Decentralized Finance (DeFi) employs blockchain technology and smart contracts with the goal of enabling perfectly disintermediated financial markets. Despite the far-reaching ambition, DeFi markets are experiencing increasing intermediation recently, as a new type of intermediary, so-called Crypto Funds (henceforth, CFs), reintroduces centralized market structures. In fact, the number of newly established active CFs has substantially grown over the last four years to more than 850 at the end of 2021, with a surge in total assets under management from $8.3 billion in mid-2018 to $57.5 billion in 2021. In a new article, we address the question of why CFs find it profitable to intermediate DeFi markets and whether CFs contribute to the overall efficiency of those markets.
CFs combine sophisticated venture- and hedge-fund style investment strategies, exploiting the fact that even very early-stage tokenized startups can be traded in public secondary markets for tokens. CFs differ from traditional funds in important ways. CFs mostly trade in tokens that are classified as “non-securities,” which exempts them from most securities regulations that traditional funds face, such as the Investment Company Act or the Advisers Act. For example, CFs may raise funds from small, individual investors that are neither accredited nor qualified, resulting in a relatively low-median minimum investment requirement of $100,000 (Crypto Fund Research, 2021). It also exempts CFs from any management and performance fee restrictions chargeable to their investors.
Despite the DeFi promise of perfect disintermediation, CFs may be value-adding if they are able to reduce market frictions and thus improve the DeFi market’s efficiency (e.g., by overcoming asymmetric information and agency problems and reducing participation costs for individual investors).
Because CFs are a novel financial intermediary, research assessing their role in DeFi markets is very limited. Our study exploits a unique dataset combining proprietary performance data of CFs with detailed information on tokenized firms and Initial Coin Offerings (ICOs).
Our analyses reveal three key findings:
First, we examine whether tokenized firms achieve higher valuations when they are backed by CFs during an initial coin offering (ICO). We find that tokenized firms substantially benefit from CF backing. In fact, the average tokenized firm’s valuation roughly doubles if the firm is backed by a CF. The effect is much stronger if the backing CF’s investment strategy resembles that of a venture capital fund, rather than a hedge fund.
Second, we investigate whether CF-backed tokenized firms outperform their peers in the long run. Our results suggest that the average token price of CF-backed firms outperforms that of non-CF-backed firms by 18 percent, as measured by buy-and-hold abnormal returns (BHARs) within the first two years after the token exchange listing. Interestingly, the outperformance effect is stronger if the firm is backed by a hedge-style CF, rather than a venture-style CF.
Third, we shed light on the performance and performance persistence of CFs themselves. We document that CFs outperform the market by 2.69 percent per month, as measured by the traditional CAPM-alpha. CFs’ performance is even persistent over subsequent investment periods, suggesting that their outperformance is due to skill rather than luck.
Finally, we show that all these results – that is, the higher valuations, the long-term outperformance, and the fact that CFs are able to beat the market – are driven by CFs’ investor networks. The more central a CF in the market, the higher the valuation and performance effects. This suggests that access to proprietary information in segmented DeFi markets may be why we see a growing number of CFs in DeFi markets.
Overall, these findings are intriguing because they rationalize the seemingly paradoxical re-introduction of centralized market structures in DeFi markets.
Our study has several important implications for entrepreneurs, investors, and policymakers. For entrepreneurs, securing CF backing is always beneficial, no matter whether it is in the primary or secondary market. In the primary market, entrepreneurs are well-advised to seek backing from venture-style CFs, while endorsements from hedge fund-style CFs pay off more in the secondary market. For individual investors, putting their money into CFs yields higher returns than investing directly in, for example, Bitcoin or Ether. For policymakers, our findings suggest that the token market may to some extent become more efficient on its own because intermediaries reduce costly frictions and have an incentive to do so because they benefit from above-market risk-adjusted returns. Our results also provide a solid empirical basis for policymakers and legislators to help adapt securities laws to the domain of tokens and intermediaries that trade in non-securities, such as crypto funds.