How Do Cryptocurrencies that’s worth Nothing and Essentially do Nothing Much Gain Value

One of the first questions that’s been asked by those new to blockchain technology is how and why does a cryptocurrency starting from a worthless token at its outset begin to have any value in time. Why would anyone or any merchant agree to provide value for a token or currency that’s based on nothing? First, let’s examine a historical price chart of bitcoin, the oldest cryptocurrency.

Source: Plotted from CSV Data extracted from blockchain.info[1]

As the chart shows, the price of a bitcoin started at zero, and stayed close to that value up until 2013. So how did a large number of people begin to agree to pay something of value for something that had no value? In a prior paper and article [2], it is shown that the price of tokens on a blockchain network is related to the number of active users on the network. This is known as network effect. In the article, Metcalfe’s law which was formulated for Ethernet networks and helped give rise to the Internet, was shown to model the historic value of three selected cryptocurrencies. Metcalfe’s law states that the value of a network is related to the square of the number of users on the network [3]. An alternate relationship relating the value of the network to the exponential of the root of the number of active users on the network was also derived and shown to model the historic value of the network well.

The paper also showed that a critical mass had to be reached on the network at which this network effect began to take hold. However, this only answers the question of its value growing as the number of active users seeking to participate in acquiring and participating in transactions in those tokens on the network. It does not answer the question of why they would chose to pay such price to participate on the network, and in many cases why they wanted to hold the tokens in the first place since the tokens are not really being used much for anything currently.

Let’s examine some of the elements that possibly cause new users to begin to acquire worthless tokens and how the tokens appear to slowly transition into value in time.

The Tokens are Simply a Store of Value

Firstly, the premise behind the question is a bit faulty in that it frames the acquisition of a token almost as an end activity. Actually, the acquisition of a token is usually intended to simply transition the original value into a stored value in the token. The user’s expectation is that the value can be recovered back into its original currency at some point by selling back the token or exchanged for some other good or service of same or higher value at some point in future. Therefore, any of the tokens have to provide an easy way to move the stored value back and forth between other prior established currencies or spent or transferred. The easier a token can be converted to local currency the likely that token will be more valuable to users. (This is the likely similar for fiat currencies. If you exchange your currency for a fiat currency in some other country and you cannot easily get it back to your original currency, that currency will likely slowly lose demand and eventually value.)

The exchange rate of the stored value is itself not the major attribute as long as the same rate can be used to transition the value back instantly, less some exchange rate fees. This is little different from if USDs are converted to JPYs, the fundamental value has not changed. The fact that the rate is 1:100 or 1:200, or that it is say 1:0.8 for some other currency does not mean that the value changed due to the exchange. Therefore, the first element is that a token should immediately be able to be converted back into whatever value was stored in it.

Limited Supply

The second element that determines if a token will grow in value in time is supply. It needs to be a scarce resource. Therefore, its demand can meet a supply scarcity and result in its price slowly inching up. If a new user wishes to acquire such a token, and they can only get them from an existing user, it puts the existing user in a position to charge a small premium to let go of some or all of their tokens leading the price to slowly go up.

Value Proposition

The tokens need to provide some current value or describe some future value to users, value that does not exist currently without acquiring the tokens. Some of the current or potential value that have been presented to users for today’s blockchain tokens include:

1. The tokens provide privacy of transactions in a way that was not available with debit or credit cards in fiat currency. Part of the initial growth of bitcoins was undoubtedly driven by dubious transactions that those behind it wished to keep away from established authorities and institutions. For instance, if someone gets paid in some tokens and they no longer need to pay up to 10% in some levies, that token becomes potentially worth 10% more than an alternative that would trigger the levies.

2. The technology behind the token will allow transactions to be completed with lower transaction fees. Transactions could use the token as a payment method to purchase goods and services, and as a payment rail to transfer money. This promise has so far not been realized by the largest cryptocurrency [4][5]. In fact, as a payment method, the use of cryptocurrencies is not increasing by much; which was a subject of a previous article [6]. But the promise likely gives users a sense that in some future a good proportion of transactions would be denominated in the tokens they are acquiring.

3. Being digital, the tokens will bring in more people that were hitherto not in the financial system; the so-called unbanked.

4. The tokens are highly secure due to their encrypted nature, and do not utilize a trusted third party entity (usually banks). Some have interpreted this characteristic as attractive but the promise here has also not been realized. The lack of user friendly way to handle keys has resulted in serious losses for many users of the technology thus far[7][8].

5. Some of the tokens are programmable, versatile in ways not possible with fiat currencies, and provide new use cases that would provide basis for new users to acquire them. Some of those tokens for instance allow the blockchain to also broker online secure contracts, for example for deeds, stocks, commodities contracts etc. Increased use cases would of course lead to increase user adoption, which according to the network growth models would lead to increased value.

6. The tokens are seen as a speculative investment vehicle. This is likely one of the largest drivers of adoption currently [9]. As users see other users profit from the rise in value of the tokens they hold, they wish to participate in those profits by also acquiring the tokens themselves. This leads to more and more users acquiring the tokens.

The leading value proposition for adoption right now is the speculative one based on prior surveys of new users [9]. So this leads to a chicken and egg question of how value came to be ascribed to the tokens in the first place, before other users saw that value increasing, creating a demand with more users seeking to acquire the tokens. Which also begs the question of if eventually the value propositions do not live up to expectations or catch up with the speculative one. Take for instance, the promise of privacy and hidden transactions. Regulations are already being visited on the activities of blockchain networks by authorities in many jurisdictions that almost completely neutralize that low regulation value proposition [10].

Very Large Network of Users Have an Intrinsic Value

This final element partially answers the question of how the token ultimately transitions from zero value to one of value or how critical mass is reached, and how say, a first merchant begins to agree to provide value for the cryptocurrency. It turns out that for every business there is a cost of acquisition per customer. This comes in the form of radio, TV, Internet, social media, print media advertisements, discounts, referral and agent fees, large event sponsorships, etc. As the picture below shows, merchants knowing their acquisition costs have been willing to give up some value to acquire new customers. The expending of that value is usually designed to ensure that the customers are retained by tying some conditions to that initial give away.

Discounts and Free Offers Have Always Been Offered by Businesses to Defray Customer Acquisition Costs

Let’s say as an exercise that the cost of acquisition of a customer to a certain business is $50, with the average lifetime value of that customer being $500. Then the business would seriously consider accepting value for a token held by hundreds of thousands of its potential target customers provided the following condition holds:

· The cost of acquisition of customers on the network now goes down close to zero

· Majority of the users do not hold more than $50 worth of the tokens each

· Eventually, the stored value of the token can someday be converted to value.

Usually, the merchants also have to design creative conditions for accepting the tokens to maximize the chances that the customers are retained.

As more and more new tokens get created, this leads to another financio-social network science or study of initial distribution of tokens that allows them the chance of success or eventually gaining value. Considerations such as what are the ratios and income levels of those holding the tokens, their geographical location and distributions, demographics, etc. For instance, tokens that are concentrated in few hands or where a few users hold large amounts of the worthless tokens may be doomed to failure simply by the nature of their initial distribution.

The Best Tokens are those Issued on an Existing Network:
Facebook Coins, Amazon Coins, Walmart Coins, Ebay Coins, Macys Coins, Delta Air Coins?

This final element leads to an observation: the best tokens are those issued on an already existing network. Right now given the proliferation of many new tokens, some simply duplicating features of existing more grounded tokens, the chances of success of some of the new tokens are dwindling. In fact, as at 2014 it was observed that half of all new cryptocurrencies have failed. The ratio is only bound to get worse. However, tokens issued on existing networks that have all the other elements have a greater chance of success.

Think of a Facebook issued coin that allows users to spend the coins when they purchase among themselves from the thousands of Facebook thrift groups, with the coin still issued to include elements of scarcity, provide discounts or token points to customers with their use, discounts or advantages to merchants to advertise and reach more Facebook users. In addition, the coins could provide social good by allocating some of the proceeds of its use to worthy social programs, that users can even play a part in voting on or deciding. Such a coin automatically has potentially base in billions or users.

Or consider a bank issued coin that provides greater interest rates to customers, is extremely fungible since users can now use the bank’s ATMs to instantly exchange and withdraw local currencies from it, and can immediately incorporate the bank’s network of merchant customers. This goes slightly beyond what Ripple currently does. Payment processing companies with large numbers of merchant customers also have an existing network that could benefit from developing and issuing tokens. Or consider an Amazon, Walmart, or Ebay token that provide special accesses and discounts to customers and merchants that use it, and can increase in value. Or an airline issued token in place of most of the frequent flier schemes, where the token can additionally increase in value since the currency underlying it no longer gets inflated away. In fact, some of the value that gets attributed to all such token examples comes from the federal monetary policies that currently redistributes that value away if fiat currency were used, from their underlying economic activity via loose supply, interest rate manipulations, treasury bonds issues , and other methods that reallocates that value. Owners of large networks could even come together to allow compatible exchange and use of their tokens or issue the tokens together as one large variegated network with lots of upsides for users.

To conclude for now, the answer to how a token with zero value that currently does nothing much slowly gains in value is that it needs to provide a value proposition that makes users acquire the token, be limited in supply, have an attractive distribution of network of users acquiring the tokens, and provide structure that will eventually enable the value stored in it to be converted back and forth to local value. As more and more tokens proliferate much of them would prove worthless and the long term chances of success of the tokens or their networks lie in how useful the tokens are and if there is an existing network of target users of the token. The software engineering behind the tokens and the network supporting them, their security, transaction costs, the strength and demographics of the network of existing users holding the tokens, size and strength of the network of processing nodes, number of merchants, and developers creating valuable instruments and products using the tokens will likely all prove to be factors determining the future viability of issued online tokens.

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References

[1] Data on the Bitcoin Network. https://blockchain.info/charts, Retrieved Jun 15 2017.

[2] Alabs K, “A Macro-Mathematical Model for the Observed Value of Digital BlockChain Networks”, Published on Medium. https://medium.com/@alabi.ken/a-macro-mathematical-model-for-the-observed-value-of-digital-blockchain-networks-23cc8e0dc7ea, Jun 16 2017., Retrieved Jun 17 2017.

[3] Metcalfe B. Metcalfe’s law after 40 years of Ethernet. IEEE Computer, 2013, 46(12): 26–31, 2016

[4] Bitcoin Cost Per Transaction. Blockchain.info. https://blockchain.info/charts/cost-per-transaction. Accessed May 20 2017.

[5] TrustNodes Article, “Bitcoiner Asked to Pay $26 in Fees For One Bitcoin Transaction,” http://www.trustnodes.com/2017/05/31/bitcoiner-asked-pay-26-fees-one-bitcoin-transaction. May 31 2017. Retrieved Jun 17 2017.

[6] Alabs K, “Why Cryptocurrencies are not yet Making a Big Impact in Payment Processing”, Published on Medium. https://medium.com/@alabi.ken/why-cryptocurrencies-are-not-yet-making-a-big-impact-in-payment-processing-3ea1f71d2dee, May 25 2017. Retrieved Jun 17 2017.

[7] “Free Exchange. Money from nothing. Chronic deflation may keep Bitcoin from displacing its rivals.”. The Economist. http://www.economist.com/news/finance-and-economics/21599053-chronic-deflation-may-keep-bitcoin-displacing-its-fiat-rivals-money. 15 March 2014. Retrieved Jun 17 2017.

[8] “Vulnerability Summary for CVE-2010–5139”. National Vulnerability Database. 8 June 2012. Archived from the original on 9 April 2014. https://nvd.nist.gov/vuln/detail/CVE-2010-5139. Retrieved 22 Jun 17 2017.

[9] Claire Greene, (2016) Virtual Currency: User Points of View, Survey of Consumer Payment Choice (SCPC), Consumer Payments Research Center, Federal Reserve Bank of Boston, https://payments.nacha.org/sites/payments.nacha.org/files/files/Virtual%20Currency.pdf, Accessed May 20 2017.

[10] Santori M, “BitLicense 2.0: What The Latest Revisions Mean for Bitcoin Businesses”, Published on Coindesk, May 25 2017. http://www.coindesk.com/bitlicense-2-0-latest-revisions-mean-bitcoin-businesses/. Accessed Jun 17 2017.