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The New Pachinko? Exploring the Economics of Initial Coin Offerings
Dr. Avtar Sehra is CEO and chief architect at Nivaura, a startup aiming to bring blockchain and distributed ledger efficiencies to financial services.
In this opinion piece, Sehra explores the emerging markets being built upon cryptocurrencies, shedding light on important aspects of the underlying structural and dynamic economics of ICOs.
The market for initial coin offerings (ICOs) is a novel and complex phenomenon wherein projects issue blockchain-based transferable assets known as “tokens” to the public in return for payment in a cryptocurrency.
One of the most obvious use cases for such ICO token issuances is to represent some form of traditional security – e.g. equity, debt, participation in profit sharing. However, since the “offer and sale” of securities is highly regulated, several models have been devised by startups to enable ICO distribution models without falling afoul of securities regulations.
This alternative asset class – known as “appcoins” – enables holders to access a product or service at some preferential commercial arrangement (e.g. discounted price or exclusive access), and the tokens can be traded on an open market.
The U.S. Securities and Exchange Commision (SEC) recently issued an investigative report cautioning market participants that the offer and sale of digital tokens by “virtual” organizations may be subject to the requirements of federal securities laws, also noting that potential classifications of tokens as a securities will be assessed on a case-by-case basis and will relate to the facts and circumstances, including the economic realities of the transaction.
Despite the SEC’s stance, though, it is still not entirely clear what the boundaries are for token issuances in general both in the U.S. and globally, as such cryptocurrencies and ICOs remain the “Wild West” of financial services, where value is being created through regulatory arbitrage, and more could be at stake now than during the development of the World Wide Web.
Playing pachinko
In order to gain a better understanding of emerging appcoin markets, it is helpful to draw attention to the little-known Japanese gambling sensation Pachinko.
Gambling was illegal in Japan prior to 2016. Until then, exceptions existed such as horse, boat, motorcycle and bicycle racing and lotteries.
Nevertheless, over the years determined entrepreneurs found simple yet effective methods to bypass Japan’s gambling laws. One of the most popular methods was utilized by parlors operating the pinball-style arcade game known as pachinko.
Whilst almost unheard of outside of Japan, pachinko caused the emergence of a thriving gambling market within Japan with approximately 11,000 pachinko parlors nationwide generating gross revenues of $209 billion in 2015, approximately 4–5 percent of Japan’s GDP.
Players participate by purchasing small metal “pachinko balls,” then load these into a pachinko machine and operate a lever mechanism that deposits the balls at the top of the machine. There the balls lose momentum and fall into a playing field littered with obstacles and targets. Hitting targets yields returns in the form of more balls.
The balls themselves have little intrinsic value as they belong to the gaming parlor. However, once players decide to call it quits, they take their remaining balls (including extra balls won) to a prize booth in the parlor where they exchange these for prizes. Now this is where it gets interesting.
As the pachinko parlor is forbidden by law from awarding cash prizes, it gives a “cash equivalent prize” in return for the pachinko balls the player returns. However, the pachinko parlors have an associated, but normally separate, independent business located outside the parlor that “buys” the prizes for cash! This effectively makes the balls and prizes a mere promise for cash.
Pachinko parlors have built a thriving gaming (and closet gambling) industry operating subtly yet effectively in plain sight. Pachinko’s market size shows there is either huge demand for this type of game, or that it is a substitute for the simple and unadulterated concept of casino style gambling.
The key question is which is it?
The ‘pachinko effect’
Pachinko parlors have been one of the easiest ways for the Japanese market to fulfill its gambling demand by the only means it could – a contrived mechanism designed to overcome legal restrictions on casino-style gambling with cash.
The legalization of casino style gambling in Japan stemmed from the government recognizing the opportunity to tax the sizable gambling market, increase tourism and stimulate economic growth. These new laws are likely to encourage the gambling market to expand as casinos start providing a greater variety of gaming to satisfy a wider range of customer interests. Pachinko’s market share will likely decrease as demand shifts toward a casino model of gambling.
However, there is also a strong possibility that contrived business models, like those used by pachinko parlors, will adjust to increase their appeal in the new gambling environment.
Pachinko is an interesting example to demonstrate what may be happening in the world of ICOs, as it draws similarities with the creative explanations and models in the crypto space designed to distance ICOs and issued tokens from securities, in particular those classified as “non-profit infrastructure tokens.”
The construction of these “workarounds” that leverage regulatory arbitrage opportunities to execute undercover securities issuances, may be limiting the vision and creativity required to see the true scale of what ICOs and digital tokens could represent; blinding many in the industry to possible risks if they take the wrong path.
Economic realities
The theory is that, if appcoins provide access to a future product or service, their value will increase as the product is launched and appcoin usage increases. Therefore, early adopters (ICO participants) benefit from the upside through capital gains of the issued appcoins.
However, there is significant complexity in understanding the boundaries where a token goes from being a “simple” appcoin to a security.
The economic reality is that people are giving money (cryptocurrency) to a counterparty to execute a project where the buyer will gain some benefit in the future, and this benefit goes beyond a simple one-off product or service. Unlike reward-based crowdfunding, such as a Kickstarter campaign, the upside for an ICO participant is not limited to receiving a single product or service.
ICO participants are essentially buying into the ongoing commercial viability and success of the issuing project or organization, and participants are likely anticipating that the value of their appcoin holdings will increase – in which case they either earn a greater financial return by selling the tokens (capital gains), or gain more credit to access the underlying product or service.
In any event, an ICO participant’s expected returns may be seen as linked directly to the pooled funds of the ICO and the efforts of the issuer to use those funds to execute its proposed plans to generate returns – i.e. participants are buying into the ongoing commercial proposition.
Due to such complex economic realities of ICOs and the resulting appcoins, it becomes increasingly difficult to distinguish coins with these rights from analogous existing structures which are long established forms of securities. If analyzed correctly, how can a token issued with attendant voting rights, rights to benefits and potential involvement in management decisions, be any different from an equity security?
This is the key questions that needs to be answered by issuers of an appcoin.
Deteriorating arbitrage opportunity
The increasing frequency of such offerings leads to a strong possibility that in the coming years many ICOs will fall under the stringent regulatory oversight common for securities.
Many contributors to the blockchain use case debate are already advocating greater consistency in the application of existing regulations. For example, in its response to the U.K. Financial Conduct Authority’s recent consultation on the use of “distributed ledger technology,” the Association of Financial Markets in Europe (AFME) argued that “regulation should focus on the activity taking place, not the technology that delivers it.”
While greater application of existing or even new regulation will increase the complexities and costs of token issuances, it is also likely to open this asset class to new categories of investors, and therefore a deeper pool of capital. As a result the industry could see more regulated trading platforms emerge on which tokens can be traded from issuance and in the secondary market.
Such additional regulatory burdens will reduce the regulatory arbitrage opportunities driving current ICO growth. All other things being equal, more economically efficient financing instruments executed through ICO distribution channels may gain prominence, such as debt and equity or fund-like structures.
Therefore, greater regulatory oversight of the ICO process may elicit the true benefits of appcoin type tokens, which could accelerate the refinement of real use-cases rather than just being mechanisms for bypassing regulatory burdens. This may lead to appcoins becoming an asset class in of themselves, requiring significantly different approaches to risk management and investor protection.
Additionally, while the industry is operating in regulatory limbo, there may be ICOs that are misclassified or legally ambiguous. These may later be determined to have violated securities laws in one or more jurisdictions.
If the impact on investors is seen as sufficiently detrimental, retrospective prosecutions cannot be ruled out.
Structural and dynamic properties
Read More : Coindesk.com, By Avtar Sehr, The New Pachinko? Exploring the Economics of Initial Coin Offerings