To clarify right at the beginning, there are two types of token swaps: The first and most often discussed type is the one that was employed in the EOS or the TRON project for instance, where the first version of tokens was deployed on Ethereum’s blockchain and, after a successful completion of development steps, exchanged for official “mainnet” tokens on the respective project’s own blockchain afterwards. Maximilian Boelster, Research Assistant at Crypto Finance AG, discusses the ERC20 token swap topic in this article.
The second type of token swaps — the focus of this article — became very popular during the recent bear market as a tool to announce successful cooperation among ICOs. What at first glance appears as a major project achievement for potential investors and stakeholders, is actually associated with significant risks for the funding of a project. Coin or token swap deals should not be regarded as being bad in general, but they need to be communicated transparently to assess potential risks related to the deal.
To demonstrate the risks for investors, allow me to illustrate the problem from an ICO’s perspective:
Imagine you are responsible for your own company’s ICO and have just started your token sale with a soft cap set at USD 1 million (or 5’000 ETH equivalent) and a hard cap set at USD 10 million (or 50’000 ETH equivalent). Right after the start you observe that there are only few investors buying your tokens as everyone is waiting at the side lines to see how big the hype surrounding the project is (potentially) going to be. You are facing the challenge of deciding which marketing efforts might be the correct ones to fuel sales and foster investor appetite. For simplicity we assume that there are neither bonus nor discount levels, the exchange ratio is set at 1 token per 1 ETH and 70% of the token will be distributed to the community.
Besides all the (by now) “standard” ICO madness, you receive an enormous number of messages; by email, by telegram, by other channels. If it is not Martins Hacks inquiring for the twelfth time about reviewing your ICO on his YouTube channel, it may well be another guy asking for a cooperation with your company, while offering you a token swap at the same time. A token swap that would immediately resolve the problem of hesitant investors as mentioned above and potentially even bait new investors to support the project. As there exists, naturally, a large number of synergies between the aforementioned project and your own, the offer contains a token swap amounting to a value of 5’000 ETH equivalent.
What appears to be a significant benefit to your own ICO, is frequently associated with rather unpleasant consequences:
- The most obvious advantage is that your ICO progress bars rises by 5’000 Tokens (considering the exchange rate of 1 Token per 1 ETH) as you have basically sold that amount to an investor. Congratulations you have already reached your soft cap.
As a consequence, many investors will be attracted to your project, enabling you to reach the soft cap in almost no time. ‘Oh, they already reached the soft cap after only a few hours, this appears to be a solid investment’.
- As you have sold the equivalent of 5’000 ETH you will receive tokens from the other project as the respective means of payment. Given the fact that the other project is in the exact same situation, namely, raising money through a token sale, you won’t be able to sell the tokens before the latter is listed on an exchange. As such, swapping for a significant number of tokens goes hand in hand with a significant lump risk, as the price development of the token can be heavily influenced by your potential token swap partners (and by yourself naturally). If thereafter no significant investments are received from investors, you will have a really hard time financing your project. Moreover, in some cases you have to expect a vesting over a specific period, complicating matters even further.
- Put differently, do both your team and your service providers accept payments in a token currency of another project (with which they are most likely not associated)? If not, paying your salaries and bills will become increasingly difficult and ultimately liquidity constraints may grind operations to a halt.
- Engaging in swapping activities will lead to a dilution of your investors, which will not exactly render them happy and put a strain on your investor relations.
- Moreover, should you manage to meet the soft cap and get listed on an exchange in the process, your ‘swap partners’ will probably try to offload your tokens immediately (provided there is enough liquidity), which will result in a contraction of the price, once again making sure that your investors are not going to be content with your course of action (if you are transparent enough to let them know of course, another potential pitfall).
Switching back to the role of an investor, would you still invest in a project engaged in such token swap deals? If not, then you might understand why projects often refrain from reporting such information transparently. However, such agreements need to be shared with investors, as they put the whole project at a significant risk and should therefore also be part of a professional due diligence. Moreover, nobody stands to gain anything from employing such strategies, given that the latter, in most cases, do not enhance a project’s liquidity, which is what is needed to fund the development of the business case and create long-term value for investors.