An Overview of the Economics of Cryptographic Tokens and Initial Coin Offerings (ICOs)

Blockchain based projects have adopted initial coin offerings (ICOs) as means to simplify the process of raising capital. The cryptographic tokens offered within these ICOs are aimed at fulfilling a myriad of roles across various platforms. Some of these tokens resemble currencies, while others are similar to securities, and others offer features that are completely new. Each startup’s technological strategy yields a token that possesses unique characteristics and uses.

A recently published paper developed the economics underlying cryptographic tokens and ICOs. The authors of the paper highlighted the significance of putting into account specific aspects of financial economics, monetary theory and game theory, in order to be able to design a successful cryptographic token. Failing to adapt to these concepts can lead to creation of a useless token. They also explored what economics can tell us regarding how we can efficiently assess the actual value of tokens, how companies should design their ICOs, and what the impact of assigning different roles to tokens on a given platform could be.

ICOs and Cryptographic Tokens:

Even though some of blockchain based startups are simply providers of altcoins, the majority utilize the blockchain technology to introduce new services, or markets, or render existing markets more efficient. Nonetheless, many of these startups include native cryptographic tokens that are designed to play a myriad of roles. They also occasionally serve as an internal account unit that tracks services including verification and block-writing provided by users to the platform, or to intermediate cryptocurrency transactions between sellers and buyers across markets supported by the platforms. On the other hand, cryptographic tokens are occasionally assigned more creative uses including aiding in spam prevention on the chain, provision of proof-of-stake (PoS), or assigning owners of tokens access privileges, rights to share specific streams of revenue, or rights to help in the development of the platform.

Apart from their functions and uses, cryptographic tokens have become a very effective way for companies to raise financing capital. Instead of having to go through the expensive process of setting up an initial public offering (IPO) for stock, or the long way of convincing venture capitalists to finance the company, blockchain based companies have adopted ICOs.

Typically, the company publishes a white paper that outlines its business model, goals, and technical approaches. The white paper should include details regarding the issued token functions and details of the process of token issuance. The number of issued tokens should be limited, or deflationary, and these limits should be clearly outlined. Tokens are then sold in an auction and the money raised is used to finance the project. In 2016 only, around $250 million was raised via ICOs. This represents a significant portion of the $1.4 billion predicted to have been invested in various blockchain companies collectively this year.

Lessons Learned From the Study:

The paper outlined 2 groups of lessons learned from this study; lessons for startups and lessons for investors:

Lessons for startups:

1. Monetary systems are rather hard to operate and innately unstable.

2. Consider allocating a part of the fund in order to stabilize the price of tokens, particularly if the token is mainly a cryptocurrency.

3. Avoid holding back tokens throughout an ICO.

4. Avoid burdening owners of the tokens with work. Work should be paid for separately.

5. If owners of the tokens can control any of your platform’s aspects, note that they can use this power for their own interests rather than the ecosystem’s. Think about their rewards within the ecosystem and also how malicious actors can exploit such power to profit using dishonest means.

6. Companies don’t have to commit to or disclose anything during the launch of the ICO.

7. Generally, clarifying the value proposition increases their willingness to buy the tokens.

For Investors:

1. Relying on appreciation of token value to justify investing in an ICO is not a rewarding long term strategy. Prices of cryptocurrency tokens depend on prediction of future prices and such predictions are almost always fragile.

2. If the prices of your bought tokens are going up, this doesn’t necessarily mean that you have made good choices, it just means that you were lucky, as examples of market bubbles bursting are many.

3. Tokens that are designed on the basis of clearly outlined revenue streams represent safer investments.

4. Tokens are never associated with full voting control over the startup or the company.

5. Make sure that the specific interests of other token holders, who have voting rights, agree with yours.

6. An incomplete, confusing or nonexistent white paper should alarm you to lack of clear vision of the founders, and/or immaturity of the project.