Signaling Product Quality in ICOs with Funds Regulation

Posted: 1 Sep 2021 Last revised: 12 Jul 2023

See all articles by Yulin Hu

Yulin Hu

School of Management, Zhejiang University

Weili Xue

Southeast University - School of Economics and Management

Yi Yang

School of Management, Zhejiang University

Xiaohang Yue

University of Wisconsin - Milwaukee - Sheldon B. Lubar School of Business

Date Written: August 31, 2021

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

Suggested Citation

Hu, Yulin and Xue, Weili and Yang, Yi and Yue, Xiaohang, Signaling Product Quality in ICOs with Funds Regulation (August 31, 2021). Available at SSRN: https://ssrn.com/abstract=3913769 or http://dx.doi.org/10.2139/ssrn.3913769

Yulin Hu (Contact Author)

School of Management, Zhejiang University ( email )

38 Zheda Road
Hangzhou, Zhejiang 310058
China

Weili Xue

Southeast University - School of Economics and Management ( email )

Sipailou 2#
Nanjing, Jiangsu Province 210096
China

Yi Yang

School of Management, Zhejiang University ( email )

38 Zheda Road
Hangzhou, Zhejiang 310058
China

Xiaohang Yue

University of Wisconsin - Milwaukee - Sheldon B. Lubar School of Business ( email )

P.O. Box 742
3202 N. Maryland Ave.
Milwaukee, WI 53201-0742
United States

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