Drowning in Tokens

A pragmatist’s take on perceived scarcity and artificial demand

The world has fallen in love with the magical Rube Goldberg machine of money — TOKENS. Everyone wants to tokenize everything, and there’s a massive pipeline of token supply that is coming to market. But without any demand for these assets, what is a token actually worth?

Supply Without Demand is a Dangerous Game

I’ve seen the story of markets with a glut of supply but no natural demand play out before. When I started working in Oil & Gas in 2008, shale gas was the hottest thing around. Companies focused on the exploration and production of assets — finding shit and getting it out of the ground — were going absolutely crazy. Companies saw a cheap resource that could be exploited to juice valuations and rushed to get it out of the ground. Here’s a 5 part rundown of how to flood the market and destroy price:

Production Costs Skyrocket due to Demand for Production Assets

Rigs, which were an important part of the production process and often rented, were leasing at 10–20x their normal rates. Some companies even starting buying rigs in the midst of the frenzy. Crews of labor would rent at 3 to 4x their normal rate. There used to be a joke that the lowest member of the crew on a rig, the so called “rig pig“ was living a life better than most company executives. I worked with several waste trucking companies that were making $20 million PER YEAR hauling waste with re-purposed garbage trucks.

Everyone Overpays to “Squat” on Assets they Believe are Scarce

In the US onshore oil industry, there’s someone called a “landman” who goes around leasing subsurface and mineral rights from private citizens. During the shale boom, landmen were making out like bandits. Companies were buying up leases left and right, and paying ridiculous amounts to lock up land in what they believed was a constrained supply market. Prices skyrocketed from $2 an acre in 2000 and $30 an acre in 2005 to $2,400 an acre in 2008 to $5,000 an acre in 2014 (yes I know wet and dry leases command different prices, simplifying here, go with it).

Infrastructure Capacity aka CAPEX Investments Constrains the Ability to get Supply to Market

However, in the rush to pump assets (CASH MONEY HONEY) out of the ground, companies forgot that this proliferation of new supply coming to market also required entirely new infrastructure. Now the challenge was that in traditional asset plays, once a well was built, assets would flow for 20 years or longer, declining slowly over time. Therefore, most companies would build a pipeline to get gas from the well to a processing plant, where the gas would be turned into a product that was homogenous enough to sell, and from there, connected to a national network of pipelines that all lead to Henry Hub — the primary exchange point where most US gas is priced. Because assets flowed for a long time and because the value chain was vertically integrated, capital investments in this “gas gathering and processing” infrastructure were often recouped within the first few years.

Artificial Demand Can Only Last So Long

MLPs operate on a “toll road” model. Here’s the problem with toll roads. If you want to connect, say, Dallas and Houston — the first toll road will make money. If someone builds a second toll road, then you either need more demand i.e. more cars on the road, or prices will fall to a point where Toll 1 at t1 + Toll 2 at t1 = Toll 1 at t0. Here was the problem with midstream MLPs. A bunch of money, or CAPEX, was spent building toll roads between locations that had temporal, or short term demand. When no long term demand materialized, they were stuck with toll roads few people wanted to drive on.

Source: MarketWatch $EEP
Source: MarketWatch $PAA

In the End, a Lack of Natural Demand Trumps Speculative Demand

Anyone who has ever taken Econ 101 has conducted a simple exercise to find price at the intersection of the supply curve and the demand curve. Here’s what was so fascinating about the shale gas boom. When natural gas prices first spiked in the early 2000s, many E&P companies set out to find new sources of gas that had some basic characteristics:

  1. A large reservoir that could justify $20 billion or more in capital expenditure (CAPEX)
  2. A friendly political environment and relative geopolitical stability, or the ability to influence / create it
  3. Proximity to markets with demand but no supply (natural buyers)
  4. MOST IMPORTANTLY — profitability in a wide range of supply demand scenarios and market price scenarios (this is called risk management FYI)
Source: EIA.gov (link here)
Source: Marketwatch $CHK

Let me ask you — does this sound familiar?

Here’s my takeway — history doesn’t always repeat, but it often rhymes. Let’s take the lessons from one market and apply them to another.

Production Costs Are Skyrocketing due to Demand

The cottage industry of ICO service providers are charging absolutely exorbitant rates. I’ve seen figuring ranging from 3 to 10% and they’re absolutely jaw-dropping. Projects that want to capitalize on the “closing window for ICOs” (a phrase I have been hearing since the summer of 2017 and I have yet to see the window because at this point it’s a fucking garage door and we should just back up the BRINKS truck and take people for all they’ve got) are more than happy to pay any price so long as they believe they can get their turn at the Rube Goldberg magical money printing machine. The problem is that people then start making long term capital planning and investment decisions based on a short term anomaly in the market. I have every reason to believe that over time, the price charges by ICO service providers will fall to the marginal cost of production.

Everyone is Overpaying to “Squat” on Assets they Believe will be Scarce

I am increasingly skeptical of the idea that traditional venture investors are well suited to investing in the emerging crypto asset class. Venture investors and family offices have fueled the “landman” hype of token land. The problem is that just like in the real world, there’s limited land to squat on. So-called “hot” token deals don’t even go to average investors anymore, they get farmed out to VC’s, crypto funds (I refuse to call them hedge funds), and industry insiders who are basically buying options on the protocols they believe will win the battle for the “Web 3.0” (I don’t know what that phrase means so don’t ask). Prices for tokens continue to skyrocket despite the fact that token sales are increasingly sketchy and in the bad parts of the oil field. However, under this continued illusion that supply is somehow constrained, the frenzy for tokens will continue unabated. I have yet to see a single VC run a price sensitivity analysis on the entry price for a token. If someone has, please publish it. Venture land needs you! The VC thought leadership olympics around crypto are so loud it’s getting hard to hear, but it’s deafeningly silent when it comes to data-driven insights.

You former consultants will chuckle fondly at this series of images from a deck called “The Shit Rolls Downhill”

Infrastructure Capacity aka CAPEX Investments Constrains the Ability to get Supply to Market

This is my favorite crypto investment thesis. “I invest in infrastructure.” I’ve fallen into this trap myself, and have only recently begun examining what I actually mean when I say this.

Artificial Demand Can Only Last So Long

We are living in a world where token projects are trying desperately to use their massive pools of financial capital to recruit social and human capital aka attention and talent. We’ve seen many interesting ways cryptocurrency projects have tried to generate demand, or at least create the perception thereof. Let’s think through the dynamics.

From a longer presentation on cryptoassets and capital formation

In the End, a Lack of Natural Demand Trumps Speculative Demand

Please stop saying “tokenomics.” I fully appreciate “tokenomics” will likely be the name of the next Nassim Taleb book and then I can just speak only in his book titles and say “skin in the game” and “black swan” and “tokenomics” and “fooled by randomness” and someone will have to put me out of my misery (Jill Carlson I give you permission to take me out back like Ol’ Yeller).

  1. A large pool of supply that could justify capital expenditure (CAPEX) — Check! Since we are minting our own tokens, and in most cases, keeping 80–90% in the coffers of the company, projects have continued supply to keep flooding onto the market long after the initial sale.
  2. A friendly political environment and regulatory stability — Not Clear. I could fill entire volumes writing on the regulatory environment in crypto, but suffice it to say that regulators are watching closely, trying to figure it out, and some jurisdictions will be unfriendly while others will become natural havens where market activity flees.
  3. Proximity to markets with demand but no supply (natural buyers)Fail! There is no *proven* natural demand for tokens. There are hypothetical models for demand, but since most systems and network architectures have yet to be implemented or even tested, most demand is speculative. Demand is also driven by financial investors seeking gains, rather than applications or users needing the token for a specific purpose. Sale structures have been geared towards financial investors instead of natural buyers, which may in turn create a disincentive for natural demand to exist, because speculators have driven up token prices to a point where natural users would rather substitute another asset.
  4. Profitability in a wide range of supply demand scenarios and market price scenarios — Fail! I have only seen one project ever offer supply and demand sensitivity modeling to its token holders. I have yet to see a project offer a detailed capital management plan to token holders. The practice of risk management in crypto is a big fat zero, and in the rare cases it does exist, the scenarios entertained by both sellers (suppliers) and buyers (demand) are simplistic and naive in design. This is not a blanket criticism of projects. It’s simply an observation that the art and science of risk modeling in crypto investing is still largely immature and underdeveloped. I plan to spend more of my time focused here in the coming months.
I made this on IMGflip. My gift to you.

Damn, You’re Depressing Me

So if you’ve gotten this far, you’re probably thinking I must suffer from cognitive dissonance.

I am Excited about Tokens, but we Don’t Need to Tokenize Everything

There are natural limits to the market’s ability to absorb the endless supply of tokens. There is a bound to how quickly we can push supply onto an increasingly saturated market. Until the marginal value that can be extracted from the investment community for ideas that have no demand is 0, I imagine we’ll continue to see the effects of market saturation depress growth. Here’s what I ask myself:

  • What is the natural demand for a token or a cryptocurrency?
  • Instead of focusing on the ICO or the fundraise as the goal, can we start to develop the body of thought around how natural demand fits into these tokenized networks?
  • Can we develop new financial models for how we can measurably and reliably curate demand instead of blindly throwing money at ideas?
  • Instead of pushing tokens to market in an attempt to curate artificial demand, can we use natural demand to pull tokens to markets when they are needed?

making benevolent mischief. investing @coinshares.

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