Do Institutional Investors Prevent the Market for Tokenized Assets from Failing? The Case of Initial Coin Offerings (ICOs)

By | November 30, 2020

Initial Coin Offerings (ICOs) are a relatively novel mechanism for entrepreneurs to raise capital by selling digital tokens to a crowd of investors. Tokens are cryptographically protected digital assets implemented on a blockchain, which is a novel approach to recording and transmitting data across a network in an immutable manner.

ICOs are attractive for entrepreneurs and investors alike. For entrepreneurs, ICOs are interesting because they allow them to raise growth capital at close-to-zero transaction costs (mostly because no intermediary is involved) and because they do not require entrepreneurs to (partially) give up corporate control. For investors, ICO firms are attractive because their issued tokens can be traded almost immediately in liquid token exchange markets at negligible costs.

Despite the surging adoption of ICOs in the entrepreneurship community, regulation lags behind and an institutional framework for investor protection does not yet exist. In its current state, the ICO market lacks institutions that certify the quality of entrepreneurial firms as well as legal rules that would effectively punish dishonest entrepreneurs. As described in a previous FinReg Blog post based on a recent Journal of Business Venturing publication, the  absence of institutions certifying the quality of entrepreneurial activity ex-ante or punishing dishonest activity ex-post, may create moral hazard in signaling.

Moral hazard in signaling refers to a situation in which entrepreneurs have an incentive to publish not perfectly accurate information (i.e., they often exaggerate the start-ups’ positive qualities) to attract investors. This form of moral hazard in signaling is particularly pronounced in the ICO market where mostly uninformed retail investors invest in start-up firms based on whitepapers, which are documents in which start-ups outline their business plans and are typically not verified by independent auditors. Momtaz (2020) shows that moral hazard in signaling is evident in ICO whitepapers and causes ICO investors to invest in start-ups at valuations above fair value.

Given the absence of an institutional framework that could effectively mitigate the moral hazard in signaling, we ask, in a recent Journal of Corporate Finance publication, whether the ICO market is able to efficiently cope with this problem on its own. Specifically, we study whether institutional investors, such as Venture Capital (VC) funds, can extract economic rents associated with market-wide services such as rigorous due diligence and certification of high-quality start-ups.

We find that institutional investors do indeed earn significantly positive excess-market returns. We econometrically disentangle the drivers of these excess rents and find that both selection and treatment effects are driving the results. The selection effect is associated with the notion that institutional investors are able to identify those ICO firms that would have yielded superior performance even in the absence of VC involvement. This suggests that VCs are able to pick better start-ups and thereby provide certification services to less sophisticated ICO investors. The treatment effect shows that ICO firms outperform their peers when they are backed by institutional investors, for example, because they benefit from coaching and access to exclusive networks.

Overall, our findings suggest that the ICO market is able to (at least partly) overcome the problems associated with the lack of an institutional framework, such as moral hazard in signaling. However, the continuing lack of ICO regulation may constitute a de-facto wealth transfer from unsophisticated to sophisticated investors because the former incur costs in the form of foregone excess returns that compensate the latter for their certification services. Thus, effective ICO regulation could create a more level playing field among the various ICO investor types.


Fisch, Christian, and Paul P. Momtaz. “Institutional investors and post-ICO performance: an empirical analysis of investor returns in initial coin offerings (ICOs).” Journal of Corporate Finance 64 (2020): 101679.

Momtaz, Paul P. “Entrepreneurial finance and moral hazard: evidence from token offerings.” Journal of Business Venturing (2020): 106001.

Paul P. Momtaz is a PhD student at UCLA Anderson School of Management.

Christian Fisch is a postdoc at Trier University (Germany) and Erasmus University Rotterdam (The Netherlands).



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