Here at Glassbox, our primary goal is to bring clarity to the brave new world of cryptoassets. Unfortunately, many of the Crypto 2.0 platforms have been breeding grounds for malicious actors to perpetrate scams of varying levels of sophistication. Most of these ponzi schemes, shell games, and pump-and-dumps could have been avoided if only investors – and asset creators themselves – had leveraged the inherent transparency that blockchain technology offers.
Prior to the creation of Glassbox, we’d been brainstorming ways in which the blockchain could provide investors with deeper level of transparency. These formative thoughts were captured in this Bitcoin Magazine piece by one of Glassbox’s co-founders in early 2014.
Of course, a lot has changed over the past year – namely, the rise of Ethereum as (in our humble opinion) the ideal platform for issuing cryptoassets. We suspect that the rise of the decentralized application and open source contract will bring about a flourishing ecosystem of assets. Investors will have no shortage of options. Which will be legitimate? Which will be malicious? The blockchain can help us answer those questions.
In short, now is the time to explore and define the building blocks of transparency.
With that in mind, our new article series will delve deeper into the subject. We’ll begin by looking at a simple-yet-powerful way investors can manage risk – while at the same time, affording asset creators with an opportunity to send a clear and unambiguous signal about their legitimacy. Meet the “canary in the coalmine”: Genesis Attribution.
Even in these early formative stages, the Crypto 2.0 world has become crowded with tradable assets. From NXT to BitShares to Counterparty, investors and speculators have no shortage of options to choose from. Whether it’s a subcurrency used for the fees to run a decentralized app (DApp), cryptoequity that comes with profit-sharing and even voting rights, or a fund that gives investors exposure to multiple assets, there are many legitimate reasons to tie a crypto-based enterprise to a tradable token.
However, the ease with which nearly anyone can create a crypto-asset has led to a continuation of an unwelcome phenomenon that plagued the first generation of altcoins: the pump-and-dump. The setup is simple: a malicious individual (or group) creates an asset, ties it to a “shell” business that is hyped on forums and social media, and drives up the price. Once the asset has appreciated in value, the asset creator bails out – leaving its duped investors holding the bag.
Stock market investors are all-too-familiar with pump-and-dump; it’s been employed in traditional equity markets for decades – if not centuries. An individual taking a time machine back to the 1700’s could probably even spot the scheme amongst Dutch traders on Wall Street.
The prevalence of pump-and-dumps – owing, perhaps, to the ease with which they can be implemented – has led to the creation of regulatory guidelines that companies must follow in order to bring their shares public. A standard procedure for an IPO is that company officers will have their own shares locked for a predetermined amount of time – typically 6 months – before they can sell them. This “lockup period” prevents insiders from liquidating their assets immediately after the company goes public.
While holding a hefty percentage of shares in their own enterprise is to be expected for creators of blockchain-based assets, there is nothing to prevent them from dumping their holdings and sending the price plummeting downward; the crypto world lacks a regulatory oversight agency to enact and enforce a lockup period. But for those seeking similar safeguards against immediate insider selling, there’s very good news: creators of assets can follow a standardized protocol that provides similar protection, thus increasing their trustworthiness in the eyes of potential investors.
The Canary in the Crypto Coal Mine
The inherent transparency of the blockchain gives us the ability to detect whether insiders are buying or selling. All we need to know is the following:
- What is the initial distribution of an asset?
- How many tokens do the asset creator(s) hold?
- Where are the asset creators assets held?
To ensure the accuracy of the data, these questions must be answered by the asset creators prior to the ICO (Initial Coin Offering) – hence the name Genesis Attribution. Let’s take a closer look at how this might work.
Imagine that the ubiquitous Alice is an enterprising developer has built a decentralized auction service which is generating steady profits just three months after launch on a Crypto 2.0 platform. In order to fund ongoing development of the project, she decides to issue an ICO for the service
In an announcement thread, Alice details the service’s business model, its current revenue, and its plan for future growth. She knows that the service already has a good reputation within the platform’s community, but wants to provide added confidence that the investment is legitimate, and that she (and other early stakeholders) won’t head for the exits after the asset begins trading.
After publicly announcing that the ICO will occur in two weeks, she creates the asset that will be tied to her service. In this primordial state, the asset consists of 1 million tokens which carry no actual value. Alice, knowing that investor money will soon inject value into the tokens, sets aside 10% of these tokens for herself. It’s these holdings that will help to fund the organization’s future growth.
Next, she sets aside another 5% for early seed investors in the project, and another 5% for a UX designer who joined the business at an early stage. Both took on risk – by investing money and time, respectively – and hope to be rewarded now that the service is going public.
After determining this distribution, Alice sends the appropriate amount of assets to corresponding addresses. At this stage, she announces the following:
Our decentralized auction service will ICO in three days. The distribution is as follows:
Founder Equity: 10% – 100,000 tokens held at <Address 1>
Seed Round Equity – 5% – 50,000 tokens held at <Address 2>
UX designer Equity – 5% – 50,000 tokens held at <Address 3>
Shares Allocated for Public Trading – 80% – 800,000 tokens held at <Address 4>
In this one simple message – verifiable by signing of the various addresses – the asset’s creator has given investors the ability to detect insider selling. In the event Alice begins dumping her shares shortly after the ICO, the declining amount of tokens at her address will immediately provide verifiable proof that she is selling. Investors will thus have early warning that a pump-and-dump may be taking place.
In this case, Alice is glad to provide this deeper insight into insider holdings; she has no intentions of selling early-on, and believes that the added transparency will help attract more buyers. She also knows that the benefits will last beyond the initial few months of trading. When users hold a large percentage of the overall assets, it’s relatively easy to manipulate the market in various ways. However, such manipulation would be much easier to detect if users could see that large chunks of Alice’s original holdings were being sold.
Above and beyond making her holdings public, Alice could demonstrate even deeper dedication to her business by creating a contract that locks up a large portion of her assets for a predetermined period of time – say, a year or two. This would provide a strong indication that she believes in her service’s ability to growth over the long-term; in other words, she’s putting her money where her mouth is. The advent of smart contracts such as those built on Ethereum could offer more nuanced solutions – for example, the ability to profit from dividends on her assets even though she lacks the ability to sell them until the lockup period ends.
Can Genesis Attribution be gamed? In terms of pre-ICO share distribution, probably not. Thanks to the transparency of the blockchain, we can see where the shares are held, and in what amounts. Attempts to make changes to stated holdings and addresses would be easily detectable.
It is possible that an asset creator might buy shares on the open market immediately after the ICO. They could do so anonymously, in an effort to drive the price higher (thus building hype and encouraging investors to jump onboard) and in order to accumulate a larger share of the overall assets which they could leverage to manipulate the asset’s price in the future. Yet the opportunity to take advantage of investors would be far smaller; a malicious asset creator would actually have to spend money on those tradable, post-ICO assets. Pre-ICO assets, meanwhile, are created out of thin air. Manipulation with these assets, then, becomes trivial and cost-free for a malicious insider.
Genesis Attribution is not a magic bullet. For one, it requires the asset-issuer to voluntarily take certain steps prior to the ICO. Additionally, if holdings and addresses haven’t been provided before the assets begin trading, it would be extremely difficult – if not impossible – to trustlessly verify where insider holdings are held. So this standard applies only to future assets – not those already being traded.
Nonetheless, asset creators have a powerful incentive to take these steps. As described above, the resulting confidence would make it more likely that investors would buy the asset. They’d also be more inclined to hold it for a longer period of time, in hopes that the founder’s belief in the project’s long-term growth will come to fruition.
As outlined here, Genesis Attribution sends a powerful message to investors regarding the founder’s intentions and expectations, and gives them the power to assess what insiders are doing. Yet it’s only one element of Real-Time Transparency. In our next post, we’ll discuss ways in which the owners of crypto-based services can provide clear, verifiable indications about their company’s health and performance.