The Crypto token market is valuable because it accelerates liquidity in private markets. However, the current way ICOs and tokens are issued today is unsustainable. The gap in understanding between buyers and sellers is causing a bubble formation. There are no fundamentals, no underlying equity but artificial demand to access product (unless its for charity). The solution for a responsible liquid secondary market is issuing tokens backed by real shares — Crypto Equity.
Point 1: A secondary market is important and tokens bring liquidity
There is an untapped opportunity in the secondary market. To summarise my findings:
- There is exponential growth in transactions in alternative financing to fund primary markets.
- There are more entrepreneurs venturing out with increasing members in the unicorn club in the last years.
- There is a trend staying private longer (11 years to IPO, 7 years for M&A).
- Illiquidity is caused by asymmetric information in non transparent nature of private markets. Hence, price determination is usually done by brokers or private placement companies charging an average of 7 per cent.
- It also takes an average of 90 days to conduct due diligence, get board permission, and settle transactions.
- Despite all of the above, there is still exponential revenues reflecting the interest for vested founders, early employees and primary market investors to cash out early and for buyers to diversify portfolio (US$900m in the first half of 2014 for one of the US based private placement companies- SecondMarket now Nasdaq Private Market).
A market is essential as it serves as checks and balances among players.The market is sensitive to new information. When the startup is hot, limited supply drives prices up until no one is willing to buy the offering. The same happens with lemons in the market where market corrects prices. Bubbles correct prices by weeding out unsustainable players; however, when it implodes it results to consequences such as increased unemployment and increased default on debt. (ex. 2007 Financial crisis/ Internet bubble).
With social media, globalisation, and identifiable groups in the community, the market is quicker at adjusting to new information and punishing players that have a linear alignment in compensation. When mispricing happens, the market seeks for more information to arbitrage, moving prices closer to fundamentals (in theory).
The issue here is, the market corrects at the expense of investors that failed to identify a lemon. This can be driven by irrational sentiment as Maynard Keynes called it animal spirits or as Robert Shiller expounded on herding behaviour. There is also Moral Hazard waiting for regulators to ensure order, transparency and efficiency. Unfortunately, technology evolves so quickly that it makes it difficult to find the right policy that provides balance between promoting innovation and protecting the market against risks.
Point 2: The current ICO token market has existing gaps
Theres a huge potential for tokens because it makes a secondary market possible. However, the first wave of tokens today are not sustainable. There is liquidity but there is no transparency- an information gap in the token’s fundamentals, which means buyers might be buying lemons- don’t know what they’re getting into.
1. Misalignment of incentives for team to deliver
The moment founders or early employees get to cash out their Ethers from their token sale they no longer have an incentive to deliver. Their tokens get recycled back in the secondary market while they already have cash upfront. The average 4 year vesting and 1 year cliff periods of their tokens need to be in place. This can be done through a token plan with a token cap table.
2. Mismatch on what the value of these tokens truly represent (credits vs equity)
Tokens are equivalent to credits to access the product just how tickets are priced for a concert or Top-up to make a phone call. There are no fundamentals in these tokens but its price is determined by the scarcity to access product when released.
In addition to this point, the scarcity of supply of tokens to use product is artificial, driving prices higher. Why not accept fiat currency, BTC or ETH to access product? That’s the creation of “artificial demand” for tokens.
Here is the gap, buyers don’t know they are just buying access to the product. In fact, a number of token buyers don’t plan to use the product. Instead, they are attaching the value of the token to the potential of the product to create future revenue streams and value the potential of the team to deliver the product. This reflects the valuation of the startup building product and not credits to access product. Buyers want to be “invested” in the startup. Therefore, equity should be attached to the value of these tokens.
Token buyers are not buying the real fundamentals they think they are getting — a sign of a bubble formation.
3. Misunderstood gap between ETH, BTC and Other tokens
ETH and BTC are in a different tier. Lets apply the analogy of gold and silver. These commodities could have easily been emerald, sand or bronze but gold is perceived and accepted valuable by the market. If I got my gold from Japan with Yen, India will accept gold for Rupees. The same is happening in the digital age with cryptocurrency.
BTC presented the use case for a decentralised “commodity” proving blockchain’s use case while ETH does the job of BTC while representing credits used to self enforce smart contracts widely used today and tomorrow because of its enterprise alliances with credible institutions using smart contracts. The market perceives ETH and BTC as the new gold and silver of the digital age. While other tokens are not yet proven valuable.
Point 3: Crypto Equity is the solution
To issue more sustainable tokens, it should be backed with the company’s equity if buyers want to be invested in the startup. This is similar to fiat currency that is backed by commodities and baskets of other stable currencies. Equity is more applicable in the case of companies because shares represent the valuation, voting rights, and a claim to its earnings such as dividends and claim to its assets. There should be correct alignment- skin in the game for market players, protection for supporters, fundamentals reflected in its prices.
This article was originally published on Medium. Up next: Crypto Equity and the regulatory landscape.
Beryl Chavez Li is Founder and CEO at CapchainX, the next generation crypto equity platform to create, manage and trade equity on the Ethereum blockchain. Tokens can be exchanged for share certificates. Sign up on CapchainX and help the team improve Alpha!
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