Regular visitors to our website know that there are thousands of cryptocurrencies floating around in cyberspace. We have referenced this multiple times in our blog posts. But it's curious to note that only a small percentage are actually active. Upwards of 80% are either inactive or have already failed. The question is, why?
Given that the Bitcoin core is open source, it would seem fairly easy for anyone who knows anything about software development to copy that code and create an entirely new cryptocurrency within just a few hours. Then it is a matter of pitching the project to people willing to invest money in it. How hard could it be?
It is apparently a lot harder than it sounds. Though no one knows why for sure, there is plenty of speculation regarding the differences between successful cryptocurrencies and those that fail. A recently published paper from two researchers out of the University of Vaasa (Finland) offers a few suggestions about what separates success stories from failures source.
Failure by the numbers
Before we get to the research paper, let us look at some raw numbers presented by Forbes contributor Simon Moore. Moore is an investment expert and author with personal and professional insight into the world cryptocurrency.
Moore wrote in his Forbes piece that more than 2,000 cryptocurrencies have already been launched since Bitcoin's introduction source. We have previously referenced other sources who claim the number is closer to 4,000. Be that as it may, Moore says that 743 projects defaulted in 2018 alone.
When a cryptocurrency goes into default, there are not enough funds remaining in the project to cover the value of all outstanding coins. That makes all the coins in circulation utterly worthless. Defaulting also doesn't inspire confidence among either investors are casual buyers.
Moore further wrote that upwards of 60% of all cryptocurrencies launched prior to 2014 ended in failure before the close of 2018. When he looked at all the cryptos launched between 2009 and 2019, he discovered a default rate of 80%. That is stunning by any measure.
If there is a silver lining here, it is the fact that those coins that have succeeded have done fairly well. Bitcoin is the shining example. Since its launch, Bitcoin has been the clear leader in both volume and market capitalization. It has dominated crypto prices as well. At the time of this writing, Bitcoin was hovering around USD $8,600.
Four interesting factors
With the back story behind us, let's look at the University of Vaasa research paper. Authors Klaus Grobys and Niranjan Sapkota laid out four interesting factors they believe could be precursors to whether or not a coin will succeed. They acknowledge that their research is somewhat limited, but they say that what they have uncovered does provide a starting point for analyzing the potential success of a new coin.
Without further ado, here are the four factors:
1. First-day performance
Noting that the first two factors apply to initial coin offerings (ICOs), we start with first-day performance. In other words, how an ICO performs on the first day coins are made public is an indicator of long-term success. The research shows that those coins achieving the most long-term success also had the best first-day performances.
Strong first-day performance suggests that those behind an ICO have done the work necessary to drive enthusiasm prior to launch. Whether that means they have solicited large-scale investors is unclear. First-day performance could be just as strong with a higher number of small-scale buyers, just as long as the cumulative amount is comparable to what large-scale investors would spend.
The researchers were quick to point out that first-day performance is not always indicative of performance over the first week of on ICO. In fact, those coins that perform best on the first day of trading also experience high volatility. That volatility becomes a liability if it continues past the first week.
All of this suggests that the first-day performance of ICOs is similar to that of IPOs. An ICO that does well on the first day and then levels off in volatility before the end of the week is likely to do fairly well over the long term.
2. Pre-mining activity
The next factor is the level of pre-mining activity that takes place prior to ICO launch. A high level of activity raises a red flag. Excessive pre-mining doesn't necessarily guarantee failure, but it does raise suspicions of a potential bait-and-switch - also known as 'pump and dump' in the investment world.
Moore explains that an elevated level of pre-mining could indicate that a coin's developer is mining a larger share of the first release of coins for himself. What would be the point? To get those coins for next to nothing and then hope for a big rally during that first week. The idea is to sell those coins at rally peak, take the money, and run.
Excessive pre-mining is a red flag because it raises suspicions that a coin developer really has no intention of setting up his/her new coin for long-term viability. He or she is just interested in making some quick profit and then abandoning the project. This would certainly increase the chances of default.
3. Developer anonymity
Despite the continued anonymity of Bitcoin's original developer, researchers discovered an interesting correlation between anonymity and failure. Their research indicates that 79% of all defaulted cryptocurrencies are developed by anonymous developers. A correlating statistic shows that 58% of new coin developers choose to remain anonymous.
Why is Bitcoin the anomaly here? Probably because it was the first ever cryptocurrency released to the general public. Being first carries a lot of weight. In Bitcoin's case, it carries so much weight that its founder - who goes by the pseudonym Satoshi Nakamoto - is highly revered in the cryptocurrency community.
As for the rest, anonymity may be a curse in that investors are wary of developers unwilling to identify themselves. This hasn't always been the case, but investors have been burned by pump and dump schemes too many times over the last 5 to 6 years. They are beginning to show some reluctance to put money into new coins if they have any reason to believe they are being set up. Developer anonymity could be a trigger.
4. Rewards and supply
Finally, researchers stumbled across a correlation between longevity and two other factors: lower minimum rewards and coin supply. This is rather puzzling when you consider how critical coin mining is to the health and well-being of any cryptocurrency.
Without coin mining, a cryptocurrency network could not be maintained. Transactions would not be processed, records would not be kept, and any digital coins active in the marketplace would become useless. So developers know it is important to keep miners happy. They do so by rewarding them for the work they do.
It turns out that coins offering lower minimum rewards tend to do better over the long term. This is true in both absolute terms and relative to the total number of coins in the overall supply, explains Moore. Similarly, coins with a more limited supply seem to last longer.
Both of these conditions would seem to indicate more work for miners in exchange for less reward. Common sense dictates that fewer miners would be willing to do the work. But perhaps that is a positive influence rather than a negative one.
Perhaps having fewer miners in the game prevents some of the things that could lead to coin failure. Transaction fees are a good example. Fewer miners gives those that are actively working more opportunity to earn rewards. Because they earn more, transaction fees do not have to be so high.
No guarantees of success or failure
The University of Vaasa research is fascinating if nothing else. Understand that none of the four factors described in the paper is a guarantee of success or failure. They might be indicators of long-term viability, but the researchers have stopped short of labeling them accurate predictors.
In the end, all the research has done is create links between the four factors and how they relate to coin success and failure. If we were to discuss something similar in medical terms, what we would have here is an epidemiological study. Links have been established, but those links do not equal causation.
It could be that the causes of coin failure have nothing to do with the four factors explained here. The factors could actually be symptoms of some underlying cause no one has uncovered yet. On the other hand, one or all four could be major contributors. We just don't know.
So where do we go from here? We continue on as we have all along. If you are a casual cryptocurrency user who buys bitcoins in order to play slots online, keep doing what you're doing. If you are an investor with money in platforms like Bitcoin, Bitcoin Cash, and Ethereum, keep investing according to whatever strategy has worked best for you. If you are somewhere in between, there's no need to make wholesale changes to your current activity.
There is no point looking so deeply into the research as to obsess over the details of the paper. A lot more research has to be done before we can definitively say what leads to cryptocurrency success or failure.