Coins, Tokens, and Tokenomics

Topic:

Coins and tokens as financial instruments

Coins and tokens as financial instruments

Cumulative sales since Jan 2016

Data: coinschedule

$25B total

$18.7B in '18

Coins vs Tokens

Money vs Financing

Coin

Token

  • native to a blockchain for payment

  • examples: Bitcoin, Bitcoin Cash, Ether, Lumens, Cardano

  • build on top of or linked to an existing blockchain
  • various uses, not just payments

Blockchain Tech Stack: Where would tokens matter?


Infrastructure
 

reward and
internal currency

usage fee
or
incentive


usage fee
 


Service
 


Application
 

Tech Stack Layer

Role of Token

Tokens as financial instruments

  • to understand token/coin offerings, we must understand
    • venture financing
    • crowdfunding
  • Most tokens to date run on Ethereum.
  • Since someone will ask:
    • What is an ERC-20 token?
  • Set of 6 mandatory functions that yield 4 items:
    • total token supply,
    • account balance,
    • transfer of  token from one party to another;
    • Approve the use of token as a monetary asset.

The financing journey

The financing journey

  • Stage 0: Initial capital required to start a business
    • usually provided by the entrepreneur and their immediate family.
  •  Stage 1: Friends and Family
  • often go to people who they know.
    • Empirical evidence: F&F firms do substantially worse than those that find other sources of financing (Zaccaria 2015)
  • Alternative Stage 1: Angel Investors
  • Individuals who buy equity in small private firms
  • Finding angels is typically difficult.
  • Stage 3: Venture Capital Firm
  • A limited partnership that specializes in raising money to invest in the private equity of young firms
    • Usually sets up a time-limited fund
    • Usually charge substantial fees.
    • Most VC firms charge 20% of any positive return they make.
    • Annual management fee of about 2% of the fund’s committed capital.
    • General partners take a share of any positive return generated by the fund in a fee referred to as carried interest.
  • Focus is on "massively scalable" activities
  • Often expect annual return of >20%
  • Key: you cannot collect money from anybody!

The financing journey: the exempt market

  • accredited investors
    • Outside friends and family, entrepreneurs can approach wealthy individuals who meet certain criteria
    • Income about $200K, wealth (non-leveraged) in excess of $1M, etc
    • commonly these are Angels or limited partners in VC funds 
  • Datasource: Ontario Securities Commission

The financing journey: the public

  • public listings come with the full regulatory reporting burden
  • Idea of securities regulation:
    • ensure that market participants can base their decisions regarding investments such as equities or bonds on a reliable and defined set of information.
    • Trading should be fair, reliable and offer efficient price formation.
  • accredited investors are considered to be "sophisticated enough" not to get easily duped
    • => that is why they are "exempt"
  • New thing: Crowdfunding
    • Recently permitted by the SEC in the US and the CSA in Canada; restrictions (among others)

    • Limits for investors (per firm and total portfolio value)

    • Must used registered platform

Crowdfunding around the world

  • Source: Law, trust, and the development of crowdfunding by Raghu Rau, (WP 2017)

Crowdfunding around the world

  • Source: Law, trust, and the development of crowdfunding by Raghu Rau, (WP 2017)

Economics of Crowdfunding

  • Type 1: 
    • traditional securities, just made available in different mechanism
  • Type 2:
    • Pre-sale of a product
    • helps entrepreneur ascertain demand

Crowdfunding around the world

  • Source: Law, trust, and the development of crowdfunding by Raghu Rau, (WP 2017)

Crowdfunding in Canada

Crowdfunding in Canada

  • Equity portals: 16
    • Often do real estate deals
    • Example: NexusCrowd, Crowdmatrix
  • Lending portals: 9
    • Examples: Borrowell, Lendified, LendingLoop
  • Other portals: 45

Crowdfunding through tokens

What is it that an ICO can do that you cannot get elsewhere?

  • Entrepreneur’s vision?
    • => use crypto-token investor appetite as a benchmark. 
    • => like crowdfunding, learn product demand.
  • Lower commissions with cryptocurrencies (no intermediaries to feed).

  • Can be pre-programmed to carry out the company’s incentive payouts — or returns — as set out in White Papers and Investor Prospectuses.

  • Contingent fundraising.

  • Milestone automation.

What is it that an ICO can do that you cannot get elsewhere?

My view: currently, the biggest difference to "traditional" world is:

Venture financing open to everyone

Small minimum investment amounts

Global investor base

Tokens are immediately tradable

Are tokens/coins securities?

“I believe every ICO I’ve seen is a security. … ICOs that are securities offerings, we should regulate them like we regulate securities offerings. End of story.”

 

Jay Clayton, Chairman, U.S. Securities and Exchange Commission, testimony before the United States Senate, February 6, 2018

“I have asked the SEC’s Division of Enforcement to continue to police this area vigorously and recommend enforcement actions against those that conduct initial coin offerings in violation of the federal securities laws”

Tokens are immediately tradable

What is a security? The Howey Test

  • 1946 U.S. Supreme Court case of SEC v. W.J. Howey Co.
  • instrument = security if
    • involves investment of money or other tangible or definable consideration used in a common enterprise
    • with reasonable expectation of profits to be derived primarily from the entrepreneurial or managerial efforts of others.
  • Note from furniture store to finance a customer’s purchases:
    • not a security (purpose is to facilitate the purchase)
  • Notes issued by a corporation for the general use of the company
    • buyer is primarily interested in the economic gain from the entrepreneurial efforts of others => is a security!
  • Form (formal certificate, nominal interests in the physical assets, etc) is irrelevant.

What is a security? The Howey Test

What is a coin/token a security? Swiss Regulator's View

  • Securities regulation:
    • ensure that market participants can base their decisions regarding investments such as equities or bonds on a reliable and defined set of information.
    • Trading should be fair, reliable and offer efficient price formation.
  • Legal definitions:
    • Standardised certificated or uncertificated securities, derivatives and intermediated securities which are
    • suitable for mass standardised trading
    • publicly offered for sale in same structure/denomination or are placed with more than 20 clients

Token and Coin Financing Categories

  • a debt or equity claim on the issuer.
  • Asset tokens promise, for example, a share in future company earnings or future capital flows.
  • Economic function: analogous to equities, bonds or derivatives.
  • Also: Tokens that enable physical assets to be traded on the blockchain

Payment

Asset

Utility

  • intended to provide access digitally to an application or service by means of a blockchain-based infrastructure.
  • Synonymous with cryptocurrencies; intended to be used, now/in future, as
    • a means of payment for acquiring goods or services or
    • as a means of money or value transfer.
  • Cryptocurrencies give rise to no claims on their issuer.

Categories => Securities? (Swiss finma view)

  • treated as a security
  • in pre-financing and pre-sale phases of an ICO, tokens that confer claims to acquire tokens in the future

    • treated as securities

Payment

Asset

Utility

  • if only to pay for application or service:
    • not a security
  • if additionally or only has an investment purpose at the point of issue:

    • => treated as security

  • treated as money
    • => not a security

Secondary features

  • underwriting and offering of a third parties tokens is a licensed activity
    • => must become broker-dealer
  • issuance of tokens with interest-like return promise
    • => deposit character
    • => must obtain a bank license
  • anyone who maintains payment services is subject to AML (not for utility though)

Considerations for Canada

  • Considerations above were for Switzerland
  • If you want to legally run an ICO and
    • reach a large group
    • have it tradable, 
  • then you either
    • need to abide by the strict public offerings rules, or
    • target only accredited investors ("exempt market offering memorandum"), or
    • avoid Canadians/Americans
    • hope that your coin does not get classified as a security.

So what if they are securities?

  • Regulation of public securities is burdensome
  • Early-stage firms (often just an idea!) unlikely to tick all boxes that IPO firms must tick.
    • Is this the end? => No.
  • US and Canada have provisions for private firms
    • Reg D (USA => SAFT-compliant)
    • Exempt offering memorandum (Canada)
  • token contract can restrict who can own and transfer the token!
    • => maintain list of accredited investor IDs
    • => restrict issuance and transfers to "suitable" investors
  • Simple Agreement for Future Tokens (“SAFT”) 

The SAFT protocol

  • Premise
    • utility or payment token is not a security once it is in operation.
    • before operation it is a security
  • Idea:
    • Simple Agreement for Future Tokens (“SAFT”) 
    • limit investor-base before usability to accredited investors by using a forward contract
    • don't worry about the "after"
  • Recent trend:
    • private, Reg-D compliant tokens (almost all 2018 fall under this rule)
    • on-chain "regulator" = limit the addresses that can trade

Source: Harbour (a tech firm)

Case Study 1: KIN

  • closed last year
  • a KIN token for a yet-to-be-issued coin
  • issued by KIK
    • company that had invented the Blackberry Messenger
    • unique model whereby users could unlock features (stickers!!!) if they agreed to, for instance, take surveys or watch ads.
  • KIK want to grow the ecosystem and issued the token to incentivize developers
  • total issue size: ~$90M
  • implied maximal valuation:
    • $1.25 billion
    • seriously???

Case Study 1: KIN

  • comments: from Raquel Jackson on Medium
    • "Everything KIK wants to do can be accomplished with fiat currency or a simple payment integration with their app."

Case Study 2: Tokenfunder

  • currently running
  • their coin is a security and they market it as such
  • has asked for exempt offering memorandum (via OSC LaunchPad)
  • => uses
    • the exempt market
    • applies crowdfunding rules (maximal investment amount)
  • is the first legal asset ICO in Canada

Time for the Ugly?

Classification (Source: Satis Group LLC)

  1. Scam (pre-trading) (never intended to go anywhere)
  2. Failed (pre-trading): (not enough funding)
  3. Gone Dead (pre-trading): got funding, never made Github code contribution
  4. Dwindling (trading): got funding, wrote code, but hasn't gotten much tangible
  5. Promising (trading): as dwindling but got more done
  6. Successful (trading): steams ahead

Now for the ugly truth

Now for the ugly truth

Source: Satis Group LLC

Now for the ugly truth

Source: Satis Group LLC

Now for the ugly truth

  • New.bitcoin.com using Tokendata:
    • 902 crowdsales in 2017
    • 142 failed at the funding stage
    • 276 have since failed
    • => 46% of 2017 ICOs have already failed.
  • Some comparative stats:
    • U.S. Bureau of Labor Statistics reports: 1st year failure rate of businesses with employees is about 20%.
    • Gosh (2012, HBS study):
      • of 2,000 VC-backed startups $1 million from 2004 to 2010,
      • 75% never return cash to investors
      • 30% of the 75% implode.

Common features of ICOs

  • many different sales mechanisms
    • auctions
    • staggered sales (prices increase from phase to phase)
    • usually send money to smart contracts
  • often, you buy a token that you get to use for a coin in the future
  • commonly, there is a foundation that manages future issuance
    • the role of the foundations are often undefined
    • foundations are located in low touch regulation jurisdictions

Blockchain Tokens: A New Financing Tool?

  • Since Jan 2016: $31 billion for 1,700+ early start-ups
  • TMX Venture (successful, since 1999, for junior firms)
    • $42 billion market cap (since 1999!)
    • In 2018: 52 IPOs, $2.2 billion
  • Private markets in Ontario: raised $70 billion in 2017 

Lessons?

  • Significant interest in FinTech
  • Appetite by retail investors for risk/early-stage firms
  • Possible to raise funds directly from investors
  • VCs and intermediaries do provide a service
    • money does not substitute for business plan/advice
    • "wisdom of the crowd" is non-existent (?)

Tokenomics:
When Tokens Beat Equity

Katya Malinova & Andreas Park

Is there economic merit to tokens?

Do tokens solve an economic problem?

State of Debate on Tokens

This paper & nascent literature: tokens can achieve more economically than just regulatory arbitrage

Blockchain Tech Stack: Where would tokens matter?


Infrastructure
 

reward and
internal currency

usage fee
or
incentive


usage fee
 


Service
 


Application
 

Tech Stack Layer

Role of Token

Tokens as Seignorage Money to Power a Network

Infrastructure

reward and internal currency

Sustainability of network security

        Chiu & Koeppl (2016), Budish (2018)

How do cryptocurrencies have value?

        Biais, Bisiere, Bouvard, Casamatta (2016),
        Schilling and Uhlig (2018)        

Cryptocurrencies as payment for "real" costs

        Sockin and Xiong (2018)

Development and subsequent seignorage 

         Canidio (2018), Catalini and Gans (2018)

Blockchain Platforms: Economic Transactions with "Decentralization"

Two-sided markets with fixed roles

        Consumers - Producers

        Consumers - Intermediaries - Producers

Traditional economy

Multi-sided or peer-to-peer markets

        Consumers = Producers

        requires platform building

Decentralized economy

Traditional "centralized" economy

Service Platform Tokens: Enabling Decentralization?

usage fee or incentive

Service

How do you get people to contribute to a peer to peer platform?

         Li and Mann (2018)

How do you finance development without future income flow?

         Canidio (2018)

What is the relationship between token prices and platform adoption?

         Cong, Li, and Wang (2018)

Tokens as Payments: a New Financing Tool?

usage fee

Application

What can (utility) tokens finance that traditional securities cannot? 

Chod and Lyandres (2018):

  • Token \(\Rightarrow\) underinvestment, except under VC under-diversification

Davydiuk, Gupta, and Rosen (2018)

  • Token retention policy is a quality signaling tool                             

Lee and Parlour (2018)

  • Tokens as crowdfunding tool that allows producers to extract untapped customer surplus

Malinova and Park (2018)

  • Tokens \(\equiv\) output pre-sale; generically equivalent to debt and equity and better than equity under moral hazard

A Simple Model of Token-Based Financing

entrepreneur wants to produce a good or service
 

Setup cost for production \(C_0\)
 

Marginal cost of producing \(c\)
 

Demand is uncertain: revealed after the setup cost has been paid but before production.
 

Inverse demand \(p(q)=x-q\)

\( x\) is uniform on \([0,\theta]\).

\(x_i\)

\(x_j\)

\(x_k\)

 \(c\)

price

If financing with own funds  

\(\Rightarrow\) entrepreneur
     maximizes monopoly profits

\(\Rightarrow\) produces
     monopoly quantity

demand

marginal cost

marginal revenue

Equity financing 

\(\Rightarrow\) max \((1-\alpha)\)(monopoly profits) 

=> no distortion

\(q^m=(x-c)/2\)

\(MR=x-2q\)

\(p(q)=x-q\)

Benchmark: own funds

Benchmark: equity

general idea: sell future output

two approaches for token sales

sell a fraction of future revenue

sell units of future output

Token Financing

  • we call it revenue sharing
  • formally: sell \(\alpha_t\) of \(T\) tokens
  • produce \(q\) units a require \(T/q\) tokens per unit
  • we call this output presale
  • formally: sell \(t\) tokens
  • produce \(q\) units and keep revenue from \(q-t\) tokens

price

demand

marginal cost

marginal revenue

Entrepreneur does not internalize the effect of an extra output unit on the token value for the tokenholders!

Result: overproduction

entrepreneur issues \(t\) tokens

   for \(x\le t\): earns zero 

   for \(x>t\): solves \[\max_q  q (x-q-t)-cq.\]

 

effectively solves
     \(q\) s.t. \(MR(q)+t=c\) 

Output Presale

price

demand

marginal cost

marginal revenue

\(\Rightarrow\) tilts marginal revenue for
     entrepreneuer left because
     get only fraction of revenue

\(\Rightarrow\) solves \((1-\alpha)\)MR(q) = c

Result: underproduction

NB: Similar to Chod and Lyandres (2018)

Revenue Sharing

revenue sharing: underproduction

output presale: overproduction

\(c\)

\(MR\)

"does not internalize" = externality

address externality: TAX!

here: tax future token income

incremental token income gets shared

\(\Rightarrow\) combine the two to get the monopoly quantity!

  • issue \(t\) tokens ex ante
  • share \(\alpha_t\) of new tokens
  • token share \[\alpha_t=\frac{t}{c+t}\]

Is token financing inferior?

Is token financing inferior? No!

Presell \(t\) tokens.

As with equity, the entrepreneur receives the full NPV.

The entrepreneuer produces optimally at \(q^t=q^m\)

If \(q<t\)  \(\Rightarrow\) redeem at rate \(t/q\) and tokenholders receive refund of \(c(t-q)\).

If quantity produced \(q>t\), then share \(\alpha_t\) of revenue from incremental \(q-t\) tokens with tokenholders

Formal Result: Optimal Token Contract

  • costs her \(0\)
  • \(\theta\sim U(0,\theta_l)\)
  • \(\theta_l<\theta_h\)

Idea:

entrepreneur can influence expected demand

  • costs her \(C_e\)
  • \(\theta\sim U(0,\theta_h)\)

with effort

without effort

common topic in corporate finance

very relevant in "decentralized" world where developers are scattered around the globe

also applicable to, e.g. established firms that do something new

assume \[\textit{NPV}(\text{effort})>0>\textit{NPV}(\text{no effort})\]

Token Issuance with Moral Hazard

Investors (equity or token holders) only finance the project if the entrepreneur undertakes the effort

Solve for the optimal funding conditional on the entrepreneur taking the effort
 

Derive conditions such that the entrepreneur undertakes effort

Token Issuance with Moral Hazard

1.

2.

Key insight: a token contract incentivizes effort better than equity (similarly to canonical debt vs. equity insights)

Optimal token contract has debt features:

    get nothing if demand is low (only original
    tokenholders get anything)
 

    benefit if demand is high

all projects that can be financed by equity can be financed by the optimal token contract but

Token Issuance with Moral Hazard

some projects that can be financed by optimal tokens contracts cannot be financed by equity.

Simple model of revenue-based ICO vs equity financing from the standard corporate finance + IO toolbox

Theorem 1: Without frictions,  an optimal token contract finances the same
                      projects as equity

Theorem 2: With entrepreneurial moral hazard,

          any equity-financeable project can be financed by an optimal token

          some token-financeable projects cannot be financed by equity

​\(\Rightarrow\) There is economic and conceptual merit to token financing

Summary

Another Model: Cattelini & Gans (2018)

  • Gans and Cattelini (March 11, 2018)
    • model as three stage process:
      • Stage 1: offer
      • Stage 2: first round of interaction
      • Stage 3: possible additional issuance of tokens
    • ICO used as a pre-sale mechanism
    • "monetary policy" = possible future issuance
    • Results:
      • crypto tokens reveal consumer demand
      • => "sometimes" entrepreneurial returns with crypto > with traditional equity financing.
      • Lack of commitment in monetary policy can undermine saving
  • formally, coins need to be thought of with models such as 
    • small open economy in which
    • means of payment =/ unit of account
  • amount of money in the system affects
    • savings
    • price level
    • speculation
    • goods market production
  • => monetary theory is just as relevant as corporate finance...

Further Economic Considerations I

Further Economic Considerations II

  • equity token
    • "forever" share of profit (not revenue!)
  • utility tokens 
    • can be used once
    • pre-sell "one round" of usage = one round of revenue
    • limit in price rise to what people are willing to pay for the good once
    • conceptually closer to a money-market instrument (like commercial paper)

Topic 8: Economics of Tokens (MBA)

By Andreas Park

Topic 8: Economics of Tokens (MBA)

This set of slides describes tokens as a form of financing of operations.

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