Investable Token Models
Token staking as the value transfer mechanism of the decentralised economy
Only a very small number of the ICOs to date are likely to turn out to have been good investments, much fewer than the typical startup success rate. This is not only because of the initial exuberance around the ‘technology of the future’ without sufficient investment discipline, or the lack of reliable metrics and data to base investment decisions on, but also because token models are not sufficiently refined yet for most tokens to be a good representation of the economic value a project can catalyse.
A small number of crypto assets have made fortunes for hodlers, but the vast majority made money for some while leaving others holding the bucket through what some colloquially term ICO ‘sh*tcoin waterfalls’ and secondary market pump & dump schemes. While the rising tide of the crypto bull market had raised all the boats (most at least), the bear market has resulted in wariness towards ICOs that a renewed crypto bull market will only partially remedy.
Harsh off the record comments such as ‘most tokens are worthless’, ‘with startups you can expect a 1 in 10 success rate, with ICOs it’s 1 in 100’ will only be addressed by better token models and a more mature understanding of value in crypto assets.
Three models for value
There are three fundamentally different (and valid) approaches to structuring tokens – albeit with many experimental variations and combinations.
In the first model, the token’s value is determined by the size of the monetary base required to support the economy transacting in the token – this applies to global cryptocurrencies such as bitcoin, or tokens that are the mandated payment mechanism for their ecosystem (either to pay for transaction costs on the chain, or for goods and services provided). The token is valued by estimating the potential size of the ecosystem, making assumptions about the velocity of the token, and calculating the required monetary base to support transactions in the ecosystem (which equals the coin’s market capitalisation). The equation of exchange formula used in macroeconomics is applied:
MV = PQ, where M= monetary base, V= velocity, P= price of the digital resource being provisioned, Q= quantity of the digital resource being provisioned (ie PQ is the size of the ecosystem the token supports).
The weaknesses of these models are twofold: adoption and velocity.
First of all, the token needs to be adopted widely to justify a significant token market capitalisation. To expect a $100bn market cap for a coin, with a velocity of 15-20x, one must expect $1.5-2tr of annual transaction volume in the cryptocurrency which only a small number of them can aspire to. Vying for widespread global adoption as a payment currency is a narrow field, and doesn’t leave room for hundreds or thousands of ICOs to reasonably claim such upside.
Similarly, if the token is used to pay for on chain transaction costs, a $100bn market cap would require a very ambitious $1.5-2tr of annual transaction cost payments to go through. And while future volume assumptions for the dominant global platform may be high, only a very small number of platforms can conceivably vie for the dominant position. For a long list of ICOs to base their value on the token being the nominated currency for transaction costs on the platform and expect high market capitalisations is unrealistic.
Mandating the use of the token to pay for services provided in the ecosystem (plane tickets, data storage fees, dental services, etc) does not address this issue as it limits the adoption of the service and can easily become counterproductive if users are reluctant to hold the token.
Which leads to the second problem that unless there is confidence that a token will hold its value, every user who is forced to acquire tokens to transact, or to accept tokens as payment, will want to offload their holding as quickly as possible, leading to a hyperinflationary increase in velocity. Much like with fiat currencies that no one wants to hold, faster and faster velocity means a smaller and smaller monetary base is required to support the transaction volumes, destroying the value of the currency.
Outside the small number of leading cryptocurrencies and leading platforms, tokens structured as payment mechanisms are vulnerable to such destruction of value.
On the positive side, crypto assets that come to be regarded as reliable stores of value will see the circulating supply reduced as the coin is held long term (as ‘digital gold’) and accepted as collateral. This increases demand for the token and reduces the blended velocity, leading to a higher monetary base required, ie higher market capitalisation for the token.
Much has been written about the requirements and likelihood of a crypto asset to come to be regarded as a good store of value – suffice it to say, only a small number of tokens can realistically aspire.
In summary, if the token structure is based on the ‘monetary base required to support transactions in the ecosystem’ model, only a few projects that realistically aspire to become dominant cryptocurrencies or dominant platforms can have valuable coins.
(A variation on this model is the ‘mint and burn’ approach where the token velocity is capped by destroying all tokens used in a period which de facto provides a floor to token market capitalisation equalling at least the expected annual transaction volumes.)
The second model is where the token confers economic rights (rights to cashflow, assets, discounts). These tokens are usually classed as securities, and are valued on the same basis as a similar security would be valued.
While this token model assures that the token will have an intrinsic value equal to the value of the economic rights, security tokens also have two major weaknesses.
One is that they import a lot of the limitations of centralised economic models to the decentralised economy thereby losing the very advantage and upside decentralised ecosystems promise. They usually hinge on delivery by a centralised organisation, and the value transfer to the token is often disadvantaged by cost and friction. The upside to security tokens is necessarily similar to the upside of traditional investments – they rarely hold the promise of a ‘Moonshot’.
They also need to carry a significant cost burden of regulatory compliance – necessary as centralised organisations are not transparent thus it is vital that regulation ensures that investors receive sufficient, accurate, and not misleading information in a timely manner, and without disadvantaging certain investors relative to others.
The other weakness is that security tokens currently suffer from very poor secondary market liquidity as only exchanges regulated to trade securities can trade them which the major crypto exchanges are not. While regulated security token exchanges are appearing and are likely to take significant market share due to their superior pre trade, post trade and price discovery propositions, security tokens are nonetheless mostly a distribution opportunity for traditional investments but not a suitable structure for a decentralised platform’s token.
The third model is where users of the platform or of second layer applications are required to stake tokens to get access to services or to have the right to perform certain activities. This model is applicable to a wide range of decentralised projects, and translates into a much higher intrinsic value for the token than the above two models.
The innovation of ‘proof of stake’ based cryptocurrencies was motivated by other factors not tokenomics, however, proof of stake does have the consequence of making the token much more valuable. Validators will be prepared to stake amounts that are proportionate to the future returns they expect. Simplistically, if a validator is happy to earn 10-20% annual returns on his investment in a token stake, the market capitalisation of the token should be at minimum 5-10 times the annual value of transaction costs. Contrast this with the monetary base calculation where the annual value of transaction costs is divided by token velocity – the same annual transaction cost volume is divided by 10-20 vs multiplied by 5-10, translating into a hundredfold difference in token value for the same transaction cost volume.
But even more importantly, this model is applicable to a lot of projects – including smaller ICOs. It is not only a small number of major platforms that can have valuable tokens with this structure. And the application of the model is not restricted to validation and transaction costs but can be applied to all a wide variety of second layer applications, services, and activities.
Diagram – Comparison of token models (“monetary base” vs “staking” models)
Further advantages of the staking model
Investment decisions: the volume of bonded tokens is transparent to all. This allows potential investors to accurately judge the project’s progress real time. In contrast, it is difficult to ascertain how much of the transaction volume in a coin
is real economy transactions vs speculative trading.
Regulation: staking models make the regulators’ job much easier and with this reduce the ongoing regulatory cost for projects. The regulatory objective of protecting investors, especially small/private investors, can easily be achieved by the real time transparency provided by staking models. Traditionally corporations need to comply with requirements for sufficient, accurate and timely disclosures to achieve the same which comes at a cost to both the company and the regulator.
Incentive to adopt: unlike requiring companies to use the token to pay for services, and to accept the token as payment, which necessarily turns away a portion of potential users, staking tokens to get access to platforms and applications is an economically more advantageous proposition relative to the alternative of having to pay for the same products and services as ownership of the tokens is retained.
Incentives of ecosystem participants are better aligned: as most ecosystem participants are tokenholders in a staking model, their positive actions (increased adoption, referrals, greater volumes directed to the platform, etc) benefit token value which feeds back to inviting further growth and expansion of the ecosystem and greater confidence in the token (including possible wider acceptance of the token beyond the project’s intended purpose as well as possible acceptance as store of value).
Security: staking models have an added benefit of disincentivising bad behaviour by market participants through the threat of the token stakes being slashed.
The staking concept is still work in progress
As the crypto asset market matures, and token models are experimented with, several issues remain to be worked out in full around the practical application of staking models – issues around licensing, technical questions, governance issues. These necessarily vary from project-to-project and by jurisdiction (eg questions about accounting treatment and taxation).
The specific economic models also need refining and need to be fitted to the needs of each project to avoid unintended dysfunctional incentives (for example through token stakes that have appreciated significantly but cannot be accessed) or an unhealthy secondary market in the token (for example by very large token blocks having to be traded by end users, creating unhealthy volatility and difficult liquidity conditions as well as inviting possible market manipulation).