Signaling Quality in Initial Coin Offerings with Funds Regulation

Abstract

In this paper, we study how funds regulation influences a venture’s token issuing strategy, cash diversion behavior and signaling effectiveness, when he has private knowledge on product quality (i.e., high or low). We first analyze this problem under complete information, which extends Gan et al. (2021) to the case when funds are regulated. We find that a higher funds regulation level incentives the venture’s cash diversion behavior and induces a higher profit. Then, under information asymmetry, we characterize the high-quality venture's token issuing strategies under strict funds regulation and no funds regulation, respectively. We find that the relative sizes of informed and uniformed investors are important in token sizes' signaling effectiveness, which in turn influences the venture's token issuing strategies. Moreover, our theoretical results are (partially) consistent with some empirical observations in quality signaling and open new avenues for future empirical study. At last, we show that funds regulation may improve signaling effectiveness but it does not always benefit the high-quality venture under information asymmetry. Specifically, we show that a strict funds regulation may hurt the high-quality venture in a small ICO market; and even when the ICO market is large, the high-quality venture may prefer a moderate funds regulation level. Our results are robust when the number of investors in the ICO market is random.