The Controversial, Lucrative World of Crypto Premines

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2 years ago

Are you brand new to crypto and not sure where to begin to learn about it? Check out my intro to cryptocurrency and intro to blockchain posts or my cryptocurrency archives to learn more about this fascinating new technology!

Retail and institutional investors alike are familiar with the realities associated with startups and startup culture. New startups are born everyday and older startups fail almost as rapidly. Startup founders often have little in the way of money or investment security to offer to early employees and investors when the company is brand new. They need to come up with appealing ways to entice people to take a chance on their business, even though the risk of failure is off the charts. When unlimited PTO policies, casual dress codes, free food, and more don’t bring outsiders in the door, or when traditional companies cherry pick those offerings for their own employees, startups have an option that isn’t available to anyone else: startup equity.

Offering ownership in a startup to early employees and investors can be extremely rewarding, at least for companies that avoid failure and make it big. Take Dustin Moskovitz, one of the first people involved with Facebook after Mark Zuckerberg created the company. Dustin still owns around 2% of Facebook even though he left his position in 2008. As of this writing, Facebook’s market cap is just north of $1 trillion U.S. dollars, meaning that Dustin’s stake in the company is worth around $20 billion USD. At that price, was he adequately compensated for his efforts and risks at the startup? Many of us would say that he was.

Observers often find many similarities between the cryptocurrency industry and startups. Both are often on the cutting edge of technology. Both require a significant amount of effort to stave off failure and bankruptcy. And both involve a significant amount of risk for founders, developers, and early investors. Perhaps it is unsurprising then that many nascent cryptocurrency companies have resorted to a method of rewarding those early participants that seems almost identical to granting startup equity: coin premining.

Yours, Mine, or the Pre-mine?

There is one common difference between crypto and non-crypto startups, and that is centralization. Traditional companies have well-defined hierarchies and the company’s leadership lords over the rest of the organization with an iron fist. The company exists solely to manage and sell a product or service.

Some crypto companies, like Coinbase and BlockFi, have mirrored that level of organization themselves. However, there are many entities within the crypto sphere that have no defined structure and no specific purpose outside of creating a new cryptocurrency or blockchain. The Ethereum blockchain and its native token are a good example. Vitalik Buterin and the blockchain’s other early developers shepherded the project through the idea and implementation phase. Once the blockchain went live though, they largely faded into the background and have, arguably, limited influence over it at this point in time. There is no Ethereum company and so there was no startup equity to offer early developers and investors.

This is where a coin premine typically comes into the picture. Since most blockchains have at least one native token, and because those tokens can usually be traded quite easily on exchanges or peer-to-peer after the blockchain goes live, the founders and developers behind the blockchains will often set aside a percentage of the native tokens for themselves before making the tokens available to outsiders (aka, everyone else). The Ethereum premine, for example, was about twelve million tokens, which at the time was over 15% of the total supply.

Premines have become quite common in the cryptosphere. Supporters will argue that premines incentivize developers to put effort, often while unpaid, into creating new blockchains and blockchain-based products. Critics will argue that premine allocations are often confusing and can significantly dilute the investments of people who buy into the cryptocurrency after launch when the premined coins get dumped on the market. In my opinion, there’s a certain amount of truth to both sides. Nevertheless, one of the most important impacts to understand in the context of premines is that of reduced decentralization.

Centralizing Crypto One Blockchain at a Time

Premines and centralization are really most problematic in the context of Proof-of-Stake blockchains and governance tokens:

Proof of Stake (POS)

Proof of Stake blockchains are all the rage these days, primarily because they don’t have as large of an environmental footprint as Bitcoin’s blockchain and don’t require the expensive specialized mining equipment common to Proof of Work blockchains. In the simplest of terms, “mining” power in Proof of Stake blockchains is determined by the amount of the blockchain’s tokens that a person owns. If you own more tokens, you’ll receive a higher percentage of new tokens generated with each confirmed block.

Perhaps you’re starting to see how premines and Proof of Stake mining could lead to some gray areas. Developers of Proof-of-Stake blockchains with premines don’t just give themselves a part of the initial token supply for free, they also give themselves the ability to generate new tokens in perpetuity for free. While it is true that any token holder can generate new tokens by using their current holdings to validate blocks, everyone who didn’t or couldn’t participate in the token’s premine has to pay for that privilege. As a cryptocurrency’s value soars, owning a portion of the supply comparable to the amount given to premine participants becomes all but impossible. For example, purchasing 15% of Ethereum’s outstanding supply at today’s prices would cost around $50 billion U.S. dollars.

Governance Tokens

Governance tokens were initially used primarily on decentralized applications (dApps), but they have since started to be used in centralized crypto companies as well. A governance token grants its holders the right to vote on the future of a blockchain, company, or dApp and is typically credited with transferring power from developers to end users. The more tokens you own, the more power you have in determining the direction that the blockchain will take moving forward.

Premined governance tokens are a serious threat to the real amount of decentralization on the blockchains that use them. For example, I wrote several weeks ago about the company ShapeShift’s plan to cease operations and hand over control of its cryptocurrency exchange to holders of the newly created FOX token. Many within the cryptocurrency community, including ShapeShift employees and investors of course, applauded the company for its seemingly selfless decision to put decentralization over profits. However, a closer examination of the proposed distribution of FOX tokens reveals that over 40% of the token’s supply, not far from a majority, would be granted to employees, managers, and investors of the soon-to-be defunct company.

The Beauty of Bitcoin

Say what you want about Bitcoin, but it is hard to argue that the release of any other cryptocurrency was more fair. No Bitcoin were premined at any point and the blockchain was open to be mined by anyone starting with block no. 1. On top of that, Bitcoin’s pseudonymous creator, Satoshi Nakamoto, has never moved or sold any of the estimated one million Bitcoin that she/he/they mined in the earliest days of the blockchain. In a very real sense, thanks to Bitcoin’s hard supply cap of twenty-one million, Satoshi’s inaccessible holdings essentially increase the value of everyone else’s Bitcoin holdings. After all, all else equal, lower supply tends to drive up an asset’s price.

Premines are Likely Here to Stay

That said, it seems highly likely that premines will remain a part of cryptocurrency and blockchain well into the future. As we discussed above, they can be highly lucrative to those who are lucky enough to participate. And cryptocurrencies with premines can still bring great wealth to early investors who buy into the cryptocurrency shortly after launch, as exemplified by Ethereum’s exponential growth over the past several years. Nonetheless, premines are not without their risks. Anyone who is contemplating investing in a cryptocurrency with a premine should weigh the risks and benefits in the context of their own situation before making any amount of investment.

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