"Burn and mint": the best approach to launching an ICO?
There is one particular approach to launching ICOs for blockchain-based start-up projects that strikes the right balance for potential investors
Over the past six years there has been a boom in investments in start-up projects that use blockchains such as cryptocurrencies and non-fungible tokens (NFTs). There was a strong surge in these investments around 2017-2018 by way of initial coin offerings (ICOs), a new vehicle for fundraising in the blockchain world that is the equivalent of an initial public offering (IPO).
ICOs have become a popular method of raising capital owing to their advantages over traditional financing options. In an ICO, a firm raises capital for a project (such as a new cryptocurrency) in three steps. First, it creates a digital asset, called a “token,” that gives owners the right to some value from the firm’s project. This value can either be the dividends of the firm (a “security” token) or rights to the firm’s output (a “utility” token). Second, the firm tracks the ownership of the token on a blockchain ledger. Third, the firm sells those tokens to investors (who usually purchase with legal tender or other cryptocurrencies such as Bitcoin (BTC) or Ethereum (ETH)) and the proceeds of the token offering are used to execute the project.
ICOs raised nearly US$33.4 billion (A$51.3 billion) through to December 2018. In 2017 alone, even before the number of ICOs peaked, ICOs raised $6.5 billion. This was more than the total amount raised via venture capital investment in all internet projects, while the top 10 highest-grossing ICOs have collectively raised $7.6 billion (A$11.7 billion). While there was a crash in the ICO market in 2018 following regulatory attention from the US Securities and Exchange Commission over concerns with ICO scams involving high risks and promised high returns, investment in blockchain start-ups bounced back in 2021 with NFTs. Although some of these were final sales of digital art (as opposed to digital currencies), others were sales of digital assets that entitled owners to additional services later, like many ICOs. Moreover, first-time ICOs are still possible, although they now require (costly) disclosures under securities laws.
“ICOs have become an increasingly popular way to raise money as an alternative source of financing to IPOs, venture capital funding or even other forms of debt financing,” says Richard Holden, Professor of Economics at UNSW Business School. However, ICOs have inherent limits and Prof. Holden says it is important to understand these limits – and how to overcome them – in a new co-authored paper, An Examination of Velocity and Initial Coin Offerings, which examines the economic pros and cons of ICOs and how to overcome challenges associated with raising capital through token sales and similar financing structures. Importantly, the paper focuses on a particular and unexpected trade-off faced by such ICOs that limits their ability to raise funds.
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A paradoxical ICO trade-off
There is a paradox that exists when issuing ICOs, which limits the value of utility tokens as an alternative to traditional financing options, according to the paper. “There is a fundamental kind of trade-off. The more efficient you can make the use of these coins, the better. You don't want there to be big transaction costs, you don't want them to be slow and you don't want there to be an illiquid market in them,” Prof. Holden explains.
“On the other hand, if you get rid of these ‘frictions’, you essentially reduce the scarcity of tokens. In a world where a token gets used up, and then a nanosecond later somebody else has that token and can use it for their purposes, basically tokens are no longer scarce. And in that world, if you increase the velocity of tokens, it ends up having close to no value – similar to if you increase the velocity of money circulating in the economy.
“So, on the one hand, you want to get rid of frictions as much as you can to make utility tokens valuable. On the other hand, if you do that really, really well, they're not worth anything – so when you go to ICO them, you can't sell them for anything. That's a fundamental tension, so what we point to is that somewhat paradoxically, you want some kind of Goldilocks approach to these things where you don't want there to be such big frictions that nobody wants to use them. But you need enough frictions so that they're actually scarce and therefore worth something.”
Burn and mint: striking a value balance with ICOs
The paper explores a number of ways to reduce the cost of using utility tokens to raise capital in order to make them more competitive than traditional methods for raising funds. Specifically, Prof. Holden and co-authors examined three different types of blockchain consensus protocols firms could adopt to better control frictions in order to optimise the market capitalisation of all tokens.
They concluded that only one approach – “burn and mint” – will address this paradox in practice and increase the total amount raised via an ICO. In this approach, utility tokens that are used to pay for an underlying good are essentially destroyed, and then reminting after some delay. This approach was pioneered by Factom and subsequently employed by cryptocurrencies including Gnosis and Spankchain (a platform for adult entertainment videos).
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The primary value of the burn and mint approach to ICOs is that introducing a delay between the use of a token to purchase a good and the time it is reintroduced to the market functionally increases validation time – but does not require an increase in miner compensation because the network holds the token from the market after the miner has been paid. This decoupling allows the miner fee to stay low so as to support the quantity of trade but the velocity to be low to support the token price.
“Basically, this is a way to throw some sand in the gears and basically reintroduce scarcity of tokens,” says Prof. Holden, who concludes that it is crucial that firms get their ICO approach right as part of their overall business strategy. Apart from affecting decisions about revenue generation and financial structure, the paper says they might also indirectly affect choices over blockchain technology, which impact finance and revenue.
“Finally, the amount of revenue that firms receive and capital they have access to will affect a litany of other decisions the firm makes, including marketing and technology adoption,” the paper concludes.
Richard Holden is a Professor of Economics at UNSW Business School, director of the Economics of Education Knowledge Hub @UNSWBusiness, co-director of the New Economic Policy Initiative, and President-elect of the Academy of the Social Sciences in Australia. His research expertise includes contract theory, law and economics, and political economy.