Tokenomics: Financing with Tokens

Instructors: Andreas Park & Zissis Poulos

Tokens as financial instruments

to understand token/coin offerings, we must first understand
- what is a security
- who you can sell to
- what's different about tokens
then
- what types of tokens exists?
- how do we assess their value?

The crypto-asset landscape

Current (Nov 2022) Status

VCs/Funds in Crypto

Time for the Ugly?

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.

How are tokens brought to market?

Old way: own website etc

Dedicated services: Coinlist

Initial Dex Offering

Initial Exchange Offering

Cumulative sales during the first bull-market

Data: coinschedule

$25B total

$18.7B in '18

Speaking of Coinschedule

Dedicated services: Coinlist

Token sale management tools
- Pre-sale allocations
- Whitelisting
- Investment control (tiers etc)
- Analytics and documentation
Compliance framework
- KYC/AML, verification tools
- Legal support
Payments
- ETH, BTC, USD with phishing protection etc

Around 1B in token sales so far

Popularized in 2019
Partnership with a crypto exchange (e.g., Binance, Gate.io)
- Trust: expectation that exchange has performed due diligence
- Reach: event promoted to exchange's userbase (reduced marketing budget)
- Liquidity: token listed on exchange that handles IEO
- Vesting options
BUT:
- Strong centralization: exchanges become gatekeepers
- Large fees paid to the exchange by project
- Exchange can enforce holding/staking requirements for their own token

Initial Exchange Offering

https://cryptorank.io/

IEO Data for 2022

about 490 projects
total raised about $440M
$\approx$ $1M per project

Popularized in 2020
Distribution via launchpad/DEX (e.g., Uniswap, BSCpad, DAO maker)
- More decentralized
- Low cost, no fees to an exchange
- Participants retain custody
- Immediate liquidity and trading via AMMs
- User buys "IOU"s -> receives tokens during Token Generation Event
BUT:
- Still have to satisfy launchpad criteria (staking, whitelisting)
- Lopsided towards DeFi, sophisticated DeFi users

Initial Dex Offering

https://cryptorank.io/

IDO Data for 2022

about 550 projects
total raised about $180M
$\approx$ $400K per project

	count	Total Raised (M)	Mean Raised (M)	Mean ROI	Mean ATH ROI
IEO	324	266	1.8	28x	47x
IDO	779	35	0.25	10x	30x

Smaller projects opt for IDO

https://cryptorank.io/

Data for 2021

What is a security?

most conversion contracts; subscription to shares, stock, units or interests; share or interest in a trust etc;
Any profit-sharing agreement or certificate.
Interest in an oil, natural gas or mining lease, claim or royalty; collateral trust certificates; non-insurance income or annuity contracts
Any investment contract.
Derivatives that are prescribed to be a security.

What is a security? Ontario

Any instrument or unit commonly known as a security.
Any title to, or interest in, the capital, assets, property, profits, earnings or royalties of any person.
Any option, subscription to or other interest in a security.
A debt security or a share, stock, unit, unit certificate, participation certificate, certificate of share or interest, preorganization certificate or subscription that is not [regulated in some other way as some kind of deposit]

A crypto asset – other than one that falls within [other definitions]

Sidebar: “crypto asset” means a digital representation of value or contractual rights, which may be transferred and stored electronically, using distributed ledger or similar technology;

Sidebar: Designation orders (CMA Section 127) (paraphrased)

If the Chief Regulator considers it not in the public's interest, then it can designate a security not to be a security.
If the Chief Regulator considers it in the public interest, it can designate
- a crypto asset to be a security;
- a crypto asset to be a derivative.

What is a security? Ontario

Key takeaway: many investment contracts can be deemed securities

What is a security? The Howey Test

Note: in Canada, it is the Pacific Coin test

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.

So: is PoS-ETH a security?

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.

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)

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)

Who can buy a security, who can you sell it to?

The financing journey

own funds
friends and family
angel investors
institutional money (private equity or venture capital)
public:
- accredited investors ("exempt market")
- crowdfunding
- general

Considerations for Canada

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.

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"

"third" route: 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
- CTPs have recently been informed to limit new investments to $50K

Taxonomy of Tokens

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 standards

Most tokens to date run on Ethereum.
https://eips.ethereum.org/EIPS/eip-20
Common language: "Our token is ERC-20 compliant"
ERC=Ethereum Request for Comment
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.

Common standards:
- ERC-20: fungible token
- ERC-721: non-fungible
- ERC-1155: mix of both

tokens are a re-imagination of value, ownership, use, rewards
tokens live on a single infrastructure and can interact with other tokens
tokens are immediately transferable & immediately usable in DeFi
token can be programmed to have many features and have many different uses

tokens can assign ownership to "things" that could not be owned before

What's a crypto-token and what's special about it?

tokens are immediately transferable
tokens can be used immediately in DeFi
token can be programmed to have many features
tokens live on a single infrastructure and can interact with other tokens

What's special about tokens

Tokens by use

payments:

you use them strictly to pay for something
example: native cryptocurrencies

utility

you use them to access a specific service of function
example: filecoin

stablecoins

digital representation of fiat money
centralized/decentralized
examples: DAI, USDC, USDT

governance

voting rights to determine parameters of a project
example: UNI, Compound etc

asset

representation of ownership
pool claims, digital items
example: receipts from UniSwap, Compound, NFTs

derivatives

tokens based on other tokens & functions
Example: tokensets

Disclaimer: this list in non-exhaustive, new ideas come up every day!

“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

tokens enter the public market and become accessible to the general public => huge implications on transparency and disclosure requirements

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.
Crypto-assets are available world-wide
- Which regulator do you need to satisfy?
- How do you resolve conflicting rules?

Regulators in the US

Securities and Exchange Commission
Commodities and Futures Trading Commission
Federal Reserve Bank
Office of the Comptroller of the Currency
FINRA
State regulators
FDIC
Congress (for laws)
The Executive (for executive orders)

Regulation in Canada

Provincial Securities Commissions:
- British Columbia Securities Commission
- Alberta Securities Commission
- Financial and Consumer Affairs Authority (Saskatchewan)
- Manitoba Securities Commission
- Ontario Securities Commission
- Autorite des marches financiers
- Financial and Consumer Services Commission (New Brunswick)
- Superintendent of Securities, Department of Justice and Public Safety, Prince Edward Island
- Nova Scotia Securities Commission
- Securities Commission of Newfoundland and Labrador
- Superintendent of Securities, Northwest Territories
- Superintendent of Securities, Yukon
- Superintendent of Securities, Nunavut
plus provincial ministries that oversee the commissions
Bank of Canada + Dept pf Finance
IIROC
FINTrac
OSFI
CDIC
Parliament, Privy Council, PM's Office

Regulators in Singapore

Monetary Authority of Singapore (MAS)

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

Monetary Authority of Singapore (MAS) View

Singapore is a developed country and it is anything but lawless.
It has bank, exchange, and securities regulation
The crypto world likes Singapore because they have provided clarity and they have ONE regulator to content with.
Cryptocurrencies = goods => transactions taxable
no cap gains tax
crypto exchanges require a licence
digital payments tokens as securities regulated under Securities and Futures Act (SFA).
payments services act (2019) => crypto & exchanges under MAS authority

Example: ML/TF laws

regulation of account issuance, money transfer services, e-money issuance, merchant acquisition, digital payment token services, FX
all have Service Act Requirements in line with ML/TF regulations, Tx monitoring, screening (sanctions, political exposed persons) and customer due diligence (KYC)

Historical data on ICO projects

Now for the ugly truth

Source: Satis Group LLC

Data from early 2018

Anybody can create a token

The Squid Game Token: does nothing than borrow the name from the game

total gain: 230,000%

The Shiba Inu coin is nothing. It stands for nothing, it's linked to nothing.

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

Classification (Source: Satis Group LLC)

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

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.

Monetary Authority of Singapore (MAS) View

https://www.bbc.com/news/uk-england-essex-59069662

Payment

Asset

Utility

The crypto world likes Singapore because they have provided clarity
Cryptocurrencies = goods => transactions taxable
no cap gains tax
crypto exchanges require a licence
digital payments tokens can be considered securities under Securities and Futures Act (SFA).
payments services act (2019) => crypto & exchanges under MAS authority

treated as money
- => not a security

How do we evaluate tokens?

Blockchain Tokens: A New Financing Tool?

Since Jan 2016: $31 billion for 1,700+ early-stage blockchain start-ups
TMX Venture (successful, since 1999, for junior firms)
- $42 billion market cap (since 1999!)
- In 2018: 52 IPOs, $2.2 billion

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