How to Regulate ICOs: First Figure out What They’re Good for
What to do when regulators seem to lack a basic understanding of the thing they’re about to regulate? Bring in the academics. In a new paper, ”Initial Coin Offerings and the Value of Crypto Tokens,” Christian Catalini of the MIT Cryptoeconomics Lab and Joshua Gans of U. Toronto establish one advantage and one limitation in raising startup capital through initial coin offering (ICO). Here’s a brief summary.
The advantage is: An ICO is a test for product-market fit; the disadvantage is the inflexibility inherent in token fundraising, compared with equity capital. These factors make tokens a complement, not a competitor, to venture capital, the authors argue. They don’t tell us where tokens should fit amid other asset classes, but they provide some theory to lean on.
Into a hypothetically mature market where “pure fraud is not possible and teams without the ability to execute on their promises are unlikely to be funded, Catalini and Gans inject a simplified example of a tokenized startup: a company that requires its customers to access its services via a proprietary token. This model leaves out an essential piece of a token’s value, which is its ability to function as a gatekeeper the other way, allowing users to contribute value into the network, as well as pay to extract it.
Still, the paper’s simplified model allows for some insights beyond the obvious advantages of an ICO.
The most salient of these insights is: Tokens allow market testing for product-market fit and price discovery. An equity-funded startup does not know how a customer values its product, until after the first version of the product is shipped. In a token sale, “the scarcity of tokens induced by the pricing choice causes buyer competition that reveals consumer value” ahead of shipment, Catalini and Gans write.
However, to support the token’s value, the entrepreneur must commit to limits on the token’s total supply. These limits are a critical factor in equations Catalini and Gans offer for calculating how likely it is that buyers will “save” — or, hold — the token, rather than immediately using it to purchase the company’s product or converting it to another currency.
This may seem self-evident to ICO operators. (In any event, toying with token supply would be a foolish way to attract regulatory attention.) But the paper makes a point that may not have occurred to token issuers: equity capital does not suffer from this limitation. As soon as expectation of future earnings increases, new equity capital should be available, without necessarily disadvantaging the company or its existing investors: “Equity finance, because it is based on the lifetime value of the venture, will always raise sufficient funds if it is financially viable,” the authors write.
As a result, the authors argue, ICOsshouldn’t be viewed as a replacement to angel or venture capital, but as a complement to it. They’re leaving out a number of other advantages: Ethereum smart contracts’ potential to reduce counterparty risk; improved liquidity for investors; value capture in bootstrapped, open-source projects; and the possibility that equity shares themselves will be transacted as tokens, to name a few.
And, there are big questions left to answer: What rights over tokens does an equity share convey? What happens to token holders in an equity acquisition? Amid US regulators’ seeming confusion about Bitcoin and whether a token is a commodity, a security or a currency, this paper provides an early toehold.
