Governance in the Absence of Regulation: A Study of Initial Coin Offerings

By | November 5, 2019

Courtesy of William C. Johnson and Sangho Yi

Initial Coin Offerings (ICOs) are a novel financing method in which crypto tokens are auctioned to the public in return for fiat or cryptocurrencies using blockchain-based platforms such as Ethereum. The technology building ICOs creates a new landscape within financial economics where many important economic concepts need to be carefully considered. The technological properties of ICOs which enable smart contracts as well as decentralization complicate the effective regulation of ICOs. Additionally, crypto tokens are a new and unique asset which does not plainly fit into the traditional criteria regulators have used to determine whether assets are securities. How crypto tokens should be treated by regulators under current law and in the evolving regulatory environment is still ambiguous. Therefore, regulatory intervention in the ICO market is difficult.

ICOs are characterized by pervasive information and incentive problems for two main reasons. First, ICOs typically lack the certification of a third-party broker such as an investment bank or a venture capitalist. Second, ICO funds are normally utilized to finance early stage and innovative projects with a high level of uncertainty. This is why SEC chairman Jay Clayton claims that ICOs currently have limited investor protection, with many possibilities for fraud and manipulation in the market for ICOs. At the same time, ICOs provide unique benefits which have not been available from more traditional fund raising methods, such as revealing consumer demand, completing markets, and a new and economically complex financing method.

In our paper, we investigate how ICOs can overcome severe information and incentive problems when regulatory intervention is difficult. By overcoming these problems, ICOs can facilitate a sustainable way of financing entrepreneurial projects. We test whether firms are driven by market dynamics to voluntarily adopt curative measures, alleviating the severe information and incentive problems of ICOs. The finance literature argues that in the absence of significant regulation, firms will endogenously adopt curative measures such as strong corporate governance to alleviate asymmetric information and incentive problems. This process is facilitated by the mechanism of market dynamics.

The Substitution Hypothesis

Though ICOs are a new technological phenomenon, the aforementioned theory applies to both traditional fund-raising methods and ICOs. We propose that in the absence of regulations protecting investors, crypto token issuers are driven by market forces to adopt curative governance mechanisms. These mechanisms lower managerial moral hazard, improve long-term token performance, and enhance efficient price discovery in the secondary market. We call this hypothesis the substitution hypothesis. More specifically, we test the following implications of the substitution hypothesis. First, do ICOs have a high level of information asymmetry and incentive problems? Second, do certain endogenously arising mechanisms effectively deal with the pervasive information asymmetry and incentive problems in the market for ICOs, even with limited regulatory involvement? Third, are ICOs able to improve efficient resource allocation when compared to traditional methods of funding projects?

To systematically test this issue, we first examine whether ICO issuers are more incentivized to adopt strong governance mechanisms when these mechanisms are valuable. Specifically, we test whether these governance mechanisms are more common when potential managerial moral hazard problems are severe, when regulatory protection of investors is unlikely, when a greater percent of investors are less sophisticated, and when information asymmetry between ICO issuers and investors is large. In addition, our substitution hypothesis predicts that issuers in a country where regulation is less likely will have stronger incentives to adopt more governance mechanisms. Second, we examine whether ICO issuers choose governance mechanisms stringent enough to effectively constrain their own actions and reduce the potential for managerial moral hazard. Third, we examine whether these strong governance mechanisms are related to the likelihood of ICO success. As long as the market for ICOs is efficient, the ability of governance mechanisms to limit asymmetric information and incentive problems will lead to a higher likelihood of ICO success. Fourth, we examine the impact of governance mechanisms on ICO underpricing and ex-post performance of ICO firms in in the secondary market for exchange-traded ICOs.

Support for the Substitution Hypothesis

We find results supporting our substitution hypothesis. First, 69% of ICO issuers voluntarily adopt at least one governance mechanism and 31% adopt at least two, even without regulatory intervention. Even though there is no regulatory requirement to do so, token issuers adopt governance mechanisms similar to traditional corporate governance mechanisms. In addition, the structure of token issuers is strikingly similar to that of corporations and these structures occur endogenously in the absence of regulatory and legal requirements. ICO issuers are even more likely to adopt governance mechanisms when they are located in a jurisdiction with little or no regulatory scrutiny. We find that the most commonly adopted governance mechanisms for ICOs are voting rights, cash flow rights, managerial token allocation, and lockup agreements. We also find that firms located in countries with fewer ICO regulations adopt more governance mechanisms. ICO issuers voluntarily adopt governance mechanisms which can at least partially substitute for regulatory scrutiny, particularly when the regulatory protection of investors is weak, severe information asymmetry exists between ICO issuers and investors, investors are less sophisticated, and the conflicts of interest between ICO issuers and investors are severe.

Second, we find that firms with greater usage of governance mechanisms correspond with managers exerting greater effort and lower levels of shirking. Third, we find that firms with more governance mechanisms as measured by voting rights, cash flow rights, managerial token allocation, and lockups have a significantly higher likelihood for raising capital in the ICO, raise a greater dollar amount, and have a higher likelihood of eventually being listed on an exchange. Fourth, we find that firms allocating voting rights to managers and adopting lockups have a lower level of underpricing when they issue their tokens. This finding suggests that strong governance mechanisms reduce managerial moral hazard problems, as predicted by the substitution hypothesis. Finally, we find that strong governance mechanisms can enhance the price discovery function of ICO tokens.


Our findings indicate that the market for ICOs has endogenously adopted governance mechanisms to effectively alleviate severe information and incentive problems. Even without strong regulatory intervention, token issuers voluntarily adopt governance mechanisms which are strikingly similar to traditional corporations. When ICO issuers are not subject to strong regulator discipline, they endogenously adopt governance mechanisms to compensate for the lack of investor protection and other regulation which limits the opportunistic behavior of issuers. Thus, our findings support the idea that several features of ICOs—the lack of regulatory governance due to technological features, crypto tokens not fitting the current regulatory framework, the lack of certified third-party intermediaries, and the pervasive information and incentive problems due to the kinds of projects being funded—can be alleviated by endogenously adopted curative mechanisms driven by market dynamics.

We also utilize the aforementioned nature of ICOs as an empirical laboratory to separate law and regulation from an issuer’s choice of governance mechanisms. Our paper investigates how market forces incentivize managers to adopt value-enhancing governance mechanisms and serve as a key driver in firm governance choices. This issue is one of the most fundamental and long-standing issues in the field of finance. However, this issue is nearly impossible to empirically investigate since regulation and law are pervasive and it is impossible to separate between market mechanisms and regulatory drivers of corporate behavior. ICOs provide a rare opportunity to investigate this issue since they are lightly regulated due to their recent development and unique technological features. Also, ICOs provide a useful laboratory to empirically investigate evolutionary governance theory by testing whether the ICOs that survive or are successful have optimally adopted value-increasing governance mechanisms. Our study is one of very few studies which empirically investigate and find evidence supporting the aforementioned questions.

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