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In this article I analyze a recent publication (March 2019), Initial Coin Offerings and the Value of Crypto Tokens (SSRN 3137213) where Christian Catalini and Joshua S. Gans explore the economic dynamics of an Initial Coin Offering (ICO) .
Why continue to talk about ICOs when all observers believe that the future is in the hands of STO regulated ecosystems?
Because it is my opinion that, although the STOs (Security Token Offering) will soon become an extremely effective tool for accessing risk capital, this instrument remains extremely centralized and can be strongly influenced by political and lobbying dynamics, while today there is a class of problems with value propositions that must necessarily be implemented with a purely decentralized approach, applications that we can call decentralized native (I have not found a better terminology in this regard) which means that they become fully effective only if developed in a decentralized manner.
These value propositions aim to build decentralized and therefore permissionless versions of primary digital services, such as infrastructures for communication, storage and computing, architectures that must be resistant to the dynamics of their centralized counterparts, all controlled by multinationals.
The paper in question explores how it is possible to use the Initial Coin Offering (ICO) tool for the collection of venture capital to finance the startup costs of a project, which is proposed by a company or in general by an organization. While performing this analysis it introduces some constraints. Other ICO variants such as IEO (Initial Exchange Offering) are not considered.
The first constraint, not always obvious, is that the service implemented by this network can only be used by spending the tokens received during the ICO, the second constraint is that at the beginning of each analysis period (primary market, secondary market, subsequent issues) the supply is known from the first sale (informed purchase) and is not changed in any case, a condition easily implementable by linking the logic of the supply in the Smart Contract that regulates the token, necessarily open source.
These operating constraints are easier to apply to purely digital services such as storage and computing services rather than services that interact with the physical world. So these constraints lend themselves well to native decentralized services.
The study also assumes, as a less obvious requirement, that all the participants, in particular all the agents (the issuing organization and the token holders), act reasonably, so they do not use the token irrationally but make strategic choices that optimize profits. We use here the term organization, and not simply company, as this approach is not limited to the use of centralized legal entities, but can be also used by distributed organizations made up of individuals who are also token holders, linked by a loose cooperation relationship, in achieving goals that tend to maximize the value of the token in their possession.
Starting from these conditions, a first predictable result can be demonstrated, namely that the token value is constructed by the competition of buyers for the purchase of the token, as actually already observed in various ICO projects that emerged between 2017 and 2018.
The most interesting result, on the other hand, is that the return on risk capital is independent of the token supply plan, so it is absolutely not relevant that the total supply is final. The supply is the criterion for issuing / destroying tokens on the market, the simplest version can envisage a single issue, more complex versions, generally with milestone, may include subsequent issues at incremental token costs.
Going into details of the article, the simplified model used to examine the market dynamics is based on three different time periods or phases of the project: the first issue of the token and any two subsequent issues, with the presence of a secondary market. In all phases the applied discount factor is the same. It is also considered a quality index of the project that influences the token pricing, in the first phase the quality is the perceived one, while in the subsequent phases it is the actual one (ie measured according to the satisfaction of the expectations of the token holder).
According to the conclusions of Catalini and Gans, the return of venture capital is independent of any commitment strategy, provided that this strategy is declared in advance at every stage.
The funds raised by the project are maximized if a single and final issue is declared, but this strategy is less efficient than an equivalent project financed with the issue of equity, in general the use of tokens, although it guarantees flexibility, if combined with a lack of prior commitment in the monetary policy (ie a lack of vision in the supply plan) compromises access to subsequent capital increases.
Summarizing the various considerations, it can be stated that, for projects where the use of the ICO instrument is appropriate, the best method to optimize the collection of risk capital consists of a clear and predefined token issuance strategy, which it can be easily achieved through the correct use of control tools and guarantee of financial governance, such as DAICO (Distributed Autonomous Initial Coin Offering) or other automatic forms of monetary policy management.
Furthermore, with the above premises the organization is economically incentivized to use pricing policies to ensure that tokens retain their value. On the other hand there are token holders who may not share these pricing policies and perform sales operations in the subsequent market phases at a lower price than that applied by the organization. So there is a need for the organization to have full discretion on the token issue pricing.
Finally, as a personal consideration, I think it would be interesting to explore what would happen if the token holders could, exercising governance rights weighed on stakes, decide the volume and pricing for subsequent token issues. In this case, speculative strategies linked to the appreciation of the token could be avoided by the same token holders.
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