Faculty of law blogs / UNIVERSITY OF OXFORD

Certification arbitrage in digital finance markets: A blind spot for financial regulators?


Niclas Dombrowski
Consultant with the Boston Consulting Group
Wolfgang Drobetz
Full Professor of Finance, University of Hamburg
Lars Hornuf
Professor of Business Administration at the University of Bremen
Paul P Momtaz
Researcher, UCLA Anderson School of Management; House of Finance, Goethe University, Frankfurt

The recent popularity of blockchain technology is accelerating the tokenization of assets among many sectors and firms, with startup firms pioneering the development. Not only startups tokenize assets, however; most recently, private equity giant KKR announced moving a $4 billion fund on-chain. Asset tokenization promises transparency about ownership, transactions, and the aggregate health of the tokenized economy. Assets on blockchains significantly reduce both settlement delays and transaction costs.

A consequence of firms moving assets on-chain is that those asset-backed cryptocurrencies can be traded on crypto exchanges 24/7, creating public and liquid markets for some goods and services that have been illiquid before. A new research paper published by CESifo investigates the implications for the functioning and efficiency of public markets in the context of startup companies and documents a striking empirical pattern that should concern policymakers and financial regulators.

Startups that tokenize their assets through Initial Coin Offerings (ICOs) with the help of a crypto fund exhibit signs of operational underperformance and financial outperformance in the short run. While this may sound paradoxical at first, Lars Hornuf of the Technical University Dresden, Niclas Dombroswki of the Boston Consulting Group, Wolfgang Drobetz of the University of Hamburg, and Paul Momtaz of the Technical University of Munich developed a new concept of ‘certification arbitrage’ that reconciles these patterns.

Traditional certification theory in entrepreneurial finance posits that there is substantial asymmetric information between the startup and the market. Unlike retail investors, institutional investors have the financial resources, the skill, and the economies of scale to produce information on the startup, suggesting that institutional investors can better than the market gauge startup value. Therefore, if an institutional investor backs a startup, the market may take this as a positive signal about the startup firm’s quality. As a result, institutional investor backing often leads to an appreciation of startup firm value. Institutional investors benefit from this appreciation and are, thus, compensated for their effort to certify the startup in the first place.

Now, the core of our modified certification theory is that, in the context of tokens, certifiers are well aware of their certifications’ market impact on the startup’s value and of their certifications’ market power to manipulate prices, which they may exploit to extract private benefits. These conditions lend themselves to a novel moral hazard in entrepreneurial finance (one may even call it a professional pump-and-dump scheme), which we refer to as certification arbitrage

Certification arbitrage occurs when institutional investors, who attest to the quality of the venture with their financial backing, have an incentive to quickly exit a target’s venture as long as token valuations are favorably impacted by their certification. Put differently, certifying investors buy tokens at the pre-certification price and, thanks to liquid secondary markets, sell their tokens almost immediately at the post-certification price, with the difference being their arbitrage profit.

To summarize, the certification mechanism may work well in illiquid entrepreneurial finance markets, while it is problematic only in liquid entrepreneurial finance markets. It works in illiquid markets because venture capitalists take several years to exit a position, which is sufficient time for retail investors to learn about the startup's fundamental value so that certifying venture capitalists would typically exit at fair value. It does not work in liquid markets because certifying crypto venture funds can exit positions immediately; thus, it is possible to exit at the inflated (or: certified) value, leaving retail investors worse off.

These considerations help to understand why some crypto funds may hurt the operational performance of tokenized firms, even though the token price appreciates. Importantly, these arguments lead us to two overarching takeaways from our paper that have implications for policymakers and financial regulators.

The first takeaway is that public and liquid markets for startups may not be efficient. The possibility of certification arbitrage plausibly exacerbates market myopia. Myopia refers to the phenomenon that some managers focus on short-term gains at the expense of the long-term interests of the stakeholders. The theory of market myopia submits that long-term, uncertain projects are difficult to communicate and therefore are not fully reflected in the stock price, which is why myopic managers forego those projects; that is, they avoid projects that are good for operating efficiency in the long term and focus instead on projects that are good for the stock price in the short term. The presence of institutional investors can exacerbate myopia. Therefore, asset tokenization may lead to detrimental economic outcomes if tokens with high asymmetric information can be traded in liquid markets.

The second takeaway is that certification arbitrage may lead to market failure. If certifying investors implement trading strategies that loot retail investors, retail investors will stay away from markets for tokenized assets, potentially leading to a market for lemons problem. The good news is that certification arbitrage is a problem that policymakers and financial regulators can easily address by creating rules that strengthen the information content of institutional investors market signals. For example, mandatory lock-in periods for institutional investors in token markets would ensure that retail investors have more time to learn about the true value of asset-backed tokens and to evaluate the information content of certifications. The market would also benefit from more rigorous disclosure obligations, eg, whether crypto funds have invested only in tokens or also in equity, the ownership percentage, and at what valuations.

Niclas Dombroswki is a Consultant with the Boston Consulting Group.

Wolfgang Drobetz is a Professor at Hamburg University.

Lars Hornuf if a Professor at Technical University of Dresden.

Paul P. Momtaz is a Professor at the TUM School of Management.


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