DeFi has been on a tear lately. Bull markets, be it in equities, bonds or crypto, bring with them a spate of capital raises. While in equity markets, IPOs (Initial Public Offerings) are the standard way to raise capital, things on the crypto side are a lot more fluid. We had Initial Coin Offerings (ICOs) in 2017-18, Initial Exchange Offerings (IEOs) in 2019 and now we are seeing the rise of Initial Dex Offerings (IDOs).
ICOs were a game changer. The Ethereum blockchain provided an easy way to create and sell tokens through smart contracts. This unlocked such a powerful and innovative method of raising capital that a total of $8 billion were raised through ICOs. IEOs can be thought of as derivative of ICOs and could quite scale up to match the size and impact of ICOs.
This brings us to the question we aim to analyse in this article: can IDOs snowball into something as powerful as ICOs and create a new gush of capital into crypots, resulting in substantial price rally in the near term and growth/ advancement of the crypto ecosystem in the medium term.
How IDOs Work
Fundamentally, an Initial Dex Offering entails four steps:
- Pre Sale: The network is initially bootstrapped with financial resources from early stage-backers and venture capitalists. They are offered tokens at a slightly discounted rate for taking risks early on.
- Public Sale: Public sale is conducted on decentralised exchanges (DEXs). So far we have seen two different methods of public sale:
- The issuer sets limit sell orders at various levels of increasing price. This structure gives a better price to early buyers and was used in the sale of the DMG governance token
- Instead of fixing the price, the issuer conducts an auction which results in a demand-supply driven sale price. The sale of MTA tokens was conducted in this fashion.Unlike ICOs where the capital raised by almost completely denominated in ETH, in IDOs capital is raised in a mix of ETH and stablecoins (USDC, DAI and USDT).
- Listing: Listing is done on automated market maker (AMM) based exchanges like Uniswap and Balancer. Because of the decentralised and permissionless nature of these exchanges, listing doesn’t entail any approvals or fees. The issuer can create a pool using its tokens and part of the sale proceeds. This is all the issuer needs to do to create a liquid secondary market in its token.
- Liquidity Incentivization (optional but important): Liquidity incentivization referral to a broad set of programs that the token issuer can run to kickstart usage of the issuer’s product/ service. In its most popular form, users are able to earn tokens by doing some actions (e.g. becoming liquidity providers a platform). While liquidity mining is in vogue currently and seems to create strong incentives for people to support a platform, there is no reason why other incentivisation mechanisms won’t work here.
Case Study: mStable Initial Dex Offering
mStable team conducted the initial sale of its MTA token through an auction mechanism. Of the 100 million token supply about 2.6 million of the total was put up for an open auction. Individuals were allowed to put in their bids 24 hours prior to the sale occurring. Once a pre-agreed time came, sell orders were issued to match each of the bids on Mesa – a platform for auctioning tokens designed by Gnosis. The capital collected during this sale is then handled through a DAO. The auction model is used to determine the price of the asset when it is listed on a Balancer pool.
The team from mStable also allocated a large amount of tokens to offer incentives to individuals offering liquidity in MTA pools on Balancer. Previously, the value that is being currently passed to the liquidity providers would have been captured by a centralised exchange and/ or professional market makers.
One of the advantages Mesa offers in comparison to a conventional ICO is that it limits people front-running. How does this occur? Where ICOs used to be vulnerable to individuals doing transactions with large gas costs, Mesa orders matches on the basis of time a bid is made. This makes it possible for everyone to have an even opportunity at acquiring the tokens as long as the bid is high enough.
How are IDOs different from ICOs & IEOs?
Initial Capital Offerings (ICOs)
ICOs can be thought of as the crypto version of crowdfunding. A major part of conducting an ICO was to run a marketing campaign to create awareness and interest in the issuer’s project. The complete absence of regulations meant a lot of bad actors too took advantage of this innovation to raise capital.
Moreover, a successful capital raise wasn’t sufficient. Post ICO, the project team had to work with centralised exchange to get their tokens listed. This entailed substantial listing fees. Further, listing on exchange came with requirements for ensuring “liquidity” in the token, which had its own costs.
Initial Exchange Offerings (IEOs)
ICOs eventually gave way to IEOs. The pitch was simple. Exchanges will curate good projects on the basis of internal due diligence and let these projects leverage the exchange’s distribution to raise capital. Moreover, listing of the token on the exchange is usually part of the IEO. So, exchanges served as intermediary between the token sellers (projects) and token buyers (exchange’s customers) and helped to alleviate the major pain points in ICOs. Basic due-diligence combined with assured secondary market liquidity is quite attractive for buyers. And, projects are willing to pay for access to the exchange’s customers. While it does appear that IEOs are better than ICOs, the centralisation of power with the exchanges is a risk. Much like VCs, exchanges become the gatekeepers to decide which projects get listed.
IDOs vs. ICOs vs. IEOs
IDOs shine in three areas: (a) given the permissionless nature of DeFi, any project team can do an IDO if it so chooses, (b) a liquid secondary market for the token can be taken as a given and (c) combination of secondary market listing with liquidity incentivisation schemes can create powerful feedback loops to drive growth.
It is important to note that for the token to be successful, both secondary marketing liquidity and an effective liquidity incentivisation scheme are required. And, a functioning product is a prerequisite for a liquidity incentivisation scheme to exist. This means it would be quite difficult for a project to do an IDO purely driven by a marketing hype machine. This factor alone helps to weed out bad actors that misused ICOs to scam investors.
Interestingly, the permissionless nature of IDOs also presents a challenge. Depending on the economics, certain tokens could be considered securities. Since securities laws generally are not very clear on cryptographic tokens, projects typically block investors from more aggressive jurisdictions like the US. While this could be done relatively easily for IEOs, this is just not feasible for DEX offerings.
The Future of IDOs
Can initial DEX offerings become the go-to method for crypto projects to raise capital, like ICOs and IEOs were previously? The answer is nuanced.
Firstly, as we highlighted earlier, IDO route is suitable only for projects that have a functioning product. This means projects that are pre-product or are looking to raise funding on the basis of a whitepaper will not be able to rely on IDOs.
As of now, only DeFi projects have raised money through IDOs. There’s no reason why projects from other areas of the crypto ecosystem too can raise funding through this route. That said, these projects will have to attract existing DeFi users to invest in the project’s tokens. This is the case because using DeFi platforms entail a learning curve, which will serve as a barrier to entry for an average crypto trader/ investor.
Lastly, despite the recent explosive growth, DeFi is still a relatively small niche in crypto. DeFi users are a small fraction of the number of crypto investors. IEOs on Binance were successful because Binance has millions of users. That made getting the word out about a token sale pretty straight forward. The same cannot be said about DEXs like Uniswap or Balancer which are hugely successful in their own right. Therefore, unless the addressable investor segment expands significantly, IDOs are unlikely to become a reliable channel for raising capital.
Initial DEX Offerings are certainly a powerful innovation. But the true power lies in the combination of secondary market liquidity for tokens on AMM based exchanges and liquidity incentivisation schemes. Together these two can create strong feedback loops that can lead to massive adoption and growth. Projects can potentially raise capital through other channels such as private token sales and then use the DEX route for secondary market liquidity. This path may be more viable for non-DeFi projects.
Overall, our sense is that IDOs are unlikely to become a major capital raising channel for crypto projects. Even if the current bullishness around DeFi and liquidity mining led growth continues, the kind of capital that can be raised through DEX offerings is not going to come close to the scale of capital raised through ICOs. That said, we do expect many projects to leverage AMM based exchanges for facilitating secondary market liquidity in their tokens. And, we also expect to see various variations of ‘liquidity mining’ to bootstrap their platforms.
About the authors
Jitender Tokas: is the Co-founder and Chief Business Officer of Delta Exchange. Prior to starting up, Jitender was a stock analyst with Citi and has over a decade of experience in financial markets. You can follow him on Twitter.