Kleros: Fighting Scams and Abuse in Token Sales

Building the Fundamental Institutions for the Future of Finance.

By Federico Ast and Clément Lesaege

The rise of token sales is unstoppable. From January to September 2017, over 1.7 billion dollars were raised with this mechanism, surpassing investment by traditional venture capital firms.

Token distribution events are key for developing the infrastructure of the decentralized Internet. However, as is usually the case with new economic practices, situations of abuse have occurred, including companies vanishing with backer’s money.

Financial regulators are monitoring closely this new phenomenon. But developing a framework for token sales can be challenging for state regulators. After all, they have to tackle a 21st century problem with 18th century tools.

When traditional, state legal systems were developed, who would have foreseen that some day they would have to deal with crowdfunding? Jurisdictional boundaries don’t play well with a practice where thousands of participants from dozens of countries enter into a contract with a startup team which is also distributed around the world.

The decentralized global economy requires a global and decentralized institutional framework native to the Internet Age. Kleros may contribute to this framework by creating a safer environment for crowdfunding and token distribution events.

How it Works Now

A team starts a blockchain open source project. They build a website, usually they develop some lines of code in GitHub, they define milestones for the product and set a date for a token distribution event.

During the token distribution event, backers from all over the world send payments in crypto to the team. In exchange, they receive some amount of the platform token. The backer’s money stay in an address controlled by the team.

After the token distribution, different things may happen. In the best case scenario, the team executes the plan as promised and develops the product. In the worst case scenario, the team simply vanishes with the backer’s money.

But things can go wrong even while the team behaves honestly. Running a successful crowdsale (and raising millions of dollars) does not necessarily mean that the team is qualified to run a software company. They may end up misallocating that money because of incompetence.

The traditional startup world has a set of practices and legal safeguards to minimize such risks. The law deals with scammers and specialized investors are usually good at spotting rotten apples. Besides, teams don’t get all the VC money upfront. Funding follows a predefined sequence (seed, Series A, Series B, etc.) where founders get to control more resources as they prove their ability to reach product/market fit and to run the company.

A team failing to reach product/market fit (maybe because their product was based on a wrong market hypothesis) or that is unable to manage the company will not make it to Series A. If it fails, then damage will be contained to seed round investors and usually a couple hundred thousand dollars.

A big question is: how can we reduce risks in blockchain open source projects with distributed backers and teams?

The blockchain ecosystem needs a framework against predatory behavior. Credit: The Wolf of Wall Street. Martin Scorsese, 2013.

How it Should Work

A team starts a blockchain open source project. They build a website, they develop some lines of code in GitHub, they define milestones for the product and set a date for a token distribution event.

During the crowdsale, backers from all over the world send payments into a smart contract which will release payments to the team as some predefined milestones are met. For example: “Next payment will be done when the team releases a new version of the software with substantial improvements”.

When the team claims a milestone is reached, token holders have some period of time to dispute it. If a sufficient amount of token holders reject the milestone completion claim, a dispute arises between the team and the token holders (Was the milestone met? Should the money be released?). Kleros is the dispute resolution mechanism.

Kleros selects jurors to evaluate the agreement along with the evidence and vote a decision: “Conditions are met/not met for releasing the payment”.