Decentralized finance (DeFi) markets for startups: search frictions, intermediation, and the efficiency of the ICO market

This paper examines the efficiency of the Initial Coin Offering (ICO) market through a search-theoretical lens. Search intensity associated with the process of identifying valuable startups is increasing in market granularity. DLT increases market granularity because asset tokenization lowers entry barriers. Lower-end entrants, however, increase aggregate search intensity but may lack search skills. The resulting search-related inefficiency creates a niche for intermediaries or institutional investors that specialize on search. Consistent with the theory, specialized crypto funds increase ICO market efficiency by reducing search frictions, inter alia, by shortening the time-to-funding and increasing the funding amount. At the same time, crypto funds extract sizable economic rents for their intermediation services. Overall, the study relates to the general trade-off between centralization and decentralization in entrepreneurial finance. It suggests that market frictions specific to early-stage crowdfunding of entrepreneurship may prevent “perfectly” Decentralized Finance (DeFi) markets from functioning efficiently. Decentralized Finance (DeFi) markets may require a substantial degree of centralization to function efficiently. We show that centralization in the form of institutional investors that intermediate Initial Coin Offerings (ICOs) lead to, first, shorter time periods to reach fundraising goals and, second, higher valuations. In a search-theoretical model, we quantify the extent to which centralization mitigates frictions in a decentralized market. Centralization reduces trading delays and improves decentralized market efficiency especially in times of market downturns and when there is uncertainty about the team or product quality. Thus, the principal implication of our study is that decentralized markets for startups may not be optimal for society. Centralization is valuable because it improves the speed with which entrepreneurs and investors meet, and because it mitigates market frictions arising from asymmetric information.