simply not needed to fund new businesses. There’s no shortage of capital out there for startups, whether it’s from VC, private equity, corporate venture funds, or other sources. There’s plenty of “dry powder” — money ready to go. Just because it’s possible to raise money through initial coin offerings doesn’t mean it’s necessary.

Individual investors have even more reason to be wary. Crypto can be a slot machine. While some small-time investors have won big on Bitcoin, it’s a wildly speculative, unregulated market that puts personal investors on the same playing field as risk-prone hedge funds and VC firms, but without the risk management apparatus or any of the regulations that come along with raising capital for an IPO. At a conference recently, one attendee argued with me that crypto allows an average citizen with a smartphone to play at the same table as VC firms. The chances of that ending well for an individual investor from Lagos to Louisiana are not good.

Then there’s the wild volatility. Swings of several hundred dollars a day or even hours have been common enough with Bitcoin as well as other cryptos. The market dynamics are squishy. The participants tend to be incredibly bullish and don’t really allow a true bear bet. (Think of Brad Pitt in The Big Short trying to unload his prescient bet against rising home prices.) There are even complications about how these investments are taxed, something that befuddled individual investors this past April 15.

And there’s the murky regulatory environment when it comes to crypto. Are these securities or currencies? Massachusetts recently ordered a slew of ICOs to cease and desist. It’s little wonder that a group of venture firms recently met with the U.S. Securities and Exchange Commission to lobby for a so-called safe harbor that would allow some tokens to be categorized as “utility tokens” rather than securities, according to The New York Times. It’s telling that when Forbes released its list of richest people in crypto, they were largely folks who started their own currency and created their own rules, not their outside investors. As I often say, buying ICOs can be like buying airline miles for an airline that doesn’t exist yet and doesn’t have any planes built. It may prove to be a smart bet, but it’s a risky one.

Consider Telegram, the secure messaging app that’s already raised more than $1.7 billion through its ICO. The Berlin-based service is battling with the Russian and Iranian intelligence services over encryption keys to the service. We know there’s been a big run-up in money going into ICOs. Token sales continue to boom. Startups raised more than $3 billion through ICOs in just the first two months of the year, more than half of what they took in through all of 2017, according to CoinDesk data. Initial coin offerings raised more money in the first three months of 2018 than in the whole of 2017, according to data collected by CoinDesk.

At $6.3 billion, ICO funding in the first quarter is now 118 percent of the total for 2017. By contrast, Dow Jones found that VC firms raised just over $8.78 billion during the same period.

But just because something is new and booming doesn’t make it better. Need anyone remember the financial crisis and the proliferation of collateralized debt obligations (CDOs) and the mania for offshoots like synthetic CDOs and CDOs squared? I understand that VC firms understandably want to get an edge on their competitors and see opportunities in crypto. But they should proceed with caution. And individual investors? Crypto allows them to play in a very risky asset class, just like hedge funds and VC firms, which is precisely why they should be extra, extra cautious. Venture investors are experienced at evaluating and taking risks as well as having diversified portfolios. As John Oliver joked, you could get in on the ground floor of a one-story building.

Jeff Grabow is US Venture Capital Leader at EY.