De-crypto-ing Signals in Initial Coin Offerings: Evidence of Rational Token Retention ∗ Tetiana Davydiuk, Deeksha Gupta, and Samuel Rosen Original Draft: October 2018 This Draft: July 2019 Abstract Using the market for initial coin offerings (ICOs) as a laboratory, we provide evidence that entrepreneurs use retention to signal their quality to investors in the presence of asymmetric information. ICO investors face a high degree of uncertainty because of the unregulated and opaque nature of the ICO market. Using a detailed dataset on 7,450 ICOs, we show that ICOs that retain a larger fraction of their tokens are more successful in their funding efforts and are more likely to develop a working product or platform. Specifically, we estimate that a 1 p.p. increase in token retention leads to a 0.1-0.3 p.p. increase in fundraising success. Moreover, we find that signaling incentives are stronger in periods of elevated market noise. Keywords: asymmetric information, signaling, entrepreneurial financing, ICOs JEL Classifications: D82, G32, L26 ∗Tetiana Davydiuk ([email protected]) and Deeksha Gupta ([email protected]) are at the Carnegie Mellon University. Samuel Rosen ([email protected]) is at the Fox School of Business at Temple University. We would like to thank James Albertus, Gurdip Bakshi, Hugo Benedetti, Dean Corbae, Selman Erol, Marvin Goodfriend, Todd Gormley, Hanna Halaburda, Zhiguo He, Burton Hollifield, Stephen Karolyi, Theresa Kuchler, Bryan Routledge, Harald Uhlig, Ariel Zetlin-Jones, attendees at the 2019 Toronto Fintech Conference, the 2019 NBER meeting on Blockchain, Distributed Ledgers and Financial Contracting, and seminar participants at Temple University, the Office of Comptroller of Currency, and Carnegie Mellon University for their helpful comments and discussions. Electronic copy available at: https://ssrn.com/abstract=3286835 1 Introduction A classic concept in economics is that a privately informed seller may want to signal information about quality to less informed buyers. Although the theoretical literature has long proposed costly retention as a method for signaling quality, studying this question empirically poses a number of challenges. First, the presence of regulators, intermediaries, and legal protections reduce the problem of asymmetric information in many markets. Second, in-person interactions between buyers and sellers can also affect the information asymmetry problem through the conveyance of soft information. Third, a researcher must have sufficient data to control for information that could affect a buyer's decision besides retention. In this paper, we address these empirical challenges by studying the role of retention in an ideal laboratory that has not yet been considered: the market for initial coin offerings (ICOs). ICOs can be thought of as a hybrid form of crowd-funding. They have emerged in the last few years as a novel form of financing for young firms with $33.4 billion raised in aggregate through 2018. In simple terms, an ICO is the sale of digital assets, \tokens", by an entrepreneur or company to fund the creation of an online platform or ecosystem that uses blockchain technology.1 The token being sold can be used on the platform that the issuer is creating. Typically, the token is the sole currency that can be used to purchase products and services on the platform. Thus, the value of the token is derived not from profit-sharing as most tokens do not have any cash-flow rights. Rather, the token gets its value because once the platform is completed, the token can be exchanged for the product that is being sold on the platform, making it similar to crowd-funding. Unlike crowd-funding, however, investors can sell their tokens in liquid secondary markets (exchanges). To study how retention affects signaling, we ideally want a market that is liquid while being prone to a high-degree of information asymmetry. The ICO market has grown rapidly, but remains largely unregulated and is inherently opaque. The lack of regulation is due in part to the fact that ICOs take place globally over the internet, which makes potential enforcement difficult. The market is opaque because there are neither intermediaries nor 1We will refer to the digital assets sold in an ICO as \tokens" and reserve the word \coins" only to refer to cryptocurrencies. We realize this may seem confusing given that the word \coin" is in the term ICO, but it is growing convention to refer to these digital assets in this way. In fact, some parties in the crypto industry are pushing to replace the term ICO with either \token sale" or \token generation event" (Token Alliance, 2018). 1 Electronic copy available at: https://ssrn.com/abstract=3286835 face-to-face interactions between ICO investors and entrepreneurs. This combination of features is unique relative to other forms of financing (e.g., initial public offerings or venture capital). As a result, ICO investors face a uniquely high degree of information asymmetry with prospective issuers. The contracts underlying ICOs are unique in that their terms are enforced through software instead of the legal system. This software, which is publicly available and verifiable, is known as a \smart contract." This feature of ICOs creates a clear distinction between promises that are enforceable and those that are not. Essentially, something is contractible through a smart contract if and only if it can be written in computer code.2 For example, an issuer can clearly state the total number of tokens to be created and the number of tokens available for purchase by investors. However, any piece of information (e.g. resumes of entrepreneurs) or future promised action (e.g. legal enforcement) that cannot be translated into computer code could not be included a smart contract, thereby being unverifiable from an investor point of view. As such, ICO issuers would face no ex-post repercussions of misrepresenting such information. There is no comprehensive public database available on ICOs so we compile our own rich dataset of 7,450 ICOs. We do so through a combination of web scraping, PDF scraping, collection by hand, and manual review. Our primary sources are websites that provide information about ICOs to potential investors, but we also rely on documents provided by issuers and manual validation. For each ICO, we have numerous ex ante characteristics as well as several ex post outcomes of interest. We use the fraction of tokens available for sale to potential investors as our measure of retention. It is important for our analysis that this retention measure can be coded into a smart contract so that it is a credible ex ante commitment. Before describing our empirical analysis, we formalize the intuition using a stylized model of the ICO market. The model is similar to standard models of retention such as Leland and Pyle (1977) and Demarzo and Duffie (1999). Unlike equity value which is based on profit- sharing, the value of the token derives from the expected value of the services that it can be traded for if the platform is completed successfully. In the model, penniless entrepreneurs raise funds to develop their platform through an ICO from a large measure of deep-pocketed 2A smart contract can be thought of as containing \if-this-then-that" statements. It is important that the \then-that" is something that can be executable through a computer and not something that requires any real-world actions (for example, legal action). 2 Electronic copy available at: https://ssrn.com/abstract=3286835 investors. Entrepreneurs have private information about their type. Greater token retention by insiders is costly as it forces ICO entrepreneurs to hold a large share of their wealth in a single, risky asset. However, it is less costly for ICO issuers with high-quality projects to retain a share of tokens because they are more likely to successfully build their platform making their tokens more valuable. In the model equilibrium, high-type entrepreneurs choose to retain a larger fraction of tokens than low-type entrepreneurs to signal their quality and separate from low-type entrepreneurs. This outcome causes a positive relationship between the fraction of tokens retained by entrepreneurs and the quality of the ICO. When noise in the market increases and the quality of information investors get through a public signal about ICOs decreases, this relationship becomes stronger and high-type firms retain a larger share of tokens on average. We perform numerous empirical tests to assess our theoretical predictions. First, we examine whether ICOs that retain a greater fraction of tokens are more likely to fund raise successfully. When a firm announces its ICO, it usually states a \hard cap," which is the maximum amount of funds it wants to raise and is willing to accept. For each ICO in our dataset, we divide the funds they raised by this hard cap to get a continuous measure of ICO fundraising success. In line with retention as a means of signaling quality, we show that a 1 percentage point increase in the fraction of tokens retained by entrepreneurs is associated with an increase in fundraising success by 0.1-0.3 percentage points. Second, we test if the relationship between token retention and fundraising success is stronger when the market is noisier. We measure noise in the market at the time an ICO is happening by the number of other ICOs that are happening at the same time, adjusted for the amount of information provided by token issues in ICO prospectuses (commonly referred to as \whitepapers"). If only a few ICOs are happening in a month and/or whitepapers have less content, investors can undertake more due diligence on each ICO - they have more time to study the various ICOs, examine their prototype, read analyst reports etc.