Equity Crowdfunding Software, Feature Insight of a White Label Equity Crowdfunding Software
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Master’s Degree Programme
Economia e Gestione delle Aziende
Curriculum “International Management” Second Cycle (D.M. 270/2004)
Final Thesis
The Evolution of Equity Crowdfunding
Through Blockchain Technology: The Bloomio case
Supervisor Ch. Prof. Giovanni Vaia
Graduand Giovanni Avogadro Matriculation Number 844580
Academic Year 2016 / 2017
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ThankstoIhadthechancetowork,butmostimportantlybecomefriends,withsomeofthemost
interestingandcapableindividualsI’veevermet;duringthecurseofthisunforgettable
universityexperience.Theyhavechangedmeprofoundly,andhelpedmetogrowintoa
new and better professional and individual. I owe a lot to them, and I am extremely
thankful.
Mygratitudegoesespeciallytomyfamily,thattaughtmetheimportanceofeducationand
themeaningoflearning.
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AbstractThenewconceptsbroughtupbytheintroductionofBlockchaintechnologyarechanging
many industries at once, with the promise of democratization and of the increase in
transparency of company infrastructure and of operations. The equity crowdfunding
industryisoneoftheindustriesthatcouldberadicallytransformedbytheintroduction
ofthetechnology.
Throughthisthesis,wewillpresentanintroductiontotheconceptsbehindblockchain
technology, and equity crowdfunding. We will then analyse the limitations that the
currentmethodologiesandservicesassociatedwithequitycrowdfundingmightpresent,
andhowtheintroductionofthetechnologymightmitigatetheseinefficiencies.
WewillfinallyanalysethecaseofBloomio;aSwiss-basedequitycrowdfundingcompany,
which is the first one in theworld to have implemented blockchain technology in its
operations.
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TableofContent
Introduction………………………………………………………………………………...1
CHAPTERIBlockchainTechnology,aFocusontheEthereumNetwork…………..2
1.1.Trust……………………………………………………………………………………....31.2.DigitalSignature………………………………………………………………………....51.3.HashesandtheSequenceofTransactions……………………………………………...71.4.ConsensusandMining...………………………………………………………………....71.4.1.TheMiningProcess………………………………………………………………....81.4.2.NakamotoConsensus…………………………………………………………….....91.4.3.PermissionlessandPermissionedConsensus……………………………………....91.5.Ethereum………………………………………………………………………………..111.5.1.Accounts…………………………………………………………………………...121.5.2.TransactionsandMessages………………………………………………………131.5.3.SmartContracts…………………………………………………………………...141.5.4.SmartIdentity……………………………………………………………………..181.5.5.SmartProperty…………………………………………………………………....191.5.6.EthereumVirtualMachine(EVM)………………………………………………..191.5.7.Ether………………………………………………………………………………201.5.8.Gas………………………………………………………………………………....201.5.9.ConsensusProtocolinEthereum…………………………………………………211.5.10.Security…………………………………………………………………………..24
1.5.11.ScalingonEthereum…………………………………………………………….251.6.ThePotentialofEthereum……………………………………………………………..26
CHAPTERIICrowdfundingMechanismsanditsLimitations………………………30
2.1.CrowdfundingPlatformsandIntermediaries………………………………………...312.2.EquitybasedPlatformsanddifferentBusinessModels……………………………...322.2.1.Peer-to-PeerContributionMechanism…………………………………………..362.2.2.EquityBasedandRoyalty-BasedModels………………………………………...382.3.DifferentServiceModels………………………………………………………………412.3.1.ServiceModularization…………………………………………………………...422.3.2.ServiceModulesforCrowdfunding……………………………………………….422.3.3.PlatformInteractionandServiceProvision……………………………………...452.4TheGrowingIndustryofEquityCrowdfunding………………………………………472.4.1AdvantageswithRespecttoVentureCapital……………………………………..482.5.Inefficiencies……………………………………………………………………………522.4.1.MicroeconomicChallenges………………………………………………………..522.4.2.RisksAssociatedwithCrowdfunding…………………………………………….55
VI
CHAPTERIIICrowdfundingIntegratedinaBlockchain-BasedEcosystem:DecentralizedApplications(DApps)........................................................................58
3.1.Functionality,StructureandDesignofaCrowdfundingDApp……………………....593.1.1.FunctionsPerformedbytheDApp………………………………………………...603.1.2.EquinityCrowdfundingDAppRelationalStructureintheNetwork……………..683.1.3.ServicesandFunctions..……………………………………………………...........693.2.Blockchain-BasedEquityCrowdfundingEnvironments:BusinessandInteraction
Models…………………………………………………………………………………..703.2.1.Peer-to-PeerContributionMechanismTroughaDecentralizedApplication……713.2.2.Equity-BasedorRoyalty-BasedContributionMechanismTroughaDecentralized
Application........................………………………………………………………...723.3.ServiceModulesforCrowdfundinginaBlockchain-BasedEcosystem……………..733.3.1.ServiceModulesImplementedwithBlockchainTechnology…………………….743.3.2.PlatformInteractionsandServiceProvision…………………………………….773.4.EffectsofDecentralizedApplicationsonCrowdfundingInefficiencies……………..793.4.1.MarketInefficiencyReductionwithBlockchainTechnology……………………803.4.2.MarketInefficienciesThatCouldBeSoftenedbyDAppFunctionalities……….. 823.4.3.FinancialRisksThatCouldBeSoftenedbyDAppFunctionalities……………….88CHAPTERIVBlockchain-BasedEquityCrowdfundingPlatform:TheBloomioCase………………………………………………………………………………………………..92
4.1.The“CryptoValley”Regulation………………………………………………………..934.1.1.CryptoValleyAssociation………………………………………………………....934.1.2.FINMAinterpretationandLegislationonTokens……………………………......964.2.TheOriginofBloomio,TheVisionoftheFundersandtheLegalBattle…………......994.3.CompetitiveAdvantageandKeyFeatures…………………………………………...1014.3.1.CompetitiveAdvantages…………………………………………………………1014.3.2.BloomioKeyFeatures……………………………………………………………1044.4.FutureDevelopments……………………………………………………………......1074.4.1.TheFutureofBloomioandtheCryptoValley………………………………..…107
Conclusion………………………………………………………………………………...111
References…………………………………………………………………………….….113
ListofFigures…………………………………………………………………………....120
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Introduction
TheinventionoftheDatabasebyIBMin1970,revolutionizedtheworld;somuchthat
right now, every aspect of our societydepends on this idea of recovering and storing
information.
Blockchainisnowabouttorevolutionizedatabases,whichwillinturnrevolutionizeagain
everyaspectofoursociety.
Blockchainisaboutcreatinga“database”whichisaccessiblebyanyoneoranythingatany
time,working like a network instead of having a single point of failure. The secret is
Decentralization.
Decentralization offers the chance to individuals to interact and cooperate with each
other,withouttheneedofacentralauthorityoramiddleman.
Thisnewtechnology is influencingstepbystepmany industries,andthepromiseofa
democratizationoftheworldisincreasingitsnotorietybytheminute.
Wheneverthemiddlemaniseliminated,efficiencyrisessubstantially.Theneedtoscalein
ordertosatisfythehugesupplychainswehavecreated,makesusrelyondealsmadeon
humongousquantities.Blockchainanditsdecentralizedsystemwouldchangethat,and
wouldhelpsmallbusinesstocompetewiththeindustrygiants.
Thetechnologyisstillnewandnoteveryonehasacompletegraspofitsfunctionalities,
potentialandfuturedevelopment.Eventhoughthetechnologyisalmost10yearsold,we
arejustseeingnowthefirstattemptstotransformitinsomethingvaluableforcompanies
butmostimportantlyforpeople.
Asitfrequentlyhappens,regulatorsarebeingscepticalandslowinthedeterminationof
the legal boundaries of the technology, but this is not scaring industry giants and
innovationenthusiastsintheexplorationofit.
Many industries are changing to adapt to this innovation, but the first industry to be
affectedisofcursethefinancialone.Giventhenatureofthetechnology,thecrowdfunding
industryisalsochangingratherrapidly; it isacceptabletobelieve,thatthisecosystem
andtheworldeconomy,willundergoextremechangesinthenextfewyears.
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CHAPTERI
BlockchainTechnology,aFocusonTheEthereumNetwork
“Sayingthatblockchainisanewformofdatabase,islikesayingthat
e-mailisanewwaytosendpeopleletters”BillGates,2017
Blockchainisapublic,trustedandsharedledger(TheEconomist,2017).Sharedsinceit
isbasedonpeer-to-peernetwork,meaningthatitisnotcontrolledormanagedbyasingle
individual,butbyallitsparticipants.Itisavailabletoall,hencepublic;anddatacannotbe
manipulated without being approved by everyone in the network, which makes it a
trustedledger.Thisspecificsetofattributes,maketheBlockchaintechnologynotonly
moresecurewhenmanagingsensibledata,butalsoabletoeliminateintermediarieswhen
transferringinformationinadecentralizedmanner.
Blockchaintechnologyisusuallyassociatedwiththevirtualcryptocurrency“Bitcoin”but
thepotentialofitisnotnecessarilyassociatedwithcurrencytransactions.Blockchaincan
beadaptedtofitmanyindustriesandbusinessmodels,butmostimportantly,itcanbe
used to create organizations able to support themselves in a complete decentralized
matter.
TheBlockchainhasbeenofinterestformanypeoplesinceitcameoutin2009.Itispart
ofthe4thindustrialrevolutioncharacterizedbyafusionoftechnologiesthatisblurring
the lines between the physical, digital and biological sphere (Schwab, 2017), full of
disruptionanddisruptors, and togetherwithmanyothershas thepotential to impact
heavilyonsociety.
Blockchain can be defined as a “distributed database or ledger”, which uses a secure
protocol where a network of servers, also called “Nodes”, collectively verifies a
transactionbeforeitcanberecordedandapproved.Therefore,blockchainscanbeused
to create trust, not reliable on a thirdparty anymore, but on the technology itself; by
enablingpeoplewhodonotknoweachother(andthushavenounderlyingbasisfortrust)
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tocollaboratewithoutgoingthroughacentralauthority(Schwab,2017).It isashared
databasecontrolledbythenetworkwithnoindividualpartyexercisingcentralcontrol.
Innon-technicalterms,ablockchaincanbeseenasalargeandtransparentspreadshit,
wherealltransactionorassetsofanorganizationarechronologicallyandpermanently
stored since the creation of that entity. All the transactions are also maintained and
verifiedbyallpeersinadecentralizedway,makingitextremelytransparentandglobally
recognizedastrue.
To better understand this technology and its process, we want to go deeper in the
descriptionofallthemostimportantcharacteristicsandtermsassociatedwiththisnew
technology.
1.1.Trust
Twopreconditionoftrustareriskandinterdependence(Chen&Dhillon,2003).There
hastobeinfactinterdependencebetweenthetrusteeandtrustor.Ifthat’snotthecase,
nomatterhow intricate theiractionsare, theydonoteffectoneanother.Moreover, if
thereisnouncertainty,noactionbythetrusteecanchangetheevents,andthus,notrust
isneeded.Trust canalsobedefinedas a two-sided, asymmetric relationshipbetween
entities;thetrusteeorrecipientofthetrustcanbeanything,fromaperson,anobject,a
process or a computer algorithm. Sometimes though, the trust relationship has to be
constructed from both sides of the relationship. Trust has also a scope and can be
contingenttospecificcircumstances;thatdefinesunderwhichrulesoroccasionswemay
wanttotrustsomeoneorsomething,andwhatactionswetrustthemtoperformonour
behalf.
Intheeconomicexchangeworld,wecanfindthreedifferenttypesoftrust:institutions-
based,characteristic-based,process-based.
Institution-basedtrust:
Institution-basedTrustcomesfromanauthoritythatiscentralized.Thisistheexample
ofacommercialbank,thatwetrusttomanageourmoneyasacentralizedinstitution.
Characteristic-basedtrust:
Characteristic-basedtrustisthetrustwehaveinsomepeoplebecauseofthesimilarities
betweenoursandtheircharacteristics,taste,origin,orevenvaluesinlife.Wetendtotrust
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morepeoplewithasimilarbackground,andthatsharesimilarperceptionoftheworldto
ours.
Process-basedtrust:
Process-basedtrustisrootedintosocialmicro-rulesandnorms,accordingtowhichwhen
facing a known interaction with someone, we are able to theoretically predict the
responsebythecounterpart.Forexample,weexpectsomeonetoanswerwhenaskeda
question.
Consequently,giventhedifferencesinthetypeoftrust,therearealsodifferencesinthe
typeoftrustfaildependingonthetypeoftrustwearefacing.Trustcanbelostifacentral
organizationfails,ifthepersonyoutrustfails,orifthetheprocessyoutrustfails.
On-linetrustassumesanevenmoreimportantrole,since:
“Thedegreeofuncertainty,dependency,andriskishigherintheon-lineworld
thanintheoff-lineworld”ZainabM.Aljazzaf,2010
Uncertaintyanddependencyassumeanevenstrongerroleintheon-lineworld,where
traditionaltechniquestoholdtrustdonotholdanymoreandtrustworthyrelationships
arecreatedaroundareputationsystem.
InusingBlockchaintechnology,peoplemayfindithardtotrusttheprocessoracomputer
program,butsomeofthemaredrowntotrustthetechnologywhenfriendsorpeoplethat
share a similar vision and interact in the same sphere become early adopter of the
technology. Note that the types of trust involved in this type of relationship are
characteristic-basedandprocess-basedtrust,thatcomposethemixoftrustrelationship
thatevolvearoundblockchaintechnology.
Weneedtorememberthatisnotthetechnologyitselfthatdefineswhatisreallytrue,and
itcouldoccurthecaseinwhichnoteverythingthatisontheblockchainistrue.Whatthe
blockchaindoesinfact,isverifythatacertaindatawasinputtedinthesystemataspecific
momentintimeandstorethatinformationforever,butitcannotguaranteethatthatpiece
ofinformationisnecessarilytrue.Theonesthatdefineifthatinformationistrueornot,
aretheusersinsidethenetwork,thatvalidatethetransaction.
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Blockchainaffectstrustinseveralwaysinthebusinesscontext.Theprotocollayerand
thebusinesslayeroftheblockchain,bothaffecttrustanditsperceptioninthesystem.In
theprotocol layerwecanhave twomajorbenefits,namely transparencyandsecurity.
These two characteristics aremadepossibleby the technology, through theuseof its
system of immutable history of transactions and the use of public and private keys1.
Security canalsobe increasedbydecentralizationandencryption,making the system
moreprivateandsafer.Securityandtransparencycanbeconsideredsomeofthemost
importantcharacteristicofthistechnology,thatdirectlyinfluencetrust.
In the business layer instead, trust is affected by the creation of rules, rights and
restrictiontouser’sactions,thatcanbeimplementedinthecodeoftheprogramsthat
regulatethetransactionscalledsmartcontracts2,thatcanimprovetrustorevenmakeit
pointless.
1.2.DigitalSignature
Thedigitalsignaturescheme,inventedbyWhitfieldDiffieandMartiHellman,explained
intheirseminalpaper:“NewDirectionsinCryptography”,isthedigitalcorrespondentof
apapersignatureused in theblockchain transactionsystem.Through it,everyuser is
allowedtohaveoneormore“publickey”and“privatekey”.
Apublickey isapubliclyavailablekey, in the formofastringofbits. It is likeabank
accountnumber,anyonecanseeit,anditisassociatedwithonepersoninparticular;itis
thanatraceableandtransparentwaytoidentifyaperson.Theprivatekeyontheother
hand,isstillastringofbits,butitisonlyavailableandvisible,tothesingleuser,itcanbe
definedasadigital IDthanonlytheuserholds,andnooneelsecan. It isadigitaland
uniqueidentificationforanindividualoramachine.
Publicandprivatekeycanbeusedinthevalidationofatransaction,inwhichbothparties
involvedagreeontheexecution.Thetransactioncanbeatransferofcurrency,property,
data,orasimplecommunicationortheexpressionofaright; thisentitlestheusersto
determinewhethertheywanttobeinvolvedinthattransactionornot.
Thissystemwascreatedtoallowforahighlevelofsecurityandtransparencyandtomake
surethatbothpartiesinthetransactionareprotectedandawareofthetransaction.The
processofvalidationofatransactioncanbesummarizedassuch:
1Section:1.2DigitalSignature.2Section:1.5.3SmartContracts.
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1) Thetransactionisbroadcastedbythesendertothenodesinthenetwork.Each
transactionisprotectedbya“digitalsignature”.Transactionsaresenttothepublic
keyofthereceiverusingtheprivatekeyofthesender.Byusingapreciseprivate
key,thesenderisprovingtheownershipofthatprivatekeylinkedtohisidentity.
The receiver of the transaction verifies the digital signature on the transaction
throughtheuseofhisownprivatekeyprovinghisidentityanddemonstratingthat
heacceptedthetransactionandisawareofit.
2) Onceitisacceptedbythepartiesinvolved,thetransactionissenttoallthenodes
intheblockchain,thatcheckitandapproveitmakingsurethatalltheconditions
inside the transaction are met to be recorded permanently in the system.
Consensus3betweenthenodesinsidethenetworkisnecessaryforthevalidation
andtranscriptionofthetransactioninthepublicledger.
Wewilltakeacloserlookattheconceptof“Consensus”insection1.4,butforthesakeof
clarity,wecansaythatconsensusmeansthatbeforerecordinganytransactionsinthe
public ledger, verifyingnodes4have to agreeon the truthfulness and feasibilityof the
proposed transactions before recording it in the ledger. One of the conditions for the
transactiontobefeasibleforexample,istoensurethatthespenderowntherightamount
of currency; hence that he has sufficient funds to support the transaction. Evenmore
important condition for the system to certify a transaction, is the presence and the
validationofboththesignaturesofthepartiesinvolved.
Theuseofsignaturesisnotlimitedtocommercetransactions,butcanbeusedforevery
formofofficialtransaction,infactwiththissystem,allsortsoftransactionsandtransfer
ofownershipcanbecarriedoutdigitally.Digitalandpaperbasedsignatureshavetwo
important characteristics in common; they both guarantee that a defined piece of
informationpassed fromonesite toanotherwithoutbeingaltered;and theycanboth
allow the receiver toprove toa thirdparty thathe received thatpieceof information
directlyformthesigner.Themaindifferenceliesinthefactthatthetraditionalmethods,
relyonthecertificationofthetransactionbyatrustedthirdpartylikeabank,alayerora
notary; in the case of the blockchain on the other hand, transaction validation is
performedbythenetwork,inadecentralized,transparentandsecureway.Furthermore,
3Section:1.4ConsensusandMining.4VerifyingNodes:Nodesinthenetworkdevotedspecificallytothevalidationoftransactions.
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information about all transactions and interactions, are secure and not guarded by a
single individualbutbythewholesysteminadecentralizedmatter. Wewouldliketo
inform the reader, that the similarities to the traditional system of certification of
transactions, ledtothecertificationbytheunitedstatesofDigitalSignaturesaslegally
binding5.
1.3.HashesandtheSequenceofTransactions
The Blockchain construction is composed by “blocks” containing all transactions; this
means that every transaction ever made on the platform is stored in groups of
transactionsthathavehappenedatthesametime.Theseblocksarelinkedtoeachother
inside the blockchain, creating a chronological order of transactions that are secure,
immutable,anduntouchable.
Havingthisconceptinmind,thechancemightbethatoneormoreuntrustworthynodes
willmakeparalleltransactions,sendingthesameamounttotwodifferentrecipients.This
actiscalleddouble-spending,andamechanismisestablishedtoavoiditfromhappening.
Themechanismthatpreventthesesituationsfromhappeningiscalledmining;basedon
theproof-of-work(PoW)schemethatwewilldiscussinthenextsection.Beforewego
intodetailwithminingandPoW,wewanttoexplainwhatdefinesthechronologicalorder
betweentheblocksintheblockchain.
Toensure thatallblocks followeachother in thedefinedorder, eachblock isgivena
“hash”thatwilldeterminetheorderoftheblockinsidethechain.
Thefirstblockiscalledthegenesisblock,andeachblockthatfollowedcontainsthehash
ofthepreviousblock.Thechainofhashes,constitutesthe“chain”inblockchain.
1.4.ConsensusandMining
Theuseofconsensusisnecessaryformanyfunctionsbotheconomicandsocial.Thereare
benefitsandempowermentforeveryonetrustingasingleledger,startingfromafaster
way to reach a settlement, or the elimination of fraudulent actions. Traditionally,
consensusisgivenbyacentralauthoritylikethegovernment,notaryagencyandsoon,
but the traditional system is expensive, labour-intensive and centralized. What the
blockchaintechnologyaimsat,iscreatingaconsensussystemthatischeaper,democratic
andlessrisky.Thisisdonebymakingconsensusdecentralized,makingitmoresecure,
5http://usinfo.state.gov/opical/global/ecom/00063001.htm
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and creating rewards for maintaining it cost effective; improving processing power,
withoutincurringintoomuchsocialcosts.
Consensusmeans thatnodesagreeon the samestate6all the time (HenningDiedrich,
2017),andtheorderinwhichtheblocksoftheblockchainshouldbeput.Allthenodesin
chargeofconsensus,needtoagreeonthetruthoftransactionsandontheorderofthe
blocksthatcomposetheblockchain
Theonesthatneedtoachieveconsensusarethesocalled“miners”,andtheyarethenodes
thatdecidetotakeparttotheconsensusbuildingmechanism.Throughthismechanism,
valid transactionsare selectedby thenetwork to composeablockwhichminers than
validateinordertomakeitabletoattachittothenextavailablespotintheblockchain.
1.4.1.TheMiningProcess
Wewillnow try togiveamore indepthdefinitionofminingandexplainwhy it is so
importantforthecreationofthechain.
Miningistheprocessthroughwhichtransactionsareverifiedandonceverified,stored
insidethepublicledger(Sterry,D.R.,2012),andthemethodfortheextractionandrelease
ofcryptocurrency.
Theminingprocessconsistsintheaggregationoftransactionsintoablock,andusethe
computing power at the disposal of theminer, to find the solution to amathematical
problem.Theresultofsuchamathematicalproblemwillbetherighthash,meaningthe
hashthatisconsequenttothehashofthelastblockattachedtotheblockchain.
Minersneedtowintheminingprocess(theracetofindtherighthash)tobethefirstone
to attach the new block to the blockchain.Whoeverwins themining process,will be
allowedtobroadcastthenewblocktotherestofthenetworkupdatingthechain;this
way, only real and approved blocks can be put on the chain, avoiding the creation of
maliciousblockswithfalseinformation.Thewinneroftheminingrace,isalsoreworded
withcryptocurrency;thisprocessallowsforthedistributionofnewcoinsinthesystem,
andatthesametimeprovidesanincentivefornodestoparticipatetotheminingprocess.
Without this incentive, theminingprocesswouldbe tooexpensive in termsofenergy
consumption,topushnodestominetransactions.
Theminingprocessforthefindingoftherighthash,usuallytakes10minutes.Withthe
increasingof the velocitywithwhichmines are able to findhashes, themathematical
6State:isthetotalityofthedataandthetransactionsthathavebeenwrittenontheblockchainsincethegenesisblock.
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problems to be solved become harder, in order tomaintain the hash finding process
aroundtenminutes.
1.4.2.NakamotoConsensus
TheconsensusprotocolofBitcoinisalsocalledthe“Nakamotoconsensus”,namedafter
thecreatorofBitcoinsSatoshiNakamoto(NakamotoS.,2008).Nakamotoconsensuscan
bedefinedwithasentenceas:“thelongestchainwins”.Tounderstandthisdefinition,we
firstexplaintheconceptofafork.
Asweknow,consensusreferstothesituationinwhichallminersagreeontherightspot
inwhichanewblockshouldbeput,dependingonthehashthattheblockisassociated
with.Thereistheremotepossibilitythough,inwhichtwominerswillfindthesolutionto
the mathematical problem - and hence the right hash - at the same time. In these
situations,thechainsplitsandcreatedwhatiscommonlyknownasa“fork”,whichcanbe
resolvedthroughdifferentmethodsdependingonthenatureoftheledger.Inthecaseof
theBitcoinledger,minerskeepminingonbothbranchesofthefork,butwilltrytoattach
theirnewblocksonlytothebranchoftheforkthathasthemostblocksattachedtoit.
Afteracertainnumberofblocksaremined,thebranchwiththemostnumberofblocks
attached to it wins, and the other branch is eliminated. This does not result in an
eliminationoftransactions,sincetheblocksthatareeliminated,areexactlythesameof
theonesthatarepresentonthewinningbranch.
1.4.3.PermissionlessandPermissionedConsensus
Therearedifferencesinthemodalitiesofparticipationtoconsensusbynodes,depending
on the type of ledger that is being created. Participation to the consensus can be
permissionless and permissioned; this difference affects deeply the reaching of
consensus.
Inapermissionlessledger,everyonecontributestoconsensus.Apublicblockchainsuch
as “Ethereum”7, is constructedas such. In aPublicblockchain, allparticipantshave to
reachconsensusovereverychangetothedata.Thismeansthateverytransactionhasto
beapprovedbyeverypeer,eveniftheydonotparticipatedirectlytothetransactionitself.
7Ethereum:isanopen-source,public,blockchain-baseddistributedcomputingplatformfeaturingscriptingfunctionality.ItprovidesadecentralizedTuring-completevirtualmachine,theEthereumVirtualMachine(EVM),whichcanexecutescriptsusinganinternationalnetworkofpublicnodes.
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Allpeershaveagreeduponacommonledgerandtheyallhaveaccesstoalltransactions
everrecorded.
Thissystemraisessomeprivacyissueseventhoughinformationisencrypted,together
with the effect on performance on transaction processing. The requirement of having
everymemberagreeonthestateoftheledgertakestimetoachieve,anditalsorequires
afairamountofenergy.
In a permissioned ledger, to the contrary, consensus power is given to a previously
selectednumberofnodes,onlytheonesthataredirectlyinvolvedinthetransaction.With
thissystemthere isa strongcontrolover thecirculationof information, resulting ina
higher degree of privacy. Furthermore, with having just a limited number of peers
obligated to reach consensus, theprocess results faster andmoreefficient.Consensus
definitionhereisbroadandconsidersthewholetransactionflow.Thissystemrequires
for different roles to be given to nodes when reaching consensus, differently form a
permissionlesssystem,wherepeershaveidenticalroles.
Eachpermissionedledgerhasitsownwaytovalidatetransactions,dependingontherole
thatisbeengiventothesinglepeer.
Within“Fabric”forexample,anothertypeofledger,wehaveclients,peers,orderersand
endorsers, thatrespectively invoketransactions,maintainthe ledger,orderupdatesto
the ledger to record new transactions, and check if new transactions fulfil certain
sufficientconditionstobeputintheledger.
Anotherblockchainsystem,called“Corda”,usesadifferentsystem,whereconsensusis
determinedbyvalidityanduniqueness.Specificallydevelopedsoftwareassociatedwith
thetransactiontakecareofvalidity,whetheruniquenessmakessurethatthetransaction
inquestionistheuniqueconsumerofallitsinputstate(Sanders,P.2017).Notarynodes,
ontheotherhand,reachconsensusoveruniquenesswithapluggablealgorithm.
Blockchainisawayforinformationtoberecordedandsharedbyacommunity(Deloitte
University Press, 2016), a community in which every member has a copy of the
informationandallmembersmustvalidateanychangecollectively.Theinformationcan
be anything that can be described digitally like transactions. Information in a public
blockchainaretransparent,permanentandsearchablemeaningthateachmemberofthe
communityisabletoviewallofit.Everyupdatecreatesanew“Block”thatcomposesthe
“Chain”.Newentriestothechainaremanagedbyaprotocolthatdecideshowtheyare
initiated, validated, recorded and in the end distributed, and sets the differences that
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characterizethedifferentledgers.
1.5.Ethereum
Theblockchaintechnologycanbeimplementedinmanydifferentways,andresearchon
thefieldhavecreateddifferentwaystoexploit it,creatingdifferenttypesofDLT8with
differentpurposesandconstruction.AtthemomentthreeofthemostdevelopedDLTs
are “HyperledgeFabric9” (Fabric), “R3Corda10” (Corda), and “Ethereum”11.TheseDLT
have different visions of the application of blockchain, especially because of the
differencesintherespectivefieldofwork.
DevelopersfromFabricandCordafocusonspecificapplicationsandconcreteusecases
(Sandner, 2017); Fabric focusses on creating a modular and extendable architecture
employable invarious industries, focusingonbankingandhealth care, over to supply
chain;whereasCordafocusesonthefinancialserviceindustry.
Ethereum on the other hand presents itself more independent than Fabric of every
specificfieldofapplication.WhatstandsoutforEthereumisnotit’smodularity,butthe
goalofcreatingagenericplatformforallkindoftransactionandfunctions.
Ethereum is ahighly flexibleDLTwith itsowncurrency, thatwith itspowerful smart
contractsiscapabletomakeitapplicabletoanykindofapplication.Thepermissionless
systemandthetotaltransparencyalthough,leadstoperformancescalabilityandprivacy
issues.
Ethereumhasamoregenericapplication,andit’sveryflexibleinternalsoftware,canhave
many applications and the capability of creating a “world computer”. Ethereum and
Bitcoin are both peer-to-peer networks, and share many characteristics, but some
conceptsandimplementationsdifferfromoneanother.Thesedifferenceshowever,make
itpossible forEthereumtosupportandprogramdigital contractsdefinedbycomplex
logic.ForthesereasonswewillfocusourattentiononthisspecificDTL,thattogetherwith
the related DApp (Decentralized Applications) and DAOs (Decentralized Autonomous
Organizations)ischangingandwillchangedrasticallythewaywedobusinessandhow
wehandlesensibleinformationandtransactions.
8DLT:DistributedLedgerTechnology.9https://hyperledger-fabric.readthedocs.io/en/release/10https://www.corda.net/11https://www.ethereum.org/
- 12 -
1.5.1.Accounts
AccountsisthesystemusedbyEthereumtorepresentownershipofvalue.Anyentitythat
holdsa state inside the system in fact, is associatedwithanaccount, thathas itsown
privateandpublickey.TheprivatekeyisthedigitalIDoftheowneroftheaccount,andis
neededtosigntransactions,certifyingtheidentityofthosewhosign;thepublickeyon
theotherhandistheaddressoftheaccount,whichispublicandworksastheaddressof
theaccount.
Accountobjectsarecomposedbyfourdifferentfieldswithspecificvalues.Dependingon
the typeofaccount, thevalues for these fieldschangeresulting indifferentproperties
(Wood G., 2014). These properties are: “Nonce”, a counter of the transactions and
contracts thatwent throughtheaccount; “Balance”, thevalueretainedbytheaccount;
“storageRoot”,theroothashofthe“MarklePatrishaTree12”,constitutingthestorageofthe
account;andthe“codeHash”,ahashofthecodethatshowshowtheaccountworks.
Accountsarethandividedintoexternallyownedaccounts(EOAs),andContractAccounts.
Externallyownedaccountsarecontrolledbyaprivatekeyandarepersonal,allowingfor
interactionbetweenprivateusers likeexchangeofcurrencyandmessages.AContract
Accountontheotherhand,isacomputerprogram,whichiscomposedbycodethatholds
thelogicthatcontrolsit(Ethereumfrontierguide,2016).
AContractAccountfunctionsasadepositaccounttostorevaluewhiletransactionsare
taking place on the platform, and can have different functions depending on the
informationandthecodestoredinsideit.WecanthinkofanexampleofContractaccount
ifweconsiderUser-A,whichwantstobuygoodsfromUser-B,butbothdonottrusteach
otherduringthetransaction.User-Aisabletoputthemoneyinapreviouslyconstructed
ContractAccount andwait for the goods to arrive.Once the goodshave arrived, both
partieswillsendanothermessageto thecontract, thatwillsendthemoneytoUser-B.
Untilbothpartiesapproveofthetransaction,themoneywillbelockedinsidetheContract
Account.InordertoavoidmaliciousactionsbyUser-Athatwouldnotreleasethemoney
evenafterreceivingthegoods,theagreementcouldbeconstructedsuchthatatrusted
thirdpartywillbeinvolvedtosettlethedispute.
12MarklePatrishaTree:acryptographicdatastructureusedtostoreallkeys.
- 13 -
1.5.2.TransactionsandMessages
InsideEthereumthereisadistinctionbetweenwhatcanbeconsideredatransactionand
whatcanbeconsideredaMessage.Thisdistinctionexistsbecauseof thetwodifferent
typesofaccountspresentinthenetwork.
Peersinsidetheblockchain,transfervaluethroughtransactions.Thesetransactionsare
generatedsingularlyandthendistributedtotherestofthepeer-to-peernetwork.
Inordertoavoidmaliciousactionsfromothernodesinthesystem,alltransactionsmust
be signed by generating account through the use of their own private key; this will
authorizethetransitionbythenodethatgeneratedthetransaction.
Transactionsinordertobecalledassuchmustcontainalltheinformationnecessaryin
ordertomakethattransactionuniqueandrecognizablebythenetwork;thismeansthat
they must contain: the total number of transactions sent from the senders account
(nonce), the price per computational step (gasPrice13), the maximum price for the
computationofthetransaction(gasLimit14),therecipientaddress(to),theamounttobe
transferred(value),thesignatureofbothparties(v,r,s),andspecifyifthetransactionwill
createanewaccountorwill refer toanalreadyexistingaccount (Data/Int) (WoodG.,
2014).
Messages on the other hand differ from transactions in the sense that they are
communicationsgeneratedby theexecutionof transactions.Messagesarrive fromthe
transactionthatgeneratedacontract.Massagesarenotneededtobesignedbecausethey
areneverbroadcasted to thenetwork,but theyare justpartof thesystemsexecution
environmentastheresultoftheexecutionofacode.Figure(1),showshowmessagesand
transactions interface with EOAs and contract accounts. As we can see, the external
ownedaccountistheoriginofalltransactions;messagesontheotherhandaregenerated
from contract accounts to the outside, and in between contract accounts; after been
triggeredbytransactionsinthecontractaccount.
13Section1.5.8Gas.14Section1.5.8Gas.
- 14 -
Figure(1):Messageandtransactionsinteractionsscheme.
Messages have a specific structure composed by elements that carry important
information necessary for the functioning of the process.Messages need to contain a
sender,theaddressofthecontractthatstartedthemessage;atransactionoriginator,the
addressoftheEOAthatcalledthesendercontractcodeexecution;arecipient,theaddress
of thebeneficiaryof themessage; thecodeaccounttobeexecuted, theaccountwhose
codeshouldbecarriedout,usuallyacopyoftherecipientcode;startGas,gasavailablefor
theoriginationofthemessage;value,thevaluetobetransferredthroughthemessage;
gasPrice,thepricenecessaryforthecomputationalsteps;data,optionaldataneededfor
themessage;depthofexecutionstack,theextentoftheexecutionload.(WoodG.,2014)
1.5.3.SmartContracts
SmartcontractswereinventedbyNickSzaboin1994,andrequiredacentralauthorityin
hisvisioninordertofunction.Withtheintroductionofblockchain,theyfoundanother
systemwheretheycouldbeimplemented.
WhatcharacterisesEthereuminfact,isthepresenceofthesocalled“SmartContracts”.A
smartcontractcanbedefinedasanagreementwhoseexecutionisautomated(SzaboN.,
1994),orastheyhavebeendefinedmorerecently:
- 15 -
“Acomputerized transactionprotocol that executes the termsofa contract.Thegeneralobjectives are to satisfy common contractual conditions (such as payment terms, liens,
confidentiality,andevenenforcement),minimizeexceptionsbothmaliciousandaccidental,
andminimizetheneedfortrustedintermediaries.Relatedeconomicgoalsincludelowering
fraudloss,arbitrationsandenforcementcosts,andothertransactioncosts.”(TapscottD.,TapscottA.,2016)
Such agreement is concluded between two actors as in a peer-to-peer, peer-to-
organizationorperson-to-machineinteraction.Assoonascertainconditionsaremet,the
contractwillbeexecutedandassets,ownership,orcurrencycanbeexchangedbetween
thetwoparties.Thetransactionresulting,isvalidatedbythemembersofthenetwork;
andthoughtthemethodswepreviouslyanalysed,storedinsidetheblockchain.
AccordingtoNickSzabo,smartcontractsinordertobedefinedassuch,needtohavethe
following characteristics: visibility, on-line enforceability, verifiability and privity.
Visibilitymeans thateachparticipant to thecontract shouldbeable toseeeveryone’s
compliancetothecontractandperformancewithrespecttothetermsofthecontract;this
meansthattheymustalsobeabletoprovetoathirdpartytheirfulfilmenttothetermsof
thecontract.
On-lineenforceabilityreferstotheprofofthefulfilmentofallthetermsinthecontract.
Inordertofulfilthistask,measurescanbetakenthancanbedividedinproactiveand
reactivemeasures.Proactivemeasuresmakeitimpossibletocrackterms,whilereactive
onesblockmaliciousbehaviour.
Verifiabilityreferstothepossibilitytoverifytheexistenceandthevaliditybyexternal
thirdparties.Verifiabilityofcontractsisnecessaryforconflictresolution.
Lastly,smartcontractsshouldbeprivate,meaningthatthecontentandconditionsofthe
contractshouldbeavailableonlytothepartiesinvolved.
The use of the smart contract, enables the transfer of assets and the execution of
transactionswithoutathirdpartybeingnecessarilyawareandinvolved.Thesevirtual
agreements could allow for the creation of a system in which intermediaries are
completely eliminated and transactions are carried out without the intervention of a
trustedthirdparty.
Smart contracts are simply software written in a programming language. Difference
thoughexistbetweendifferentblockchains in the role that these codeshave. In some
networks, thesecontractsarenot justmadebycode,butmayalsocontain legalprose.
- 16 -
Ethereumhaveasimplerconstructionforsmartcontractsanddonothavethisfeature.
These contracts can be seen as a binding agreement that can move information and
money,basedontheagreementsdefinedinthem.Theyareunstoppable,guaranteedto
resolvethemselves,dependingontheblockchainandnotbyalegalsystem,andeasierto
readthanalegaltextthatcouldbefalselyinterpreted.
Ethereumrunsageneralblockchain,butithasembodiedinsideit,asystemormachine
calledEthereumVirtualMachine(EVM)15,whichithasbeencreatedspecificallytorun
andmanagethesesmartcontracts.ThepresenceoftheEthereumVirtualMachineiswhat
distinguished-atfirst-Ethereumfromtherestoftheblockchain-basedplatforms.
ThesesmartcontractsarewritteninSolidity,whichisaprogramminglanguagesimilarto
JavaScript16. Solidity is now used by different systems that allow for the use of such
contracts, sincemanydevelopersunderstood thepotential of smart contracts andare
implementingthem,withcertainvariations,totheirversionoftheblockchain.Whenthe
contract is complete, it is linked to the EVM and deployed to an Ethereum address,
initiatingtherelation.
Sincesmartcontractsaredeployedtotheblockchain,werealltheinformationrelatedto
it areaccessible toallusers, therearea fewrules that these contractsmust follow to
ensureacertainlevelofsecurity;thesecharacteristicsare(BergquistJ.H.,2017):
Damagecontrol:
Thereshouldbelimitationstothevaluetobeputonasmartcontract.Ifinfact,inthecase
ofthepresenceofabuginthecontractonwhichthevalueisstored,amalfunctioninthe
contractmightcauseapermanentlockingdownofthatvalueinsidethecontracts;without
anypossibilityorreachforitbyanyone.
Modularity:
Smartcontractsshouldbeassimpleandasshortaspossible,inordertokeepreadability
andavoidmisunderstandingbyusers.Contractscanbeinterconnectedwithoneanother,
allowing for the modularization of more complicated transactions. As modularity
increases,thesystemitselfimproves.
15Section:1.5.6.EthereumVirtualMachine(EVM).16 JavaScript:Programminglanguagecommonlyusedinwebdevelopment.
- 17 -
Checks-EffectsFunctions:
Thesecontractsshouldbeabletocheckifsomepreconditionsarereachedasthefirststep
ofthealgorithm.Ifthepreconditionsaremet,thecontractcanmovetothesecondstep,
which isable toapplychanges to thestate-variable.Once thesestepsare fulfilled, the
transactioncantakeplace.
In order to be embodied in the contracts, elements like rights, responsibilities, or
allocationofpropertyshouldhavethestructuretobetranslatedintocode,andallowfor
anautomatedachievementofresults.
Traditionalsolutionstothisproblem-liketheuseofathirdtrustedparty-involveahigh
levelofhumaninteraction,hencehighermanagerialcostsandrisk.Withadecentralized
system,thereistheeliminationofthepossiblecreationofmonopolisticpowerexercised
byconsensuscentralizedauthorities.Thesefactsallowforadifferentdefinitionofsmart
contractsas:
“Smart contracts are digital contracts allowing terms contingent on decentralized
consensusandareself-enforcingandtamper-proofthroughautomatedexecution”.(CongL.W.,HeZ.,2016)
Thisdefinitioncanbeassociated,andisconsistentwith,commondefinitionsusedinthe
legalworld(Lauslahti,Mattila,Seppala,etal.,2016),andbySzabo(1998).
Aswerealizedsofar,thedecentralizedtechnologyofferedbyblockchainenablestheuse
ofsmartcontractsandallowsforagreatercontractibilityandenforcementofagreements,
facilitatingtheexchangeofcurrency,propertyandanythingofvalue,throughtheuseof
automatedalgorithmsandavoidingconflicts.
InsidetheEthereumblockchain,thesystemusescryptocurrencytomakesmart-contracts
function,thiswaythereisthealmosttotaleliminationofatrustedthirdpartynecessity.
Ethereuminfact,hasitsownbuiltincurrencycalled“Ether”.Thiscryptocurrencyisused
to rewardminers but also to pay feeswhenever a transaction or a smart contract is
executed.
Definingsmartcontractstoatisstillcomplicatedgiventhenatureofthephenomenon
andtherelativeyoungageofit.Whatweknowthough,isthatitscorenotionistocreate
contractsonpossibleeventsbasedonadecentralizedconsensus;withlowcosts,andwith
- 18 -
mathematicalandalgorithmicexecution.Inordertosupportthesecontracts,weneeda
distributedledgerwithself-executingcapabilitiesliketheblockchain.
1.5.4.SmartIdentity
Insection1.2wetalkedaboutdigitalsignaturesandtheconceptofprivateandpublickey.
Oneofthepossibleimplicationoftheintroductionoftheseapplications,isthecreationof
thesocalledSmartIdentityorDigitalIdentity.
Inthetraditionalsense,identityreferstothesetofinformationandcharacteristicsthat
distinguishoneindividualfromtheothers.Inthecyberworldontheotherhand,identity
ofanindividual,consistsofthedigitalrecordassociatedwithhim/her.Theserecordsare
formatted in a standardized way, so that they could be utilized to provide identity
informationandbeusedinastandardizedwayinthedeploymentoftransactions.The
construction and standardization of these digital documents, supported by the
blockchain, has a list of positive attributes such as: existence, control, access,
transparency, persistence, portability, interoperability, consent, minimization, and
protection,togetherwiththeimplementationandsupportofSSI17.
Users are enabled trough the blockchain to manage and control their own data
independentlyandnotbyutilizingatrustedexternalthirdparty;andatthesametime
prove their identitywhen performing any type of interactionwith other users in the
system.
The process of identity verification on a blockchain-based system, requires what is
usuallyreferredtoasthe“handshakemechanism”(KikitamaraS.,2017).Themechanism
iscomposedbyaprocessdividedinthreeseparateactionsthat,inthatsequence,allow
foraproperidentificationofusers.“Login”,“Verify-Request”,and“CreateResponse”are
thethreestepsofthismechanismandinaccordancetothese,someapplicationsbasedon
blockchaintechnologyhavebeendevelopedtomanageauthenticationsystems.
Digitalidentityisnecessaryanddecisiveinsecuringinformation;itallowsforthecreation
ofaccessmechanism,andallowsuserstohaveapersonalizedandaccountablepresence
on-line,limitingthethreatofidentitytheft.Thissystemalsoallowsforthereductionof
unauthorisedaccesstopersonalinformation,anddatainfringement.
17StandingSettlementInstruction:areinstructionstofollow,everytimeatradeismade,usuallyassociatedwiththetransferoffundsand/orsecurities.
- 19 -
1.5.5.SmartProperty
Thedefinitionofsmartpropertycanbesummarizedasthecapabilityofapropertytobe
byitself,partofastipulatedcontract.
Smartcontractscanhavemultipleapplications,oneofthoseislinkedtoproperty,andthe
possibility of creating around them, through these contracts, a digitalized security
structure.The technologywouldbeable in theory, toconstruct contractual termsand
securityobligationsaroundproperty,turningtheminactualsmartproperty.
Ifwetakeforexampleacar,asimplecontractwouldgivetotheownerpermissionforthe
usageofthevehicle,throughtheuseofcryptographickeys,basedoncontractualterms.
These applications can have many implications and benefits in terms of ownership,
transferofpropertyandpermissionstotheuseofcertainassets.
This systemcanbeapplied toanyassetwhosepropertyorusagecanbegranted toa
persontroughacontract;thisincludespropertyrightsandcopyrights.
1.5.6.EthereumVirtualMachine(EVM)
The Ethereum Virtual Machine (EVM), is the execution environment for Ethereum
(Ethereumcommunity.TheEVM,2016);itisthecomputersystemthatallowEthereum
torunsmartcontractsanddistinguishitselffromtherestoftheDLTs.Alltheactivenodes
of the system run the same items of the EVM, and whenever a new transaction is
introducedandexecutedtothevirtualmachine,thesystemchangesandmakeseveryone
in thenetworkupdate to the latest versionof the stateof the system,where thenew
transactionisincluded.Throughoutthisprocess,trustisensured,evenifalargenumber
ofcalculationsarerequired.
Externalactorsgenerateinputs,ortransactions,throughtheuseofEOAs18attheedgeof
the system, and Contract Accounts can be tackled trough transactions that can
communicatetooneanotherthroughmessages.EVMstaysabovethem,beingthesystem
that allows for the creation of these accounts and consequently, the fulfilment of
transactionsandinteractionamongusers.
EVMisaglobalmachineinthesensethatitisrunbyallthenodesinthesystem;thevirtual
machine is in fact spread out to all the nodes in a peer-to-peer fashionworkingwith
commonaccountobjects(RudlangM.2017).Interactionsbetweenobjectsisallowedand
permittedthroughmessagesandtransactions,andaccountsaremonitoredandgoverned
18EOAs:ExternallyOwnedAccounts.
- 20 -
bythekeyusedbythenodes.
1.5.7.Ether
Like many other blockchain-based environments, Ethereum requires the use of an
internal cryptocurrency in order to runmost of its operations. “Ether” is Ethereum’s
cryptocurrency, and in the Ethereum system is in fact used mostly as fuel to run
operationsontheplatform.Itismostlyusedtopayfeestospecificnodesofthenetwork
for the effort of participating in the consensus mechanism. Ether can be obtained in
differentways;bymining,orbypurchasingitfromanotheruserorthirdparty.
1.5.8.Gas
AlanTuringin1936,provedthatitisnotpossibletodeterminebeforeitisexecuted,ifa
computerprogramwillrunforeveroritwillfinishrunning,giventhedescriptionofsuch
aprogramandaninput.
Asweknow,eachtransactionthatisexecutedinsidetheblockchain,hastoberanbyevery
nodeinthesystembut,iftheprogramcodeinvokedbythetransactioncreatesaninfinite
loop,thiswillcreateseriousproblemstotheplatform,immobilizingandshuttingdown
thewholenetwork.Thepossibilityinfactexiststhatanodewillgenerateacodethatwill
runforever,eitherbyavoluntarydestructiveact,orbyaninvoluntaryhumanmistakein
thewriting of the code. In order to avoid such an eventuality, Ethereumdeveloped a
security system for smart contracts, thatmakes themconsume “gas”,having thougha
limitedamountofenergyfortheexecutionoftheoperations.
Gasisdescribedironicallyas“cryptofuel”,andtheideabehinditistoassociate-toevery
computationalsteprequiredbytheminer-acostoftransactioncalled“gasPrice”,payed
totheminerbytheuserthatoriginatesthetransaction.
A“gasLimit”isalsosetbeforethetransactiontakesplace.ThegasLimitsetsthelimitfor
the total amount of gas that the operations involving that transactionwill be able to
consume.Everyoperationthatneedstobeexecutedwillconsumesomeofthegasatthe
disposalofthetransaction.Ifsomeofthegasisnotconsumedbytheminerthroughthe
computations,theremainingfuelwillbesentbacktotheoriginatorofthetransaction.If
duringthecomputation,thegasLimitisreached;thetransactioniscancelledbutthegas
used,goestothemineranyway.
Thissystemallowsfortheinterruptionofanycomputationthatmightresultinaloopand
mightimmobilizethesystem;sinceeventually,everycomputationwillrunoutoffuel.
- 21 -
Theseprecautionswilldiscouragesomehackersfromattachingtheplatform.Thissystem
makesitimpossibletocreateinfiniteloops,butitstillallowsforverybigonesthatwill
slow down the system and give time to malicious users to take advantage of the
temporarystallofthenetwork.InthesectionabouttheSecurityofEthereum19wewillgo
furtherintodetailsonthistopic.
Withtheintroductionofthisfeeformining,minersarenotde-incentivisedtoundertake
harderandlongercalculations,sincetheeffortforsuchmathematicalcalculationswillbe
fairlyrewarded.
Gasprice isdependentontheamountofcomputationrequired,andbytheagreement
betweentheminerandtheuserofthetransaction.Itcannotbedefinedasastandardized
Etheramount,alsobecauseoftheheavyvolatilityofcryptocurrenciesinthefreemarket.
MinersarealsoentitledtoavoidcomputationsthatofferatolowgasPrice;thiscreatesa
marketforcomputationandgas.
1.5.9.ConsensusProtocolinEthereum
As we seen in the consensus section20; consensus consists in the mechanism that is
createdbetweennodes,inordertodeterminewhichblocksaretobeconsideredauthentic
andtrue,andwhicharenot.IntheBitcoinsystemweknowthattheconsensusmechanism
iscalledNakamotoconsensusanditfollowstheruleof:”Thelongestchainwins”.This
system though,may delay the broadcasting of the authentic blocks to the rest of the
system,affectingthesecurityofthewholenetwork.AccordingtoYonatanSompolinsky
andAvivZohar(SompolinkyY.,ZoharA.,2013)inthetimebetweenthecompletionofa
blockandthebroadcastingtotherestofthenetwork,thesystemisvulnerabletopossible
attacks,anddelaysinthepropagationofthebocksmayhaveserioussecurityissues.We
canidentifytwomajorfactorsthatinfluencethepossiblecreationofthisstateandthey
are“Blockcreationrate”and“Blocksize”.
Blockcreationratereferstothetimeinterposingbetweenthecreationoftwoblocks.
Let’sassumethatthetimetobroadcastanewblocktoeverynodeisalwaysthesamead
fixed;ifwereducethetimethatexistsbetweenthecreationofoneblockandtheother,
wewillputthesysteminanotsecuresituationmoreoften,increasingthetimeinwhich
thesystemisvulnerable topossibleattacks. InFigure(2)below,wecansee theblack
arrowasthetimenecessarytoreachallnodesandinwhichthesystemisinavulnerable
19Section:1.5.10Security20Section:1.4ConsensusandMining
- 22 -
state.
Figure(2):Shorterblocktime
Blocksizeontheotherhandreferstothevolumeofinformationembodiedineachblock.
Wheneveranewblockcontainsalotofinformation,itwilltakemoretimetobroadcast
allthatinformationtoallthenodesinthesystem,thiswillincreasethedeltaoftimein
whichthesystemsisvulnerable.TheblackarrowinFigure(3)showsthedifferencethat
Blocksizemakesinmakingthesystemmorevulnerable.
Figure(3):Biggerblocksize.
Theseassumptionsmakesenseinasystemwhereallnodeshavethesamecomputational
powerandareabletotransferequallywelltheinformationbetweenotherpeers.Vitalik
Buterin(ButerinV.,2014)pointoutthough,thatthereisasubstantialdifferencebetween
differentnodes,intermsofbothcomputationalpowerandcentralizationwithrespectto
othernodes;thismeansthatsomenodesaremorelikelytoproducenewblocksandbe
abletoreceivethemfasteraswellasbroadcastthemfasterinsidethenetwork.Forthese
reasons,Ethereumusesadifferentsystemtoachieveconsensuswithoutimpactingthe
securityofthesystem.Thissystemiscalled:“TheGreedyHeaviestObservedSub-Tree”
commonly referred to as GHOST. First introduced by Sompolinky and Zohar, GHOST
differsfromtheBitcoinconsensussysteminthesensethat:“theheaviestsub-treewins”,
- 23 -
ratherthat,“thelongestchainwins”(SompolinkyY.,ZoharA.,2013).With“theheaviest
sub-treewins”werefer to the treewith themostcomputationsworkrelated to it.So,
wheneverafork,orasplitfromablockoccurs,thesub-chainthatshouldbeselectedas
trueaccordingtoEthereumistheonethatisnotnecessarilythelongest,buttheonewith
thehighestnumberofblocksgeneratedbelowitandrelatedtoit.Figure(4)showsthe
differencesintheselectionofthesub-treeforthetwodifferentnetworks.
Figure(4):Subtreeselectiondifferences.
Aswe can see, a forkhas been created starting from “Block-0”, creating two sub-tree
called“Subtree-A”and“Subtree-B”withdifferentdepth,respectively4and3.According
totheBitcoinorNakamotoconsensus,Subtree-Ashouldbeselectedbecauseofthehigher
depth.InthecaseoftheEthereumconsensusmechanismontheotherhand,Subtree-B
willbeselectedbecauseofthehighernumberofblocksassociatedwithit;itisinfactthe
heaviestsubtreebetweenthetwo.BlockB2’iscalledaOmmerBlock,anditiscreatedby
smallerminersthatwouldcontinuetomineonablockevenifanothervalidblockhas
beencreated;sincethesenewvalidblocksmaytakemoretimetoreachthem.Inorderto
avoidwastingtheminingeffortgivenbythesesmallerminers,theworkcreated,isadded
up to the system to increase the tree size. The miners that create the Ommers are
rewordedfortheircomputationaleffort,evenifitisafractionofwhattheminerofthe
- 24 -
globallyrecognizeblockisbeengiven.Themaximumlevelofdepthofasubtreeallowed
is six, and themaximumnumberofOmmersallowed insidea tree is two (RudlangM.
2017).
1.5.10.Security
Thedependencyonglobalconsensusinsidetheblockchainsystem,createssomesecurity
flawinthenetwork.Oneofthemostknowntypeofattackisthe“51%”attackconsidered
tobethemostdangeroustreattothesecurityofthesystem.
Aswe have seen before, in order for a transaction to be recorded on the blockchain,
consensus by all miners has to be provided. This means that the introduction of a
maliciousblockortransactionwouldbespottedbythenetworkandrejected;unlessa
groupofminestogetherwouldbeabletocontrol51%ofthetotalcomputingpowerof
thenetwork.Thiswouldmeanthatthoseholdingthe51%oftheminingpower,wouldbe
abletocreateafakemaliciousblockthatcouldnotberejectedbytherestoftheminers
being them in numerical disadvantage. The attack could change the rules of the
blockchain,creatingprogramsthatbenefitthat51%majority.
Thecreationofsuchasituationwouldrequireanimmensecomputationalpower,thatnot
evenpoolofminers21couldgather. It is interestingtonotice though, that the freeand
opennatureofthenetworkcouldtheoreticallyallowforsuchascheme,sincenoauthority
exists thatwould prevent such an attack. It is important also to notice that if, such a
circumstancewouldcometohappen,thesystemwouldrecognizethetreatandabandon
the platform, that would be permanently compromised, leaving the attacker with a
uselessnetwork.
The“LongRangeAttack”(ButerinV.,2017)isanadaptationofthe51%attack,thatallows
fortheslowingdownoftheauthenticationprocessbyminers,allowingahackertohave
thetimetodevelopitsownblockandattachittothechain.Inordertodoso,anhacker
wouldhavetoslowdowntherestofthevalidatingnodes,creatingaverycomplicated
transaction,towhichonlyheorshehasthepossibilitytoactivatespeciallydesignedtrap
doors22andgetaheadofotherminers.Thiswouldallowhimorhertoattachtothechain
21 Poolofminers:Alargegroupofminersthatputtogethertheircomputingpowertowinminingraces. 22 Trapdoor:consistsinanunknownentrypointinsideacomputerprogramthatallowsonlythecreatoroftheprogramtohaveaccesstospecificsectionswithouttheconventionalprocessofidentification.
- 25 -
ablockinsideofwhichtherearecontractsortransactionsthatwouldvoteinhisorher
favour.Theattackercaninfactre-writetheblockchain,whiletherestoftheminersare
occupiedexecutingthelonglooptransaction.
AsweknowtheEthereumsystemallowsusertowritetheirowncontracts,programs,and
applicationsthatareputontheblockchain;theseprogramsmayormaynothavesecurity
flawsdependingonhowwelltheyareprogrammedandwritten.Thepossiblepresenceof
bugscouldbeexploitedbymalicioususersandunderminethestabilityofthecontracts.
There has been a case inwhich an unintentional loop hole in a smart contract in an
Ethereuminstancewasexploitedbyahacker.Thehackerwasabletowithdrawfromthis
companycalled“TheDAO”,asignificantamountofmoney(ButerinV.,2017).Thecontract
of the “The DAO” worked as it was programmed to do, but unfortunately who
programmed itdidnotrealize that it couldhavebeenusedagainst them.Users in the
systemrealizedthattheTheDAOhadbeenhackedandmostofthemagreedtomakeaso
called“HardFork”,thatcreatedanewblockincontrastwiththemaliciousblockcreated
bythehacker.Thisnewblockwasrecognizedbyalmostthemajorityofthenetworkand
themoneystolewentbacktotheoriginalowners.Thishardfork,createdasplitinthe
blockchain, creating two different network, “Ethereum” and “Ethereum Classic”, that
containthesameinformationuntilthemomentoftheattack.Bothchainsnowworkand
havetheirownusers,butworkinparallel,withoutanyinteractions.
The hack of the TheDAOwas awarning sign for those thatwant to construct smart
contract.Buterin(ButerinV.,2016)intheEthereumblogreassuresusersthatevenifthe
platform is perfectly safe and allows for the creation of perfectly functioning smart
contracts,itisstillnecessarytopayparticularattentiontothepresenceofpossiblebugs
insidecontracts.Thereareon-linecompaniesrightnowthatcanhelpuserscreatesafe
andsoundsmartcontractsandpreventthesehacksformhappeninginthefuture.
1.5.11.ScalingonEthereum
Unlike the Bitcoin network, Ethereum contains not only transactions, but also the
informationonthelateststateofthecontractswrittenontheEthereumplatform.This
will create a serious issue for scalability of the platform. One of the solutions to this
problem is the fact thatEthereumnodes, canhavedifferent rolesandstore just some
sectionsofthestate,andnotthefullblockchainhistory(ButerinV.,2014);onlyactive
- 26 -
nodesinfactmuststorethecompleteblockchain,likeintheBitcoinnetwork.Theoriginal
Ethereumprotocol doesnot force all nodes to store thewholeblockchain in order to
validatetransactions.
With this arrangement, there is though still the problem of the centralization of
information.Fullnodes,as thesizeof theblockchain increase,maybecome fewerand
fewer,creatingtheopportunityofworkingtogethertousetheplatformattheirinterests.
In order to copewith this problem, Ethereum uses a verification protocol, creating a
“proofofinvalidity”thatwillavoidverificationofinvalidblocks.
1.6.ThepotentialofEthereum
Now that we have some knowledge of what a blockchain is and what are the
functionalitiesof thisnew technology,wecan try todefinewhatmightbe itspossible
applications.Thepotentialof the technology in fact,goesbeyondthemerecreationof
cryptocurrency.Applicationofthetechnologycanspaceacrossfinanceobviously,public
records, private records, physical assets keys, business, government, andmany other
industries.
TheLegalProfession:
Thelegalindustryisfacingatransformationleadedbytheuseofblockchaintechnology,
andmorespecifically,bytheintroductionoftheconceptofsmartcontracts.Throughthis
technology,someaspectsofthelawcanbedigitizedandconvertedfromlegalproseto
flawlesscode.
Currently,thelegalsystemanditsbureaucracycreatestonsofpaperworkwhichishard
tokeeptrackof.Eachaction, transactionor legalacthas toberecordedandstored in
ordertohaveanactualproofofwhathappenedandwhoweretheactorsinvolved.The
blockchaintechnologyoffersasysteminwhichanyinteractionorchangeofstateinan
asset can be recorded and remain in the ledger for ever. This will reduce drastically
administration costs and reduce time needed to gather necessary information about
single cases. The introduction of the technology in this environment could be a game
changerthatwouldhelpthecreationofabetter,moretransparentandconsequentlyfair
system.
We need to keep in mind that blockchain technology and functionalities, cannot be
applicabletoeveryaspectofthisenvironment.Thetechnologycan,andprobablywillbe
appliedtothosetasksthatcanbenefitfrombeingautomatized.
- 27 -
Whenitcomestosmartcontracts,whattheycandoisnotsubstitutethealreadyexisting
structureoflaws,buttheycanhelpinthecreationoftrustbetweenthepartiesinvolved.
Withthecreationofnewmarkets,willcomethecreationofnewneeds,inwhichsmart
contractswillcertainlyplayacentralroleinthedefinitionofrelationshipsandtrust.
Clearing&Settlement:
TheuseoftheblockchaintheClearing&Settlementservices-usuallyofferedbyfinancial
institutionsandthirdparties-isprobablythemostinterestingandusefulapplicationof
theblockchaininthefinancialsector.The“Fintech”industryisinfacttheworldinwhich
theDLTtechnologyhasbeenappliedandstudiedthemost.Theseactivitiesusuallycost
billionstofinancialinstitutionseveryyear,andfinancialgiantslikeSantander23believe
thatthistechnologywillsavetheindustrybillionsinthenextfewyears.
SomeofthemajorbenefitsoftheapplicationofDLTtechnologyinthefieldofpayments.
Clearingandsettlement,couldtackletheissuesthathavebeenpartoftheindustryfor
quitesometime;theseinclude:end-to-endsettlementspeed,dataauditability,resilience,
andcostefficiency.Thepromiseoftheresolutionoftheseproblemsledtheindustryand
itsactorstoinvestigateonthepotentialofthetechnologyanditspossiblebenefits.The
technology could changedrastically the industry and theway inwhichpayments and
otherfinancialservicesareprovided.
Thetechnologyisnotfullydevelopedyetatthispointintime,transactionsinfactcould
befaster,andscalabilityisstillanissue;butmanyfinancialcompaniesareinvestinginit
andwillsoonmaketheirdevelopedsolutionspublic(Mills,David,WangK.,MaloneB.,
Ravi A., Marquardt J., Chen C., Badev A., Brezinski T., Fahy L., Liao K., Kargenian V.,
EllithorpeM.,NgW.,BairdM.,2016).
Smart/DigitalAssets:
Thetechnologyaroundblockchain,allowsforthecreationofthesocalledSmart/Digital
Assets.Asmartassetcanbedefinedasaproperty,whoseownershipiscontrolledthrough
ablockchainandtheycanbetransferredusingcontracts;thisallowsforarathercostless
andtrust-lesstransferoftheownershipofassets.Transactionsandtransferofproperty,
through the use of smart assets,will reduce substantially transaction fees andwould
allowtradesthatwouldhaveneverbeenpossiblewithoutthetechnologybehindit.
23http://www.santanderconsumer.it/prestiti?gclid=Cj0KCQiAyZLSBRDpARIsAH66VQKkUEcGphSjM6aALj6DlbiB5iJY6jEsTjA-uV5h55uyy5vAKoNpmQUaAvtzEALw_wcB
- 28 -
Thetechnologyallowsonlythoseinpossessionofthekeytobeentitledtotheownership
oftheasset.Thisapplicationwillalsochangethewayinwhichloansandcollateralsare
distributed and collected, since the ownership of anything can be traced easily in the
publicblockchain.
Thosethatwillinvestinthissortofsystemnow,arebelievedtohaveanadvantageinthe
futureforwhatconcernspropertyrights,traceabilityofassets,andproofofownershipof
thoseassets.
DigitalIdentity:
Every individual inorder to interactdigitallywith the restof theworld,must relyon
digitalidentityinordertoberecognizedandinordertorecognizetheonesheorsheis
interactingwith.However,thestateoftheartinsecurityfordigitalidentity,makesithard
totrust thepersonweare interactingwiththoughtthe internet,since it is fallibleand
disjoint; and furthermore centralized and costly. The introduction of the blockchain
technologywillallowforthecreationofadigitalidentitythatisunique,trustworthy,not
managed by few individuals that hold our private information, and secure. This will
empowerpeopletobeentitledoftheirownidentityandshareitbetweenothertrusted
individualsinatrustednetwork.
Thiswillimprovecustomerprotection,andsecurity,whilehavingcontroloverpersonal
datatobedisclosedtothepublic;whileontheotherhandwillallowbusinessestoreduce
theriskandthecostofstoringsensibleinformationontheirservers.Ontheregulatorside
although, it will help them to standardize processes, while increasing efficiency and
qualityoftheirwork(IBM,2017)24.
Voting:
Traditionalvotingsystemscanbeconsideredriskyinthesensethatapaper-basedsystem
canbemodifiedbymaliciousauditors,anditiscostlytomanageandkeeptrackofallthe
information associated with it. It currently exists a type of digital voting, that still is
centralizedandmanagedbyasingleentityandasingleserver.Thisallowsforthecreation
ofasinglepointoffailure;asinglestorageofinformationthatcanbehackedandmodified
bymalicioususersorbythetrustedthirdpartyitself.
It is necessary to create a system that would be digitalized, secure, transparent and
24 https://www.ibm.com/blockchain/identity/
- 29 -
flawless,inwhichinformationaboutvotescanbestoredandimpossibletobemodified.
With the introduction of the blockchain technology in the voting system, these
characteristicsaremetandcancreateasecuresysteminwhichvoterscanbesuretheir
informationandtheirwillisbeingpursued.
Thesystemwouldallowforaclearandpreciserepresentationofthewillofthevoters.
Thissystemcanbeappliedinanysituationinwhichthevotingrightscanorhastobe
implemented,meaningthatitcanbeimplementedinthegovernmentsystemaswellas
insideacorporationwherethewilloftheshareholdersshouldbepursued.
Healthcare:
Oneofthemajorproblemsinthehealthcaresystemistheinabilityorthedifficultiesfor
differenthospitalsorplatformtoshareinformationaboutpatients(CollenM.F.,2011).
this limits the knowledge for medical institutions and doctors of the conditions of a
patientthathasbeentreatedintheirinstitutionforthefirsttime.Theintroductionofthe
blockchaintechnologycouldchangethistrend,byallowingnotjustforacleardefinition
ofthepatient’smedicalhistory,butwillalsoallowforthecreationofadatabasewhereall
theinformationaboutdifferentcaseswouldbestored,creatingalearningplatformfor
doctors,andpossiblyalearningartificialintelligence.
Obviously,theinformationrelatedtoeachpatientwouldbeprotectedandthroughthe
useofdigital identity, is thepatient thatwilldecidewhowillbeable toseehisorher
medicalrecordsandespeciallywhattheywillbeabletosee.
These are only some of the possible applications and the improvements that this
technologyisbringingtothetable.Butaswecansee,conceptsandthestructurebehind
it,areabletochangepositivelyandsubstantiallymanyoftheaspectsofourlives.
Inthenextchapters,wewilltakeacloserlookofoneofthepossibleapplicationofthis
technologyandwewillseehowtheimplementationoftheblockchainwillimprovethat
industryandevenbeabletocreatemanynewsideindustriesthatwillcompensatesome
ofthecurrentissueswehavewiththetraditionalmethodologies.
- 30 -
CHAPTERII
Traditional&EquityCrowdfundingMechanisms,Limitations,and
Potential
Inthecreationofanewventure,raisingcapital foranentrepreneurmaybehardwith
traditionalmethodsoffunding.Creditcanbeuncomfortabletocarryespeciallyforanew
venture.Crowdfundingtriedtosolvethisproblembycreatingspecificinternetplatforms,
onwhichapersonoranorganizationcouldraisecapitalfromthecrowdforaparticular
venture.Theobjectiveistobeabletoraisesmallamountsofcapitalfrommanymembers
ofthenetworkformingthecrowd.
The reward for contributing to the capital raising can be different depending on the
typologyofcrowdfundingused.
ApossibledefinitionofcrowdfundingcanbethefollowingbyBelleflamme(Belleflamme
P.,2013):
“Crowdfunding involves an open call, mostly through the Internet, for the provision offinancialresourceseitherintheformofdonationorinexchangeforthefutureproductor
someformofrewardtosupportinitiativesforspecificpurposes.”Belleflamme,2013
Thisdefinitionmaybecriticizedsinceitdoesnottakeintoconsiderationthegoalofthe
investorsandthecreatoroftheventure.
Thosewhoseektocollectthemoney,maybedoingittocollectsmallcapitalsforasingle
activityorinordertocreateanewventure.Theuseofcrowdfundingcanalsoprovethe
validityofanIdea,thatwouldallowfortheraisingofexternalcapitalbysomeoneoutside
the network. These platforms and structures can also be used in order to promote
business activities and raise interest for organizations in the development stage or
creation.
Collectorsmightbeseekingtoraiseasmallamountofmoneyforaone-timeprojectorto
findseedcapital forastart-upbusiness.Furthermore,crowdfundinghasbeenusedby
collectorstoshowapotentialdemandfortheirideawhichcanleadtoincreasedfunding
- 31 -
fromothertraditionalsources.Crowdfundinghasalsobeenusedformarketing,tocreate
interestfortheprojectatanearlystage.
Inthischapterwewillfocusnotsomuchonthedifferenttypologyofcrowdfunding,but
on the specific Equity-Based platforms that allow for such an innovativeway to raise
capital.Thisnewmethod is contraposed to the traditionaloneofVentureCapital and
presentsaseriesofadvantagesandcharacteristics,thatarechangingthewayfundsare
raisedbysmallandindependentventures.Inthischapterwewillanalysethedifferent
advantagesanddisadvantagesof thesystemandespeciallyhow important trust is for
bothpartiesinvolvedinthesetransactionsthatinvestorsandtheentrepreneurface.
2.1.CrowdfundingPlatformsandIntermediaries
Crowdfundingplatformscoverthethirdpartyrole,stayingbetweenthetwosideofthe
transactionsduringtheprocessofraisingcapital.Theplatform’srolecanbeconsidered
astheoneofthemiddleman,eventhough,itdoesnotparticipatedirectlyinanycapital
raisingcampaign.
Platformsofsuchsort,participateindirectlyinthecampaigns,offeringalistofservicesto
boththecollectorsofthefundsandthecontributors,inordertomaketherelationshipas
easyaspossible,ascheapaspossibleandassecureandrisklessaspossible.
Theyoffer a platformof communicationbetween investors and entrepreneurs,where
communicationbetweenthetwopartiesisalloweddirectly;secondly,theyallowforthe
creationofapoolofpossibleinvestorsfromwhichentrepreneurscanhaveaccessto.Itis
a group of people that declare to the platform their willingness to participate in
interestingandprofitableopportunities.Furthermore,theseplatformsallowtransactions
tooccurbetweeninvestorsandnewventuresinordertoraisecapital;andfinally,they
areabletoclosedownpossiblydishonestprojects,butatthesametime,candecideto
sponsorotherones thatparticularly interest them.Theseplatformsare in factable to
create good conditions for entrepreneurs to raise capital and be able to create new
ventures(AgrawalA.K.,CataliniC.,GoldfarbA.,2011).
Theyalsoprovidethe investorwitha listofpossiblecampaigns fromwhichtochoose
from,andmostimportantly,theyareentitledoflegitimizingthecrowdfundingmarket;
meaningthattheyplaytheroleofthetrustedthirdparty,necessarytoallowtheflowof
transactionsbetweenthetwopartiesinvolved.Oneofthemostimportantrolesinfact,is
theserviceofduediligencetheyperformontheproposalsoffundraisers.Thisisthemost
interesting characteristic, that distinguishes them from the traditional form of
- 32 -
crowdfunding,inwhichanyideacanbepresentedtotheinvestingpublic,regardlessof
itsvalidity.
2.2.EquitybasedPlatformsandDifferentBusinessModels
Thepresenceofmorethanoneagentthatinteractsthroughanintermediary,characterize
thecreationofwhatcanbedefinedasamulti-sidedmarket(RysmanM.,2009).Inthe
caseofthecrowdfundingmarket,theseagentscanbecalledcapital-seekingandcapital-
giving. In thisenvironment, the roleof the intermediary thatallow for the interaction
between these two agents is played by the crowdfunding platform. Through a
crowdfunding platform, the two agents are able to connect and avoid possible
asymmetriesininformationandreducelargelycostsoftransaction(MahadevanB.,2000).
Platformsarefinancialintermediaries,thatplaytheroleoftwo-sidedfinancialallocators
inamarketcomposedbycapital-givingandcapital-seekingactors.
Financialintermediariesareabletoofferfinancialservicesthatcanbedescribedfroma
functionalperspective,anddividedinthreesubcategoriesofservices,thatare:LotSize
Transformation,RiskTransformationandInformationTransformation(HassP.,BlohmI.,
2014).
LotSizeTransformation:
These intermediariesprovideservices inordertoaccumulatecapitalandtheymake it
easierfortheactorsinvolvedtohaveaccesstoit.Theyallowtheexchangeofgoodsby
creatingadhockpaymentsystemsandmechanisms for theaccumulationof resources
betweenbusinesses;regardlessofthegeographiclocations,andtime(MertonR.C.,1995).
RiskTransformation:
Financial transactions are associatedwith risk, created also by the possibility of free
ridingbycapita-givingagents.Financial intermediariesareabletomanageandreduce
significantlycostsofmonitoring,throughdiversificationandincreasingofsuchactivities.
Thismeansthatinthefieldoffinancialtransactions,theyperformandactinsuchaway
that reduce the risks associated with financial intermediation (Gorton G., Winton A.,
2003).
- 33 -
InformationTransformation:
Intermediariescanreduceinformationasymmetriesinthesensethattheycreateabridge
betweentheonethatholdtheinformationabouttheprojects,meaningcapital-seeking
agents; and their counterpart, meaning capital-giving agents. Intermediaries hold the
trustwiththeformerandare,bydoingso,creatinginformation(GortonG.,WintonA.,
2003).
OnaCrowdfundingwebsite,thetwoagentsinteractonaninternetbasedplatformthatis
able to reduce transaction costs, monitoring costs, and enhance the interaction and
pairing of agents. Intermediaries though, through these platforms face different
challengeswithrespecttotheonesfacedbytraditionalfinancialintermediaries.Infact,
internetplatformdoesnotperformtheactofborrowingandlendingcapitalperse;infact,
their core activity is to reduce information asymmetry and reducing transaction cost
betweenthetwoparties(MahadevanB.,2000).Crowdfundingplatformsareabletotake
advantageofthedissimilarities in informationbulks,andtheglobaldistributionofthe
agentscomposingthemarket.Whatplatformsarealsocapableofdoing, isgivingboth
sidessomedegreeofguaranteeandtrustintheplatform,whichhelpsreducingtherisk
associatedwithmoneytransfersandcapitalaccumulation(MahadevanB.,2000).
Wecanalso say that crowdfundingplatformshavechanged the roleof the traditional
financialintermediatorinwhatwedefinedearlierasatwo-sidedmarket.
Table(1)(HassP.,BlohmI.,2014)showspreciselyandinagraphicalwaythedifferences
betweenthetwomodelsoffinancialintermediation.
- 34 -
FunctionalCharacteristicsofEquityCrowdfundingasaFinancialIntermediary
FunctionFinancialIntermediaries
Implementation
EquityCrowdfundingas
FinancialIntermediaries
Implementation
Lotsizetransformation
Paymentsystemsforexchangeofgoodsandservices(MertonR.C.,1995).Mechanisms for pooling funds(MertonR.C.,1995).Transfer economic resourcesthrough locations time andbusinesses(MertonR.C.,1995).Provide liquidity (Gorton G.,WintonA.,2003).
Allowing for the interactionandmatching between agents andenable funding (Belleflamme P.,2013).Provide the service of aneconomic market for theexchange and return of capital(BakosY.,2000).Allowingforcapital-givingand–seekingagentstoovercometime,space, communication, andbusiness limitations (Bakos Y.,2000).Demandandfundingmechanismregulation(BakosY.,2000).
Risktransformation Managing risk and uncertainty(GortonG.,WintonA.,2003).
Assessing credit of the capital-seekingagents.Pre-selectionofprojects.Acting as a trusted andincorruptible third party,objectivelydisassociated (BakosY.,2000).
Informationtransformation
Handling asymmetry ininformation(MertonR.C.,1995).Provide price information andinformationproduction(MertonR.C.,1995).
Accumulatinginformation.Providing information aboutprojectsforcapital-givingagents(MitraT.,GilbertE.,2014).Functioning as an electronicmarket place creating arelationship between the twoparties involved and allow forthe exchange of information(MahadevanB.,2000).
Table(1):DifferencesintermsoffunctionsbetweenTraditionalFinancialIntermediaries
andCrowdfundingasFinancialIntermediaries.
Different crowdfunding platforms can have distinctive businessmodels depending on
howtheywanttotacklethemarketandcreaterevenues;andonwhattypeofregulation
theyneedtoapplyto.Whatallplatformshaveincommonontheotherhand,isthefact
that theywant tomanage relationships between the actors in the two-sidedmarket;
meaning that they want to offer “project-regulation” and “fundraisers-screening”
services.
The typologyof fundraisersand fundersmaydetermine theapproachand thepricing
policyoftheserviceprovider.Eachplatformneedsinfacttoattractpossiblecustomersto
- 35 -
enlarge its customer base and the scope of the platform, and not just being more
competitive,butalsoofferdifferentusefulservicestofinalusers.Theperceptionofthe
validityoftheplatforminfact,isrelatedalsotothewithin-typeandacross-typeexternal
effects;thisiswhymostintermediariesusethefollowingrevenuestream(Bellaflamme
P.,OmraniN.,PeitzM.,2015),(BellaflammeP.,OmraniN.,PeitzM.,2016):
1. Theplatformcanholdinterestsonthefundsraisedwhilethecampaignisbeing
processed.Infact,thefundsraisedarenotdeliveredtothefundraisers,untilthe
completionofthecampaign.
2. Fundraisersmayberequiredtopaytransactionfeestotheplatform;inmostcases
thepaymentofthisfeeisrequiredonlyifthedesignatedamountisreached.
3. Chargescanbemadeonsupportservicesofferedbytheplatform.
Inthecaseofcrowdfundingplatforms,thissystemiswhatmostplatformsuse;theywill
holdapercentageontheraisedcapitalbynewventuresasfeesfortheservicesprovided.
Inthefigurebelow(Figure(5))weillustratethegeneralmodelusedbytheseplatforms
(BellaflammeP.,OmraniN.,PeitzM.,2016).
Figure(5):Crowdfundingplatformbusinessmodelillustration.
The next subsection is dedicated to the presentation of three different peer-to-peer
contribution mechanisms that are used to create crowdfunding models. The three
represent the most diffused models in the market. The IOSCO Research25 gives a
25 https://www.iosco.org/
- 36 -
description of themodels that led to the creation of these synergymodels (Kirby E.,
WornerS.,2014).
The interaction between the two parties and the degree of involvement of the
intermediary as a trusted external partner are the two variables that define the
differencesbetweenthethreestructuresthatwillbedescribed.Thelevelofinvolvement
oftheplatformisextremelyimportantindifferentiatingcrowdfundingwebsitesfromone
another.Thedifferencesintheinteractionmodels,movementofmoney,andthedifferent
interactionsbetweenpartiesinvolvedwillbeexplainedthroughthissectionalsowiththe
useofgraphsforabetterunderstanding.
2.2.1.Peer-to-PeerContributionMechanism
Peer-to-peer lending procedures come into play when a bank or another financial
institutiondeniescredittoapossibleentrepreneur.
Thecasemightoccurwheninsteadofacentralandsingularinstitutionwillingtoabsorb
theriskofthecreationofanewventure,agroupofpeopleiswillingtosharetheliability
formingwhatiscommonlyreferredtointhemilieuasthe“crowd”.Weshouldalsokeep
inmindthateveryloanisassociatedwithalevelofinterestratesorpaymentsatmaturity,
whichistackleddifferentlybycrowdfundingplatformsandbybanks.
SeparateAccountModel:
Thefirstpeer-to-peemodelweanalyseiscalledthe“SeparateAccountModel”.
Thetwoactors in themarkethavedistinctaccountsonwhichtheymanagerespective
funds.Whattheplatformdoesistoconnectthemthroughthecreationofacontractsthat
holdathird legallyseparatedandprotectedaccount,storingtheamountraisedbythe
campaign.Inthiscasetheplatformconstitutesatrusteeoftheaccountandwecansee
fromtheFigure(6)(KirbyE.,WornerS.,2014)thegraphicaldescriptionofsuchamodel:
- 37 -
Figure(6):Peer-to-peer“SeparateAccountModel”interactionillustration.
NotaryModel:
The second peer-to-peermodelwe analyse is called the “NotaryModel”. This system
leveragesontheuseofwhatarecommonlyknownaspublicbonds.Wheneverthelender
isputincontactwiththeborrowerthroughtheplatform,heorsheisabletoinvestinthe
newventureandisaccreditedwiththerighttotherepaymentoftheloanedamount;this
conceptissimilartotheconceptoftheinvestmentsecurity.Abankmaybeauthorizedto
managethecredit,whilethefunderstillholdstheriskoftheinvestment.Thefigurebelow
(KirbyE.,WornerS.,2014)(Figure(7))representsthenotarymodeljustexplained.
Figure(7):Peer-to-peer“NotaryModel”interactionillustration.
- 38 -
GuaranteeModel:
The third peer-to-peer model we analyse is called the “Guarantee Model”. What
characterizesthislendingmodelisthefactthattheinvestmentsarenotmadedirectlyby
thefunder,butbytheplatformitself.Theintermediaryinfact,canguaranteeapreviously
determinedrateofreturnonapreviouslysetamount,thatthelendercandecidetoputat
risk.Themoneyusedtofinancenewventuresisextractedfromafund,inwhichagroup
of investorsaccumulatedacertainamount.Byputtingmoney in thataccount, funders
agreeforthatamounttobeinvestedindifferentventures,regardlessoftheventurein
whichthosefundswillbeputinto.Thedecisiononwhichventurestofund,isinthehands
of the platform trusted by the funders. The figure below (Kirby E.,Worner S., 2014)
(Figure(8))representssuchamodel.
Figure(8):Peer-to-peer“GuaranteeModel”interactionillustration.
Aswecansee,thesepeer-to-peermodelsarethefirststepintotheinteractionbetween
equals;inasysteminwhichpeoplethatneedtointeract,donottrusteachother.Thereis
willingnesstointeractwithoneanother,buttheleveloftrustistoolowforthisinteraction
tohappenespeciallyonaninternetplatform.Thisisoneofthereasonswhytheequity
crowdfundingplatformisutilized,inordertoguaranteeacertainlevelofeligibilityofthe
marketandhelpsreducethelevelofriskassociatedwiththelowtrust.
2.2.2.Equity-BasedandRoyalty-BasedModels
Oneof themost interesting formsof crowdfunding, is also the less utilized. Equity or
Royaltybasedcrowdfundingmodelsinfactaremostlytheoretical,sinceveryfewactors
havedecided touse theirplatform insuchaway.Thismethodallows for investors in
- 39 -
crowdfunding campaigns to receive not just a reword, like in the most common
crowdfundingplatforms,butactualsharesofthecompanytheydecidetofund.Different
modelsarecharacterizedbydissimilarregulationsonequityrightforfunders,depending
onthetypologyofthesystemimplemented.
Revenueandprofitsharing,directequityandconvertiblebondsarecommonmechanisms
usedbytheseplatforms,andtheutilizationofthesetoolsvarydependingontheapproach
each platform decides to undertake. The next few paragraphs will describe a few
interactionmodelstochoosefromwhencreatinganequitybasedplatform,dependingon
thelevelofinvolvementasathirdpartythattheplatformdecidestoundertake.
LowResponsibilityModel:
Themodelwepresent first, is characterize by “low responsibility” undertaken by the
equitycrowdfundingplatform,intheroleofthethirdtrustedparty.Theintermediary’s
roleistocreatearelationshipbetweenthepartiesinvolved,grantingtheinvestorlegal
claimsonapercentageoffutureprofits,revenues,aswellasroyaltiesdependingonthe
termsofthecontract.Theplatformcanalsoadministerequity,makinginvestorseligible
forvotingrights,orownershipofshares(KirbyE.,WornerS.,2014).Thefigurebelow
(Figure(9))showsgraphicallysuchamodel.
Figure(9):“LowResponsibility”modelforanequity-basedcrowdfundingplatform.
- 40 -
MediumResponsibilityModel:
In the secondmodel, the intermediary is able to offer the service of detention of the
investmentlegaltitleinfavouroftheinvestor,thatcontinuestobetherightfulpossessor
of the shares. This model is characterized, for these reasons, by a higher degree of
responsibilitiestobeundertakenbytheplatform.Thefigurebelow(Figure(10))givesa
graphicalrepresentationofsuchamodel.
Figure(10):“MediumResponsibility”modelforanequity-basedcrowdfundingplatform.
HighResponsibilityModel:
Themodelthatfeaturesthehighestleveloninteractionbythethirdpartyplatformisthe
following; in which the platform, based on contractual agreements with investors, is
entitledtomakeinvestmentdecisionsandholdshares.Thefigurebelow(Figure(11))
showsthegraphicalrepresentationofthemodel.
- 41 -
Figure(11):“HighResponsibility”modelfora,equity-basedcrowdfundingplatform.
Thiswasageneraldescriptionofthedifferentmodelsassociatedwiththedifferentlevels
ofinvolvementoftheequitycrowdfundingplatforminthefinancingindustryinwhichit
operates.
Wewouldliketonotethelevelofinvolvementofthebankinsuchasystem.Afinancial
intermediarysuchasthebank,isalwayspresentandhasacentralroleintheinteraction
betweentheparties involved.Thefinancial intermediaryisoneoftheholdersoftrust,
andthereferenceforissuesthatregardtheborrowingandlendingofvalue.Itisimportant
to remember theroleofbanks in thenetwork,especiallywhenwewill talkabout the
differences with the system that the introduction of the blockchain technology will
introduce26.
2.3.DifferentServiceModels
Crowdfunding platforms have developed through the years, differentiating from one
another especially in the typeof services theyoffer toboth investors anddevelopers.
Whatneedstobetakenintoconsiderationwhendesigninganewplatforminfact,isthe
typeofservicesitwantstoprovide.Inordertounderstandbettertheeconomybehind
crowdfundingthan,inthissectionweanalysethedecompositionoftheservicesoffered
by crowdfunding ecosystem, into single components (Haas P., Blohm I., Peters C.,
LeimeisterJ.M.,2017).
26 CH III
- 42 -
2.3.1.ServiceModularization
“Modularizationisthedecompositionofoneobjectintodecoupledsinglecomponentswith
specifiedinterfacesthatcanbecombinedtocreatenewsingleobjectconfigurations”(HaasP.,BlohmI.,PetersC.,LeimeisterJ.M.,2017).
Bydecomposing servicesprovidedby crowdfunding institutions,we can create single
modules that canbestudied.Theseservicescanbeseparated, recombined,andhence
form new and different services. Modularization has twomajor principles to keep in
considerationinthedefinitionofthesingleservices;theseprinciplesare“Cohesion”and
“LooseCoupling”(HaasP.,BlohmI.,PetersC.,LeimeisterJ.M.,2017).Cohesionrefersto
the necessity of themodules to have defined levels of complementarity between one
another;LooseCouplingontheotherhandreferstothefactthatsingleservicesmustnot
dependoneachother.
2.3.2.ServiceModulesforCrowdfunding
Throughthestudyonthemodularizationofservicesprovidedbycrowdfundingplatforms
andecosystemsaroundtheweb,weareabletoidentifyalistofmodularservices(Haas
P.,BlohmI.,PetersC.,LeimeisterJ.M.,2017)that,inthenextchapters,willhelpussupport
a comparison between web-based crowdfunding platforms, and blockchain-based
platforms.
Herebelowwepresent a brief explanationof themajor services that a crowdfunding
ecosystemcanoffertousers,usefulforbothsidesofthemarket.
Matchmaking:
Themainobviousroleofawebplatform is tobeable toconnect the twosidesof the
market, meaning capital-seekers and capital-givers. This is done in order to spread
information,andregistercapitaltransfersandfundingactivities.
Theplatformisabletocreateabridgeandalinkbetweenthosethatarewillingtoinvest
innew,evenifriskynewventures,andthosethatareinneedtoaccumulatecapitalforto
startanewbusiness.
- 43 -
Contracting&Compliance:
Once the target funds are reached, the platform can legally validate obligations and
conformitythroughtheissuingofastandardizeddigitallegalcontract.Eachplatformcan
have their own standardized type of contract to be presented to the company or the
investors.Theconditionsstipulatedinthecontractbetweenthethreepartymaydepend
on many factors including the type of industry in which the company is or will be
operating,andtheamountofcapitaltoberaised.
CustomerSupport:
Throughtheplatform, thetwoactors in themarketcan interactwitheachothermore
easily.Certainservicesareprovidedinfact,toimproverelationsbetweenthepartiesby
loweringorclearingupobstaclesbetweenthemandresolvingconcerns.
Wheninvestingsmallorconspicuousamountsofmoney,investorsmustfeelateasein
theinteractionwiththefundraiserandtheplatform.Itisintheinterestoftheplatformto
make the transactionsand thecommunicationsbetween thepartiesas smoothandas
transparentaspossible
RiskScoring:
In an equity crowdfunding platform, risk associated to capital seekers is tracked and
ranked.This informationreferstothetrustworthiness,projecthistory,credit,andalso
projectdescriptionsandvalidityassociatedtothecapitalseeker.
Theattributionof a score to the capital seeker is ofmost importance for the funders,
especiallyforthosethatarenotabletodoitbythemselvesawell-definedduediligence
oftheprojecttheyarebeingpresented.
Somecompaniesperforminternalduediligenceandpresenttothefundraisersascorefor
theprojectsbasedon theirexperience in the field.Othercompanies, inorder toavoid
conflictsofinterests,prefertoletotherthirdpartiesperformtheduediligenceforthem.
Theseimpartialpartiesaresometimesthebestchoiceinsituationsinwhichtheexpertise
oftheplatformmaynotbeenoughtodeterminethefeasibilityofsomeprojects.
Authentication:
Identificationandauthenticationisnecessaryandthoroughlyappliedontheseplatforms.
Theuseofauthenticationisusefultoallusersinordertocomplywithregulations,and
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create a safer environment for clients, in which they know exactly who they are
interactingwith.
Informationabout investorsandfundersareanalyseddeeplyandsecurelystored;this
createsamoretrustworthyandtransparentenvironment.
CrowdActivation:
Propagative and educational activities are performed by these platforms in order to
createontheirnetworkavalidpoolofclients.Alargernumberofclientswillingtoinvest
in new ventures,will ensure a higher rate of success for proposed projects;with the
consequenceoftheactivationofanetworkeffects.
Theuseofcrowdfundingandequitycrowdfundinginparticular,ischangingthetargetfor
thefinancingindustry.Inthepast,onlytheonesthathadaccesstosufficientamountof
moneytofinancesignificantlynewventures,wereabletoparticipatetothemarket.The
useofcrowdfundingismovingtheattentiontotheconsumermarket,wherethereare
nonethelessindividualswithlowercapitalavailability,butstillwithahighwillingnessto
undertakefinancialrisksandinvestinnewventures.
InvestorRelations:
Constant interaction and communication on the performance of active projects is
disposedbetweenthepartiesinvolved.Theseprecautionsareimplementedinorderto
maintain a transparent and democratic platform; and it is done through the use of
speciallydesignedon-linetools.
Thelevelofcommunicationisdeterminedbothbytheplatformitselfandbythefirm.The
communicationinteractioncanbelimitedtotheperiodinwhichthecampaignisbeen
developedorevenafterthecampaignisover,dependingontheagreementbetweenthe
parties.
ITOperations:
Itisfundamental,inthecaseofanon-lineserviceplatform,aproper,welldesignedand
user friendly, accessible platform. The platform will have to provide the point of
interactionbetweenthetwouserstype.
Afriendlyandeasytonavigateplatformcanbeofextremeimportancetotheinvestors,
thatwouldbemorewillingtotrustitandinvestintheventuresassociatedwithit.
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Payment:
Onlinesecureandefficientpaymentactivitiesareprovidedontheplatformstoallowfor
avalidmovementofcapitalbetweentheparties.
Paymentactivitiescanbeintegratedinsidetheplatformorcanbeprovidedbyanexternal
partnerifnecessary.
Banking:
Banking services are provided that include: access to credit information, account
managementcounselling,andex-antefinancing.
Dunning&DebtCollection:
In order toprotect users fromany investment lossesdue todebtdefault, invoice and
liabilitycollectionservicesneedtobeimplemented.
These services are implemented in order to create a safer and more transparent
environmentforbothcapital-seekersandcapital-givers.
2.3.3.PlatformInteractionsandServiceProvisions
In the crowdfunding ecosystem, we can define different actors with different duties,
necessarytosupportthenetworkofservicesthatispresentedtothepartiesinthistwo-
sidedmarket. These services can be selected and divided according to their possible
disruptivenature(HaasP.,BlohmI.,PetersC.,LeimeisterJ.M.,2017).Fromtheprevious
identificationandmodularizationof services,weareable to select sevenof them that
accordingtoHassandal.canbeprovidedbyageneralcrowdfundingplatform.Sixofthese
sevencanfurthermorebeconsidereddisruptiveinthemarketofcapitalfinancing.The
different characteristics of the six services selected, allows us to divide them in two
distinctcategories;specifically,“crowd-related”and“funding-related”.Thedistinctionof
these two categories will be helpful in explaining crowdfunding decentralized
application’spossibilitytodisruptthecurrentcrowdfundingmarketinthenearfuture.
Thecrowd-relatedcategoryreferstothegroupofservicestobeimplementedtosatisfy
theneedsof theactors involved inthecrowdfundingnetwork.Theseservicesarealso
necessary inorder to incentivize the interactionbetween the twomajoractors.These
servicesarenecessaryfortheexistenceofcrowdfundingplatforms.
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Funding-relatedservicesontheotherhandrefertotheservicesprovidedbytheexternal
serviceprovidersinthemarket,thatallowfortheexecutionoffundingactions,necessary
forthecreationoffundingactivitiesandtherelativetransferofvalueandcurrency.The
twocategoriescanbethoughtas thecreationof two levelsof interactionbetweenthe
parties aroundwhich the crowdfunding ecosystem is built, namely capital-givers and
capital-seekers.
In order for the ecosystem to function, there is the need for three intermediaries to
interactdirectlyorindirectlywiththeparties.These“networkpartners”andtheircrucial
roleinsidethesystemarerepresentedinthefigurebelow(Figure(12))(HaasP.,Blohm
I.,PetersC.,LeimeisterJ.M.,2017).
Figure(12):NetworkPartnerInteractioninthecrowdfundingsystem.
Thesearesomeofthemostinterestingservicesthatcanbeprovidedbycrowdfunding
platforms.TheSixserviceswehaveselectedanddividedincrowd-relatedandfunding-
related,aredisruptiveinthefundingservicesenvironment.Theseservicesprovidefora
better communication and interaction between capital-seekers and capital-givers,
reducingriskanduncertaintyinthefundingsystem.
Theinnovationbroughtbycrowdfundingplatformshaschangedtheworldoffundingand
madeitpossibleformanyentrepreneurstogetaccesstofundsandbeabletoconstruct
strongandindependentventures.
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2.4TheGrowingIndustryofEquityCrowdfunding
Despitethepossiblerisksandthelimitationsofvariousplatforms,theindustryofVenture
CapitalthatincludesEquityCrowdfunding,havebeengrowingsubstantiallyinpastfew
years,becomingoneofthemajorplayersinthefinancingindustry.
Inordertogatherfundstoenlargeandimprovetheirbusinesses,smallcompanieshave
veryfewoptionsthatwouldguaranteeanaccesstofundsandtheconsequentpossibility
tocreateanewventure.
Thehesitationofbanksinthelastfewyearstolendmoneytoentrepreneurs,hasleftthe
spaceforsomeotheractorstoimposethemselvesasmajorplayersinthefieldoffinancing
newcompanies.VentureCapitalwasthefirstonetotakecontrolofthemarket;butEquity
Crowdfunding is making its move fast inside the market, becoming one of the most
popularmethods(GreenhalghH.,2016).
EquityCrowdfundingisoneoftheindustriesthatisgrowingthefastestinthefinancing
industry.Forecastsaythattheindustrywillraiseabout11$billionsby2020(Kocianski
S.,2016).
The graph below (Graph (1)) shows the increasing volume of capital that equity
crowdfundingplatformsareraisingandwillcontinuetoraisegiventheforecast.
Graph(1):Increasingvolumesofcapitalraisedbyequitycrowdfundingplatforms.
Both investorsandbusinessesareswitching to thismethodof funding,becauseof the
multiplebenefitsofthemethodology.Thesebenefitsincludetheavailabilitytoanyoneto
participateevenwithsmallamounttothefundingofcompaniesthattheybelievehave
0
2
4
6
8
10
12
2015 2016E 2017E 2018E 2019E 2020E
USA UKBillions($)
Source:Nesta, KPMG,BIINTELLIGENCE
- 48 -
thepotentialtobesuccessfulintheirrespectivefield.
The introduction of Equity Crowdfunding is leading to the consolidation of a trend in
whichthe fundingofnewandestablishedbusiness,couldbebroughttotheconsumer
market(StengelG.,2014).
Thetraditionalmethodsofventurecapital,allowtheparticipationtothemarketofonly
those that are willing to invest conspicuous sums of money. Venture Capital creates
enormous entrybarriers to everyonewilling to facehigh risks, butwith low liquidity
availability.
EquityCrowdfundingontheotherhandmakesiteasierformanywillingtoinvestand
undertake high financial risks, even if they do not dispose of substantial amounts of
money.
Ontheothersideofthemarket,start-upsandsmallcompaniesthatneedfinancing,are
abletohaveabiggerpoolofpossibleinvestorsfromwhichtheyareabletogetfundsfrom.
Theimportanceofcrowdfundinginallowingthegrowthofsmallcompanies,isincreasing
fast and it is establishing strongerbases tobecome thenextmostusedmean to raise
capital.
2.4.1AdvantageswithRespecttoVentureCapital
Before crowdfunding came along, Venture Capital was about the only way in which
companieswereabletogatherfundstostartabusiness.
TheuseoftheVentureCapitalmechanismscanbeinmanycasesofhugehelpfornew
ventures,andtheexpertiseoftherightVentureCapitalcompanycanreallyhelpstart-ups
toexploittheirwholepotential.Formanycompanies,ontheotherhand,theuseofthis
traditionalmethodjustdoesnotfitwiththeownerideas,expectations,andvisionofthe
market.Wehavemanyexamplesofcompaniesandfunderswhoseideaandtalentwas
not recognize by Venture Capitalists formany different reasons, including the fear of
investing a conspicuous amount of money, in something that may appear too risky,
unnecessaryornotprofitableenoughforthem.
Therearemany featuresofequitycrowdfundingthatmightcreateadvantages for this
methodologywithrespecttothetraditionalVentureCapitalways.Inthissectionwewill
analysethemandexplainwhyEquityCrowdfundingmightbetherightchoiceformany
newventuresandnewentrepreneurs.
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EasyAccess:
ThroughtheuseofEquityCrowdfunding,thedecisionofgivingcapitaltofunders,does
notcomefromonesingleindividual,butfrommanyinsidethecrowd.Theaccesstocapital
isthaneasierandpossiblepersonalconnectionstoinvestorsarelessrelevant.
Equity Crowdfunding allowsmore investorswilling to take the risk, to invest in new
companiesthattheybelievehavethepotentialtocreateasustainableentity.Theamount
ofcapitalinvestedcomesfromadistributednetworkratherthatgivenbyasingleVenture
Capitalfirm,thatwouldotherwisehavetobeartheentireriskbyitself.
VentureCapitalfirmsareusuallycomposedbyprofessionalsintheevaluationofpossible
ventures.Itisimportanttothemtolimitasmuchaspossibletheriskofthecompanywhen
lendingcapital;sotheideapresentedtothemmustbeinterestingenoughtoallowforbig
financialinvestments,limitingtheriskoffailurefortheproject.TheEquityCrowdfunding
environmentdistributes the risk amongmanyusers, and tackles a larger shareof the
market,willingtoinvestinnewandevenmoreriskybusinesses.
BetterOutcomesforMarketEstimation:
According to Ethan R. Mollick (Mollick E. R., 2013), only 75% of companies funded
through crowdfunding actually deliver the product they promised, letting down the
investorsthatbelievedinthem.Evenso,CrowdfundingVenturesdogetabetteroutcome
formarketestimationandthereasonisnotbecauseofthetypeofprojectsorideasthat
areproposedtothemarket.
Venture Capitalist have a great experience when it comes to starting a business and
evaluation how said business will perform. When entrepreneur pitch their ideas,
sometimestheydonothaveaclearviewoftheindustryorthemarketinwhichtheywill
have to compete. VentureCapitalist thanks to their expertise, are able to give amore
precise evaluation of the idea,which is usually lower than the one that a less expert
evaluatorwouldgive(WilsonK.E.,TestoniM.,2014).
EquityCrowdfundingswitchesthepowerdynamicmoreinfavourofthecompanythatis
been funded. The new venturewill have to convince very fewhundred people out of
millions thatparticipate to thecrowdfundingactivities, that theircompany isvaluable
andhasthepotentialtoreachallthegoalsthathavebeenset.
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Wemayhaveheardhowsomecrowdfundingcampaignsareunrealisticallyovervaluated,
butitisimportanttodetermineifthesecomplaintsarevalidorhavebeenpointedoutby
someonewhoisinneedtoprotecttheirownbusinessfromdisruption.
BetterFinancingConditions:
Thought the traditional Venture Capital investment deals and contracts; Venture
Capitalistsareabletogetmostoftheirrevenues.Usingfavourableinvestmentconditions
in the subscriptionof investmentdeals in fact, allows investors toprofit substantially
fromtheirinvestmentinnewventures,usuallyattheexpensesoftheentrepreneursand
theirideas.
Withtheuseofcrowdfunding,thepowerincontractingisgivenawayfromtheVenture
Capitalists and given to the entrepreneurs and to the crowdfunding platform. Equity
Crowdfundingplatformsareabletostipulateverydifferentsortsofcontractsthatmake
it able for both the funders and the fundraisers to profit from the investment in new
possiblyprofitableventures.Conditionsofthecontractsarethannotdeterminedonlyby
the venture Capitalists, but are determined by a combination of the different actors
involvedinthefinancingstructure.
Visibility:
The levelofawarenessthatcanbereachedwiththeuseofEquitycrowdfunding,goes
beyondthetraditionallevelofpublicitythatcanbegivenbyVentureCapitalist.Theuse
of an internet platforms to publicize their product, gives entrepreneurs the chance to
interactnotonlywithabroadcustomerbase;butalsowithanetworkofnewsuppliers,
distributors,andotherpossiblecollaboratingcompanies,thatmightaddsubstantialvalue
totheirventure.
Whenacompanyisputonsuchaplatform,theexposurecanbeusedbythefundraiserto
publicizeitsproductsaswellasitsvisionandmission;beingabletoimproveandenlarge
itsmarketanditsnetwork.Thepossibleexposuregivenbythesetypeofplatformscanbe
ofextremeimportancefornewventures,whetherthetypicalconversationwithaVenture
Capitalistisusuallydonethroughaprotectedandprivateconversation.
Itisimportanttonoteontheotherhand,thatthepublicpositionanewventuretakes,can
beveryriskyinthecaseoffailure.FailureonanEquityCrowdfundingplatformwould
mean a public exposure of the failure, while on the other hand through a Venture
Capitalist,thefailedattempttogetfundswouldnotleavetheroom.
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WiderInvestmentBase:
ManyofthecompaniesthatdecidetouploadtheirprojectsonanEquityCrowdfunding
platform,havea“BtoC”structure,andwouldbenefitfromanincreaseinthenumberof
shareholdersthatmightbecomesuccessively,possibleambassadors.
Having a large number of advocateswith the same interest and respond to the right
incentivesastheonesoftheentrepreneurcanbeveryvaluableforacompanythatisstill
workingonconstructingavalidcustomerbase.
Aswewillseeinthenextsection27theuseofEquityCrowdfundinghasitslimitationsin
givingtherightamountofrightstoshareholdersandinprotectingtheirinterestsonce
thecrowdfundingcampaignisover.
DoesNotEliminatetheIdeaofHavingCollaboratingInvestors:
Crowdfunding is usually associated with the idea that the investors will not bring
anythingtothetablebesidestheirmoney.Ontheotherhand,VentureCapitalisusually
associatedwith the fact that the experts associatedwith it,will be able to participate
directlyinthemanagerialactivitiesofthecompaniesusingtheirexperiencetoaddnot
onlycapital,buttheirknowledgetothepotentialofthecompanyitself.Whenfacedwith
thedecisionwhethertogetthecapitalfromoneortheothersystems,manyfundraisers
believethatthechoiceofusingequitycrowdfundingcouldresultinthepossiblelossof
possiblynecessaryknowledge.Onthecontrary,it isveryplausible,andencouragedby
EquityCrowdfundingplatforms,thatinthecrowdfundingnetworktherewouldbemajor
fundinginvestorsthatdecidetocontributesubstantiallytosomeprojects,expectingtobe
involvedintheboardofsaidcompany.
MarketResearchPossibilities:
Thecreationofanewproducttobepresentedtocustomersistheresultofacontinuous
trial anderrormechanism for theevaluationofwhat ismostlyneededby consumers.
There are different ways tomake research in order to have the right information to
develop a new product. Some companies are today turning to crowdfunding for the
gatheringofdatafortheirmarketresearch.
27 Section:2.5.Inefficiencies.
- 52 -
Thegoalistoreachearlyadopters,willingtotestonthemselvestheproductsandtogive
thecompany feedbacksonhowtomake toproductbetter formoredemanding future
customers.
This method is mostly used by already established companies that are investing in
innovation,buthavenotclearyetwhatcustomerrequirementsforsuchproductsare.The
informationthataregathered,becomeanimportantmarketingandbusinesstoolinthe
developmentofthenewproductandtherelativecampaign.
2.5.Inefficiencies
Aswehaveshownintheprevioussections,theuseofcrowdfundingplatformsischanging
substantially the fundingmarket,enabling funders tohaveaccess tosmallamounts to
fund their organizations without going through banks or other traditional financial
intermediaries. The crowdfunding system although, presents some inefficiencies and
challengesthataffectbothsidesofthemarket.
Inthissection,wewillanalysethepotentialdrawbacksandrisksofusinganequity-based
crowdfundingplatformfromthepointofviewofthecapital-givers.
Wheneverweinteractwithanonlineplatformorrelyonanintermediaryforthehandling
ofcapitalor information,weneedtokeep inmindthepossibleconsequencesofusing
suchthirdparties.Riskscanariseinmultipleforms,fromtheeconomicormicroeconomic
pointofview,todirectplatformrelatedrisks.Wewillfurtherdiscussthesemattersinthe
followingparagraphs.
2.5.1.MicroeconomicChallenges
Whentwopartiesareinthestageofdevelopmentofacontractbeforeatransaction,one
ofthetwomighthaveaccesstoalistofinformationthatmightbemorerelevantthanthe
informationavailabletotheother.Theinformationnotpublictobothparties,mightbe
crucialforbothinthedeterminationoftheconditionstoberecordedinthecontract.This
asymmetryintheamountandvalidityofinformationavailabletotheactorsinvolvedis
referredtoas“InformationAsymmetry”.Informationasymmetrymaybeconsideredone
ofthemostchallengingproblemswhendealingwithequity-basedplatforms.
In the current stateof the art of the crowdfunding system,mostlybasedona reward
system, the information asymmetry relies on the capabilities of the creator of the
enterprisetodevelopornottheproductthatheorshepromisedtodeliver.Inthecaseof
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equity crowdfunding, the information asymmetry involves not only the capabilities in
producingamaterialproductoraservice,butalsotothemanagerialandorganizational
skillsoftheentrepreneur.Thecreatorofthepossibleventureinfact,mustbeablealsoto
createasustainableentity,withequityvalueabletoworkefficientlyinthemarket.
Thelevelofriskwhichfundersface,ismuchhigherconsideringthatthecreatorwillbe
requiredtocreateastructuremadebyagovernance,reportingandaccountingstructure;
allaspectsofacompanythatarerequiredtobemaintainedinapubliclytradedmarket
(LernerJ.,SternS.,2014).
We are able to divide the concept of information asymmetry in two independent but
correlatedissueswhenitcomestocrowdfunding.Theseissuesare“HiddenInformation”
and “Hidden Action”. These complications affect the interaction that exists between
agentsthroughdifferentstagesoftheprocessofraisingcapital.Theyhavethepotential
to create market failure, limiting the possibility of the rising of value-creating
transactions. Here below we present some of the consequences associated with
information asymmetry and hidden information and actions, that can cause market
failure(LernerJ.,SternS.,2014).
AdverseSelection:
Thenatureofthesemoderatelyregulatedplatforms,allowsfortheinteractionbetween
parties that could be even geographically far from one another. Low regulation and
control, togetherwithgeographicdistanceontheotherhand,couldcauseproblemsto
ariseintermsofinformationasymmetry.Fundersinfacts,duetosuchcircumstances,may
notbeabletoperformpersonallyorefficientlyaduediligenceanalysisbeforeinitiatinga
financialcontributiontotheprojectsinquestion.Itcouldbehardforfunderstoaccess
theaccountabilityofthecreatorsincreatingasustainablebusinessinwhichtheywould
bewillingtoinvest.
Onaweb-basedcrowdfundingplatformsthisassessmentisparticularlydifficult,andasa
result,anyprojectpresented,maybediscountedandunderfunded,regardlessofthevalue
itmighthaveonthelongrun.Consequently,high-qualityproposalswouldnotbeputon
theplatformbycreators,fearingalowervaluationoftheirventureandnotachievewhat
couldbeconsideredasafairpricefortheirequity.
Thebottomlineresultforthishiddeninformationproblem,istheparticipationofonly
low-qualityventurestothenetworkoftheplatform.This“AdverseSelection”,createsa
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suboptimal equilibriumwhere high quality ventures funders and creators are left out
fromtheopportunityofcreatinghighstandardtransactions(LewisG.,2009).
MoralHazard:
Theinequalityinthedistributionofpowerandknowledge,isnotlimitedtotheperiodof
timeprecedingtheinvestmentactions.Theissuesrelatedtoimbalanceofinformationand
powerinfact,arisealsoafterthetransactionwentthroughandthefundsareraised.The
natureofthecrowdfundingcontractdoesnotgiveanyrighttothefunderovertheactions
ofthecreatorafterthefundsaretransferred.
Thecreatormightchangeitsapproachtothemarketandtorisk;actinginaselfishmatter,
andhemightactnotincompliancewithwhathasbeenagreeduponbeforetheinvestment
wentthrough(LernerJ.,SternS.,2014).
Thestructureofthesystemespeciallyinanequitycrowdfundingenvironment,doesnot
alsoallowforthecreationofasecondarymarket for theexchangeof the investments.
Meaningthatoncethecampaign isover, the investorscannotsell their“shares”of the
companytheyinvestedin,butitisallriskcapital.
Thesehiddenactionsaretheconsequenceofthe“MoralHazard”involvedinthesetypes
oftransactions(BellaflammeP.,LambertT.,2016).Asaconsequence,fundersmayavoid
using such platforms for investing, fearing possible mismanagement of the capital
invested;thiswouldresultinamarketfailureandtheshuttingdownoftheplatform.
Principal-AgentProblem:
OneofthemostcommonexamplesofanegativeconsequencearisingfromtheHidden
InformationandHiddenActionsissues,isthe“Principal-AgentProblem”.Thisproblem
ariseswhentheactionsofthecreatorsarenotinlinewiththeinterestofthefunder.These
actions may be the result of business information related to the insider position the
funderhas inthemarket;ormoresimply, thenotalignmentof the interestof thetwo
partiesinvolved.
Theabsenceofasecondarymarketforinvestments,limitstheactionsoftheinvestorsin
thecaseinwhichtheactionsofthefundraiserarenotinlineanymorewiththeirinterests.
Thesystemdoesnotallowforabackoutoptionafterthecampaignisover.
ThePrincipal-AgentProblemisacommonconsequenceof themiscommunicationthat
usuallyoccursbetweenfundersandfundraisers.Thecommunicationsysteminsidethe
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platformshouldbeconstructedsuchthatobjectivesofbothactorsareclearbeforeand
aftertheinitializationofthefirsttransaction.
CollectiveActions:
Duetotheinformationasymmetrypresentinsuchplatforms,oneoftheissuesthatmight
ariseisthe“FreeRiding”problem.Investmentinformationinsidetheplatformarepublic,
meaning that some fundersmay rely on others work in the definition of a solid due
diligence.Fundersinsidetheplatforminfact, inordertoavoidtheissueslistedabove,
mightrelyonthedecisionsmadebyotherpeers,slowingdownthefundraisingprocess.
Ifthiswouldbethecaseforeveryfunderpresentontheplatform,themarketwouldstop
andeventually fail, sinceeveryonewouldbewaitingonothers tomakethe firstmove
(LernerJ.,SternS.,2014).
InformationAsymmetrycannotbemanagedcompletelybythecrowdfundingplatform.
Thepowerandtheresourcesoftheplatform,areusuallylimitedtoitsboundaries;andit
canbedifficultfortheplatformtoofferapreciseanddeepanalysisofthefundraisersonce
theycreateanewcampaign.Theanalysiscouldincludethefinancialandcreditrecordof
entrepreneurs.Fromthepointofviewoffunders,havingaccesstothistypeofinformation
wouldmeanhaveaccesstoacompleteviewofthepersontheyareaskedtotrust,making
thetrustingprocedurealoteasier.
Samegoesforfunders;havingtherightinformationaboutpossiblefundraisersmayhelp
themtoselecttherightcrowdtofundtheirproject,makingthecrowdfundingprocedure
alotfasterandeasier.
2.5.2.RisksAssociatedwithCrowdfunding
Thereare fivemajor financial risks related toa crowdfundingplatform for theagents
involved.Wecanevaluatethepossiblechallengesbyanalysingaseriesofdifferentrisks
related to them; specifically: Risk of Default, Risk of Platform Closure, Risk of Fraud,
LiquidityRisk,andRiskofCyber-Attack(KirbyE.,WornerS.,2014).
Evenifwewillnotdiscussaboutthem,itisimportanttotakeintoconsiderationalsothe
risks associated with innovation in the open market, that include: Investment Risk,
Development Risk, Co-Ordination Risk, Motivation Risk, Control Risk, Security Risk,
GovernanceRisk,andCultureRisk(AmalarL,2010).
- 56 -
Agent risk of such sort may lead to risk of default or fraud, and unfortunately
crowdfundingintermediariesdonotcurrentlyoffertoolstoattenuatethesespecificagent
risks,exposingdangerousagentsparticipatinginthenetwork.
Oneoftheservicesinwhichplatformsinvestsubstantialresources, isthescreeningof
possiblebusinessesbeforethepresentationtothepublicof investors.Thesescreening
processesarecreatedinordertoallowfunderstohaveasmuchinformationaspossible
when making financial investment decisions, and offering appropriate and secure
projects.Thesepercussionsareinfactnecessaryinsuchcircumstancestoavoidtheissues
previouslypresented.Thepresenceofsuchattentionandsagacitybyplatformsincreases
theirprestige,butexposesthemtodifferenttypesofrisks,suchascyber-attacks.
Asweearliersaid,openinnovationrelatedtocrowdfunding leadstocertainproblems
conducing to the issue of Moral Hazard and the Principal-Agent issue. Unfortunately,
insideacrowdfundingplatform,thisrequiresanextraeffortbyfundersinscreeningthe
activitiesof thecreators.The informationtheyneedtogather,arerelatedtoboth, the
projectthatisbeenpresentedtothem,andthehistoricfinancialandcreditbehaviourof
the creator of the project. These research and analysis are time consuming as
consequentlycostlytothefunders,thatasaconsequencewillberecompensedmorein
termsofinterestsonthecapitaltheydecidetolend.
RiskofLiquiditymustbementionedandkeptisstrongconsiderationwhentalkingabout
risksassociatedwithcrowdfundingplatforms,sinceitisoneofthemostrelevantrisks
associatedwiththeseactivities.
Oncetheinvestmentisdone,andthecampaignisoverinfact,fundershavenooptionbut
toremainpartnersofthecompanyuntiltheunfoldingofthemarket.Itdoesnotinfact
exist an outside and secondary market on which obligations of this type could be
managed,soldorboughtafterthecreationoftheventure.Thislimitstheactionsofthe
fundersmakingthemfacereallyuncomfortablefinancialinvestmentdecisions,withvery
littleinformationaboutthecreatorattheirdisposal.Thishighlevelofuncertaintyleads
to an abandonment of platforms by funders and to a lowering of the position of the
phenomenonofcrowdfunding.
TheLiquidityRiskissuehasverystrongimplicationinthecrowdfundingmarket,thatmay
resultinthecreationofaclosedmarket,limitingtheentrancetotheactorsthatarewilling
tofacehighrisksanduncertainty.Theabsenceofasecondarymarketandthelocalized
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regulatoryrules, likespecificnational laws,aboutcrowdfundingandsimilarnetworks;
mightalsoleadtothecreationofclosedandconfinedwebsofinvestorsandcreators,that
hardlyconnectwithoneanother.Thenameoftheriskassociatedwiththisphenomenon
of separation of the networks is “Systemic Risk” (Kirby E., Worner S., 2014), and is
associatedwiththe limitationsthatthecreationofnationalregulationsimposestothe
opennessofthemarket.
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CHAPTERIII
CrowdfundingIntegratedinaBlockchain-BasedEcosystem:
DecentralizedApplications(DApps)
In the previous chapter, we analysed the different types of inefficiencies that a
crowdsourcingplatformmaypresent fortheparties involved,meaningcapital-seekers
andcapital-givers.InChapterIontheotherhand,weintroducedanewtypeoftechnology
thatcouldchangetherulesofthegameformanyindustriesandatthesametimeallow
for the creation of new ones. The introduction of the concept of blockchain and
tokenization, togetherwith the decentralization ofmanagerial and financial activates,
maycreatefavourablesituationsinwhichsomeofthepreviouslydefinedinefficienciesof
traditionalequitycrowdfundingcouldbemitigated.
InthisChapterwewillalsoseewhatthechallengesarisingfromtheintroductionofthis
technologymightbe, togetherwith thepossible futuredevelopmentof the technology
thathasthepotentialtodisrupttheindustry.
FromwhatwehaveseeninChapterII,wecanstatethatacrowdfundingintermediary
plays twomajor functions in the environment. The firstmajor functionplayedby the
crowdfunding platform is themechanism of creating a bridge of communication and
interaction between the two major parties involved in crowdfunding business. The
secondcrucialfunctionisthecreationofastructure,thatenablestherightfultransaction
offundsbetweenthetwoparties.
Theplatform,followingthesetwomajorfunctionsisabletoimplementalistoftoolsand
services,inordertomaketheplatformbetter,moresecure,andeasytousefortheusers.
Thoughtthedescriptionswewillprovideoftheplatformandtheservices,wewillmake
acleardistinctionbetweentools,underliningthereasonsthatledtoitsimplementation
andtowhichmajorfunctiontheyarelinked.
Wewillfocusononeofthemajorfunctionsthatacrowdfundingplatformperformsinthe
sustainmentoftheecosystem.Thefocusonthischapterwillbeonthemechanismsthat
regulatethefundingprocessesoftheequitycrowdfundingplatform.Wedecidedtofollow
thispathsince,itisinthisfieldinwhichblockchaintechnologycancomeinhandy.
Wewillseehowthetechnologyallows for thecreationof thesocalled“Decentralized
- 59 -
Application”(Dapp)andhowitcanbeadaptedtothecrowdfundingenvironmenttohelp
createaBlockchain-basedCrowdfundingPlatform,thatcanbeabletosatisfymanyofthe
needs of current crowdfunding clients, and resolvemany of the issues related to the
traditionalmethodsofcrowdfunding.
DAppshavethepotentialtoresolvemanyoftheproblemsassociatedwiththecurrent
state of the art of crowdfunding, and allow for new and better mechanisms for the
protectionofbothfundersandfundraisers.
3.1.Functionality,StructureandDesignofaCrowdfundingDApp
One of the most important innovation brought by the introduction of blockchain
technologyistheintroductionofacrowdfundingDApp.ThecrowdfundingDAppallows
for the integration in the system of many new functionalities, and creates a bridge
betweentheusersandtheblockchaintechnologyanditspotential.
Inorder toperformcertain functions ina standardizedandcomputerizedway, Smart
Contracts are used to administer the functions built inside the Crowdfunding
DecentralizedApplication.
AdeeplookintothefunctionalitiesofferedbytheDAppbackedbythetechnologyand
logics behind smart contracts, will help us understand all the applications and the
functionalitiesthataDAppisabletooffer,andthenecessitiesitisabletosatisfy.
TheCrowdfundingDAppisthebridgebetweentheusersandtheblockchain;istheholder
oftheprogramsthatregulatethenewfunctions.
Insection1.5.3,wegaveanexplanationonthefunctionsandstructureofsmartcontracts,
onhowtheycanbeconstructedandarebuilt.Thatexplanationaboutsmartcontractsis
necessary tounderstandhow theyhave thepotential tobe implemented in an equity
crowdfundingenvironment, tohelpamelioratemanyof thedifferent services that are
usuallyprovidedbyatraditionalcrowdfundingplatform.
Thestructureofthesmartcontractsthatwewillfurtheranalyse,refersspecificallytothe
all-purpose framework that is offered by environments like the one of Ethereum.
Ethereum, like many others, is in fact able to offer developers and companies the
possibility to enter in the network with a smart contract, in many different ways
regardlessoftheindustryinwhichtheyareworkingin.TheflexibilityoftheEthereum
networkcanallowtheintegrationoftransparentandcustomizableprotocols,withaset
ofgenerallydelineatedsmartcontracts.Thisisabletotomakethenetworksafe,secure,
- 60 -
immutable,anddecentralized;thoughdependentbythedecisionsofthefinalusersthat
aretheprincipalcontributorstotheequityandliquidityofthenetwork.
Inthissectionwewillseemanyofthefunctionalities,thestructureandthedesignofa
crowdfundingDApp.Wewilldosoinordertounderstandindepthhowtheseapplications
areconstructed,whytheyareconstructedthatwayandwhatistheleveloninteraction
betweentheactorsinsidethenetworkandtheDApp.
3.1.1.FunctionsPerformedbytheDApp
It is important to define first, five of the most important functionalities that a
crowdfundingDAppcanoffertobothsidesofthesystem,meaningcapital-seekersand
capital-givers.
The mechanisms explained below, give a detailed vision of the structure of a
crowdfundingDApp,andhowtheinteractionwiththemainplatformisperformed.We
will be able to see the differences between the common functionalities offered by a
traditional crowdfunding platform, and the ones offered by a blockchain-based
crowdfundingDApp.
Forthesakeofclarity,itisimportanttopointout,thatinablockchain-basedenvironment,
wheneverwetalkaboutfunds,werefertoanamountthatcanbegivenintheformof
cryptocurrencyorinfiatcurrency28.Thedecisiononwhethertoraisecapitalincryptoor
in fiat, depends on the necessities and the preferences of the funders during the
crowdfundingcampaign.Thedecisiontoallowboth,makesiteasierforinvestorsthatare
abletodecidetoinvestwithwhatevercurrencytheyprefer.
SmartPropertyTokens:
Thecapital-giversare investing incompanies inanequitycrowdfundingenvironment,
thismeansthattheyarebuyingaportionofthecompanytheyareinvestingin.Inorder
toprovetheownershipofthesectionthecompany,orasimpleproofoftheinvestment,
theyreceive“SmartPropertyTokens”fromtheDApptheyinvestin.Tokensrepresenta
portionof thecompany,andtheirprice isdeterminedbythe fundraisers.Thepriceof
tokensisbasedonwhatfundraisersbelievethecompanypotentialis,andonhowmuch
valuetheywanttogatherinordertomakethecompanygrow.
28Fiatcurrency:Fiatcurrencyismoneywithoutintrinsicvalue.Thevalueoffiatcurrencyisdeterminedbygovernmentregulations.Itcanbeconsideredofvalue,onlybecausethegovernmentusesitspowertoenforcethevalueofthatcurrency.
- 61 -
Eachprojectorentity,isabletoissueitsowntokens,thatarelinkedtotheprojectthatis
beendeveloped.Theownershipofthetokenscreatesabindingrelationshipbetweenthe
funder and the company, entitling the capital-giver to certain rights associated to the
propertyofthatgiventoken.
Tokens can be considered as holders of value, similar to the concept of shares of a
company, whose value is determined by the fundraiser at first, but can increase or
decreasedependingontherulesoftheopenmarketfortokens.
Atthebeginningofthecampaign,thefundraiserssetthenameandtheinitialvalueofthe
tokentheyarewillingtoissue,dependentalsoontheamounttheywanttoraise.Smart
tokensareissuedeverytimeacontributiontothecrowdfundedcampaignisdone.
Preciserulesregulatethedegreeandlevelofrightsandpowerthataretobegrantedto
thefundersattheendofthecrowdfundingcampaign,wherethecompanywillusethe
fundsacquiredtobuildtheprojectastheypromised.Theenforcementofthoserightsis
not given to a centralized authority, but to the software that regulates the relations
betweenthetwoparties.Asweknowinfact,thesmartcontractisinchargeofapplying
therules,andwillexecutealwaysassoonascertainrequirementsaremet.
Everytokeninordertobelinkedtocertainrights,isinpossessionofitspersonalprivate
key. The owner or holder of the private key related to the token, is consequently the
ownerofthetokenitself.
Trading of keys and tokens is allowed in a blockchain-based environment. this is of
particularimportance,sinceitallowsforthecreationofasecondarymarketfortokens.
Thesecondarymarketallowsfortheexchangeoftokensbetweeninvestors,solvingone
of thebiggestproblems for the traditional crowdfunding environment.Wewill take a
deeperlookintothepotentialofthesecondarymarketfortokensinsection3.4.2ofthis
Chapter.
Tokenscanbeconsideredtobevalidaslongasthecompanytowhichtheyareassociated
is running. In the crowdfunding phase, tokensmaintain a steady value set before the
beginningofthecampaign;assoonasthecampaignisover,thevalueofthetokensvaries
dependingontheperformanceofthecompanyandoftherulesofthemarket.
Ifthecampaignfailsbecauseofthereachingofthetimelimittoraisefunds,thetokens
becomevaluelessandtheamountoftheinvestmentisgivenbacktotheownersofthe
tokensthatinvestedinthefailedcampaign.
Ifthecampaigngoesthrough,thetokenscanbeexchangedandthepricecanfluctuate
dependingonhowthemarketisrespondingtothecompany,andonhowthecompanyis
- 62 -
performing.
Thefirstissuingofsmarttokensbyacompanyandtheinitialdeterminationoftheprice
ofthosetokens,iscalledtheICOor“InitialCoinOffering”.TheICOisthefirsttokensale
orlaunchinthemarketfortokens.
Thetokensalehelpsthecompanytoraisemoneybysellingsharesofitselftoanetwork
ofpartners.Thiscanbedoneevenoutsideacrowdfundingplatform,anditisusedlikethe
traditionalsellingofsharesinthepublicmarket.Itissimilarinfact,tothetraditionalIPO
concept,inwhichcompaniesdecidetobecomepublicandsellagivenamountofshares
toraisecapitalfornewprojectsorwheninneedofliquidity.Theyareinfactanalternative
tothethetraditionalCapital-FundingofVentureCapitalistsandEquityfirms.
2017hasbeentheyearinwhichtheindustryofICOshasboomedextremelyrapidly.The
datashowshowtheamountoffundscollectedbyICOs,hasreachedanastonishing4,4106
USDbillionsinjust2017alone.InJuly2017,theaveragecollectedfundsforanICO,was
of33.17USDmillions.Thegraphsbelow(Graph(2)&Graph(3)),showsgraphicallywhat
hasbeenjustexplained.
Graph(2):CapitalraisedbyICOsinUSDMillionsduring2017.
4,5 9,7 4,7127,80168,40
995,20
461,30330,00
802,90822,60683,50
0
200
400
600
800
1000
1200
USDMillions
Source: Coinspeaker,2017
- 63 -
Graph(3):GrowingN°ofICOsin2017.
InNovember2017,wehave the ICOs that raised singularly the greatest amounts yet.
QASH (Trading& Investing company) is leading the groupwith a 108,2USDmillions
raisedinonlyfourdays, followedbyWAX(68,4USDmillions)andGridplus(45,7USD
millions).Switzerlandisthethenationsthatiscurrentlymoreactiveinthecreationof
ICOs;4outof6 ICOs in factcomefromthiscountry, thanks to its favourablebusiness
orientedandinnovationorientedlegislations(Dr.DiemersD.,2017).Wewillgodeeper
inthisdiscussioninChapterIV.
Thebiggestdifferencefromthetraditionalmethodsofraisingcapital,relies inthefact
that through this technology, also new and small start-ups can have access to similar
financingtool;withouttheneedtorelyontraditionalbusinessangels,venturecapitalists
orbanksinordertoraisefunds.
CrowdfundingCampaign:
Beforewebegintodefinethedifferencesinthemechanismsrelatedtothenewsystemto
raise capital, it is important to note that the introduction of the technology does not
necessarilymakeitharderforuserstointeractwhittheplatform.Thefrontendofthe
platform, meaning the interaction with the crowdfunding platform by users, is very
similartothetraditionalmethodologyofcrowdfunding.Thenewtechnologystaysinthe
backgroundanddoesnotincreasethedifficultywithwhichinteractionsaremadeinside
theplatform,butsimplyhelpsimprovethequalityoftheservicesprovided.
Oneofthefirstelementsthatrequiretheinteractionwiththesystem,isthecrowdfunding
29
3 5 3
17 16
30 35
48
72
50
01020304050607080
N° ofICOs
Source: Coinspeaker,2017
- 64 -
campaign. There are several stages that lead to the success of a campaign, and they
dependontheachievementofcertainsteps.Theyespeciallydependontheachievement
of the objectives set before and during the campaign and in the end on the
accomplishmentofthefinancingobjective.
Oneofthefirstmajordifferencesbroughtbytheblockchaintechnology,isthestructure
andthemechanismsengagedfortheraisingofcapital.
Thefundsgivenbythefundersarenotdirectlytransferredtothecreators,buttheyare
stored ina separatedaccount,where theywill remain lockeduntil the fundinggoal is
reached,orthedeadlineforthecollectionofthefundshaspassed.Ifthecaseoccursin
whichthethresholdsarenotreached,thesmartcontractinsidetheDAppiscodedinsuch
away,thatwouldreleasethefundsbacktothefunders;thatwillbeabletoinvestthemin
another,moreprofitableproject.Ifontheotherhandthefundingprocesshasapositive
outcome, thesmartcontract thatmanages the funds,willmoveto thenextstepof the
crowdfunding procedure. This procedure consists in attributing the pre-determined
rightstoboththeownerofthetokensandthefundraisers,andunlockingthefundsraised
sothattheycanbeused,undercertainrules,bythefundraisers.
Inthisphase,throughtheuseofdigitalsignatures,fundersandfundraisersrelatedtothe
projectcanusetheirrightstoperformactionsonthefundslinkedtotheproject.These
rightsallowboththefundersandthefundraiserstohaveacertaincontroloverthefunds
andmakepossibleactionsandproposalstousethem.Wewillseeinnextfewparagraphs
what these rights are andhow important they are for the creationof adecentralized,
transparentandsafeenvironment.
Intheearlystagesofthecampaign,rulesneedtobedefinedwithrespecttotherightsand
powerthateachactorwantstoachieveorhaveduringthedevelopmentoftheproject.It
isofextremeimportancetohaveacleardefinitionoftherightsandtheobligationofthe
actorsinvolved,inordertoavoidfutureissuesrelatedtopoweranddecisionmaking.The
fundersforexamplewouldneedtoset,makepublicandhavecertainrightsontheamount
theyintendtoinvest,whileontheotherhand,fundraiserswouldwanttohavefullcontrol
overtheraisedfunds.Insidethesmartcontract,thatdefineseachone’srights,theserules
arewrittendownandbecomeinviolableonceanyonedecidestoparticipatetotheproject.
DecentralizedAutonomousOrganization(DAO):
A“DAO”or “DecentralizedAutonomousOrganization”has similar functionalitiesofan
investmentfund,butintegratedinablockchain-basedenvironment.Insteadofdirectly
- 65 -
investinginnewventures,fundersmaydecidetoinvestfirstinaDAO,andwaitfornew
projectstobeproposedtoit.OnceprojectsareproposedtotheDAO,theirvotingpower
makesthemabletodecidewhetherthemoneytheyinvestedshouldgotothatspecific
projectornot.
BeingmembersofaDAO,allowsuserstoproposeideastotherestoftheinternalnetwork,
andinvestinsomeoftheprojectsproposedbyothermembers.ADAOdoesnotcreate
physicalproducts,itdoesnotdevelopsoftorhardware;ontheotherhand,itisableto
receiveandpresenttoitstokenholders,differentinvestmentproposals.Inordertodoso,
itrequiresa“Contractor”,whichcanbeanyDAOtokenholderthatmakesaproposalto
theDAO;thisproposalcanbeacceptedorrejectedbyotherDAOtokenholders.
Notethattroughthissystem,thetokenholdershavethechancetomaketheDAOgrow,
bycreatingcontractsorproposalstoothertokenholders,thatwillmaketheDAOgrow
andgainmorefunds.
TherewardsforinvestingcurrencyintheDAOareindeedDAOtokensregisteredinthe
nameoftheaccountthatinvestedinthefund.Atokenempowersitsownertohaveclaims
overthecompany,meaningthattheinvestorwillgainvotingpowerandotherrightasan
associateoftheDAO.
Likesharesofanyothertraditionalcompany,thenumberoftokensreceivedisrelativeto
thevalueinvested.Pricefortokensfollowsthenormalmarketrulesofdemandandoffer,
andareeasilytransferableinsideandoutsideoftheDAO.
ProposalscanbedonedirectlytotheDAOandproposeacertainuseofthefundsstored
insideit.WheneveraproposalisdonetotheDAOforanewproject,theinitialquorumfor
atraditionalvotingis20%.Inthecaseinwhichtheamountrequestedbytheproposal,
wouldbethetotalityofthevalueaDAOhasaccumulated,thequorumnecessarytomake
theproposalpasswouldbeof53.33%ofthetokenholders(JentzschC.,2016).
Toavoidreceivinganexcessivenumberofproposals,aproposalfee(changeablewitha
proposal)isrequired.Ifthequorumisachieved,thetotalamountforthefeeisrefunded
tothecontractor;ifonthecontraryitisnotachieved,thedepositiskeptbytheDAO.
Theproposalshaveanexpiringdate,attheendofwhich,ifthegoalisnotreached,allthe
currency accumulated is returned to the contributors, and the total amount of tokens
createdareeliminated.
If the proposal is accepted, the DAO transfers the necessary currency in the Smart
Contractsthatrepresentstheproposition;andbydoingso,itstartsanewproject.
Oncethenewventureisupandrunning,decisionalpowerofusersisdirectlycorrelated
- 66 -
tothenumberoftokenstheypossess.Tokensaredivisibleinfractions,transferableinthe
secondarymarket,andidentical.
Oncethecontract isestablished,wheneverthecontractormakesaproposal,userscan
voteonitduringadefinedtimeslot.Whenthevotingwindowisclosed,arequestcanbe
filedbyanytokenholdertocertifythatthethemajorityandthequorumnecessaryto
makeadecisionhasbeenattained.
Inorder foranewdecisionabout theproject togo through, themajorityof the token
holdersoratleastaminimumamountofthem,mustagreeonthenewproposal.Thelevel
ofthequorumcanvary,andcanbechangedwithaproposal.Thequorumdependsonthe
numberofparticipants,thenumberoftokensissued,thevalueofcurrencyusedtocreate
tokens,andthetotalamountthattheprojecthasaccumulated.
TheDAOcomplexity canvarydependingon the role it is given to, and thenumberof
signatures,orconditionsitneedstofunction.Thismeansthatthenumberandthelevel
of interaction between the parties varies depending on the conditions that are
determinedtobepartoftheDAO.
DecentralizedAutonomousOrganizationscanplayanimportantroleinsideablockchain-
basedcrowdfundingenvironment.TheuseoftheDAOcanprovideaneasierwayforthe
protectionof investorstocomeincontactwith innovativeprojectsandinvest inthese
profitablenewventures.
WhatmakestheDAOwork,isalineofcode,andjustlikeasmartcontract,itisdeveloped
usingtheSolidityprogramminglanguage.Inordertowork,aDAOneedstobeuploaded
onablockchainthatsupportsit.Onceonthenetwork,itwillperformmanyfunctionin
themanagingoffunds,rightsandpermissions,aswellastheproduction,management,
andverificationoftransactions.
WhenaDAOisutilizedinacrowdfundingenvironment,itcoversoneofthekeyrolesin
thedesignoftheenvironment.TheDAOplaystwomajorroles:theroleoftheholderof
rightsforusersofferedbytheDApp,andtheroleofholdingthefundswhileanyprojects
isbeingfunded.WhendevelopingthecodeoftheDAO,particularattentionneedstobe
putinthefunctionalitiesembodiedinit,andtherightsitwillallowoncetheprojecthas
taken off. Rights and obligations of the two actors need to be clarified and specified
deeply;oncetheprogramhasstarted,itbecomesverydifficulttointerruptthecycle.
ADAOisabletocommunicate,ifnecessary,withothercontractsinsidethenetwork.This
allowsforawidelevelofpossibilitiesandfunctionalitiesacrossthenetwork, inwhich
- 67 -
automationofactiveswillsubstitutemanyofthecurrentlycommonlyusedapplications.
ThepotentialoftheDAOisenormous,giventhefactthatitrepresentscompletelythewill
of the owners or shareholders; technically allowing it to grow and evolve and
communicatewithotherDAOstocreateanevenbiggerdecentralizednetwork.
VotingSystem:
Oneofthemajordifferencewiththetraditionalenvironment,istheallocationofrights
amongusers.Thenewtechnologyallowsforastrongerallocationofrightsto funders,
thatallowsforadecentralizationofdecisionmakingthatcoulddisrupttheindustry.
Beforetheissuingoftokens,thefundraiserssetthelimitoftherightstobegiventotoken
holders.Every token canbeassociated to theabilityof a tokenholder to expressone
singlevote,whenevertherighttovotecanbeexpressedinadecisionmakingsituation.
Whenever a new proposal is issued by fundraisers, a vote can be used to allow the
generation of different actions, such as spending of cryptocurrency, interaction with
differentorexternalcontracts,oreventheeliminationofanotherproposal.Theexecution
oftheproposalthathasbeenvalidatedbythevotingactions,willbeexecutedassoonas
itreachesamajority.
Asexplainedbefore,therightassociatedwiththeholdingoftokens,likevotingrights,are
definedbythecreatorsofthecampaignbeforetheproposalbecomespublic.
Votingrightsdemocratizeddeeplytheenvironment;rightsandpowerareputbackinthe
handsoffinalusers.
WithdrawTrackingSystem:
When designing the DAO and its powers before the deployment of a project, the
fundraiserisabletocreatenotjusttherulesthatregulatevotingrights,butalsorulesthat
limit the withdraw from the funds raised. What it means is that there can be rules
embodiedintheDAOcode,thatlimittheamountofthefundsthatcanbespentbythe
fundraiserinagivendeltaoftime.Theserulesarecreatedinordertoprotecttheinterests
ofthefunders,whicharealsoentitledtodecideonhowthatmoneycanbespent. It is
importanttorememberalso,thatthenatureoftheblockchaintechnology,makesevery
transactionpublictoallthemembersofthenetwork;meaningthatallthemovementof
currency or the possible investmentsmade by the fundraisers, can bemonitored and
throughtheuseofvotingrights,alsobeblocked.
Oncethethresholdsetbythepartnersissurpassed,anytransactionthatrequiresaccess
- 68 -
tothefundswillnotbeallowed.Ifthefundersrequirenecessarilythatamount,whatthey
candoiscreateaproposal,onwhichfunderscanvoteweathertoallowforthespending
oftheextramoneyornot.
3.1.2.EquinityCrowdfundingDAppRelationalStructureintheNetwork
We now have a clearer vision on how the traditional crowdfunding platform can be
changed by the introduction of blockchain technology. We now also have a clearer
definition of some of the new actors that would compose a blockchain-based equity
crowdfundingenvironment.
IntheFigurebelow(Figure(13))therepresentationoftherelationshipbetweenthetwo
partiesandtheequitycrowdfundingDAppisshown.Inthefigureisisshownalsotherole
oftheDAOandtheservicesthatareembodiedinsideit.Theseservicesembodiedinthe
DAOaretheoneshighlightedinadarkertone.
Figure(13):RelationshipbetweenthetwopartiesinvolvedandtheDAppanditsDAO,in
theequitycrowdfundingblockchain-basedecosystem.
Fromthe figurewecanclearlysee theobligationsandtherightsassociatedwitheach
actor,andhowtheEquityCrowdfundingDAppplaystheroleoftheintermediarycreating
aninformationandrelationalbridgebetweenthetwo.
Itisimportanttorememberthough,thateveniftheDAppisactuallyplayingtheroleof
theintermediary,itisitselfdoesnotoperateanycontroloverneitheroftheactorsinthe
environment.ThemajorroleoftheequitycrowdfundingDAppistoimprovethelevelof
- 69 -
communicationbetween theparties in themarket, andallow them to collaborate ina
moresecure,safeandtransparentenvironment.
3.1.3.ServicesandFunctions
Aswehaveseensofar,therearedifferencesinthestructureofablockchain-basedequity
crowdfundingplatformwithrespecttoatraditionalequitycrowdfundingplatform.We
have also seen what are the new functionalities that an Equity Crowdfunding
DecentralizedApplicationmighthaveandwhateffectitwillhaveontheprotectionofthe
rightsofusersinthenetwork
Inthefollowingsectionwewillassociatethetraditionalservicesthatcanbeprovidedby
a traditional equity crowdfunding platform, with the functionalities that these new
decentralizedequitycrowdfundingapplicationscanhaveconstructedinsidethem.This
waywecanseehowthenewfunctionalitiesarerelatedtothedifferentservicesthatare
notoriouslynecessaryfornormalusersinsideacrowdfundingnetwork.
In order to be as clear as possible, the table below (Table (2)) shows the connection
betweenthetraditionalservices,andsomeofthenewfunctionalitiesassociatedwitha
decentralizedapplicationinablockchain-basedequitycrowdfundingecosystem.
Functionalities Services
CrowdfundingCampaign Matching,Payments,Banking,Dunning&DebtCollection
SmartPropertyTokens InvestorRelation
DAO InvestorRelation,Payment,Banking,Dunning&DebtCollection
VotingSystem(DAO) InvestorRelation
WithdrawTracking(DAO) InvestorRelation
Risk-ScoringSystem RiskScoring
SmartIdentityAuthentication Authentication
CrowdfundingApplication Contracting&Compliance,ITOperations
Table(2):FunctionalitiesofanequitycrowdfundingDAppassociatedwiththeservices
providedandnecessary.
As we can see, the services highlighted with a darker colour, are associated with
functionalitiesthatarenotpresentinthetraditionalequitycrowdfundingecosystem.
Theuseofthisnewtechnologyandinnovationisabletocreatenewfunctions,thatare
abletosatisfythesameneedsofcustomers,butwithsubstantialimprovements.
- 70 -
Major improvements brought by the new structure, are related to the Investor
Relationship side; given by the introduction of functionalities such as smart property
tokens,andtheuseofaDecentralizedAutonomousOrganization.
DAOsintroductionallowformanyadvantages inthefield;advantagesthat includethe
votingsystemandthewithdrawtrackingsystem,whichempowerinvestorsinwaysthat
werehardyimplementedbefore.InvestorRelationshipimprovementiswhatreallydrives
theadvantagesoftheintroductionofthistechnology.Withtheideabehindblockchain,
wecanhaveanempowermentofthepeoplethatsupporttheplatform;wecancreatea
safer environment where the investors feel at ease in the act of investing in new
businessesandinnovativeideas.
3.2. Blockchain-Based Equity Crowdfunding Environments: Business and
InteractionModels
Nowthatwehavea clearvisionof all the functionalitiesof ablockchain-basedequity
crowdfundingDApp,wecananalysehowtheintroductionofblockchaintechnologyand
theDAppcanchangetheinteractionmodelsinsidethecrowdfundingenvironment.
Therelationshipbetweenthetwomajoractorsandthethirdpartywillchange,andin
ordertounderstandbetterthelevelofinteractionandtheroleofeachpartyinvolved,we
presenttwodifferentinteractionmechanismstoexplaintransactionflowinthisnetwork
inwhichablockchain-basedequitycrowdfundingDAppisutilized.
It is fascinatinghowthe levelof independencyfromathirdpartyof thetwoagents, is
muchhigherinasysteminwhichtheblockchaintechnologyisutilized.
In a traditional system, the interventions of third trusted parties like a bank and a
crowdfundingplatformarenecessary.Inthetraditionalecosystem,theabsenceofthese
intermediaries would not allow for the development of services like banking and
payments,necessaryforthefinancialandcommunicationalneedsofcreatorsandfunders
inthenetwork.
Aswewill see, the role and theposition of these intermediarieswill changewith the
introductionofblockchaintechnology.Thetechnologyeliminatessomeofthetraditional
intermediaries and will simplify the network, by establishing a more direct
communication,easierandmoretransparentinteraction,andfairdistributionofrelevant
information, solving many of the issues related to the traditional methods of equity
crowdfunding.
- 71 -
Ontheplusside,theroleofmanagingtheallocationanddistributionoffunds,isnolonger
responsibility of the traditionally used crowdfunding platform itself or of a financial
intermediary,but it ismanageddifferentlyby thecrowdfundingDAppandtherelated
DAO;bothdecentralizedandconstructedtoallowahigherleveloftransparencyinthe
interactionsbetweenthecapital-seekersandcapital-givers.
The introduction of aDecentralizedApplication, has a strong effect on the traditional
structure of the crowdfunding network. In Chapter II we explained two important
contribution network structures, the “Peer-to-Peer ContributionMechanism”, and the
“Equity-BasedContributionMechanism”. In thenext twosectionswewill seehowthe
introductionoftheblockchaintechnologyhasaneffectonthestructureofthenetwork,
andhowtheDAppwillcomeintoplay.
3.2.1.Peer-to-PeerContributionMechanismTroughaDecentralizedApplication
Inthepeer-to-peercontributionmechanism,whereblockchaintechnologyisintroduced,
themajordifferencewiththetraditionalmethodliesintheholderofthemechanismthat
controlstheflowoffundsandtheflowofrights.Thisroleoftheholderofsuchmechanism,
isinfactplayedbytheDAOinsidetheCrowdfundingDApp,ofcentralimportanceinthe
network.
Aswecansee,theuseoftheDAppallowsforaresolutionoftheproblemoftransferof
rights of the shares between the creator and the funder. Thismeans that there is the
possibility for the creation of a secondary market, in which rights on tokens can be
exchanges, resolving one of the major problems related to traditional crowdfunding
platforms.
Throughthismethodfurthermore,theDAppcarriesouttheroleoftheholderofthefunds
devoted to the creator. This means that funds are not directly and immediately
transferredto theentrepreneur,butareholdby theDApp.Thisallowsthecreationof
systems inwhichaccess to the fundby thecreator ismanagedbycertain rules in the
handsofthosethatareholdingrightofthecompany.Thisempowersrightholdersina
waythatwasnotpossiblethroughtraditionalmethodsofcrowdfunding.
Thefigurebelow(Figure(14))showshowthestructureofthepeer-to-peercontribution
mechanismchangesas theblockchain technologyand theDAppare introduced in the
network.
- 72 -
Figure (14): Peer-to-Peer ContributionMechanism trough a decentralized application
Illustration.
Itisimportanttonotehowfinancialinstitutionslikebankshavenoroleinthissystem;
andhowtheinteractionofthelendersisnotlimitedtotheonestheycanhavewiththe
platform,butextendtootherlenderstoo.
3.2.2. Equity-Based or Royalty-Based Contribution Mechanism Trough a Decentralized
Application
Similar structure canbe found in the equity-based contributionmechanismstructure;
where entrepreneurs and investors can interactwith each other directly. Also in this
system,financialinstitutionslikebankshavenorole,andcanbeeliminated;trustthan
shiftsfromfinancialinstitutions,tothetechnologyitself.
Figure (15) shows how the the structure of the network changes for an equity-based
contributionmechanism,whentheblockchaintechnologyisintroduced.
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Figure (15): Equity Crowdfunding Mechanism trough a decentralized application
Illustration.
Aswecanseefromthefigureabove,theequitybasedmechanismthroughadecentralized
application is very similar to the peer-to-peer interaction trough a decentralized
application.Asweknowinfact,theintroductionofdecentralizedapplicationthatworks
onablockchainbase,willallow for thecreationofapeer-to-peercommunicationand
financialinteraction.
The left side of the illustration, shows the possible interaction between different
investors,andthepossibilityforthecreationofasecondarymarketfortokens.
3.3.ServiceModulesforCrowdfundinginaBlockchain-BasedEcosystem
Theintroductionofablockchainbasedsysteminthecrowdfundingmodel,haseffectson
manyaspectsoftheindustry.Thetechnologyhasthechancetochangealsotheapproach
tocertainissuespresentinplatformsofthistype.Blockchaintechnologyisinfactnotonly
introducedtoresolvemanyoftheissuesthatwefacedwiththetraditionalcrowdfunding
mechanisms;butitisalsoabletotransformsomeoftheservicespreviouslyprovided.
In the Chapter II, we analysed some of the services that a traditional financial
intermediary and a crowdfunding platform can offer to users; in this sectionwewill
explainhowblockchaintechnologycanimprovesomeoftheseservices.
Notalltheservicescanbeimprovedthroughtheuseofblockchain;wewillfocusonlyon
thosethatcansupportablockchainapplicationandthatcanactuallybeimprovedbythe
technology.
Oncewe have identified the services improvable by a blockchain technology, we can
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implementtheminsideaspecificallydesignedDApp.
3.3.1.ServiceModulesImplementedwithBlockchainTechnology
Starting from a blockchain-based environment, we can take some of the traditional
crowdfundingservicesandtailortheminordertofitthenewsystem.Westartfromthe
definitionanddivisionofservicesprovidedbythetechniqueofmodularizationofservices
that we analysed in Chapter II. We than describe the evolution of the services,
reconfigured in theDecentralizedCrowdfundingApplication.Whatweknow from the
definitionofthetechnology,isthattheevolutionoftheservicesinthenewecosystemwill
beabletoofferthesametypeofservices,butwithahigherlevelofsecurity,transparency,
andalowerriskforallthepartiesinvolved.
Matchmaking:
This specific service has no particular difference from the traditional form of
matchmaking.
Themaindifferenceisthescopeofthecustomerbaseinwhichtheplatformwilloperate.
Withthereductionoftheminimumamountofcapitalnecessaryinordertofundanew
venture,themarketwilltackleasectionofthemarketuntilnowuntouched.Thefocus
will infactshifttothemassmarket, inwhichmanyindividualsarewillingtoinvest in
riskynewventureseveniftheyarenotinpossessionofagreatcapital.Whatcanalsobe
developedisamoreprecisesearchmechanism,thatallowsforapartialornullpublication
ofpersonaldata,butisabletosearchaccordingtoaselectedinterestortoaselectedlevel
ofreputation.
Contracting&Compliance:
One of the most important and interesting aspects of DApps, is the fact that the
contractingandlegalbureaucracyrelatedtocrowdfundingoranyfinancialservicethata
platform may provide; can be managed automatically trough smart contracts. Costs
relatedtolegalcorrespondenceandsecurity,canbedecreasedsubstantiallyallowingfor
theallocationofresourcesondifferentservices.
CustomerSupport:
TheprotocolsthatexistinsideaDecentralizedApplicationhasthemajorcharacteristicof
beingclear-cutandcomputerized;thismeansthatafullcoveredsupportisnotneededto
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interactwithit.Oneproblemcanstillarisefromthestipulationofthedigitalcontract,and
in the understanding by the final user of the code that composes the contract. This
problemiseasilyoversteppedthroughathoroughexplanationofthecodeembodiedin
the smart contract, in the sameway itwould be overstepped through the traditional
methods.
RiskScoring:
Duediligenceanalysiswouldstillbeperformedbyexpertsinthefield,sincetheanalysis
ofthefeasibilityofaprojectscanhardlybeautomatized.Whatthetechnologycandoon
theotherhandistheanalysisofallthepasttransactionsofthefundraisers,inorderto
accesstheirfinancialeligibility.
Insteadofbeingperformedbyanexternalthirdpartythathasaccessorholdssensible
privateinformationabouttheusers;thisfunctioncouldbeperformedbyasmartcontract.
Thesmartcontractcouldbeable in fact toassignascoreassociatedwithrisk toeach
individual by going through the transactions associated with said user. Since an
automated cryptographic system is in charge of the analysis of the data, there is a
reductionoftheriskofhavinglowersecurity.Thesecontrolscouldbeperformedthrough
asmartcontractembodiedintheapplicationproposingtheprojector,byasecondary
contractthathastheonlypurposeofassociatingeachusertoariskscore.
AuthenticationThroughSmartIdentity:
The application of Blockchain technology gives the possibility to any platform, to use
Smart Identity applications. The technology allows for a more secure and precise
authenticationsystemthatcanbeintegratedinthecentralDApporoutsourcedtoanother
Decentralizedsatelliteapplication.
This is of extreme importance in the definition of the identity of the funders and the
fundraisers; not just for fiscal purposes, but especially for security and transparency
purposes.
CrowdActivation:
The application of Blockchain technology does not affect the upfront services that a
platformprovidestousers.Crowdactivationservicesremainoutsideof thescopeofa
DApp,whoseprimary activitieswill beperformed in thebackground, offering amore
secure,andtransparentwaytotransferfundsanddata.
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InvestorRelations:
InvestorRelationshipissubstantiallyimprovedbytheintroductionofthistechnologyin
thenetworkformanyreasons.
Unfortunately, regulation related to equity investment is for now inexistent or very
limited for the use of tokens for crowdfunding investments, but the newness of the
technologyisgivingspaceforthedeepexplorationofthepossibilitiesofthetechnology;
allowingfordifferent,innovativeandsmartwaysforsupplyingshares.
Thissystemisabletogivevotingpowertotokenholders,meaningthattheyareentitled
ofdecidinghowandwhenthemoneytheyinvestedshouldbespentforfurtherprojects.
The transparency allowed by the technology also has the power to give rights to
shareholderstomakedecisionsaboutanypossibletransactionrelatedtothefundsthey
invested.Thelevelofcontrolbyfundersincreasesdrasticallythisway,empoweringthem
tomakeanyfinancialdecisionregardingtheinvestmentofthefundsinsidethecompany.
Furthermore,thenewsystemallowsforthecreationofasecondarymarketfortokens;
this increases the independence of investors and the security of themarket, limiting
financialrisksandpullinginmorepossibleparticipants.
During the fundraising campaign, communicationbetween the twoparties canstillbe
managed by traditional means of communication offered by the platform; once the
campaignisover,communicationcanbetranslatedintheformofvotingrights.Voting
systems can be implemented and constructed in different ways, allowing for the
distributionofmotivationsandthereasoningbehindcertainvotingdecisions;together
withpre-setmessagestobedistributedtocertainindividualsaccordingtopre-defined
rulesofcommunication.
ITOperations:
Theimplementationofthetechnologyintheplatform,changesthetypeofinteractionthat
existsbetweenthetwopartiesinvolvedinthetransactions.Therelationshipishandled
by smart contracts; ITOperations and coding are therefore fundamental for thewell-
being of such relationships. The use of the technology allows for an extreme level of
freedom in thedefinitionof the relationships.Themarket is stillwaiting for the right
legislationtodefinethelimitationsofthismarket,butuntilthen,projectsandinteractions
ofsuchsortarehighlyindependentfromanyregulationandlegislation.
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Payment:
Aswe can imagine, one of themost important innovation brought by the blockchain
technology is theuseof a secure, transparent, andvalid formofonlinepayments and
registrationoftransactionsamongusers.This iswhythetechnologyhasaparticularly
strongeffecton thisservice.Theuseofcryptocurrencyasoneof thepossiblewaysof
exchanging value, gives thepossibility todifferent services to come intoplay in these
networks.With the use of cryptocurrency in fact,we can have different integrated or
satelliteDAppsthatareabletoofferdifferentservicestouserssuchasdigitalwalletsor
exchangeplatforms.
Theseservicesrelatedtotheuseofcryptocurrencieshavemanybenefitsanddrawbacks
thatwewillnotanalyseinthisthesis.
Banking:
Banks could be easily eliminated from the framework, since the central role usually
playedbytheseintermediariesiseliminatedinadistributeddecentralizedsystem,and
substituted by the technology. Smart contracts in fact, take care of all financial
transactions and contractual relationships between partners; while the history of
transactionsisrecordedentirelyinsidetheblockchain.
Dunning&DebtCollection:
Asmanyotherservicesthatcouldbeperformedbythirdtrustedparties,smartcontracts
couldbeinchargeofcarryingouttheseservicesinastandardizedandtrustedway.The
powerofreinforcingtheseactionscouldbegiventothefinalusersortoenforcersthat
couldworkwiththepowergivenbyvotingrights.
Oneofthepossibleapplicationofsmartcontractsisfurthermorethepossibilitytocreate
special funds financed by transaction fees, that could be used as collateral for the
eventualityoftheneedofaninsurancerepayment.Thepossibilitiesaremany,andcanbe
similartotheonesalreadyexistinginthetraditionalnetwork;thedifferenceliesinthe
useofsmartcontracts,whoseexecutionismandatorywhenevercertainconditionsare
met.
3.3.2.PlatformInteractionsandServiceProvision
In section 2.3.3., we described the structure of interaction between the actors in the
traditionalcrowdfundingnetwork.Inthissectionweprovideadescriptionofthesame
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environment,inwhichblockchaintechnologyhasbeenintroduced.
Figure (16), shows how the ecosystem of relationships and services changes as we
introduceblockchaintechnology.Thefigureshowstheroleandthepositioninthemarket
ofablockchain-basedCrowdfundingDApp;anewimportantelement,whichdrastically
changes the structure of the system. This interaction network is in contrastwith the
traditionalsystemofinteractionshowninChapterII;thenumberofactorpresenthasin
factchanged,togetherwiththedistributionofkeyactivities.Someserviceproviderscan
beeliminated,andtheirfunctionsabsorbedbyothers.Newserviceprovidersareableto
performinsuchawaythatbenefitsthetwomajoractorsinvolved,whileintroducinga
high levelofdecentralizationandreductionofrisk,usuallyassociatedwithblockchain
technology.
Figure (16): Equity Crowdfunding platform interaction and service provision in a
blockchain-basedecosystemthroughtheuseofaDApp.
The Figure shows how some of the activities like Banking and Payments, that are
traditionally performed by third partymembers, are embodied inside the DApp. The
figurealsoshowshowsomeoftheserviceslikeCrowdActivationandCustomerSupport,
are better performed by the Crowdfunding Intermediary such as a traditional
crowdfundingplatform,ratherthanaCrowdfundingDecentralizedApplication.
Thereisadistinctionbetweenthetypesofservicesthatcouldorshouldbeperformedby
acomputerprogrammesuchasasmartcontract,andthosethatarebetterperformedby
Seekers
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a traditional platform. Not all services can benefit from a total codification and
computerization; there are activities that require a certain level of flexibility and
adaptation,thatcomputerscienceisnotabletoprovide.
Itisimportanttonoticethough,howtheDAppisabletointegrateinitscode,manyofthe
servicesandtherolesthataretraditionallycarriedoutbyexternalthirdparties.These
third party service providers like crowdfunding partners and payment providers like
banks, can be eliminated from the network, decentralizing drastically trough the
blockchaintechnologymanyofthemostimportantactivities.
3.4.EffectsofDecentralizedApplicationsonCrowdfundingInefficiencies
Blockchaintechnologycanbeappliedinmanyindustriesthatarecurrentlyinneedofa
decentralizedapplication.Wedecidedtofocusonthecrowdfundingindustry,becauseof
theextremegrowthishasbeenhavinginthepastfewyears,andthehugepotentialthat
theintroductionofthetechnologyhasinthedemocratizationofthissystem.
Thecrowdfundingecosystem is inneed foranewsystemof interactionsbetween the
parties involved, that will reduce the current inefficiencies and costs, related to
crowdfunding.Now thatwehave explainedhow the traditional crowdfunding system
worksandhowablockchain-basedcrowdfundingsystemcouldwork;wecanexplainhow
theintroductionoftheblockchaintechnologycouldalleviatetheinefficienciescurrently
presentintraditionalequitycrowdfundingplatforms.
ThissectiondescribeshowtheblockchaintechnologyandtheuseofDAppsandDAOs,
can reduce or even eliminate some of these inefficiencies. In order to do so, we will
analysetheapplicationofthesetoolsintheecosysteminthreedifferentmatters.Firstof
all,wewillshowthegeneralimplicationoftheapplicationofblockchaintechnologyinthe
crowdfundingecosystem;togetherwiththeconsequencesithasingeneralwithrespect
tomarket inefficienciescurrentlypresent inthemarket.Wewill thanexplainhowthe
functionalitieswedescribedofthedecentralizedapplicationcouldsolvetheinefficiencies
we identified inChapter II for the traditionalequitycrowdfundingecosystem.Wewill
finallyassociatesomeofthefeaturesoftheequitycrowdfundingDAppwiththeresolution
of key financial risks, that through the technologywill be reduced and in some cases
completelyeliminated.
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3.4.1.MarketInefficiencyReductionwithBlockchainTechnology
Aswehaveseeninthepreviouschapters,thetraditionalcrowdfundingplatformspresent
somemajormarketinefficiencies29.Theseinefficienciescanbesummarizedbytwomajor
problems that represent the market’s and network’s limitation. These problems are
AsymmetricInformationandMolarHazard.
Asymmetricinformationrepresentsagroupof issuesthatrevelthemselvesbeforeany
interaction takesplace.Asymmetric information in fact, refers to thedifferent levelof
knowledgethatcharacterizesthetwopartiesinvolvedbeforeanyinteractiontakesplace.
While on the other hand, Moral Hazard refers to all the issues that arise once the
transactionhastakenplaceandthereisamismatchbetweenwhatwasexpectedandwhat
actuallyhappenslaterontroughtheevolutionoftheproject.
We will show how with the introduction of blockchain technology, these issues are
stronglyreducedandinmostcaseseliminated.
Whenweintroduceblockchaintechnologyanditsapplicationsinsidethecrowdfunding
system, we can see changes in the network from the first steps of the crowdfunding
process.
Startingfromthescreeningofthepossibleprojectstobepresentedtothepublicinfact,
theintermediaryroleofthecrowdfundingplatformcanpotentiallybeeliminatedsince
everyoneusingtheDAppinadecentralizedenvironment,canpresenttheirprojecttothe
fundingpublic.Itisimportanttonotethat,ontheotherhand,thismightcreatetheissue
ofanoverflowof information, thatwillnecessitateasystemfor theassessmentof the
credibility and reliability of the creators of such campaigns. Mechanism based on
reputation can also be implemented in order to allow fundraisers to certify their
professionalismandconvincecapitalgiverstoinvestintheirprojects.Ifthatwouldbethe
case, the DApp can, also in this case, come into play by creating a standardized and
mechanistic system of reputation and place itself as the trusted intermediary. The
importanceandthereliabilityofthereputationsystemcanbeseeninnotoriousexamples
suchasAmazonore-Baythatbasetheirnetworkonthis feature.Thesuccessof these
platforms,helpsusrealizehowthisfunctionalityofsmartreputationcouldreallywork
alsointhecrowdfundingandsharingeconomyfutureecosystem.
Thedecentralizationoftheeffortinofferingareputationsystemwilldefinitelyreducethe
29 Section:2.5.Ineficiencies
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costsofadministrationandwillbemoretransparentthanthecurrentone.Thecrowd-
poweredsystemwillthangivebenefitstoboththeactorsinthemarket,reducingcoston
oneside,andincreasingtransparencyontheother.
Forwhatconcernstheissuesthatariseonlyaftertheinitialinteractionbetweenthetwo
parties,theycanbeloweredthroughtheestablishmentofformsofsecurityintheDApp
that protect the interests of the funders. Hidden Actions can hurt funders, that in a
traditional crowdfunding ecosystem have very limited rights and right enforcement
mechanismsattheirdisposal.Oncetheinvestmenthasbeenprocessedandtransferred
tothefundraisersthepowerofthefundersisdrasticallyreducesandtheyhaveverylittle
controloverthecapitalinvested.TheimplementationofdefinedrulesinsidetheDAppto
protecttheinterestofthefunders,doreducetheamountofeffortrequiredbythemto
enforce their rights. These rulesmanifest in the form of Voting Rights andWithdraw
Tracking; these rules substantially improve the power that the funders have over the
fundstheydecidetoinvestinnewventures.
Theleveloftransparencyandtheimplementationofvotingrighthavealsotheeffectof
reducingnotonlythetwomajorproblemsofHiddenInformationandActions,butalso
reduce the relatedproblemof thePrincipal-AgentProblem,givingback the control to
thosethataredirectlyinvolvedinthefundingprocess.ThePrincipal-AgentProblemissue
can be solved also by making sure that both the funder and the fundraiser are in
possessionofsharesortokensofthecompany,aligningtheinterestsofthetwo.
Thepresenceofvotingrightsandthecreationofcertainrightsonthespendingof the
funds collected, is of extreme importance for the participation of the funders in the
process of crowdfunding. The absence of these rights would not push investors to
participate,making themarket fail. It is important to remember though, that it is still
important that the fundraisers remain an important presence both financially and
manageriallyinsidetheorganization.Thedesignersofthecompanyareprobablyinfact,
themostvaluablecomponentwhenitcomestodecisionmaking.They,aretheindividuals
thathavethemostinsightontheindustryinwhichthecompanywillbeimmersedinto,
andareprobablytheonesthatwillbeablemorethanothers,togivethemostaddedvalue
tothecompanyonceitwillbedeployedinthemarket.
Another major innovation brought by blockchain technology are smart tokens. The
introduction of smart tokens has major benefits, in the sense that will allow for the
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creationofasecondarymarketthatwillnotonlypushfunderstoinvestinmorethanone
company,butwillallowfundraiserstocollectfundsmoreeasilyandfaster.
Theuseofsmarttokensandtheimplementationofvotingrightsontheotherhand,might
havesomedrawbacksontheindustry.Thesenewrightsmightallowfunderstoimpose
entrepreneurs to pursue more short-term returns rather than long-term once. The
creationofasecondarymarketfortokensmightinfactmotivatefunderstopursuesuch
astrategy,backedupbythe improvementof thepowertheywillbeableto imposeto
entrepreneurs.Onepossiblesolutiontothisproblemwouldbeadiversificationbetween
thosethathaveshorttermandthosethathavelongtermvisionsorexpectationsonthe
projectstheyinvestin.Thesubdivisionofinvestorsonthebaseofobjectives,willallow
fundraiserstoselecttheirfundraisers,andhaveagroupofshareholdersthatwillnotjust
lookattheirowninterests,butwillhaveinterestsinthewell-beingofthecompanyand
theprojecttheyarebackingup.Thebestdecisionentrepreneurscanmake,istobepart
oftheinvestmentpool,inordertomixtheirvisionandinterestswiththeonesoftherest
oftheinvestors.
Themajor improvement givenby the technology is the fact that itwill create amore
transparent,decentralized,anddemocraticwaytofundsmallandbigbusinesses,where
theinterestsofboththefunderandthefundraisersaretakenintoaccount.Fraudswill
not be necessarily eliminated, but the fact is that they will be traced and will be
permanently written inside the distributed ledger could discourage - more than the
systemisdoingnow-maliciousactsformhappening.
3.4.2.MarketInefficienciesThatCouldBeSoftenedbyDAppFunctionalities
Insection3.1.1wetooka lookatthenewfunctionalitiesthatanEquityCrowdfunding
DecentralizedApplicationcouldbringtothetable.Inthissectionwewillseehowthese
new functionalities canhelp to reduceand in somecases eveneliminate,manyof the
limitationsthatthetraditionalcrowdfundingsystempresentsinmicroeconomicterms.
CrowdfundingCampaign:
Oneofthefirstproblemsrelatedtocrowdfundingistheallocationof fundsduringthe
crowdfunding campaign. In the traditional system, the crowdfunding platformwould
have to relate on a third party like a bank to hold the funds, or do it itself. This
methodologymightraisesecurityandtrust issues,whichblockchaintechnologymight
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resolve.
ADAppapplicationinthefirststepsofthefundraisingcampaign,isabletofunctionasa
holder of the funds raised. This important function, eliminates the need of the
introductionofanexternalandcentralizedthirdparty.Thefundsthatareraisedduring
the campaign in fact, arenotdirectly transferred to the fundraisers, but arekept in a
separateandautonomousaccountcreatedbytheDApp.Insidetheseaccounts,thefunds
are locked until the right amount is reached or the campaign expires. These security
measures,definedbyconditionsunderwhichtheDApphastoundergo,givethefunders
ahighlevelofprotectiononthefundstheydecidetoinvest,whichimprovesalsotheir
willingness to invest in new projects. These security measures usually consist in
thresholdsoffundstobereached,ortimelimitsafterwhichthecampaignexpires.Ifthese
conditionsattheendofthecampaignarenotmet,thefundsinvestedareautomatically
transferredbacktothefundersbythesmartcontractsembodiedintheDApp.
These security measures though, are not constructed to protect just one side of the
transaction.FundraisersinfactareprotectedtoobyfunctionalitiesoftheDApprightafter
the end of the crowdfunding campaign. As soon as the campaign is over and all the
conditionsfortheprojecttogoonaremet,thefundsareavailabletothefundersforuse
through the development of the project, andwill be used by them to construct their
company.Themostimportantthingtokeepinmindisthefactthattheamountofrights
andprotectionofthetwopartiesandtheresolutionofthemarketinefficiencies,canbe
pre-determinedthroughthecodingofthesmartcontracts.Thegoalwouldbethoughto
createabalancebetweenthetwoforcesandallowbothpartiestoworkinanenvironment
thatistransparent,andmoreimportantly,secure.
SmartPropertyTokens:
Aswepreviouslypointedoutinsection2.5.1,traditionalequitycrowdfundingplatforms
donotallowforthecreationofasecondarymarketfortheexchangeofshares.theSmart
Propertytokensinablockchain-basedcrowdfundingplatform,willsubstitutetheroleof
sharesandwillthanrevolutionizethefinancialmarket.Blockchaintechnologymakesit
notfeasibletofalsifytokensandownershipofcertainassets,allowingforarisklessand
costlessmarketizationofthem.
Theintroductionofasecondarymarketfortokens,revolutionizetheequitycrowdfunding
market;inthesensethatgivesinvestorsthepossibilitytoexchangetokensfreelyandin
asecureway.Thisisnottheonlyupsideofthecreationofasecondarymarket;infact,this
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optiongivesthemthechancetoavoidmanycomplicationsrelatedtotheinvestmentin
newcompanies,likethePrincipal-AgentProblemwediscussedearlier.
DecentralizedAutonomousOrganization(DAO):
TheutilizationoftheDAOstructure,allowsfortheadaptationofthesystemissuchways
that allows for the customization of the project involved, in linewith its needs.Most
importantfeatureofthetechnologythatinteractswiththeDAOisthevotingsystem,that
increaseexponentially theresilienceof theproject.This featuresupportsanydecision
thatcanbemadebytheparticipants.Thesedecisionscanincludealsotherelocationof
theprojectintoanewblockchainservice,thatmightfitbetterthecompanyneeds.
Allofthisallowsfortheempowermentoftheinvestors;thatwillhavemorecontrolover
thefundstheyinvest,andmorecontrolovertheactionsofthefundraisers.
Funders have an exceptionally high control over the funds,making them in charge of
almost any decision that the company is deciding to undertake. Funders have in fact,
controloveralltheaccessestothecompanyfunds,makingthemabletoallowornotthe
useofthecapitalbymanagersandowners.Byhavingcontroloverthefunds;thereisa
consequentialstrongreductionoftheprincipal-agentproblem.
VotingSystem:
Whenwearedealingwithequitycrowdfunding,theriskoffraudbythefundraiserstothe
detrimentoffundersissignificant.Havingasubstantialamountofcontroloverthefunds
invested than, has particular importance in these situations. The voting system is
designedandhasbeencreatedspecificallyforthispurpose.Withthevotingsystem,the
risksarereducedbycreatingthisrightenforcementmechanismthatgivesthepowerto
funderstocontrolthefundstheydecidedtoinvestintheventure.
TheDAOisabletocreateademocraticenvironment,allowingshareholderstobepartof
thedecisionmakingprocessandenforceactions.
This security mechanism works as a deterrent for managers to undertake selfish or
maliciousactsthatwillhurtthecompany,andconsequentlyshareortokenholders.This
canbeconsideredaninitialsolution,totheprincipal-agentproblemandthemoralhazard
problem.
Theincreaseofcontrolbyusers,isnottheonlybenefitbroughtbytheapplicationofthese
mechanisms.Moreautomatedcontrolmeansthatthecostsfromactualcontrolperformed
bythefunders,aresubstantiallyreduced.
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Probablythemostinterestingconsequenceoftheintroductionofthevotingmechanism,
isthepossibilitytoleverageonthesocalled“WisdomoftheCrowd”.Votingmechanisms
canbeimplementedatmultiplelevelsinsidetheDApp,thismeansthatfunderscandecide
where their knowledge could be of best use inside the organization. Every step and
function carried out andnecessary inside the organization, couldbenefit fromhidden
knowledgeinsidethecrowdthatfundedtheorganization.Thepositiveinterventionofthe
crowdisnotjustlimitedtothecrowdfundingcampaignandthemoneymanagement,but
especiallyextendstosituationsinwhichtheirknowledgecouldbecrucialforshapingthe
company’sstrategicpath.
The introduction of such voting rights is the clear example of the potential of the
decentralizationbroughtbyblockchain technology.Voting rights areoneof themajor
featuresofademocraticsystem;wherethedecisionmakingpowerisnotinthehandsof
few,butinthehandsofalltheparticipantstothenetwork.
WithdrawTrackingSystem:
Thewithdrawtrackingmechanism introduces two important functions, thathaveasa
consequencetwoimportantbenefitswithinthecrowdfundingsystem.
The fist function is the ability for the system to create a limit to the amount that the
managerortheentrepreneurcanwithdrawfromthefundsthathavebeenaccumulated.
Thismechanismcreatesabalancebetweenthetwopartiesinvolved,allowingforadecent
leveloffreedomofmovementforthemanagers,andatthesametimeafairamountof
controlof theresources for the funder.Thisalsoreduces theprincipal-agentproblem,
creatinganequilibriumoftheforces.
Thesecond functionallows for the introductionofahigher levelof transparency.The
function in question is the unquestionable truthfulness of the transactions that are
written on the blockchain. This mechanism makes it very hard for anyone to make
maliciousor suspicious transactionwith the fundsstored in theDAO.Moralhazard is
thereforereduceddrastically,andfraudsbecometraciable.
These rules allow the funders tohave two separate control over themoney that they
invested;theyareabletovoteforallowingatransactiontogothrough,andtheyareable
tokeeptrackofallthetransactionslinkedtothefundstheyhelpedraise.Transactionthat
doexceedtheconditionspreviouslysetbetweenthetwoparties,areontheotherhand
automaticallyblockedbythecode.
Controloverthemoneyinvestedisoneofthemajordemocraticimprovementthatthe
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blockchaintechnologyintroduced.
Risk-ScoringSystem:
Asymmetric information in the crowdfunding market can still be an issue even in a
blockchain-basedenvironment.Itcanbehardinfact,tocollectinformationandverifythe
credibilityoffundraisers.Therearethough,systemstoovercometheseissuesthatcanbe
builtinoneoftheDAppsthatworksintheenvironment.Thesesystemscancomeinthe
formof“ReputationSystems”and“HistoricScanning”.Suchfunctionswillhelpfundersto
haveaviewofthepastexperiencesofthefundraiserstheywouldliketoinvestin,andwill
givethemageneralviewontheyreputationtheybuiltaroundthemselvesthroughpast
projects.
ThesefunctionscanbeperformedbyasecondaryorsatelliteDApp;orevenimplemented
andbeautomaticallyactivatedinsidethemaincrowdfundingDApp.Thesefunctionscan
alsobeperformedbyanexternalthirdpartylikeanexternalfinancialinstitutionthatis
abletoaccessinformationaboutthepastfinancialrecordsofthefundraiser.Confidential
information does not have to be divulged necessarily, but the solution might be the
creationofasmartcontractthatallowsfortheassignationofascoretoeachindividual,
definingtheirreliabilitybasedontheircredithistoryorpasttransactions.
Somecrowdfundingplatformsmayalsodecidetohavetheirownsystemforthedefinition
oftheriskrelatedtoaninvestment.Itisimportanttokeepinmindinfact,thattherisk
associated with an investment does not only depend of the financial record of the
fundraiser,butalsoonthefeasibilityoftheprojectpresented.
Themodalities withwhich fundraisers can be screened and categorized can come in
differentformswithdifferentlevelsofcomplexity.Theconcepttokeepinmindisthatthe
blockchain technology provides a framework for the registration of all economic
activities,transactionsandmovementofownership.Traceabilityofcurrency,assetsand
interactionisextremelyaccurateallowingforasubstantialreductionoftheproblemof
AdverseSelectionandInformationAsymmetry.Asthenetworkgetsmoresecurewiththe
resolutionoftheseissues,userswillbemorewillingtoparticipatetothenetwork,making
itevenmoresecure.
SmartIdentityAuthentication:
Particular attention is naturally given to the issue of security in the crowdfunding
ecosystem,andonanywebplatformingeneral.Itisimportantforanyuserinteracting
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with someone else on the platform, to be exactly sure to whom they are talking or
interactingto.
Whenexchanginginformationorinvestments,anyonemustbeabletotrusttheidentity
ofthepersontheyareinteractingwith.SmartIdentityfunctionalityhasbeenconstructed
forthispurposespecifically.
Through the use of smart identity authentication, the fundraisers are disclosing their
identitytothepublic,showingwillingnesstobecooperativeandtransparent.Thismay
induceinvestorstotrustthefundraiserthatmakesthemabletohaveafullviewoftheir
credithistory.
Funderscanalsousesmart identityauthentication,allowingotherusersto learnfrom
their experience as successful funders, and push them to participate themselves to
lucrativecampaignsorinvestments.
Smartidentityimplementationcanalsohavepositiveconsequencesfromalegalpointof
view. Since actions can be linked more easily to people with no margin for errors,
responsibilities can be associated to the right identity easily and fast. The process of
identifyingpeoplewillthenbesimplified,andcostswillbereducedtogetherwiththerisk
ofmoralhazard.
Theuseofadigitalandsecureidentity,willnotonlyhelpgovernmentsanddebtcollection
agenciesperformamoreaccuratejob,butwillalsoallowuserstobeentitledcompletely
totheiridentity.Theywillbeabletocontrolandshareattheirwilltheirpersonaland
sensibleinformation,withoutgoingthroughathirdpartywhoseintegritycouldnotbe
provenforsure.
Table (3) representsa summaryof thepossibleapplicationsand functionalitiesof the
crowdfundingDAppwediscussed,associatedwiththepossibleinefficienciestheyhave
beencreatedtosoften.
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Functionalities ApplicationPossibilities SoftenedInefficiencies
CrowdfundingCampaign Self-governingManagementofFunds
MoralHazard&AdverseSelection
SmartPropertyTokens InvestmentTrading Principal-AgentProblem
DAO Self-governingManagementofFunds
MoralHazard&Principal-AgentProblem
VotingSystem(DAO) RightsEnforcement MoralHazard&Principal-AgentProblem
WithdrawTracking(DAO) Transparency MoralHazard&Principal-AgentProblem
Risk-ScoringSystem Screening AdverseSelection
SmartIdentityAuthentication RightEnforcement&Screening MoralHazard&Adverse
SelectionTable (3): Inefficiencies softened by functionalities od a decentralized crowdfunding
application.
Whatweanalysedinthissectioncanbeconsideredsomeofthemajorpositiveinfluences
thatanEquityCrowdfundingDecentralizedApplicationcanbringtothecrowdfunding
environment. Many market inefficiencies of the traditional equity crowdfunding
environmentcanbemitigatedthankstothetechnology.Theimprovementswillcreatea
more decentralized and transparent environment, in which both actors will bemore
willingtoparticipateandenlargethenetwork.
3.4.3.FinancialRisksThatCouldBeSoftenedbyDAppFunctionalities
Insection2.5.2,wetookalookatthepossiblerisksassociatedwiththeuseofanequity
crowdfunding platform. In this section we will see how the introduction of a
CrowdfundingDecentralizedApplicationandblockchaintechnology,couldreducerisks
usuallyassociatedwithtraditionalcrowdfundingplatforms.
Through this section, it is important to keep inmind howwith the use of blockchain
technology,theneedofatrustedthirdpartyisstronglyreduced.Thetrustshiftedfrom
centralizedparties,tothedecentralizednetworkandthetechnology.
RiskofDefault:
Riskofdefault,inacrowdfundingdecentralizedapplication,canbeconsistentlyreduced
thanks to the first phase of the blockchain-based crowdfunding process. During the
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fundingstage,thefundsarenotdirectlytransferredtothefundraiser,insteadtheyare
putinaseparateaccount.Theaccountwillbeunlockedandtheamounttransferredtothe
DAOinthecaseinwhichthecampaignissuccessful,orgivenbacktothefundersinthe
caseoffailureofthecampaign.
DuringtheperiodoftimeinwhichthefundsaremanagedbytheDAO,themechanism
associatedwithit,makessurethatthefundsaresecure,andtransactionsnotallowed.The
controlinthiscaseisofthefunders,thatwillactintheirinterestsandtheinterestofthe
companytheyinvestedin,mitigatingtheriskofdefault.Thefunderscaninfactimpose
controloverthefundsthroughmechanismslikethetransactionspendinglimitandthe
votingsystem.
Thesearetheearlystagesoftheapplicationofthetechnology, inthenearfuture,new
developmentscouldleadtothecreationofalgorithmsthatwillimprovefurthermorethe
avoidanceofthisrisk,likestrongerreputationsystemmechanismsorbettermechanisms
fortheselectionoffundraisers.
RiskofPlatformClosure:
Oneofthecharacteristicsthatdistinguishesblockchaintechnologyisthefactthatitisnot
centralized;thedecentralizationofaDAppinfact,allowsittobeimpossibletobeshut
down,sinceitisdependentbythenetwork.Inadecentralizedsystem,theDAppistheone
thatholdsthemostimportantfunctionforthecrowdfundingnetworktobecarriedon,
whilethecrowdfundingplatformcoversservicesthatcanbesubstitutedbyasecondary
entityrightaway.
Wheneveraplatformisshutdown,therelatedDAppandthesmartpropertythatused
theplatformtoenterthenetworkdonotdisappear,sincetheyaredependentfromthe
networkthatwillnotbeeffectedandcontinuetorun.
RiskofFraud:
Theuseofablockchain-basedapplicationhasthepotentialtoreducedrasticallythistype
ofrisk,throughtheuseofmanyofthefunctionalitiesthatwehaveseensofar.Tonamea
few:VotingRights,TransactionSpendingLimits,UnforgeableSmartTokens,andsoforth.
Together they are able to offer users a transparent environment, inwhich actions of
fundraisersarepermanently recorded into the ledger,making itnearly impossible for
themtolettheiractionsgounnoticed.
MoralHazardandRiskofFraudarecloselyrelated,meaningthatfurtherdevelopmentin
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functionalitiessuchastheattributionofCreditScores,willinfluencealsothereductionof
thisfinancialrisk.
Whenusingthisnewtechnology,weneedtopayparticularattentiontohowthesenew
mechanisms could be perceived and understood by the public. The structure of the
coding,andthemeaningofsomesmartcontractscouldbetrickyformanyoftheusers
approachingthenetworkforthefirsttime.Onepossiblesolutionistorelyonwell-known
platforms,credibleestablishments,composedbyindividualsthathavethereputationof
creating fairandstandardizedsmartcontractsandDAppsstructures,approvedbythe
publicorexpertsinthefield.
LiquidityRisk:
AswehaveseeninChapterII,thetechnologyintroducedtheconceptofsmartproperty,
andwith it, the possibility to trade smart tokens freely on secondarymarkets. Smart
tokenscanbethantraded,transferred,andsoldfreelywithouthavingtoholdthemuntil
maturity.Weunderlinetheimportanceofthisfeature,thatallowsinvestorstocommitto
shorter investments horizons; a characteristic ofmajor importancewhen it comes to
start-upsandthecrowdfundingenvironment.
Thecharacteristicsassociatedwiththetechnologyandmorespecificallysmartproperty,
arethanallowingforasubstantialreductionintheriskofliquidityinsideablockchain-
baseenvironment.Thetechnologyandthisframeworkareabletocreatedifferent,easier,
andmoreunaffiliatedequitycrowdfundingplatforms.
RiskofCyber-Attack:
Since thewhole system relies on the internet in order to function, the issue of cyber
securityarises.Thenatureoftheblockchaintechnologythough,makesitextremelyhard
for a decentralized ledger to be hacked. In order to hack an entity constituted on a
blockchainledger,andmanipulateinformationthatarestoredinsideit,thehackerwould
havetobeabletohavesimultaneousaccesstothemajorityofthenodesthatcomposethe
network.Suchanattack,calledthe51%attack,wouldrequireanunthinkableamountof
computingpower,andununthinkableamountofGastocompletethatoperation.
One of the other few precautions to take is the way in which smart contracts are
constructed.Smartcontractsarenotflawless if thecodingisnotdoneright.Thereare
companiesthatspecializedsolelyonthedevelopmentofsuchcontracts,whichareagood
startingbaseforwhoeveriswillingtocreatetheirownDApp.
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PotentialSystemicRisk:
Systemic risk is linked to the liquidity risk. In a traditionally constructedmarket, the
exchange of stocks or tokens can happen also between parties thatwork in different
countries or under different legislations. The process of interconnection between
different legislations andpossible different currencies, usually slowsdown the selling
processandcanleadtoliquidityrisk.
At the time of writing, the legislation about cryptocurrency and blockchain-based
crowdfundingisnotwelldefined,meaningthatblockchain-basedinfrastructuresarefor
now still independent form any form of national or international legislation. The
decentralizednature,andtheuseofdigitalprotocolsforthemanagementofactivitiesand
transactions, allows many to ignore any national legislation in term of movement of
currencyandvalue.The lackofaproper legislationontheotherhand, isdiscouraging
manyinthepursuingofblockchain-basecrowdfundingprojects,forthefearofdeveloping
aprojectthatmightbeshutdownassoonasanotherlegislationbecomesvalid.
Manycountriesaredevelopingatthemomenttheirownlegislationonthecryptomarket
andinthefirstfewyearsofthedevelopmentofthetechnologywemightseeaseparation
betweensomeofthemajormarketliketheAmericanoneandtheEuropeanone.Oncethe
technologywillhavesettledandwillbeunderstoodbyalllegislators,theinternetnature
ofthetechnologyandtheprocess,willallowforamergerofallthemajormarketandthe
creationofaglobalandopenone.
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CHAPTERIV
Blockchain-BasedEquityCrowdfundingPlatform:TheBloomioCase
Whilelookingforacasestudy,werealizedhowdifficultistodefinelegallyanentitythat
worksontheblockchain;andespeciallyhowharditistodefinethelegalandfinancial
identityofatoken.
Weliveinatechnologicalerainwhichwehaveveryfewinsightsonwhat,when,andhow
complex and disruptive innovationwill appear in themarket, putting regulators in a
thought decisional position. Regulators are battled between the creation of a fast and
responsive regulation, usually not backed up by sufficient information; or legislative
paralysis,resultinginaprocrastinationofthetacklingoftheissue.Thecommonlyused
strategyistheonethatusescaution,thathastheresultofstabilizingalreadyestablished
technologies, limiting an efficient and punctual introduction of new innovation in the
market.
It is importantto informthereader, thatgiventheearlystageofthe lifeofblockchain
technology,eachcountryiscurrentlydevelopingtheirowninterpretationoftheidentity
oftokensandblockchain-basedapplications.Fornow,infact,nolegislationorregulation
has been formed, that refer to the legal parameters around blockchain technology or
tokens. The difficulties in the definition of a common ground in the cryptomarket, is
unfortunatelyresultinginasubdivisionoftheglobalmarket.
In this chapterwewill analyseoneof the first examplesof ablockchain-basedequity
crowdfundingplatformthatwehadtheprivilegetocomeincontactwith.Theplatformis
called:“Bloomio”andisbasedinSwitzerland, inwhat isbecomingtobeknownasthe
“CryptoValley”,inthecantonofZug.
Theplatformisstillunderconstructionandtheteamisworkingonthedevelopmentof
all themost important services and functionalities, while collaboratingwith the local
governmentforthedefinitionofthelegalstatusofthecompanyandmostimportantlyof
thetokensthatitwillissue.Thepurposeofthischapteristoexplainhowtheconcepts
thatweanalysedintheory,canbeactuallyimplemented,andwhatcanbetheadaptations
necessaryforarealphysicalapplication.
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4.1The“CryptoValley”RegulationSinceBloomiohasitslegalheadquartersinthesocalledcryptovalley,itisimportantto
understandhowthisregiongainedthisepithet,andwhataretheadvantagesofstartinga
blockchain-basedbusinessinthecantonofZug.
The crypto valley is positioned in a region that ismostly known for its decentralized
political system, and matchless business environment. The region of Zug offers high
possibilityofgrowthwithitspro-businessenvironment,acceptance,andaccessibilityof
thelocalgovernment.Theregionattractsmanyinternationalandleadingcompanieswith
a system that allows for a low taxation, culture of financial privacy, and a business-
friendly environment. The region is in fact the crypto-powerhouse for companies like
Ethereum,Xapo30(Bitcoinwallet),Shapeshift31(globalwebtrading),Monetas32(financial
servicesforunbankedindividuals),andMelonport33(digitalinvestmentfund),together
withmanyothers.
Eventhoughaproperlegalframeworkhasnotbeendevelopedbyanycountryyet,the
regulatoryframeworkofthecantonofZugseemstobealotlessrestrictiveandmoreopen
todiscussion,thantherestoftheEuropeangovernments.
Switzerlandisalsorankingasthefirstcountryintheworldforattractingandretaining
talentaswellascompetitivenessandproductivity.Furthermore,thepoliticalsystemin
Switzerlandisneutral,stable,highlyresponsive,citizen-controlled,anddecentralized;all
these characteristics are in line with the bottom-up approach of the blockchain
technologyandthecryptotechnologiesthatareemerging.
4.1.1.CryptoValleyAssociation
AllthefavourablecharacteristicsoftheZugenvironment,andtheincreasinginterestof
entrepreneursinblockchaintechnology,hasledtotheformationofwhatisknownasthe
“Crypto Valley Association” (CVA). This association is independent, government-
supported,andhastheaimofcreatingtheworld’sleadingblockchainandcryptographic
technologies ecosystem, taking advantage of the region’s advantages. The association
wants to create a network to support and connect start-ups and fully operational
30https://xapo.com/31https://shapeshift.io/#/coins32https://monetas.net/33https://melonport.com/
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enterprises,bringingthemtogetherintheefforttofosterblockchainandcryptographic
technology.
Oneofthemostimportantaspectoftheexistenceofthisassociation,isthefactthatitis
collaboratingwiththegovernmentinthedefinitionofafavourablelegislationthatwould
fosterthedevelopmentofblockchain-basedbusinessintheregion.
OnDecember11th2017,PresidentoftheCVAOliverBussmann,wasinvitedtorepresent
theassociationand thecrypto technology industry, at theSwissGovernment’s second
FintechRoundtable;inwhichthefuturestructureofthelegislationoncryptographyand
blockchain technology was discussed. According to Bussmann, the government will
developaprinciple-basedapproachforthemanagementofICOs,allowingforacertain
level of freedom of movement, rather than a precise definition of inviolable rules.
Guidancewillbenonethelessallowedtobeprovidedbyself-regulatingassociations(like
theCVA)andthegovernmentitselfinthecaseoftheneedforclarification.
ThegreatadvantageoftheSwisslegislationisthefactthattechnically,anycitizenisable
torecommendachangetothelawthoughwhatiscalledtheSwiss“DirectDemocracy”.
This gavea greatmomentum to the introductionof theblockchain technologyand its
potential.The firststeps in thecreationofavalid legislation,weredone in June2016,
when three blockchain-related proposals were presented to the Swiss Parliament’s
FederalAssembly.Thesemotionshadtheaimofsimplifyingtheprocessofanticipationof
the ramification of the blockchain technology by the financial sector34, improve the
leadingpositionofSwitzerlandinthefieldofblockchaintechnology35,andfacilitatethe
growthandthedevelopmentofblockchain-basedstart-ups36.
Unfortunately, thosemotionsweredenied,but itdidnotstopSwitzerlandprogressive
wayindefiningastrongandprotectedmarketforcryptotechnologies.
CryptoValleyAssociation’sCodeofConductThemostrecentachievementinthefieldofcryptotechnologyregulation,comesonthe
9th of January 2018 from the crypto valley association, that in accordance with
governmentregulators,wasabletoconstructSwitzerland’sFirstICO’s“CodeofConduct”
(CoC).
34https://www.parlament.ch/de/ratsbetrieb/suche-curia-vista/geschaeft?AffairId=2016338035https://www.parlament.ch/de/ratsbetrieb/suche-curia-vista/geschaeft?AffairId=2016348436https://www.parlament.ch/de/ratsbetrieb/suche-curia-vista/geschaeft?AffairId=20163472
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Thecodeofconducthastheaimofbringingclaritytothenewmarket,andguideproperly
ICOsonhowtoconductinaccordancewithlegal,moral,andsecurityobligations.
The authority carried out by the CVA, makes the CoC mandatory to follow for each
companythatwantstoparticipatetothemarketandbepartoftheCVA.
Thedeclaration isupdatedannually,and iscomposedbyvaluesandprinciplesagreed
uponandrespectedbyallmembers.
TheCodeofConductisdividedinfourmainchapters:Mission,CoreValues,GeneralCode
ofConduct(CoC),andDecentralizedEcosystem(DE)CodeofConduct(DECoC).
Theirmissionisto:
“DeveloptheWorld’sBestEcosystemforBlockchainandotherDistributedLedger
TechnologiesandBusinesses.37”
Around this concept, and around the principles of decentralization and of
democratizationthattheblockchaintechnologyis linkedto, thecorevalueshavebeen
agreed to be: Trust, Transparency, Collaboration, Integrity, Innovation & Quality, and
SecurityBeneficence.Thesevaluesarestronglyinlinewiththeprinciplesthatarebehind
thecreationofthetechnology.Ontheplusside,theseconceptsandruleswillbereviewed
annually,inordertokeepupwithtechnologicalandorganizationalchanges.
ThecoreofthecodeofconductincludesguidelinesontheBusinessConductaswellas
guiding on the “Governance” and “Conflict of Interests”, “Property Rights” and also
importantguidanceontheproceduresfor“DisciplinaryActions”.
Itisimportanttonotealso,thattheCoCgivesguidancealsoonthe“BooksandRecords”
procedures.Forthispurpose,theCVAhasestablishedapartnershipwithPwC38,together
withwhichtheylaunchedonJanuary18th2018,thefirstofwhatisbeingestablishedas
the“QuarterlyReportonInitialCoinOfferings39”.Themainpurposeofthisstandardized
reportistotracktheevolutionandthedevelopmentoftheindustry,whichisstillgoing
underaquickexpansionandthroughcontinuouschanges.
TheDecentralizedEcosystemCodeofConducthasbeencreatedinordertoensurethat,
the launch of any activity inside the Association, is done in compliance with high
37https://cryptovalley.swiss/codeofconduct/ 38https://www.pwc.com/39https://cryptovalley.swiss/crypto-valley-association-collaborates-with-pwc-strategy-on-ico-report/
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standardsofprotocols,qualityandledgerenforceability,aswellasinlinewithregulations
onfinancialmarkets.
4.1.2.FINMAinterpretationandLegislationonTokens
FINMAistheSwissFinancialMarketSupervisoryAuthority,andstartingfromSeptember
29th2017-duetoasubstantialincreaseintheICOconductedinandfromSwitzerland-it
decided to investigate the ICO phenomenon. FINMA recognizes the potential of the
technology; however, since each ICO differentiate from a technical, functional and
businessstandpoint,ananalysisof thephenomenonwasmandatorytodeterminethe
legitimacyofthisnewfundingmethodology.
At the moment, as the investigation goes on, FINMA warns consumers on the risks
associatedwithICOs.ICOsaresubjecttohighpricevolatility,andusuallybackedupby
earlystageandconsequentlyhighlyriskyprojects,withvery littleornoguarantee for
futuredevelopment.Thegeneralwarningwasaddressedtothegeneralpublic,driving
theattentiontotherecognitionoffakecryptocurrenciesandfraudulentactivities,given
therecentmarketcircumstances.ThegovernmentandFINMAtransparentlyadmitthey
donothavealltheanswersinthefieldofcryptotechnology;theyaremovingforwardas
fastastheycanandtogetherwiththepublic,constructingasystemthatwouldnotlimit
innovationandwouldfostereconomicgrowth.
Regulations specifically related to ICOs, are not present in Switzerland or in the
internationallegislationsystem.Whatispresentontheotherhand,areregulationsand
laws on Equity and Debt capital-raising, deposit-taking and all activitiesmanaged by
financial intermediaries. These laws have been created to protect both sides of the
markets togetherwith the intermediaries involved, in order to have a functional and
optimalfinancialmarket.Thismeansthatinsomesituations,someICOsmightalreadybe
coveredbyexistingregulations,andwheneveranICOissuingtokens,breaksregulatory
law or is designed to circumvent financial markets law, enforcement procedures are
initiated.
ThisregulatorysystemallowsthanforthecreationofICOsandtokenizationofequity,
giventhatissuersandotherparticipantswillanalysetheirprojects,determininginwhich
existingSwissregulationthestructureoftheprojectandthefunctionalitiesassociatedto
thetokensfall.
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A broad approachwill be taken by FINMA in the assessing of ICOs and TGEs (Token
GeneratingEvents),fromwhichananalysiswilloriginateofthefunctionsandattributes
of ICOs,aswellasananalysisof thepurpose, functionalities,and legalstateof tokens.
Tokensinparticular,haveanextremelyimportantroleinthisindustry,bothintheSwiss
economyandintheInternationaleconomy.
ThereareexistingregulatoryareasinwhichaTGEorICOcouldcurrentlyfallintheSwiss
regulatoryframework,andtheyarelistedbelowas:
- Provisionforcopingwithmoneylaunderingandterroristfunding:Wheneverthe
production of a token by a TGE involves activities of financial intermediaries
(moneytransfers),theprovisionsrefertotheAnti-MoneyLaunderingAct.
- Provision on banking law: The application of the banking regulation is set off
wheneverthereistheacceptanceofpublicdepositsasanobligationofrepayment
totokenholders.
- Provisionsontradingofsecurities:Ifthesituationoccursinwhichtokensqualify
assecurities,thetokenissuerisrequiredtohaveasecuritylicence.
- Provisions in collective investment schemes legislations: Whenever assets
aggregated as components of the TGE are managed by an external party, a
potentiallinktocollectiveinvestmentschemeslegislationscouldappear.
MME40isaSwisslegal,tax,andcomplianceconsultingfirm,thathasbeenworkingwith
manycompanies(includingBloomio)insideandoutsidetheblockchainenvironment,in
order to help them to be in complete legal compliance with Swiss and international
regulationsonbusinesslaw.
OnSeptember26th2017,MMEhaspublishedanindividualandself-regulatedframework
forthedefinitionoftokenscalled:”ConceptualFrameworkforLegal&RiskAssessment
ofBlockchainCryptoProperty(BCP)”(Dr.MullerL.,D.MeyerS.,GschwendC.,HenshelP.,
2017).LukaMuller,oneofthefundersofMMEandCVA,specifiesthanthedefinitionof
token that has been provided in the paper, is not the definitive definition, but on the
contrarythe“GenesisVersion”astheycalledit.
40https://www.mme.ch/
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Themainaimofthepaperittoeducatethepubliconthisnewtechnologybycreatingan
initial framework to define the elements that compose it. Highly important for users
though, is also thedefinitionof the risks associatedwith thisnew technology, able to
improvetheirinvestmentplans,buttowhichtheyneedtopayextremeattention.
The paper introduces the definition of tokens as a new type of property, or better,
Blockchain Crypto Property (BCP), which are divided in three main categories. The
divisionoftheBCPincategorieshasbeendonetofacilitatetheconstructionofaneasier
legal,regulatoryandtaxassessmentfordifferenttypesoftokens,aswellasaneasierrisk
assessment.
Thethreemajortokencategoriesarecalledrespectively:BCPClass1(nocounterparty),
BCPClass2(counterparty),andBCPClass3(co-ownership).Weprovidebelowabrief
descriptionofthethreeclassesoftokens.
BCPClass1:
Arenativecurrencytokens,infrastructuretokensorapplicationtokens;whichdonotgive
theowneranyrightwithregardtoalegalperson,andcannotbeassociatedwithaphysical
asset.
BCPClass2:
Grant right against a legal counterparty. Contractual and participation rights, can be
consideredasClass2.
BCPClass3:
Aretokenswhichhavespecific functionsprogrammed inside them,areregisteredand
store on the blockchain, and use the technology associatedwith smart contracts. Co-
owningrightarereinforcedbytheuseofthesetokens,andtheholderofthetokenscan
participateintheco-ownershipofphysicalorintellectualproperty.
Riskassociatedwiththetechnologyandtheuseoftokenshavebeendividedinfourmajor
risk classes: Functionality & Protocol-Related risk, Storage & Access of Private Key-
Related Risk, Regulation & Money Laundering-Relate Risk, and Market-Related &
CounterpartyRisk.
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Theuseofafunctionality-basedmethodfortheclassificationoftokensandtherelative
risks,ratherthantheuseofaspecificcountry’slegalconcepts,allowsforanapplication
of these definition to all jurisdictions, disregarding the national or international
regulatoryframeworks.RelatedtothedefinitionsprovidedintheMMEpaper,different
national legislations may arise; but at least the public would be informed on the
technology and the tokenized ecosystem, having a common knowledge of the
characteristicsthatdefineadigitalpropertyandcoins.
MMEalsogivesalistofadvicestoanyonewillingtostartablockchain-basedortoken-
basedproject.The firstone is tobesmart; it is important to figureout thecompanies
blockchainandtokenfunctionalities.Alltheinformationandthedefinitionofthebusiness
caseandlegalanalysismustbedefined,inorderfortheprojecttounfoldpositively.
The second recommendation is not to commit fraud. As simple as it may sound, the
importanceofagooddisclosurecommitmentabouttheprojectandtherelatedtokensis
importantinthisnewmarketandforthecommunity.
Thirdly,MMEadvisesnewentrepreneurstothinkglobally,meaningthatthecompliance
onregulationsshouldnotbedonejustonSwisslaw,butalsooninternationallaw.
Taxesshouldalsobeconsideredwhenevercarryingouttheseprojects;theunderstanding
oftherelatedtaxsystemisofextremeimportanceduringatokenlaunch.
Finally,communicationisofextremeimportanceduringandafterthetokenlaunch.The
fundraiserowestotheinvestingpublic,toletthemunderstandwhatishappeningtotheir
investments.
MME is a strongpartner ofBloomio, and it is helping the company tobe in complete
compliance with regulations in order to enter the market in complete safety and
compliance.
4.2.TheOriginofBloomio,TheVisionoftheFundersandtheLegalBattle
Thecasestudyweanalysed in this thesis is theoneofBloomio,anequityblockchain-
basedcrowdfundingplatform,thatwillpresumablychangetheconventionalwayofdoing
businessforcompaniesinthefield.
We had the chance to interviewMaxim Lyadvinsky, Bloomio’s Chief ExecutiveOfficer
(CEO);andFrancescoDeSantis,Bloomio’sChiefMarketingOfficer(CMO).Thankstotheir
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testimony, wewere able to understandwhat their company stands for andwhy this
platformcameintoexistence.
TheideaofthecompanystartedfromthedefinitionoftheproblemsrelatedtoVenture
Capitalfunding;withalltheissuesthatgofromliquidity,lackofcapital,riskoffraudand
limitedqualityinformation.
Bloomiohasbeenfundedbythreeassociatescomingfromdifferentfields,inwhicheach
one of them have been successful. The three funders are Maxim Lyadvinsky, former
founderofAcronis,thathasbeenworking,investinganddevelopingmultiplestart-ups;
EmileOsuba,asuccessfulfinanceexecutivethatcancounton17yearsofexperienceina
topEuropeanfinancialbank;andAlexeyRaevsky,cybersecurityandblockchainexpert.
OnNovember2017,LukaMuller,oneofthemainfiguresofMME,joinedthecompanyas
the legal, taxandcomplianceadvisor; inorder tohelp thecompany tobe incomplete
compliancewithSwissandInternationallaw.Thisfigurewillbeofextremeimportance
insidethecompanyinordertomaintainthehighestlegalintegrity,andtocross-withthe
highestlevelofexpertiseavailable-the“legalgreyarea”aroundblockchain.
Bloomio defines itself as the first platform that will initiate the journey of perpetual
reformin theprocessof fundingstart-ups,byalsoenabling investors to invest innew
ventureswithaslittleasfiftydollars.
Bloomiofundersrecognizedthegrowthintheindustryofcapitalizationofstart-upsand
theincreasingimportanceandpotentialofblockchain.Thefundersalsorecognizedthe
limitationof thecurrentstateof ICOsdevelopmentandevaluation,andrealizedthata
crowdfundingplatformthatwouldresolvemanyoftheseissue,havenotbeencreatedyet.
Bloomioalsoparticipatedandwasrecognizedasoneofthe25winningstart-upsinthe
competitionheldby the “International Institute forManagementDevelopment (IMD)”,
former school of the funders, where they first decided to create this platform. This
positioning in theranking increases theirnotoriety inside thestart-upecosystem,and
togetherwiththat,allowsthemtoworkdirectlywithsomeofthebestMBAStudentsat
IMDduringthefirsthalfof2018aswell.
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4.3.CompetitiveAdvantageandKeyFeatures
Bloomio partners and collaborators, have years of experience inmany fields, starting
frommanagement,blockchaintechnology,cybersecurity,finance,law;andcancounton
beingsettledinoneofthemosttechnologicallyandregulatorydevelopedregionsofthe
world.
WhatBloomiooffersisthehighestfinancialstandardstostart-upinvestmentsforboth
sidesofthemarket.Bloomiohasasetofservicesdesignedforinvestorsandfundraisers,
thatwouldhelpbothachievetheirgoalsandcreateamoretransparent,freeandsecure
market.
4.3.1.CompetitiveAdvantages
FinancialintegrityisoneofthemajorconcernsfortheBloomioplatformanditspartners,
thatdecidedtoconstructtheplatformaroundthisconcept,creatingafair,transparent
andvaluable crowdfundingplatform forprojectsand for investorswilling to invest in
them.StartingfromthisconceptBloomiohasfivemajoradvantagesthatisproposingto
themarketofequitycrowdfunding.
BlockchainTechnology:
Blockchain technology allow for financial transactions to become highly secure, and
protectsinvestorsandfundraisers.Furthermore,thepromiseofdecentralizationbrought
byblockchaintechnology,willchangetherulesofthegame.Evenifitisstillanemerging
technologyandwearejuststartingnowtoseethefullpotential,Bloomioreallybelieves
blockchain technology to be the next frontier in the creation of a better business
environment.
“Blockchainisnecessaryasameantotransmittoourcustomerswhatthemainvaluesofthecompanyare;andexplainthefinancialandtransparencystandardsmissingonother
platforms”FrancescoDeSantis(CMO)
Blockchainwillhelpreachnewmarketsandespeciallynewcustomers,involvinganyone
who is willing to invest in valuable projects, regardless of the financial availability.
FrancescoDeSantissaidintheinterview:
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“OurTargetwillbethosewillingtospendbetween 1000and20000SFr,abiggeraudience
thanotherventurecapitalists,butequallyhungryforinvestments”FrancescoDeSantis(CMO)
On the plus side, the application of the technology brings a new and higher level of
security, transparency and freedom, that has never been proposed in the equity
crowdfundingmarket.Theadvantagesoftheuseofblockchainhasalsoamorepractical
benefit; some characteristics of the technology allow for the reduction of the project
relateddocuments,withconsequentbenefitsforthesecurityofinformationstoredonthe
blockchain,whichareuntouchablebyanyone.
“Regulatorsaremorecomfortableinapprovingouroperationsifweshowthatwecannot
accessuser'sfundsandcannotalteruser'stransactionsstoredintheblockchain.”MaximLyadvinsky(CEO)
BankingandSecurityBackground:
Bloomio’sexecutiveteamiscomposebyvaluableandprofessionalindividuals,thattake
the issueof security very seriously.AlexRaevsky is in chargeof cyber security inside
Bloomio; togetherwith EmileOsuma - in charge of the banking structure - they have
developedasolidandsafeenvironment.SecurityisoneofthemainconcernsforBloomio,
that realizes the limitations and the threats that can come from an on-line service,
especiallywhenthereareinvestmentsinvolved.Bloomiocancountonthemanyyearsof
experienceofitscollaboratorsandthestrongtrustthatexistsbetweenthem.
Forwhatconcernsbanks,therelationshipoftheplatformwiththemwillbelimitedto
investmentopportunities.Theuseofthetechnologywillallowfortheeliminationofthe
bankingintermediary,buttheinteractionwiththemcouldstillbeofimportanceforthe
constructionof investmentopportunitiesforbanksandtheirclientsinemergingstart-
ups.
“We'dliketocollaboratewithbanks,offeringaccesstoalternativeinvestmentsfromtheir
bankingapplications”MaximLyadvinsky(CEO)
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Blockchain has a major role also here, in the creation of a secure and decentralized
environment. The technology offers in fact a very high level of decentralization and
securitymeasures,withreallylowcostsofadministrationfortheplatform.
ExpertBroadDueDiligence:
Wheneveraprojectispresentedtotheplatform-inordertopresenttoinvestorsvaluable
investment opportunities - a due diligence analysis is necessary. Differently from the
otherplatforms,Bloomiohasdecidedtorelyonthirdpartyevaluation.
“Theuseofathirdpartyduediligencepractice,avoidsthepossibilityofourplatformtomakeabiasedevaluationoftheprojects.Wewanttogiveinvestorsthepossibilitytoinvest
invaluable,profitableandsafeprojectsnotdirectlypromotedbyus.”FrancescoDeSantis(CMO)
Duediligenceisaverydelicatematterandisoneofthemostimportantservicesthata
crowdfundingplatformcouldprovide.Bloomiowantstobeasunbiasedaspossibleand
givethepossibilitytouserstoinvestinvaluableandprofitableprojects,backedupbya
well-defined structure and business plan, profitable and secure for all the parties
involved.
SwissQuality:
Swiss quality plays an important role in the definition of the validity of the Bloomio
Platform. The favourable regulation, the business oriented environment and the
decentralized government of the country, makes it the perfect environment for the
developmentofprojectslikeBloomio.Bloomiowantstomakesurealsotobeincomplete
compliancewithSwissandInternationalregulations,anditisthereasonwhyBloomio
includedLukaMullerintheadvisoryboardofthecompany.
“Governmentregulatorsarecurrentlynotwilling/abletoprovideanyguidanceinthisfield,whichiswhyweneedtolaythelegalfoundationforthesetypesofproject.Ourteam
hasdonequitesomeworkregardingthetokenizationofshares(orcreatingsocalled
cryptoshares)”MaximLyadvinsky(CEO)
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The connection of the company to one of the major legal experts on blockchain and
“crypto technology”, shows how strongly the company feels the necessity to be in
completecompliancewiththelaw;andhowvaluabletheirexperienceandtheBloomio
project can be, in helping the development of new regulations and legislations. The
collaborationwithself-regulatingentities,willnotonlyfosterthegrowthoftheindustry,
butwillbenefitalltheactorsinvolvedinthisnewcryptomarket.
Process:
WheninteractingwithBloomio,userscanbenefitfromthemultipletoolsavailableforthe
definitionofwhatarethebestprojectsforthemandwhenready,investeasilyandina
safeenvironment.
Thoroughanalysisoftheprojectspresented,selectionofpartners,investorrelationsand
the multiple services available, is what defines the process presented by Bloomio.
Accordingtothecompany,thisprocesswillnotjustconnectprivateinvestorswithstart-
ups in need to raise funds, but will create a comprehensive structure that aims at
maximizinginvestmentopportunitieswithaseriesofuniquefeatures.
4.3.2.BloomioKeyFeatures
Inordertodistinguishitselffromtherestoftheequitycrowdfundingplatform,Bloomio
presentssomeindistinguishablekeyfeaturesthatmakesituniqueinthecurrentstateof
theEuropeancryptotechnologymarket.Someofthesefeaturesaredependentfromthe
relationshipthattheplatformhaswithblockchaintechnology;butothersaredeveloped
tobeanevolutionandanimprovementofwhatiscurrentlybeenofferedintheequity
crowdfundingindustry.
Start-upRanking:
Beforethepublicationofanewprojectontheplatform,thefeasibilityoftheprojectneeds
tobeaccessedproperly.Bloomioputsextremeimportancetotheapplicationofaproper
duediligence,tobeabletopresenttoinvestorsvaluableandprofitableprojects,whileat
thesametimepushingfundraiserstodevelopbetterprojectswithhigherchancestobe
fundedproperly.
Duediligenceprocedureislefttoanexternalandunbiasedthirdparty,whichissuesafive
starrankingsystem,thathelpsinvestorsevaluatethepotentialandtherisksassociated
withtheinvestmentinaprojects.Thefivekeypointsonwhichtheevaluatorsfocusonfor
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thedefinitionofthescoresare:TheTeam,theProductIdea,theLevelofInnovation,the
ProductState,andtheProductMaturity;thesefiveevaluationpointconstituteafairbase
ofevaluationforeachproject.Showingtheresultoftheduediligenceismandatoryforall
thecompaniesthatwanttoraisefunds;butmostimportantly,start-upswithoneortwo
starsarenotallowedtoraise funds foraperiodofsixmonths,afterwhichanewdue
diligencereportisfiled.
Theevaluationofeachproject iscustomizedaroundthestructureof theprojectbeing
evaluated,andaroundthenatureoftheindustryinwhichthatprojectwillbeplaced.The
evaluationofthepresentedprojectsisthefirststepinthecreationavaluable,stableand
transparentequitycrowdfundingplatform;wecanseefromthemeasuresemployed,that
Bloomioanditscollaboratorsunderstandverywelltheimportanceoftheseprocedures.
Start-upAcceleration:
Bloomioaimsathelpingstart-ups to raise capital,but itseffort in thedevelopmentof
valuable entities is not limited to that function. The platform in fact also helps new
companiestocreateastructureofconnectionsthatwillhelpthemgrowintheindustry
theyareentering.Bloomiohascreatedanetworkofthird-partyservicestobeconnected
with start-ups andhelp thembuild their team,R&Dprocesses, go-to-market strategy,
salesforce,andeverythingtheyneedtogrowandscale.
Bloomio is able to collaborate and help different levels of start-ups. One of the other
characteristics that differentiate Bloomio from the rest of the market, is the fact the
platformrecognizesthat,itisnotjusttheearlystagestart-upsthatneedfunding.Some
start-upsneed funds tomake theirbusinessstart,butotheralreadyestablished firms,
mayneedfundstoscaleoperationandexploitthefullpotentialoftheidea.Forthisreason,
Bloomiohascreatedfourdifferentstart-upcategories,thatwouldmakeiteasierforusers
toidentifythetypeofcompanytheyaredecidingtoinvestin.Thesubdivisioniscomposed
by: Seed, very early stage companieswhich are raising funds to establish operations;
Series A, in which some preliminary KPIs have been developed and need funds to
translateideasintoareality;SeriesB,inwhichtherearealreadyrevenues,butgrowth
needstobefosteredwithfunds;andfinallySeriesC,forwhichthemainfocusforfunds
wouldbetoscalebusinesstoexploititsfullpotential.
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Tokenization:
BlockchaintechnologyallowedBloomiotoimplementthetokenizationofstart-upequity,
inorder tosimplify transactions,andmake investmentsmoresecureandtransparent.
Tokenization facilitates the investment procedure for both funders and fundraisers.
Fundershaveaneasierwaytosupportthestart-uptheybelievein,andfundraisershave
afasterandalotmorefunctionalwaytoreachtheirgoals.
Eachstart-upisinchargeofdetermininghowbigisthesharetheyarewillingtotokenize
andwhatwillbethepriceofeachtoken.Bloomiohelpstheminthesedecisionsbykeeping
availableallthesupportiveservicesnecessary.
Bloomiowillalsoprovidetheserviceofholderoftokens,actingasthecustodianofthe
start-ups shares.Theplatformwill give the serviceof issuing the start-up tokens that
representtheequityofit,incompleteaccordancewithstart-upfounder’sdecisions.
Bloomioisapioneerinthisindustry,andtogetherwiththegovernmentislearninghow
theindustryworksandhowitwilldevelopinthefuture.Therearemanydifficultiesin
thecreationofaprofitableandregulatedentity,giventhefactthattheycannotrelyon
othersexperiences.
“Bloomioisthefirstprojectthattriestotokenizeindividualshareholder’srights(inthiscasetherighttoparticipateintheproceedsofliquidationandsale)andtradethemonthe
blockchain,sothereisunfortunatelynotmuchpriorworkwecanrelyon.”MaximLyadvinsky(CEO)
SecondaryMarket:
Asaconsequenceofthetokenizationofequity, thecreationofasecondarymarket for
tokens is one of the most important and interesting features that Bloomio has
implemented. The possibility to exchange tokens after the end of the campaign is an
important tool in the equity crowdfunding ecosystem. Investors are able thisway, to
managemoreefficientlyandstrategicallytheirinvestmentsandprotecttheirinteresta
lotmoreeasilywithrespecttothetraditionalequitycrowdfundingmethods.
The Bloomio market for tokens is now only restricted to the internal projects and
availableonlytothedirectusersoftheplatform.Thischoicehasbeendonefortwomajor
reasonsthatwerebroughtupbycompanylayers.MrLyadvinskyexplainedhowsomeof
the projects that are supported by the platforms, may have some problems in the
identificationofthecustomers.Asaconsequence,thecompaniesmighthaveproblemsin
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thedeterminationofwhoisthepersoninpossessionoftokens.Tokenscouldgothrough
unknownhandsandbecome“dirty”evenifthelastbuyeris“clean”.
Secondly,tokenscanremainclean,butbyopeningthemarkettoexternalones,thereisa
chancethat theymightneverreturntotheplatformoncetheyaresoldonanexternal
market.
“AfteraliquidityeventBloomiomightneedtokeepsomecashforeverwaitingforatoken
toreturntoBloomio”MaximLyadvinsky(CEO)
StatusGems:
Bloomioalsodecided to implementapoint-based reward scheme, according towhich
everytransactionorsocialactionsinsidetheplatform,willallowtheusertoaccumulate
whatarerefeedtoas“StatusGems”.Theaccumulationofthesegemswillallowusersto
unlockpremiumfeaturesliketheaccesstocampaignsbeforetheofficiallaunch,andother
additionalBloomioservices.
Gamificationofactivitiescanspurusersnotonlyto investandparticipatemoreinthe
platform,but is canalso increase thenotorietyof the industryand thecompany itself
outsidethecircle.
Beingblockchain-basedequitycrowdfundingabrandnewfieldofstudyandwork,itisof
extremeimportancetofinddifferentwaystoattractcustomers,sothattheywouldfirst
ofalllearnaboutthisnewmarket,understandit,andfinallydecidetobepartofit.
4.4.FutureDevelopments
Thepotentialoftheinnovationandthepresenceofsomefavourableregulations,might
makethecryptotechnology industryexpandrapidly in thenext fewyears.Blockchain
technology ispromisingthecreationofamarketthatwill foster innovationandatthe
sametimedemocratizethefinancialworld,andmanyotherstogetherwithit.
Likeanyotherinnovationthough,itpresentsnotnegligibledrawbacksthatwouldhave
tobeaccessedandtakenintoconsiderationwhenexploringthefutureapplicationofthe
technology,andhowitwillfitintheexistingenvironment.
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4.4.1.TheFutureofBloomioandtheCryptoValley
TheZugcantonisworkingconstantlyinordertomaintainitsreputationastheworlds
“CryptoValley”.Theecosysteminthisregionisnotonlycomposedbyinnovativestart-
upswith the sole goal ofmakingprofits; but thewhole community of companies and
regulators, are working together to promote innovation, and create more and better
opportunities.ThisattitudeiswhatdistinguishedZugfromtherestoftheregions,andit
isthisattitudethatwillfostereconomicandindividualgrowth.
Oneofthebiggestobstacleinthegrowthofthecryptomarketisandwillbetheregulatory
framework.Therelativelynewtechnologystilloriginatesadecentlevelofhesitation,so
itisuptoregulatorstoadoptaninnovativeapproachtoputthemindsofconsumersand
investorsatease.Fortunately,FINMArealizesthatthechancesforSwitzerlandtogrow,
arecloselyrelatedtotheirabilitytoinnovate;forthisreason,futureregulationswillbe
developed with the goal of removing unnecessary regulatory obstacles to permit the
developmentofnewandinnovativebusinessmodels.
RegulatorybodiesarenottheonlyonesthathaverealizedthatthefutureofSwitzerland
andthefinancialenvironmentmaydependontheevolutionoftheFintechindustry.Start-
up incubators are in factworking in order to help these new companies emerge and
organizetobesustainableintheneweconomicenvironment.Start-upsarethebackbone
ofinnovationanddigitalization,anditistheregulatorsandtheincubatorsresponsibility
to cooperate in order to create an innovation and creativity friendly environment for
thoseentrepreneursthatarecourageousenoughtodeveloptheirideas.
Switzerland has been considered for quite some time now, the global centre of the
financialworld,anditisworkingtowardtheevolutionintowhatwillbetheepicentreof
Fintech innovation.Thisprediction isdrivenbytheconstanteffortbyboth innovators
andregulators,tofostertheexplorationofthenewfrontiersofblockchaintechnology.
Thewidedistributionofblockchain,dependsontheeffortinnovatorswillmake,inthe
adoption of the technology in already established industries, in order to show its full
potential.
Bloomioisoneofthefirstattemptstointroduceblockchaintechnologyinanindustrythat
wasalreadywellestablishedandstructured.Inthedefinitionofthefunctionalitiesofthe
- 109 -
platform, we can see how many of the inefficiencies usually associated with equity
crowdfundingproviderscouldbemitigatedwiththeintroductionofthisinnovation.
Bloomioistakingthefirststepsintoanunexploredgroundthatontheotherhandmight
providetremendousopportunitiesofgrowthandthedemocratizationofoneofthemost
profitableindustriesintheworld.
IquestionedMrLyadvinskyonwhathebelievesthefutureofBloomioandtheindustry
willbe.Whathetoldmewasthedisplayofthewillingnessofinnovatorslikehimtobring
somethingnewtothetable,explorethelimitsoftheindustry,andexpandasfarasthe
companycanreachtobecomeoneofthemajorplayersintheindustry.MrLyadvinsky
anditscollaboratorsinitiative,sumsupthewillingnesstoprovethemselvesandgrowas
professionalsandpeople.
AccordingtoMrLyadvinsky,thecreationofBloomioandthesefirstservicesprovided,are
justthefirststepsintothehugedisruptionthatthetechnologywillbringtothefinancial
industry and others. Themix of this response to customer needs, and the increasing
relevanceoftheinnovation,willhelpcompanieslikeBloomiobecomethemajorplayers
intheindustryofthefuture.
Switzerlandchoiceoffosteringblockchain-basedapplicationsandstart-ups,mightresult
to be an extraordinary decision for the future development of new and profitable
industries.
When discussing the future of blockchain technology and its application in the
crowdfundingindustry,weneedtokeepinmindthat just likeanyother innovation, it
doesnotcomewithoutsomedrawbacks.Alltheconsequencesofthetechnologyneedto
beaccessedandkeptintoconsiderationbyanyonewillingtoinvest.
WehaverecentlyseenanincreaseinthenumberofpublicICOs,whichcanhavenegative
consequenceswithrespecttotheprotectionoftheinterestsofconsumers.
The technology allows the formation of autonomous ICOs, not backed up by any
institutionorplatform.TheseICOsconstitutethemajorityoftheonesrightnowinthe
market,andsomeofthemhavebeenabletoraisemillionsofdollarsovernight.
ThemajorityoftheinvestorsintheseICOsareinvestinginthesenewtokenssolelyfor
speculativereasons,withoutrealizingtheimmenserisktheyareexposingthemselvesto.
The promise of a fast enrichment is pushing beginner investors to look for the next
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cryptocurrencythatisexpectedtogrowfast.Theiranalysisisusuallybasedsolelyona
poorlywrittenwhitepaperandaflashywebsite,andsometimesnotevenonthat.
Wehavetheclearexampleofthisstatementwith“DogeCoin”,afakecryptocurrencythat
hasbeendevelopedbyanAustraliandeveloperwiththesoleintentiontoprovethelargely
spreadblindinvestingattitudetowardICOs.DogeCoinonJanuary7th2017hasreached
amarketcapitalizationof2USDbillion,wherenoprojectexiststobackupitsvalue.
WhatisimportantinthesesituationsistoremindinvestorsthatbehindeachICO,thereis
ateamofpeople,andthataproperduediligenceisnecessarybeforedecidingtoinvestin
anewproject.ThisiswhencompanieslikeBloomiocomeintoplay;theyassesstherisks,
and most importantly they educate investors on the real meaning of the technology
behindthecryptomarket.
According toMr Lyadvinsky’s expectations, the industrywill grow, andwe think that
blockchain-basecompanieswillbepowerfulenoughtosubstitutemanyofthecurrently
availableservices.Consumerwillbecomemoreawareofthetechnologyandwillrealize
therightwaytouseit,takingadvantageofitsfullpotential.
- 111 -
Conclusions
This work has been built around both the positive and the possibly disruptive
consequences of the implementation of Blockchain technology in growing market of
equitycrowdfunding.
Aswehavedescribedthroughthisdissertation,theintroductionofblockchaintechnology
canintheorymitigatemanyoftheinefficienciesrelatedtothetraditionalmethodologies
of equity crowdfunding.Wehave alsodemonstrated that the actual applicationof the
technologyinarealcaseispossibleandprofitable,likeinthecaseofBloomio.
We have started this work by analysing the concepts behind blockchain technology,
describingindetailsthefunctionalitiesaswellasthepossibilitiesthatthisinnovationis
abletooffer.Wehavespecificallyfocussedontheconceptof“tokens”andthepossibility
ofthe“tokenization”ofequityandassets,allowedbythetechnology.
Later we described the structure and the functionalities, but most importantly the
limitationsofequitycrowdfundingplatforms.Furthermore,wehaveillustratedhowthe
currentstateoftheartcreatesmanyconstraintsintermsofbarrierstoentry,security,
transparencyandfreedomofactions,especiallyforpossibleinvestors.
Inafollowingsectionwehaveanalysedhowtheintroductionofblockchaintechnology
would alleviate many of the inefficiencies widely acknowledged in the crowdfunding
ecosystem;andhowthestructureassociatedwithit,hasthepotentialtocreateamore
transparent,safe,anddecentralizedenvironmentforstart-ups.
Companies looking for capital, and small investors looking for risky but profitable
investment opportunities, can meet in a blockchain-based environment, with the
guaranteeofinteractinginasafeandtransparentecosystem.
Wehaveproposedthecase-studyofBloomio,aSwiss-basedcompany,whichiscurrently
thefirstentityintheworldtohavestartedworkinginthecreationofablockchain-based
equitycrowdfundingplatform.Thiscompanyisstillworkingonthedevelopmentofafully
functionalenvironment,thatwillbeperfectlyoperationalattheendofMarch2018.This
newplatformwillallowentrepreneursto“tokenize”apercentageoftheircompanyand
sellthosetokenstoraisecapital,throughtheinternalsecondarymarket.
- 112 -
Suchtechnologyallowsforthetokenizationofpropertyandcreateswhatarecommonly
known as ICOs (Initial Coin Offerings). Transactions, proofs of property, user’s
information, and accounts,will be all stored in ablockchain application, basedon the
Ethereumframework.Thiswillgrantatransparentandsafeenvironmentforbothparties
involvedinthetransactions.
Thecreationofasecondarymarketforthesetokenswillrevolutionizetheventurecapital
market,notonlybycreatingamoretransparentandfastwaytoraisecapital,butwillalso
introducetheventurecapitalisticconceptsintothemassmarket.Theintroductionofthe
technology and the tokenization of equity, permits themassmarket to participate in
venturecapitalisticactivitiesevenwithsmallcapitals,rangingbetween1000and20000
SFr(inthecaseofSwitzerland).
The biggest limitation remains the legal framework which these blockchain-based
companiesareworkingin.Innovation-asitusuallyhappens-isfasterthanlegislation,
thatfrequentlydoesnotallowaproper,andtime-efficientintroductionofthetechnology
inthemarket.TheZugCanton,inwhichBloomioandmanyothershavetakenoffice,has
ontheotherhandrealizedthepotentialofthistechnology,andit isworkingtofavour
blockchain-basedcompaniesandthedevelopmentofnewprojects.
The collaboration between the Swiss government, some independent self-regulating
associations, andblockchain-based enterprises, is fostering thedevelopmentof the so
called“CryptoValley”,whichmightbetheepicentreofthecreationofblockchain-based
applicationsandofthedisruptionofthefinancialsystemandofmanyindustriesaswe
knowthem.
- 113 -
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ListofFiguresTables
Table(1):DifferencesintermsoffunctionsbetweenTraditionalFinancialIntermediaries
andCrowdfundingasFinancialIntermediaries.41
Table(2):FunctionalitiesofanequitycrowdfundingDAppassociatedwiththeservices
providedandnecessary.
Table (3): Inefficiencies softened by functionalities od a decentralized crowdfunding
application.
Graphs
Graph (1): The increasing volume of capital that equity crowdfunding platforms are
raisingandwillcontinuetoraise.
Graph(2):IncreaseinthenumberofICOsin2017.
Graph(3):USDmillionsraisedthroughICOsin2017.
Figures
Figure(1):Messageandtransactionsinteractionsscheme.21
Figure(2):Shorterblocktime29
Figure(3):Biggerblocksize29
Figure(4):Subtreeselectiondifferences.30
Figure(5):Crowdfundingplatformbusinessmodelillustration.42
Figure(6):peer-to-peer“SeparateAccountModel”interactionillustration.43
Figure(7):peer-to-peer“NotaryModel”interactionillustration.
Figure(8):peer-to-peer“GuaranteeModel”interactionillustration.
Figure (9): “Low Responsibility” interaction model for a, equity-based crowdfunding
platform.
Figure (10): “Medium Responsibility” interaction model for an equity-based
crowdfundingplatform.
Figure (11): “HighResponsibility” interactionmodel for a, equity-based crowdfunding
platform.
Figure(12):NetworkPartnerInteractioninthecrowdfundingsystem.
Figure(13):RelationshipbetweenthetwopartiesinvolvedandtheDApp,intheequity
crowdfundingblockchain-basedecosystem.
Figure (14): Peer-to-Peer ContributionMechanism trough a decentralized application
- 123 -
Illustration.
Figure (15): Equity Crowdfunding Mechanism trough a decentralized application
Illustration.
Figure(16):EquityCrowdfundingplatforminteractionandserviceprovisioninablockchain-basedecosystemthroughtheuseofaDApp.