Initial Coin Offering and Platform Building

In an initial coin offering (ICO), a company or an open-source project pre-sells a cryptocurrency “coin” (or token) that is redeemable for some product or service to be offered at a later date.

This structure has recently gain tremendous momentum: According to CB Insights, in 2017 more than 800 ICO deals raised over $5B in total proceeds, overshadowing $1B of total equity investment in the blockchain sector. This trend shows no sign of slowing: Global ICO proceeds exceeded

$3B in 2018Q1, despite uncertainty in regulatory treatment of these transactions and significant price declines in many cryptocurrencies.

The startling growth in ICOs can be interpreted in different ways. An enthusiast would say that the numbers speak for themselves and prove that the ICO structure is a valuable innovation in entrepreneurial finance. A skeptic would raise concerns about dangerous irrational exuberance. Indeed, a significant problem in the ICO space is the proliferation of deals that have little economic rationale and seek only to capitalize on this exuberance. Regulators and practitioners alike have struggled to develop objective guidelines to separate valuable ICOs from worthless ones.

A fundamental challenge in developing these guidelines is that ICOs do not fit neatly into classic models of security issuance in entrepreneurial finance. Therefore, the first step is to explain whether, when, and how an ICO can create economic value, by laying out a simple theory specific to these transactions. Such a theory could guide regulators and investors on how to separate the wheat from the chaff in the ICO market. It could also guide entrepreneurs on when to employ the ICO structure and how to attract investor interest. But perhaps owing to the novelty of the ICO market, no such theory exists in the current academic literature.

In a new paper, “Initial Coin Offerings and Platform Building,” we aim to fill this gap. We identify a common characteristic in many acclaimed ICOs: They support the building of platforms, in which users benefit from interactions with other users. Examples include peer-to- peer file sharing, decentralized cloud computing, prediction markets, social networks, and decentralized exchanges, among many others. Such platforms exhibit network effects, in that the value to each user of joining the platform increases with number of other users (or the volume of activities generated by other users).

When an entrepreneur launches a platform that features network effects, she faces a classic chicken-and-egg problem: the platform only becomes valuable for a new user when it has already acquired a critical mass of other users; but how can the entrepreneur convince the critical mass to join the platform in the first place? This problem is known as a coordination game, which typically features multiple equilibria. One equilibrium is efficient: All users join, knowing that all others will also join and the critical mass will be attained. Another equilibrium is

inefficient: No users join, because they believe that no others will join and the critical mass will not be attained. Although all users (and the entrepreneur) prefer the efficient to the inefficient equilibrium, both are self-fulfilling. The outcome of the game depends ultimately on the beliefs of each user about actions by the others.

We argue that a cryptocurrency token specific to the platform can overcome this problem by serving as a coordination device among the users. When a user purchases a token, this decision is publicly observable thanks to the transparency of the blockchain underlying the ICO. The user thus signals to others his intent to participate in the platform, which in turn motivates them to participate as well. Outside observers are often puzzled why anyone would purchase a token that has no use outside of a specific platform. Our analysis shows, paradoxically, that the token is valuable to the platform precisely because it is worthless elsewhere, as this means the purchase decision is a credible signal of the intent to use the platform.

This observation not only explains the value of tokens once a platform is up-and-running, but also sheds light on the mechanics of the ICO process itself. The ICO effectively front-loads future coordination problems to the initial date on which the platform is launched. In the paper, we explain how the entrepreneur’s goal of overcoming these problems leads to features that are common to many ICOs, such as prolonged windows, rapid uptake, soft caps, and escalating price schedules.

As further extension to the theory, we consider cases in which users may have independent assessments of the platform quality, in which case the sequential nature of ICOs also helps harness the “wisdom of the crowd” among platform users. We also discuss how this channel could be subject to manipulation, consistent with the SEC’s recent warnings against celebrity- endorsed ICOs.

Overall, we provide a theoretical framework to understand how ICOs can potentially create value, emphasizing their role in the building of platforms that rely on user interactions. To be clear, we do not claim that all ICOs fit this description. Rather, the purpose of our framework is to help regulators and practitioners understand when they do or do not. Our theory can thus aid in designing effective and transparent ICO regulation, and can inform best practices among both investors and entrepreneurs regarding the use of this novel approach to launching a business.

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