Ethereum Watch

Decentralized exchanges (DEXes) have become a new way for crypto founders to raise capital. While the idea is novel, it’s broken until several major issues are solved.

The History of Token Offerings

Everybody involved with crypto during the rally in 2017 knows just how absurd the ICO bubble was. New projects with overblow visions raised outlandish amounts of funding from professional and retail investors in exchange for practically useless tokens on their platform.

It’s a novel idea. Like a regular stock market IPO but governed by the free market. But without regulation, the euphoria surrounding ICOs grew from healthy financial innovation to dangerous and malicious over 2017. There are several instances of ICOs using hype to sell tokens to unwitting investors. For example, Centra, an ICO that hired Floyd Mayweather to promote the sale, recently admitted it had no plans of delivering a real product.

A lot of genuine projects, like Kyber Network, were a part of this bubble and buckled down to give their investors utility since. But most that raised money in 2017, like Centra, were bad actors capitalizing on investor greed.

In January 2018, the peak of the bubble, the total market cap for public cryptocurrencies hit $761 billion. Eventually, the bubble popped, and investors rushed for the exit. For 2018, the market cap of cryptocurrencies fell to $91 billion—an 88% drawdown. 

Sentiment started to pick up in January 2019 as Bitcoin staged a strong rally from $3,000. Along with this improved sentiment came the concept of IEOs. They are similar to ICOs in almost every aspect, except the projects are vetted by a cryptocurrency exchange. With IEOs, a token offering is only as strong as the exchange that facilitated the sale.

Binance IEOs have seen steady price performance, thanks to the industry’s trust in the company. The same cannot be said for IEOs on less reputable exchanges like LATOKEN or Cobinhood. Eventually, the hype in IEOs died down as Bitcoin’s price began a sustained downward trend, proving that demand for tokens is highly correlated with public sentiment in the industry.

ICOs, But on a DEX

Everybody that’s been paying attention to crypto for the last two months is aware of the enormous DeFi rally. With it, a new form of raising capital is emerging: IDOs.

An IDO, or “initial DEX offering,” is the latest way for crypto projects to sell their tokens to the public. Notable IDOs include COMP (Compound), BZRX (bZx Protocol), UMA (UMA Protocol), and MTA (mStable). So what’s so revolutionary about the concept?

Like IEOs are just ICOs facilitated by a centralized exchange, IDOs are ICOs on a decentralized exchange. The core difference between IEOs and IDOs is that projects don’t need an exchange’s permission to conduct an IDO. Instead of exchanges, vocal community members are the ones who vet projects and tokens. This process is perhaps more favorable to projects because it incorporates a range of diverse opinions, but one should be wary of obviously biased assessments. 

IDOs and DEXes are a part of the push for crypto trading and investing to migrate to decentralized services. Radical decentralization is the need of the hour, especially as regulators start to turn their attention crypto. However, with decentralization becoming more critical by the day, IDOs are gaining favor among investors. The synergy between DeFi and its native exchanges reinforce the value of DEXes in the ecosystem.

The concept still needs to be refined, as evidenced by the UMA and mStable IDOs.

ICOs favored investors that set up investment funds because of their professional look. Token allocations were thus skewed in favor of these participants, putting retail investors at a significant disadvantage.

IDOs fixed this distribution mechanic. COMP, BZRX, and UMA were conducted on Uniswap. Uniswap was perceived to be the easiest way to get tokens out in a fair manner. The teams seeded a Uniswap pool with amounts of ETH and their token in a proportion that lined up with their desired IDO price, giving the public access to these tokens.

However, this method of selling a token gave tech-savvy investors an edge.

With Uniswap IDOs, price discovery can only move upwards. If people bought tokens and dumped it back into the pool, the price could only go as low as the IDO price, because the number of tokens and ETH in the pool would simply revert to their initial level.

Thus, there was an incentive to be the first buyer. Those who could automate the process were at a clear advantage.

mStable, a stable asset swapping protocol, noticed this and tried to avert the same fate by implementing a dual-legged IDO. The first leg was the sale of some tokens on Mesa, a DEX that uses an auction mechanism to settle trades. The auction method meant everyone was on a level playing field, bidding against each other for tokens. So the best bids would be the winner, rather than the first bids.

By using an auction the project could establish a fair market price. Then, mStable would seed a Balancer pool with tokens at that implied price. For the uninitiated, Balancer is an automated market that functions like Uniswap, only with customizable weights for each asset.

Unfortunately, this didn’t go as planned. Mesa relies on entities called solvers to execute trades. The solvers were unable to clear the MTA auction for over 40 minutes, delaying the sale. mStable was criticized for using a DEX that was still in beta for its token launch.

The key to true decentralization is ensuring all activities are done on a platform that cannot be captured by one or a few powerful parties. IDOs are an effort by DEXes to make the process of an IEO permissionless. The merits of each project would be judged by the community. However, positive ideology isn’t enough to turn a vision into reality. The truth is that none of the IDO models mentioned earlier create reasonable terms for either investors or those raising capital.

The IDO, Future of Token Issuance?

Decentralizing token issuance is a net positive, but will require a lot more awareness and education. That said, it is unlikely that IDOs will completely replace ICOs and IEOs, as there is still a fair amount of demand for exchange vetted programs.

IDOs could allow for a more meritocratic system. But, projects using IDOs will need to have impeccable execution and strong community support to have a successful token sale.

The idea behind cryptocurrencies is to decentralize money and finance. IDOs are a step in the right direction, but the lack of an efficient way to do this is a major obstacle at the moment.

Orderbook based DEXes could solve this pain point, but it would limit the amount of capital a project raises. On a Uniswap IDO, the project raising money can capitalize on the tokens’ rising price. A fixed price limits the project’s ability to capture upside from the token while a floating price on an automated market maker ensures speculators are rewarded rather than genuine investors.

A healthy trade-off between fair issuance and maximizing capital raised will help the IDO model attract more willing participants on both sides of the trade.