Cryptocurrency markets are in their infancy says Information Technology and Operations Management Professor Rowena Gan. The currencies are designed to develop technology firm projects and support their transactions in the future. Mature crypto projects are in short supply, however, and much of the breathless activity in cryptocurrencies has been speculative in nature. In novel research, SMU Cox’s Rowena Gan, with co-authors Gerry Tsoukalas and Serguei Netessine, shed light on the optimal design of “uncapped” initial coin offerings (ICOs), meaning that an unlimited quantity of tokens is offered on launch day. A goal for Gan is to help legitimate firms efficiently issue tokens to finance their technology projects.

One purpose of the study is in assessing “whether this type of financing makes sense,” notes Gan. The benefits of ICOs are that they are fast, without government red tape, and cost effective. “It’s like direct advertising,” Gan offers. “There are many advantages and it’s been very profitable for start-ups so far.”  She acknowledges there are scammers, but hopes this research illuminates best practices.

Crypto offerings

Initial coin offerings are an innovative method to finance blockchain projects. This emerging form of crowdfunding for blockchain-based startups is highly customizable, Gan says. Traditional forms of financing to raise funds such as bank loans, venture capital or IPOs have intermediaries unlike initial coin offerings. In an ICO, there is no middle man or third party controlling the number of digital “tokens” issued, the price, or who has access—the transaction is between firm and investors or customers directly.

In the study, the well-known Ethereum project is the case referenced, having launched the project with an uncapped ICO in 2014. According to Gan, many crypto-funded projects are in their very early stages. Thousands of projects have successfully raised funds through ICOs worldwide, with a total of more than $65 billion raised, according to a late 2019 ICObench report. Research about uncapped ICOs, however, is extremely rare to date.

Ethereum is a popular technology platform based on blockchain technology. “Ethereum is basically an open-source platform that allows software developers to develop their decentralized software applications on top of it,” says Gan. “It is similar in concept to Apple’s app store, which is a platform. Developers can build apps on top of the Apple platform.” With these new blockchain platforms that are decentralized however, the apps cannot be removed or censored, unlike with Apple store apps. Gan says, “The core idea of using blockchain is to be decentralized. For example, Bitcoin is a decentralized currency; it is not dependent on a country’s inflation rate or government actions.”

In the Ethereum project, an “uncapped” ICO was launched to raise funds initially by issuing tokens to investors, with no limits on the number of tokens minted. They issued these “utility” tokens in the form of Ether, their cryptocurrency. (They later issued more tokens for transactions.) The price of Ether has increased over time and it facilitates all transactions on the platform, with its growing user base. Many other blockchain-based platforms share the features characterized by the authors’ model, including FileCoin, Steemit, Bancor, and others. The authors study focuses on services platform, though other types of projects in which ICOs are used include cryptocurrencies and business services.

Off with the cap

In the research, Gan and co-authors show that it is always in the firm’s interest to sell as many tokens as possible to investors, regardless of token price. Uncapped ICOs have received some criticism as being “greedy,” largely because of the behavior of speculators. They often overvalue the project, bidding up price, and later lose money, which hurts the reputation of uncapped ICOs, notes the authors.  Capping an ICO leads to speculators driving up the price of a finite number of tokens (like Bitcoin).

“We modeled the case where the platform does not reserve tokens for itself,” says Gan.  “Normally, a platform might reserve tokens for itself by selling half and keeping another half for later.” Ethereum did not reserve tokens in its ICO and the authors model captures this approach.

Gan and co-authors suggest that a platform needs to either collect the right amount of commission, which allows it to credibly engage in platform building in the long-term, or to register its tokens with a regulator that penalizes firm misconduct — or both. This can assure investors of more transparent project development. “Technologically, it’s very hard to regulate something that is decentralized,” Gan mentions.

More innovation, and regulation

Recent regulation was passed by the Securities and Exchange Commission (SEC) about aspects of asset tokenization, according to Gan. If firms want to issue “security” tokens, specifically, then the SEC considers them a security. This type of token is a digital representation of an asset. In the paper, the authors consider a very novel approach called the dual token model which uses security tokens initially to raise funds and then issues “stable coins” that do not change in value for transactions.

Ethereum is not regulated, says Gan, since the window has passed for issuance of security tokens. Their tokens, (a notorious rival to Bitcoin) and widely-traded cryptocurrency Ether, are considered utility tokens. “Most tokens are advertised to have a function, be it a dividend payment you are entitled to, or to perform a transaction like buying a car.”

Their paper is a first to study dual token models, an emerging form of token issuance. The study showed that in a dual token model, “when there is a cost associated with creating and maintaining stable coins, relative to the utility token model (the main model), this always leads to a smaller profit for the firm.” Additionally, they observe that the dual token model raises the accessibility of ICOs, owing to the regulated nature and flexibility of security tokens, especially for firms with higher setup costs.

In this nascent blockchain-empowered financing ecosystem, Gan and her co-authors offer guidance on more optimal paths to finance technology start-ups.

The paper “To Infinity and Beyond: Financing Platforms with Uncapped Crypto Tokens” by Jingxing (Rowena) Gan, Cox School of Business, Southern Methodist University and Gerry Tsoukalas and Serguei Netessine of The Wharton School, University of Pennsylvania is available as a working paper on SSRN.Written by Jennifer Warren.