Signaling Product Quality in ICOs with Funds Regulation

Abstract

Problem definition: We consider a venture designing an ICO campaign for an innovative product. Product quality is known to the venture but unknown to some investors. We investigate how the venture can signal quality to investors by token size and how the funds regulation influences the venture’s token issuing strategy, cash diversion behavior, and signaling effectiveness. Academic/practical relevance: Two major solutions are underway in practice to mitigate the risks of information asymmetry and fraud in ICOs: ventures with valuable projects disclose their qualities by signals such as token size; post-raise governance mechanisms are prompted to enhance investors’ control of funds raised. However, there is an ongoing debate on whether the token size is an explicit signal in the extant literature, and the interaction between signal effectiveness and funds regulation is not yet resoundingly clear. Methodology: We develop a game-theoretic model of signaling between a venture and investors and solve for the equilibrium of the game. Results: Under complete information, we find that strict funds regulation incentives the venture’s cash diversion behavior but boosts profit. Under information asymmetry, we find that a prospective venture may distort token size upward or downward to signal quality, depending on the levels of token liquidity and information transparency, production cost, and quality uncertainty. Thus, a low token size does not always indicate a high quality, which proves some empirical observations. We also show that funds regulation does not always benefit the venture and improve signaling effectiveness, as it limits cash flexibility in a small ICO market or induces a low token size and thus increases the signaling cost in a large ICO market. Managerial implications: Our results shed light on how the venture can effectively design the token size to signal quality and how the funds regulation impacts ventures’ token issuing strategies and market effectiveness.

Keywords: information asymmetry, signaling game, initial coin offerings, funds regulation