Crypto 101: Reflection Tokens
Several strategies to attract investors and sustain prices have been developed within cryptocurrency, concepts like staking, liquidity mining, and yield farming have all gained traction in the last few years.
This article will cover a potential new strategy, one that is mainly used by “meme coins”. The strategy is known as a reflection token. They allow investors to generate passive income by just possessing their tokens.
Introduction
Cryptocurrencies have become one of the best investments by Return Of Investment (ROI) in the last decade. Bitcoin ($BTC), the most well-known, has become a widely used financial instrument, but it is still known for its lengthy history of being linked to significant volatility. Despite the volatility, Bitcoin has generated substantial returns over the years, exceeding those of conventional financial instruments.
As seen from data shared on December 13, 2022, by Raoul Pal, an investment strategist. During the last ten years, Bitcoin has been the best-performing asset in seven of these years. That said, it was the worst-performing asset in the three years that it couldn’t make the top.
Aware of this potential to make money, investors then began searching for other cryptocurrencies. Bitcoin nowadays is a consolidated asset. However, the ROI has been diminishing through the years. Initially, investors profited by trading, no matter if it was holding for the short or long term, but slowly developers and markets found new strategies to maintain investor attraction.
Technology and the sector as a whole have since expanded and developed. Investors can now profit from trading, staking, mining, yield farming, and liquidity mining, amongst other tactics. However, for small and novice investors, the complexity of some of these techniques has been prohibitive. Some are only accessible using Decentralised Applications (dApps), and others require specialist knowledge about performing the strategy correctly.
The investment strategies cited above are attractive, but there is one significant risk: a possible drop in the value of the locked assets. If the asset’s value decreases during the lock-in period, users will experience financial losses, and there’s nothing investors can do to avoid it.
A new class of tokens called reflection tokens has been developed to attract investors and make things easy. They allow investors to get passive income from simply owning their tokens.
Reflections tokens became popular, especially within memecoin circles in the cryptocurrency markets during 2021 and 2022. By promoting the idea of a token “dividend” and simultaneously disincentivising selling pressure because holders do not want to lose a portion of their gains when they sell, projects started to employ reflections in their token mechanics to attract new investors.
This token property can generate high demand and little selling pressure for projects that successfully adopt this strategy, encouraging a “buy, hold, and earn” mentality and driving up prices.
1. What are Reflection Tokens?
Because they give token holders a portion of fees collected just for holding them, reflection tokens are also known as reward tokens. Investors benefit from the ‘reflection’ in the form of a passive revenue stream.
A percentage of the trade value is awarded to token holders, the development team and/or re-deposited into the liquidity pool of the tokens as part of the “tax” that reflection tokens impose on each buy/sell transaction. The tax is levied on the token seller, which means that when they sell, a portion of their profits is withdrawn and paid to holders. The buyer is also impacted in some projects as the purchase money is sometimes subject to the same system.
This taxation system occurs on every trade for that token; hence the timing and size of the token reflections are unpredictable. Depending on how frequently the coin is traded, holders may occasionally receive reflections every second or only occasionally. It depends entirely on the individual token.
Usually, to receive incentives, owners of reflection tokens do not have to lock their assets. They typically receive payment nearly instantaneously once a transaction is completed, with the operations controlled by a smart contract.
2. Advantages of Reflection Tokens
The most significant advantage is the possibility for investors to make passive income with the reflection tokens without the need to trade or take the risk related to staking, yield farming or other “more traditional” strategies.
Also, reflection tokens can generate market value stabilisation. Crypto assets are very volatile. Values can rise or drop dramatically in a very short period. As a reflection, tokens give investors an additional source of revenue, enticing investors to hold their tokens rather than trade them. This can encourage market stability and makes it possible for investors to make money even if they don’t have the time or the knowledge to pay close attention to the market all the time.
Reflection tokens can also ensure that a certain percentage of the tax can be used to support the growth and stability of the project, as well as raise and retain cash that can be used to advance the protocol.
Even though the future value of any coin cannot be predicted with any degree of accuracy, other variables can influence token price and development. Reflective tokens can create a cascade effect and make investors naturally compelled to buy more tokens to increase their passive income because reflection tokens urge them to hold onto their tokens while enjoying a steady passive income. When this occurs, the token’s worth can increase as more people want it and hold onto their tokens, increasing its value.
3. Disadvantages of Reflection Tokens
When tokens are purchased or traded, transaction taxes are typically levied. This implies that you could have to pay a transaction tax when you first buy reflection tokens. As a result, all investors will start out losing money on their investments and will continue to do so until the tax has been recovered. It’s realistic to assume that this may take some time. So only long-term gains should be contemplated while investing in reflection tokens.
Currently, it is most common to find reflection tokens on decentralised exchanges (DEXs). Investors may therefore be more at risk of suffering fraud-related losses. A rug pull is one type of fraud to watch out for. Investors should start by capping the amount they invest due to this possible risk.
When the native token is bought and traded, reflection token owners make money. Owners of reflection tokens may experience significant gains when the cryptocurrency is actively traded. However, when trade volume is low, coin holders may see a considerable decline in their return.
4. Reflection Tokens vs Deflationary Tokens
Both reflection tokens and deflationary tokens use strategies to encourage investors to hold their tokens to make financial gains. The systems employed by each differ, however.
While in reflection tokens, holders receive compensation from transaction taxes through reflection tokens. Both purchases and sales could result in tax revenue. As a result, reflection tokens offer investors a passive revenue stream during the duration they are held.
However, deflationary tokens burn a percentage of their tokens for each new transaction causing a decrease in circulation. As a result of this burn, the token supply decreases, which can result in a price increase.
To Conclude
In theory, reflection tokens may appear to be a good solution for investors to earn a passive income. However, things are always more complex than they appear, and having a reflection mechanism doesn’t guarantee any assurance of returns.
Market volatility may cause the tokens’ overall value to fall, which could affect the investor’s balance and potentially result in a reduction in overall worth. When buying their tokens, token owners must pay a transaction fee upfront. Depending on variables like trading volume and return rate, the token holder may take months or longer to break even on their investment and begin making money, especially if the token value depreciates whilst holding.
Still today, most tokens that used/offered reflection mechanisms were “meme coins”, with few projects outside this crypto sector offering a proper protocol with reflection tokens.
After understanding reflection tokens, investors must evaluate the project before investing, search and keep track of the number of “real transactions”, and only invest in projects that could sustain interest by users and maintain a high number of transactions, as reflection tokens can create whales that won’t be afraid of selling their tokens once the activity slows down. So, proper research the investment is always a pattern that we recommend.
~ By Jordano M. Z. ~
~ This article does not imply an endorsement of any cryptocurrency or application, protocol or tooling listed above; they were listed only for educational purposes. Investors should do their own research before investing. Investors do so at their own risk. ~
