Tokenomics: Financing with Tokens

Instructors:           Andreas Park



 

 

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

Current (Nov 2022) Status

VCs/Funds in Crypto

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

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)

  1. If the Chief Regulator considers it not in  the public's interest, then it can designate a security not to be a security.
  2. 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? 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?

Taxonomy of Tokens

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 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!

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?

The Idea of a Token-Driven Flywheel

  • Liquidity pool example
    • trading requires liquidity
    • need to attract liquidity
    • offer early adopters DAO token that contains claim on protocol fees

liquidity \(\nearrow\)

volume \(\nearrow\)

protocol fees \(\nearrow\)

token value \(\nearrow\)

Insight: protocols use tokens that have equity features as incentives to users

Who controls the Projects? Decentralized Autonomous organizations

UniSwap Lab supports development

a website app accesses the code

token holders control contact features

don't own the code

operation = decentral

control = decentral

anyone can use the baseline code

core code runs on the blockchain

tokens used as rewards

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 (?)

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

What is the relationship between token prices and platform adoption?

         Cong, Li, and Wang (2018)

How do you finance development without future income flow?

         Canidio (2018)

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

         Li and Mann (2018)         

Tokens as Payments: a New Financing Tool?

usage fee

Application

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

Chod and Lyandres (MS 2021):

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

Davydiuk, Gupta, and Rosen (2018)

  • Token retention policy is a quality signalling tool                             

Tokens as Payments: a New Financing Tool?

usage fee

Application

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

Lee and Parlour (RFS 2022)

  • 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

Shakhnov and Zaccaria (2022)

  • ICO sale to entice early adopters who provide network externalities

price

An Economic Model of ICO

  • entrepreneur wants to produce a good or service
  • Demand is uncertain and only revealed after production. 
  • \(\Rightarrow\) maximizes monopoly profits

demand

marginal cost

marginal revenue

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
  • we call this output presale

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

Output Presale

price

demand

marginal cost

marginal revenue

Result: underproduction

Revenue Sharing

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

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!

Idea:

entrepreneur can influence expected demand

  • costs her more but 
  • more likely to get high demand

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

  • costs her less but 
  • more likely to get low demand

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 of Malinova and Park

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