Decentralized fundraising through Initial Coin Offerings (ICOs) for early-stage ventures is one important new business model that has only become viable through blockchain technology and smart contracts. Utility tokens, voucher-like assets providing access to a service or product that a venture promises to provide in the future, are generally considered as perfectly disintermediated peer-to-peer transactions, thus representing a prime example for decentralized finance (DeFi). Traditional venture fundraising involves substantial frictions, because many investors only trust and invest in projects with strong network ties. ICOs, as a form of token-based crowdfunding, allow startup ventures to raise funds in a trustless way from previously unknown investors across the globe. Liquid post-ICO token platforms reduce startup firm discounts associated with illiquidity and enable investors to exit rapidly.
By relying on distributed trust created by blockchains, decentralized fundraising is a way to mitigate frictions in fundraising, make entrepreneurial finance markets more efficient, and promote entrepreneurship and innovation. If DeFi fully kept its promises, its proliferation should have coincided with a reduction in financial intermediation. Against this background, however, DeFi markets have experienced an increasing degree of intermediation, with a new type of intermediary entering the market: so-called Crypto Funds (CFs). The number of newly established CFs has substantially grown, in line with the number of token-based crowdfunding projects. At the end of 2021, more than 850 CFs were active, and their total assets under management globally climbed from $8.3 billion in mid-2018 to $57.5 billion according to the Crypto Fund Research.
CFs combine sophisticated venture- and hedge fund-style investment strategies, exploiting the fact that tokenized startups are traded in public secondary markets. CFs mostly trade in tokens that are classified as non-securities, avoiding most regulations applicable to traditional funds. This largely exempts them from the Investment Company Act and the Advisers Act in the US. For example, CFs can raise funds from small, individual investors, who are not accredited or qualified, resulting in a relatively low minimum investment requirement of $100,000. It also exempts CFs from any management and performance fee restrictions chargeable to their investors.
Based on the theory of financial intermediation, there are good reasons why DeFi has not led to a reduction in intermediation in the entrepreneurial finance market, but simply moved it to other parts of the value chain. For example, ICOs involve substantial investment risk, a high degree of information asymmetry, incentives for moral hazard, and new technological risks. All these frictions increase participation costs to an extent that investors in the crypto market particularly benefit from the CFs’ risk management and liquidity transformation function. CFs use their skills to create token portfolios with relatively stable payoffs (as compared to the high volatility of individual tokens).
Because CFs are a novel financial intermediary, research assessing their role in DeFi markets is very limited. In our new article, we exploit a unique dataset combining proprietary performance data of CFs with detailed information on tokenized firms and ICOs. We address the question of whether CFs, through their intermediation activities, contribute to the overall efficiency of DeFi markets.
Our analyses reveal four important findings.
First, we examine whether tokenized startups achieve higher valuations when they are backed by CFs during an ICO campaign. As expected, we find that tokenized firms substantially benefit from CF backing. The average tokenized firm’s valuation roughly doubles in the presence of CF backing.
Second, we investigate the long-term performance of CF-backed tokenized firms relative to their peers. The average CF-backed firms’ token price outperforms that of non-CF-backed firms by 18% in terms of buy-and-hold abnormal returns within the first two years subsequent to token exchange listing.
Third, we shed light on the performance and performance persistence of CFs themselves. CFs outperform the crypto market by as much as 2.69% per month on a risk-adjusted basis, as measured by the traditional CAPM-alpha. Because capital is likely not allocated purely on a competitive basis in the crypto market, CFs’ performance is also persistent over subsequent investment periods. This suggests that their outperformance is largely driven by skill, rather than luck.
Finally, we show that all these results – the higher startup valuations, their long-term outperformance, and the fact that CFs themselves are able to beat the market – are moderated by a CF’s network centrality. The status associated with a CF’s network centrality offers a certification effect to the invested startup venture, thus creating even stronger valuation and performance effects. This suggests that the privileged access to information in segmented DeFi markets accounts for the growing number of CFs in DeFi markets.
Overall, our findings explain the seemingly paradoxical incorporation of centralized market structures in DeFi markets. For entrepreneurs, investors, and policymakers, our results suggest that securing CF backing is always beneficial, whether in the primary or secondary market. For individual investors, putting money into CFs yields higher risk-adjusted returns than investing in tokens directly, e.g., Bitcoin or Ether. Finally, policymakers and legislators should understand that the token market – at least to some extent – may become more efficient on its own because highly skilled intermediaries contribute to the reduction of costly frictions.
Douglas J. Cumming is the DeSantis Distinguished Professor of Finance and Entrepreneurship at Florida Atlantic University.
Niclas Dombrowski is a PhD student at Hamburg University.
Wolfgang Drobetz is the Chair of Corporate Finance and Asset Management at Hamburg University.
Paul P. Momtaz is the Chair of Private Equity at the House of Finance at Goethe University and the Metzler Visiting Professor at the Wharton School at the University of Pennsylvania.
This post is adapted from their paper, “Decentralized Finance, Crypto Funds, and Value Creation in Tokenized Firms,” available on SSRN.
The views expressed in this post are those of the authors and do not represent the views of the Global Financial Markets Center or Duke Law.
