Exchange Tokens, Equity Tokens and No-bullshit ICOs
Current ICO environment has grown into bubble proportions arguably not seen in the tech world since the late 90s. Millions, sometimes tens of millions of dollars are raised for teams with no prior experience and for products with no real value proposition, unclear incentive model, and dubious go-to-market strategy. There are a handful of token sales introducing distributed exchange and smart contract capabilities into existing ecosystems with proven value and business models, but these are very rare exceptions to the rule.
While the sheer scale and seeming irrationality of many of the investments can be partially explained by current regulatory environment prohibiting regular investors from betting on early-stage startups via an institute of “accredited investor”, much of the phenomenon must be attributed to the hype, FOMO and lack of basic understanding of cryptoeconomics.
Leaving aside applications of blockchain to fifty shades of nonsense and experiments with private/permissioned blockchains (i.e. slow and expensive databases) with no cryptocurrency as an incentive to uphold consistency, my biggest qualm with most token (pre-)sales is in the approach of centrally issuing and bulk-selling the exchange tokens and even package-wrapping them as equity shares. Imagine you would have to own shares of Uber to use its service and that those shares would be used as a medium of exchange between drivers, users and that the company would use them to collect their cut of the transaction.
In cryptocurrencies with pre-determined inflation, a block reward plays a critical part in cryptoeconomics as it provides an incentive for others to contribute their computing power to the network. Pre-selling big chunk of tokens diminishes that incentive and potential security of the network. For cryptos issued via a 2-way-pegs like Rootstock, the pre-issue is of course completely out of question.
Another problem is, that one-off sale of a large number of tokens (in many cases, all tokens that would ever be introduced into the underlying market) makes it subject to much higher uncertainty and volatility compared to a token issued gradually by predetermined inflation rules.
Bitcoin had clear rules of continuous issuance, which allowed it to find the market price based on utility and value the users attributed to them and the scarcity implemented in the issuance rules. Bitcoin Hivemind has two tokens: an exchange token pegged to Bitcoin (Cash) via a two-way-peg and an equity token, which serves as a consensus mechanism for determining outcomes of the contracts exchanged on the prediction market. Oracle-based stablecoins pegged to fiat currencies could (with a certain degree of risk) have the issuance pre-determined based on the necessity to maintain their respective currency peg.
The pre-issued tokens in comparison are subject to value the market attaches to the token’s underlying economy at the point of the product release and their investors are betting on that value to be higher than what they have paid at the point of the token issuance and sale. This in my opinion massively skews price discovery mechanism process and diminishes a potential of the token to serve as a medium of exchange.
Separate from the issuance problem is the functional, security, and scaling risk of having smart contract functionality in the exchange token. The most prominent examples in the Ethereum world include DAO (which security flaw led to bailout-by-hard-fork) and Cryptokitties (volume of which made the whole platform virtually unusable for a period of time).
The last but not least is the clash of incentives, which mixing the equity with medium of exchange. Users of the platform are not the same as its equity shareholders. By mixing their interest into one token, one necessarily mixes their interests and incentives, which are not necessarily aligned.
The approach I would like to see more of should be to decouple the functions of exchange and distributed organization. The exchange token should have the minimal functionality necessary to facilitate the particular market’s exchange. If not issued as stablecoin or two-way-peg, it should find its price through transparent and pre-determined issue mechanism. Equity token with smart contract capabilities would represent equity share in a distributed organization providing service for the market and collecting dividends in the exchange token (while leaving a room for competition to prevent someone feeling a need to fork a fee-free chain).
To finance the development, the equity token could be issued in rounds by a company who created the marketplace in a similar fashion as startups are raising funds in the legacy world. While the blockchain, the cryptocurrency, and the access must remain completely open and distributed to create real value, the startup which would have launched them along with the basic product suite could learn the ways of the marketplace and automate services it provides for it and distributes those functions via the equity token. As the crypto market would grow in size and its equity token would sustainably grow in function in a similar way as startups and their products grow with every customer and every round of funding, the whole ecosystem would accrue appraisal that would make it more valuable.
In the end, similar to a startup going public, the equity token could be issued to the public with the consensus of the existing shareholders and would be appraised by public investors based on real fundamentals like customer growth, profit, and other metrics. We could even see a distinction between exchange and equity token exchanges, similar to commodities and stock exchanges in the legacy world. The results could not only lead to ICOs with orders of magnitude larger valuations but also much more manageable growth and risk on the way.
For those who want to object, that cryptocurrencies are here to disrupt, not follow the legacy model, keep in mind that the basic shapes of the existing model were based on fundamental mechanics of the investment market, not by regulations or entrenched interests. There’s much more value than the cash that a good angel or VC brings with an investment and the fact, that they’re being regulated in who can invest in them doesn’t make any difference to how that value is perceived by startups they invest in. And the commodities and equity markets were created by private companies who provided services other than a floor where traders could shout numbers and acronyms at each other. These benefits won’t disappear in a crypto-economy and the upcoming crypto startups should learn how to navigate them.
There are certain regulatory challenges to this model. Mainly, equity tokens are subject to much larger regulatory scrutiny than exchange and utility tokens. It is much easier to get a rubber stamp on exchange token as a product rather than security, which in turn makes it much easier to sell them to risk-averse and institutional investors. That, however, shouldn’t be an excuse to forgo the principles, let alone be oblivious to them. If anything, startups should find a way how to launch via more friendly jurisdiction or ignore jurisdictions altogether (which arguably would be much more difficult with fiat-pegged stablecoins, but since when is launching a startup supposed to be easy!).
It will take a collapse of the ICO bubble and the resulting ecosystem cleanup for entrepreneurs and investors to understand the cryptoeconomics and change to (perhaps less sexy and more difficult, but) more sustainable approach.