Product at Ledger
It’s been nearly a decade since cryptocurrencies have disrupted primary markets.
But what are they in the first place?
Crypto-primary markets issue new digital tokens for the first time to investors, who purchase it directly from where it is created.
Every cryptocurrency has to kickstart at some point in time, and its issuance mechanism dictates its token fundamentals.
As the cryptocurrency industry is evolving, token issuance mechanisms have drastically changed over the past decade and introduced fairer interactions between investors and issuers. Let’s review them.
It starts with Bitcoin.
The original cryptocurrency kickstarted its network when Satoshi computed the genesis block in Proof-of-Work (PoW). The first cryptocurrency issuance mechanism involves miners allocating their resources (time, equipment and energy) to solve computational problems.
When miners invest real resources into the network and manage to mine its first block, they are purchasing the asset on cryptocurrency primary markets as they pouring in real resources in exchange for newly minted coins.
Additionally, developers can “pre-mine” their digital assets before it goes into circulation. In this case, the cryptocurrency is generated in closed doors before introduction to primary markets which can be considered as an unfair asset distribution.
Cryptocurrencies run on open-source code that miners have to execute to compete to earn their mining reward via PoW.
When a cryptocurrency is up and running, anyone can fork the software, make a modification on the codebase, and start mining new blocks.
In this case, a new cryptocurrency is issued by forking the original one. If miners continue to invest in the forked cryptocurrency, they purchase it on primary markets by allocating their resources to it.
After the introduction of smart contract development platforms, several enterprises have sought to implement blockchain data architecture for their operations.
For instance, consortiums of banks implemented Distributed Ledger Technologies (DLT) for fund remittance. Blue-chip institutions have also explored blockchain applications for mainstream industries, such as supply chain or health.
In this instance, because DLTs are set up in closed doors and in a permissioned and closed environment, the DLT tokens are not offered to public investors but remain within a closed network of companies.
Here, investors are both the token issuers and holders. The distribution and asset issuance is the result of private negotiations with other members of the consortium or within an organisation.
After the cryptocurrency craze and global averse regulations on the industry, issuers have explored the case for security tokenization.
Security tokens are assets backed by regulated financial instruments. The digital asset represents a claim on securities issued in a specific jurisdiction.
For instance, a tokenized security can represent equity in a company, a debt, a real asset or even another cryptocurrency.
When tokens are backed by securities, issuers have to coordinate with financial watchdogs to offer them in a responsible environment. And just like any other security issuance, tokenized security primary markets require heavy compliance for both investors and issuers.
As such, issuers have to follow existing security law frameworks and holders often have to register as accredited investors in order to purchase on primary markets. Additionally, issuers need to make sure holders are able to have a direct claim on the said security.
Issuing a “stable” gold-backed token, for instance, should involve a fast-track to redeem the asset for gold and provide a transparent mechanism to assess the token’s reserves.
There are also cases for tokenized assets backed by other cryptocurrencies, in the form of indexes. Whether these tokens fall under security laws is still debatable, as the reserved assets do not fall under an existing legal framework.
After Ethereum’s mind-boggling expansion, many token issuers went through the tokenized sale route via smart contracts. On paper, it’s a fair deal compared to PoW and fork issuance mechanisms that often over-reward developers at the expense of late investors.
In this case, issuers organise a sale of tokens via a smart contract and offer them to prospective investors, who can assess the token economics and decide whether to purchase tokens or not.
Unfortunately, the first generation of token sales, often referred to as ICO (Initial Coin Offering), has offered limited bargaining opportunities to investors, that fell for over-valued projects.
By nature, ICOs are single round token sales, where issuers sell digital assets to primary market investors in exchange for mainstream cryptocurrencies, and that, without any sort price negotations.
The capped token sale involves the issuance of a token that is or will converge to a ceiling limit. In other words, there is only a finite amount of tokens that will be issued in a capped sale.
It gives clarity to sale participants on the network valuation, but the introduction of soft and hard targets have added complexity to asset evaluation.
A soft cap represents the minimum amount of money to be raised for the sale to be successful while the hard is the maximum amount.
A range of fundraising target introduces opacity in the valuation of the network.
For instance, issuing a 20% of tokens with a soft and hard cap between $1 and $5 million values the network between $5 and $25 million — a large spread.
Additionally, in the event a sale raises an amount between the soft and hard cap, there are three possible outcomes for unsold tokens that can drastically change the post-money valuation of a network:
Prevalent in 2017, and 2018, capped sales benefit issuers rather than primary markets investors that often forget to take into account key token fundamentals.
Rather than putting a limit on the token supply, token issuers can organise an uncapped sale, which has no ceilings on the amount of tokens.
It gives no clarity on the valuation of an asset but guarantees participation in the sale for participants.
Here, investors only acknowledge the price of a token, without knowing the valuation of the network nor the maximum amount of funds the issuers wishes to raise.
Uncapped sales are dangerous games for investors, but a money-making machine for issuers. Hopefully, uncapped sales never really took off as issuers and public investors discarded this issuance method.
Also known as reverse auctions, it is a method of selling tokens (or any goods/services for that matter) in which the price of a single asset reduces over time until a buyer agrees to purchase the said token.
It creates a competitive environment between token purchasers who want to outdo other bids to get their hands on a token.
On the other hand, issuers are the ones defining the pricing curve of the auction, without market feedback, which can result in an overvaluation of the network, in case FOMO arises amongst investors.
The case for unsold token constitutes another stressing issue in dutch auctions. Issuers can either keep them in reserve or burn them, but sale participants historically have no influence on how unsold assets will be managed.
These three types of sales follow a Caveat Emptor trade rule: it is the token issuer’s way or the highway — and investors have virtually no bargaining power. Coupled with a weak understanding of token economics, public investors have often burned their hands in these sales.
A second generation of tokenized sales has surfaced in 2017–18, only months after the craze for capped, uncapped and dutch auction sales. As first generation sales do not provide enough bargaining power to investors, it is refreshing to witness constant innovation in sale mechanisms that facilitate a fairer relationship between issuers and investors.
The interactive sale, co-authored by Jason Teutsh, Vitalik Buterin and Christopher Brown solve the dilemma of participation and valuation tokenized sales. During a capped sale, investors have clarity on the proposed network valuation but struggle to participate (because there are limited tokens) while uncapped sales guarantee participation but blur the project valuation.
To circumvent this phenomenon, investors can place personal bids on the capitalisation of the network in IICOs. During the first stage of the interactive sale, participants submit bids in the form of personal maximum caps for the network and can withdraw them. Then, the smart contract finds the equilibrium between investors and any personal cap under the actual cap is refunded.
Vitalik combined the Decentralised Autonomous Organisation (DAO) and the ICO model into a DAICO to reduce the risk for token issuers to run away with the funds raised.
Rather than getting access to a large amount of money, the DAO issues the funds raised over a predetermined amount of time, forcing issuers to deliver on their promises.
This new generation of one-off token sales has just kickstarted their journey to primary markets. Although it introduces fairer relationships between issuers and investors, the market is yet to shift from capped/uncapped/dutch sales to faires ones.
Rather than conducting a one-time token sale event, continuous sales facilitate the exchange of tokens over time via a market-making smart contract. Investors can purchase tokens and liquidate their position by interacting directly with it.
First introduced by both Simon de la Rouviere as “bonding curves” and Bancor as “smart tokens”, bonding curve contracts facilitate an automated market making mechanism that purchases and sells tokens depending on a predetermined price curve.
Unlike sales that rely on a one-off token issuance event, bonding curves contracts emit assets continuously, effectively aligning the token price with market conditions and expectations.
Thibauld introduced the continuous organisation model, a legacy organisation that sets up a Decentralised Autonomous Trust (DAT) as a financial manager to continuously raise funds and share dividends to token holders.
The DAT is a smart contract with a bonding curve contract and sponsored burning that automatically issues and converts tokenized securities.
The last couple of years have introduced vital innovations in token issuance mechanisms. But the major obstacle to market adoption, in addition to heavy technical requirements, remains the Caveat Emptor situation, in which token issuers are not incentivised to organise such issuance mechanisms until investors formally demand them.
A token-curated registry for cryptocurrency primary markets, enabling investors to accept or reject token issuers from a curated whitelist of good actors.
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Any token issuance mechanism I forgot? Comment below and I’ll add it.
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