Crowdfunding and blockchain: the future of decentralized financing

The world of finance has undergone a real earthquake with the establishment of the blockchain technology, tokens and cryptocurrencies, which have opened up scenarios still not fully explored for economic transactions and financial investments. These innovations also affect crowdfunding: blockchain is the basis of a new model of decentralized financing who could join the ranks of Alternative finance tools available to businesses to raise capital.

In this article we explore the new, possible frontiers of online capital raising and discover What opportunities blockchain can offer for crowdfunding, analyzing emerging patterns, challenges and critical issues.

Limitations of crowdfunding: blockchain to overcome them?

To understand why it might be interesting combine crowdfunding and blockchain, we start with some structural limitations that can be detected in traditional crowdfunding models:

• Presence of centralized intermediaries (platforms and payment systems) that make entry selection and manage the flow of funds
• Commissions to pay and often long technical times
• Possible opacity in companies' use of funds and reporting
• Regulatory constraints and geographic barriers
• Trust-based exchanges and risk of fraud in reward crowdfunding (lending and equity, on the other hand, are supervised by Consob and Bank of Italy and more regulated)
• Illiquidity of investments, particularly in equity crowdfunding.

Crowdfunding, although it has already done a remarkable job of democratizing access to funding for startups and SMEs, is still tied to a centralization that some believe limits its potential. Such centralization, on the other hand, is deemed necessary to regulate the instrument so as to protect investors. Regulation, however, creates complexities and limitations.

The blockchain has some features that could enable it to overcome many of these problems of balancing security and accessibility. As a DLT, Distributed Registry Technology, in fact, allows value to be transferred safely, transparently and without intermediaries.

What is blockchain

At this point it may be useful to review the basic features of blockchain technology, which is a distributed digital ledger-also known as ledger - structured as a chain of sequentially connected and encrypted blocks.

• Decentralization: control of the blockchain is divided among all the nodes (servers) that make up its network, and no data resides on a single server, rather all are replicated on multiple nodes. This makes the system non-manipulable from a center and more resistant to attack or failure. 
• Immutability: no block can be modified or deleted once validated by the network consensus mechanism, so if a transaction is added no outside agent can arbitrarily alter or delete it. This ensures constant access to the historical data set for any transaction. 
• Transparency: Transactions recorded on the blockchain are visible in the same way to all participants in the network or authorized participants in a private network, so all players in a transaction see the same data. Users, however, can use digital identities that do not necessarily have to correspond to real ones, prioritizing privacy.
• Consent: Each new transaction must be validated as legitimate by the network in order to be added to the ledger, according to predefined rules that may vary from blockchain to blockchain. 
• Cryptographic Security: Transaction data and user identities are encrypted and protected by public or private keys to prevent tampering.

These features make blockchain not only a secure database, but also an enabling infrastructure for new paradigms of interaction and value exchange.

What blockchain can offer crowdfunding

In light of its features described in the previous paragraph, blockchain technology can offer crowdfunding some operational solutions that can make it an even more accessible, practical and democratic tool.

1. Transparency and security

All information about a crowdfunding campaign can be entered into a shared, decentralized digital registry that is accessible to all participants: funding target, bid document, any notarized deeds on the operation, participants, amount paid by each, flow of capital raised. This ensures traceability and instills confidence in potential investors, drastically reducing the risk of fraud. 

On ledger anyone can verify who has invested, how much they have contributed, and how the capital is being used. Immutability ensures that campaign rules and transaction records cannot be altered retroactively

2. Disintermediation

Blockchain enables direct interactions between promoters of a crowdfunding campaign and potential backers, eliminating The need to rely on a crowdfunding platform. This reduces costs and time and makes this capital raising tool even more accessible to a wide range of businesses. 

Without stringent selection at entry, it expands the range of projects that can raising capital in crowdfunding.

Without a central platform, it decreases the vulnerability of the computer system underlying the operation. In addition, geographic barriers are broken down, allowing anyone in the world with Internet access and a digital wallet to participate as a supporter or launch a campaign as a bidding company. This benefit is in keeping with the purpose of creating a Crowdfunding market increasingly global which is the basis of the European ECSP Regulation For cross-border operation in Europe.

3. Smart contract

Smart contracts are computer programs that automatically execute the instructions entered into them. They contain the rules and terms of an agreement and automatically execute them when predefined conditions that can be verified on the blockchain itself are met. 

Thanks to smart contracts, the conditions of a crowdfunding campaign can be executed automatically: for example, capitals are released only when certain goals are reached or certain events occur; digital rewards are automatically distributed to investors at the end of the campaign, etc.

By automating these processes, smart contracts can dramatically reduce administrative burden, execution time and the possibility of human error, making the entire crowdfunding cycle more efficient.

4. Tokenization

The digital assets (tokens) can represent company shares (equity crowdfunding), credit rights (lending crowdfunding), but also licenses to use or future products (reward crowdfunding). Tokens are exchangeable, fractional, and programmable, expanding the possibilities for investor involvement and the variety of securities, rights, and rewards that can be offered to incentivize campaign participation. 

Particularly practical, for example, is the use of tokens for the real estate investments: thanks to digital assets, it is easier to offer a fraction of a property's ownership to investors.

5. Potential liquidity

Through secondary markets on blockchain network dedicated to tokens, it opens up the possibility of more easily selling one's stake even before the company's exit, reducing one of the main limitations of traditional equity crowdfunding. Secondary market crowdfunding bulletin boards, in fact, are still uncommon and infrequently used, even though the European ECSP Regulation seeks to incentivize them.

All this can strengthen the role of the Crowdfunding as a transparent and participatory means of raising capital and for companies it means the ability to access new markets, more directly engage supporters and innovate their business models.

Crowdfunding models with blockchain: ICO, STO and DAO

La Crowdfunding capital raising via blockchain can take place according to different operations. Practical applications of crowdfunding on blockchain are still being tested and developed. We had already discussed this in our article on tokenization.

ICO and IEO

Initial Coin Offerings (ICOs) and Initial Exchange Offerings (IEOs) marked a pioneering phase of fundraising in cryptocurrencies by offering tokens privately issued by companies or traded on an exchange. However, lack of regulation has led to much fraud and failure.

Indeed, between 2017 and 2018, the explosion of ICOs was followed by a market crash, largely due to a wave of fraudulent projects (scams), failures, and lack of investor protections. Many ICOs were launched anonymously, without proper documentation, solid business plans or minimum working products (MVPs), relying purely on speculation. This severely damaged the reputation of the industry and brought to light the need to develop a more secure system.

Security Token Offering (STO)

They represent the most mature evolution of the crowdfunding on blockchain: are platforms regulated by a regulator for the placement of certified digital financial securities, enabling the tokenization of equity, debt or real assets. They offer transparency and regulatory compliance, aiming to inspire greater investor confidence and also attract institutional investors.

DAO (Decentralized Autonomous Organizations)

Organizations based on smart contracts and managed by communities of users who own governance tokens, which represent voting rights. DAOs can raise funds and collectively decide how to deploy them, enabling Decentralized and participatory forms of crowdfunding. The capital thus raised is kept on the blockchain and can only be used according to the rules voted by participating users and executed by the smart contract. A DAO can be said to be an evolution of crowdfunding that tends toward hybridization with the concept of venture capital: users not only decide to fund a project, but also determine how and for what purpose.

Risks and challenges to overcome

Despite the potential, The integration of blockchain into crowdfunding is not without ethical and practical obstacles and critical issues to be addressed.

• Regulatory uncertainty: token classification and compliance requirements are still evolving and are not uniform globally. In Europe, the ECSP regulation and the MiCA regulation have made strides in this regard, but the framework is still not sufficient to provide clear and comprehensive guidelines for operators and investors. Security Tokens, moreover, unlike Utility Tokens, are subject to securities regulations rather than the regulations just mentioned, so there is also no uniformity among the various types of digital assets.

• Volatility: cryptocurrencies can experience large fluctuations in value, which can only be mitigated in part by using stablecoins. This creates uncertainty for bidding companies about the capital actually raised and for investors about the value of their tokens.

• Technical barriers: wallets, smart contracts, and private keys are complex tools for the average user. It should also be noted that blockchain technology does not have a good reputation, as public perception is affected by the numerous scams and volatility of cryptocurrencies.

• Complexity of development and implementation: Creating blockchain-based crowdfunding platforms and developing smart contracts requires specialized and expensive technical skills. Very large blockchains also have high power consumption, which imposes power costs and environmental concerns.

• Security: bugs in smart contract codes can compromise entire campaigns, as the well-known case "The DAO" demonstrates. 

"The DAO" was an ambitious capital raising project aimed at investing in decentralized startups on Ethereum, funded through a crowdfunding campaign of more than $150 million in 2016. However, a vulnerability in the code of its smart contract was exploited by a hacker, who managed to embezzle about $60 million in the benchmark cryptocurrency.

In addition, in decentralized Web architectures, users are often responsible for the safekeeping of their private keys, which provide access to their funds. Loss or theft of these keys can result in irreversible loss of assets.

• Theoretical liquidity only: secondary markets for startup tokens are still underdeveloped and fragmented.

Crowdfunding platforms on blockchain

Some international platforms are already exploring these new models, we can give some examples.

Binance Launchpad, CoinList, Seedify make collections in tokens for technology projects.

Republic, Crowdcube, Wefunder are experimenting with equity tokenization on Ethereum.

Brickken and Token City provide blockchain technology for tokenization to third-party platforms.

LenderKit provides white label software for creating crowdfunding campaigns with tokenization.

DAOstack provides infrastructure to create dedicated DAOs for funding.

Kickstarter is developing a decentralization protocol for running campaigns on a blockchain network.

There are still no dedicated platforms in Italy, and experimentation is still cautious and carried out more by companies, which rely on foreign platforms. Turbo Crowd, for example, followed the marketing side of an Italian company's STO campaign launched on the Austrian platform Black Manta.

The Future of crowdfunding: hybrid models and gradual transition

Blockchain is unlikely to replace traditional crowdfunding in the short term. More realistic is the emergence of hybrid models, in which crowdfunding platforms progressively integrate blockchain functionality To improve their operations, such as:

• Cryptocurrency payments (e.g., stablecoin)
• Increased transparency of transactions and reporting through distributed networks
• Asset tokenization options in the post-campaign period
• Smart contracts for automations of certain processes, such as reward distribution.

This approach makes it possible to Balancing technological innovation with regulatory soundness and ease of use, key elements for engaging a wider audience. With the experience, earned trust, and regulatory soundness of crowdfunding platforms, it would thus be possible to Take advantage of some of the benefits of blockchain staying within the perimeter of legality and avoiding as-yet-unknown risks that may lurk behind the use of these new technologies.