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IEO vs ICO vs IPO vs STO vs Traditional or Debt Offerings

Jeff Dorman, CFA
May 28, 2019
Note: I first posted the content below in a 40-tweet thread on Twitter. Due to the overwhelming positive response, our team has decided to turn my tweet into a blog post. 
 
Every crypto investor is chasing IEOs ($CELR, $MATIC, $BTT, $FET and soon Harmony). I worked on capital markets desks and syndicate desks at Lehman & Merrill for 2 decades. I'd like to clear up a lot of misconceptions that I've been hearing from others.
 
This is not advice nor even an opinion on any of the specific IEO investments. It is simply an explanation of the capital raising and syndication process based on my past experience.
 
Preface: Many argue (correctly) that IEOs are illegal (in the US) since the tokens are clearly securities, & unregulated exchanges are acting as broker/dealers. Thus, U.S. investors can't participate. This article does a nice job explaining B/D rules:  https://www.linkedin.com/pulse/looming-sec-ieo-fintech-smackdown-john-reed-stark/ 
 
Further, we all know regulation is coming, and for good reason. @arca 's own @PhilipLiu explains this further:  https://www.ar.ca/blog/reading-the-merkle-leaves-2-19-19 .
 
BUT, let's assume there are no legal issues. I want to explain HOW these tokens are priced & distributed. Traditional equity / debt offerings have the following players:

1) Issuers
2) Investment bank (Underwriter)
3) Cap Mkts desk
4) Syndicate desk
5) Market Makers
6) Investors
 
1) The issuing company needs to raise capital. Thus, they will choose an underwriter who gets them the most money (best price). This is not the best price for investors. The issuers' goal is to raise as much as possible, at the cheapest cost to themselves.
 
In bonds, that means largest amount sold at the lowest coupon with the least restrictions. In equities/tokens, it means highest price/share (price/token). The issuer only cares about investors if they need to raise money again in the future (i.e. don't kill the golden goose).
 
With token sales, you can argue that issuing companies/projects have more of an incentive to appease investors, since buyers will ideally be users and evangelists of the platform -- but let's not kid ourselves, they still want to raise money at the best price first.
 
However, unique to tokens vs equity/bonds, the issuer usually owns the majority of non-sold tokens, as do the Exchange and Market makers. So as an investor, you are at least aligned with those that control your fate. Whereas with debt/equity, that's not always the case.
 
2) The inv bank has to win the business first. So they pitch issuing companies and make statements regarding the price they think investors will pay-- this may not actually come true (it's "best efforts" typically). But they steer the issuing companies to a desired outcome.
 
The level of due diligence these underwriters perform is typically not to protect investors. It's to protect themselves. They get paid only if the security is sold - so they are incentivized to "pass due diligence". They turn down business only if they find a GLARING red flag.
 
In IEOs, the Exchanges are acting as investment banks. Sure, their due diligence is probably better than the average retail investor, but again, it's a CYA policy, not a statement of merit regarding the issuer or the investment. Do your own research.
 
3) Once the investment bank wins the business, the capital markets desk takes over. It's their job to figure out the "clearing price" and the best structure of the investment that investors want. This usually involves relative value, competitor analysis, and market conditions.
 
If it's a "hot deal" (like $FB IPO), the cap mkts team may "buy the offering" -- meaning they buy the whole deal at a price below where they think they can re-sell it. In a bidding war, the investors usually get a worse price b/c the investment bank had to pay up to win the deal.
 
Again, the Exchanges do this themselves, but w/out a lot "comps" to compare tokens too, and w/out a lot of competition for business. The price they choose to offer the IEO at is somewhat arbitrary, but at least they aren't bidding up the price ahead of offering to investors.
 
Recall, the issuing company just wants highest price -- but the capital markets desk (or Exchange) needs to also appease investors. Unlike the issuer who may never issue again, the Exchange/cap mkts desk will ALWAYS issue again. So now you have a tug-o-war.
 
The Issuing company wants highest price, but the underwriter wants a lower price to ensure the security trades higher -- the happier investors are, the more likely they will buy future deals. This is why most IPOs, bond deals and now IEOs trade up in the first few days/weeks.
 
BUT they don't care what happens 3 months later. Underwriters measure success based on what happens immediately AFTER the deal prices, not in the future. After a certain amount of time, the price of the security is "out of their control", and absolve themselves of responsibility.
 
Most cap markets desks have pitchbooks that show how their deals perform 1-day, 7-days, 30-days after pricing. They don't care after that -- their job ends after the initial burst. Their incentives differ from the investors who probably have longer holding periods.
 
is doing the same thing now -- showing performance of their deals (with an assist from @lawmaster). This appeases issuers (who have confidence it will succeed) and investors (who start to believe no deal will ever fail).
CZ Binance Tweet crypto project chart - ICO vs IPO

The good news for investors: w/out competition, Binance holds all of the power. Issuing companies are at the mercy of the Exchanges' advice. But this will change when competition increases. Plus, people are greedy. Someone will kill the goose (read -->  https://www.ar.ca/blog/crypto-market-recap-04-01-19 )

4) Syndicate desks are in charge of allocating the security. They talk to investors before a deal prices, and try to gauge preliminary interest. They typically have half or more of the new issue spoken for before they even announce it publicly to reduce the risk of failure.

Clearly, in the case of Ocean Protocol, their first underwriter (CoinList) and second underwriter (Bittrex) didn't have a good pulse on market conditions OR hadn't earned investor trust like Binance has (thus far). This is why it was a disaster  https://blog.oceanprotocol.com/what-happened-with-the-ieo-54cc5c6c3db9 

$LEO on the other hand soft-raised all of the money quietly before even announcing the deal to the public, to ensure that it was a success. And you know they have market makers and investors ready to buy every token if it dips below $1.00 to ensure that this never trades down.

For investors, a new issue is like a call option - never exercise early. So you are incentivized to wait til the last minute to put your allocation in to gather as much information as possible about how the deal is going and who else is investing. Big investors get away w/ this.

BUT, since all new issues (debt, equity, tokens) are about hype - this won't shock you. Underwriters lie all the time! They tell you every deal is oversubscribed whether it is or isn't, in order to entice investors to allocate capital to the deal. They create sense of urgency.

The syndicate desk may offer better terms to early investors, or will guarantee allocations to future deals, or will flat out lie that it is already oversubscribed just to create that sense of urgency. That's why you get 1000 updates throughout the process. They create FOMO.

If a deal is going well, you may request more than you want because you'll get scaled back. If the deal is going poorly, you may put in for less or not at all. But only the syndicate/underwriter really knows the true demand. It's guesswork for everyone else.

This hasn't been really necessary yet with Binance IEOs b/c demand has been off the charts and investors are capped, but it's coming. It may have happened with $LEO(fake high demand created real demand). Syndicate desks are trained liars to instill that sense of urgency.

It's true gamesmanship to get a lot of people to commit to something all at once... easier said than done. But once the demand is truly there, the deal can be priced and will start trading.

5) Once the deal prices & starts trading, the market makers take over. In debt/equity deals, the market makers work for the underwriter, and as such, are focused on appeasing investors by ensuring that the deal doesn't trade down.

Typically, the underwriter builds a short into the offering (they sell more than the issued amount) so they become natural buyers on the break. They will lose money covering their short at higher prices than where it priced, but that comes out of the inv bank's underwriter fees.

With tokens, the market makers are "independent" - so they have to be incentivized other ways. They are given tokens, and are thus incentivized to push prices higher to help themselves. The issuer (& maybe the exchange itself) provides them with capital to cover any losses.

The syndicate desk must warn the market makers about the investors who bought. How many will want to buy more, how many will "flip" it immediately for a quick profit? The success of a new deal will largely be determined by how well the syndicate desk prepares the market makers.

But again, this "defending of the price" only happens for so long. Ultimately, market forces take over, and it won't matter how much effort is put into the pricing and the bidding after the break -- ultimately if there are no "long term buyers", it is doomed to fail. #hotpotato

In debt/equity deals, the underwriter isn't the only market maker - all competitors will trade it as well. This hasn't happened yet with tokens, but Binance can't underwrite AND dominate trading forever -- other exchanges will want these trading fees too.

Not only will this increase liquidity, but it means investors who want to flip won't have to flip it back to the underwriter. Binance knows if you buy through them and sell immediately -- and you won't get an allocation on their better deals if they know you are going to sell.

So it’s not just IEO vs IPO or ICO vs IPO etc., All in all -- these IEO tactics are not new, just slightly different. But those that are buying these new deals without understanding the mechanics are at risk. Hopefully this helps to shed some light on the capital markets process.

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