Moral Hazard in Signaling in Initial Coin Offerings (ICOs)
Research Paper Title:
“Entrepreneurial Finance and Moral Hazard: Evidence from Token Offerings”
Authors:
Background:
It is a common objective of startups to attract as much funding as early and at as high valuations as possible. Investors are willing to back startups that are best able to signal quality. While this is a healthy market mechanism in theory, it is the source of many problems in practice. Because startups' prospects are highly uncertain and the startups' quality cannot be perfectly determined (neither by the startup itself nor by the investor), startups have some incentives to exaggerate their signals. This leads to a "moral hazard in signaling." Strikingly, this study finds that startups that do not exaggerate signals have a competitive disadvantage (they raise less funding), leading to adverse incentives in the crowdfunding market. However, startups that exaggerate signals perform relatively poorly in the long run, when investors learn about the exaggeration of the initial signals.
Methodology:
Sample: Token Offerings Research Database (TORD) [https://www.paulmomtaz.com/data/tord]
Sample Size: 495 ICOs
Analytical Approach: Machine learning and regressions
Hypothesis:
Manifestations of moral hazard are profitable for token issuers in the presence of dispersed investors with limited information exchange (“asymmetric information hypothesis”). [supported]
Manifestations of moral hazard backfire on token issuers as soon as dispersed investors can pool information (“crowd-learning hypothesis”). [supported]
Results:
1. Token issuers systematically exaggerate information disclosed in technical whitepapers.
2. Exaggerated projects attract substantially more funding in significantly less time.
3. Exaggerating signals backfires as soon as investors learn about the bias through trading tokens issued in ICOs with other investors.
4. Investor disappointment about the exaggeration causes the cryptocurrency to depreciate and the probability of platform failure to increase.
Conclusion:
This study provides an explanation for the large amount of documented ‘exit scams’ in token offerings. Ventures with biased signals are more likely to fail. The findings of this paper highlight the role token trading plays as a corrective for the moral hazard in signaling created by the absence of institutions in the infant market for token offerings. Entrepreneurial finance markets need a strong institutional framework to prevent a "market for lemons" problem.