Kleros: Fighting Scams and Abuse in Token Sales
Building the Fundamental Institutions for the Future of Finance.
By Federico Ast and Clément Lesaege
The rise of token sales is unstoppable. From January to September 2017, over 1.7 billion dollars were raised with this mechanism, surpassing investment by traditional venture capital firms.
Token distribution events are key for developing the infrastructure of the decentralized Internet. However, as is usually the case with new economic practices, situations of abuse have occurred, including companies vanishing with backer’s money.
Financial regulators are monitoring closely this new phenomenon. But developing a framework for token sales can be challenging for state regulators. After all, they have to tackle a 21st century problem with 18th century tools.
When traditional, state legal systems were developed, who would have foreseen that some day they would have to deal with crowdfunding? Jurisdictional boundaries don’t play well with a practice where thousands of participants from dozens of countries enter into a contract with a startup team which is also distributed around the world.
The decentralized global economy requires a global and decentralized institutional framework native to the Internet Age. Kleros may contribute to this framework by creating a safer environment for crowdfunding and token distribution events.
How it Works Now
A team starts a blockchain open source project. They build a website, usually they develop some lines of code in GitHub, they define milestones for the product and set a date for a token distribution event.
During the token distribution event, backers from all over the world send payments in crypto to the team. In exchange, they receive some amount of the platform token. The backer’s money stay in an address controlled by the team.
After the token distribution, different things may happen. In the best case scenario, the team executes the plan as promised and develops the product. In the worst case scenario, the team simply vanishes with the backer’s money.
But things can go wrong even while the team behaves honestly. Running a successful crowdsale (and raising millions of dollars) does not necessarily mean that the team is qualified to run a software company. They may end up misallocating that money because of incompetence.
The traditional startup world has a set of practices and legal safeguards to minimize such risks. The law deals with scammers and specialized investors are usually good at spotting rotten apples. Besides, teams don’t get all the VC money upfront. Funding follows a predefined sequence (seed, Series A, Series B, etc.) where founders get to control more resources as they prove their ability to reach product/market fit and to run the company.
A team failing to reach product/market fit (maybe because their product was based on a wrong market hypothesis) or that is unable to manage the company will not make it to Series A. If it fails, then damage will be contained to seed round investors and usually a couple hundred thousand dollars.
A big question is: how can we reduce risks in blockchain open source projects with distributed backers and teams?
How it Should Work
A team starts a blockchain open source project. They build a website, they develop some lines of code in GitHub, they define milestones for the product and set a date for a token distribution event.
During the crowdsale, backers from all over the world send payments into a smart contract which will release payments to the team as some predefined milestones are met. For example: “Next payment will be done when the team releases a new version of the software with substantial improvements”.
When the team claims a milestone is reached, token holders have some period of time to dispute it. If a sufficient amount of token holders reject the milestone completion claim, a dispute arises between the team and the token holders (Was the milestone met? Should the money be released?). Kleros is the dispute resolution mechanism.
Kleros selects jurors to evaluate the agreement along with the evidence and vote a decision: “Conditions are met/not met for releasing the payment”.
It’s important to note that Kleros acts as a safeguard both for token holders and team members. The token sale is an agreement that works in two ways. Team members make a commitment to the token holders that they will build the product following some predefined timeline. Backers promise that funding will be available for the team, provided it meets the milestones that were agreed upon.
It is important that the token holders do not simply have the choice of voting to be reimbursed. Even if the team reaches the milestones, backers could ask for their money back if the amount of ETH locked is worth more than the tokens. In this case, Kleros works as a protection for the team.
We see, in our days, people claiming that token sales should be forbidden because it’s fertile ground for scams. But token models have a raison d’être: they help build the protocols of the decentralized Internet.
We wouldn’t want to forbid selling apples just because some happen to be rotten. Instead, we need better methods to detect the bad ones and prevent them from doing harm. Kleros may give backers a high degree of control over the funds committed to support the project. If a team fails to produce the expected results, token holders may claim their money back. And the decision would be done by a decentralized jury.
In 1993, Douglass North won the Nobel Prize in Economics for his contribution to the understanding of institutions on economic development (read his seminal book Institutions, Institutional Change and Economic Performance). Good institutions create trust, certainty and enable transactions. Bad institutions create opportunistic behavior and reduced transactions.
Kleros may provide certainty to a new decentralized economy. It may provide an institutional framework for crowdfunding.
We leave these questions open for discussion. Join the conversation here and contribute with your feedback. We are building together Kleros, The Justice Protocol.
Kleros is an Ethereum autonomous organization that works as a decentralized third party to arbitrate disputes. It relies on game theoretic incentives for jurors to rule cases correctly. The result is a dispute resolution system that renders ultimate judgements enforced by smart contracts in a fast, inexpensive, transparent and decentralized way.
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