Financing 101

Before we look specifically at financing in Web3, it is important to establish a baseline understanding of the financial system and the purpose it has traditionally served.

The financial system allocates wealth from those individuals who have surplus wealth (but insufficient investment opportunities) to those individuals who have investment opportunities (but insufficient wealth). In return, the financial system allocates financial claims on those investment opportunities.

The financial system is a very important part of the overall economy. The financial system can affect productivity growth in the economy via any (or all) of four channels:

• by screening entrepreneurs to select the “best” projects
• by mobilising resources to undertake investments
• by diversifying investors’ portfolios
• by indicating the benefits of undertaking productivity-enhancing activities

Financial markets and various institutions make up the financial system. For our purposes here, we focus on financial markets.

The function of financial markets within the financial system is to:

• mobilise savings into investment opportunities
• allocate resources to their best use
• provide opportunities for risk management
• facilitate trade
• provide governance functions

In particular, financial markets exist to trade financial assets (see below) and provide three very important functions:

• price discovery
• liquidity
• reduction of transaction costs

Assets in financial markets can either be traded for immediate delivery (in practice usually about 2 days) or delivery at some point in the future – forward or futures markets.

An equity market is a market in which shares are issued and traded, either through exchanges or over-the-counter markets. Equity has the following characteristics:

• It represents an ‘ownership stake’ in a company – i.e. a residual claim on the assets
• Shareholders are entitled to a dividend (if declared) and/or capital gain/loss
• Shareholders are entitled to vote – usually on a one-share-one-vote basis

Bond markets are where debts of various maturities are traded. In contrast to equity, debt does not represent an ownership stake in the company. Rather a debt instrument entitles the owner to a coupon payment (i.e. interest) and repayment of the face value of the bond at maturity.

The table below sets out the difference between equity (stocks) and bonds.

It is also possible to trade various derivative products based on underlying financial instruments and commodities. These products include options, forwards, futures and the like.

Are Tokens Debt or Equity?

A good question to ask is whether Web3 tokens are debt or equity. Clearly some tokens are meant to function as a ‘money’. But what about all the other tokens?

The answer is tokens are often neither debt or equity. Many tokens have a mixture of features that blend the characteristics of debt and equity.

It has not been possible, before the advent of blockchain and smart contracts, to create instruments with blended features. Largely because debt relies on rules and equity tends to rely on discretion and people could quite reasonably disagree on when discretion or rules should apply. With trustless technology and smart contracts it is possible to create those instruments.

So tokens very often are a combination of the two – an instrument first imagined by economics Nobel laureate Oliver Williamson in 1988. He called such hybrids ‘dequity’, a term that aptly describes many tokens.