Welcome to the third and (hopefully) final installment of my analysis of utility tokens.
In the first piece (aka The Lead Pipe Analogy), I highlighted blockchain world’s principal-agency problem, and identified agent reward as the determinant of transmission token valuation.
In the second (MV = P…Que?), I explored the importance of inflation in monetary policy and token design, and determined that current token pricing methodologies were wholly inappropriate.
This final piece concludes the trilogy by examining the economic bounds of utility tokens. Using simple examples, we build a bottom-up narrative of how utility tokens might some day be used in a decentralized network called FaceLook.
We arrive at the surprising conclusion that in a fiat-currency world, the market or traded price of the token is completely de-linked with the usage and velocity of the token.
A few important distinctions before we start:
- We look past form (whether securities or not) and focus on substance — utility tokens that bestow upon holder the right to obtain a product or service
- We define utility tokens as distinct from ‘principal’ tokens — lending- or ownership- substitutes that generate income returns and principal repayments
- This exercise, as are any other posts dealing with token economics — is entirely theoretical. Because. Utility. Tokens. Do. Not. Exist. Placeholder ERC20 tokens do. And certain other tokens or currencies whose sole purpose is the generation and acquisition of yet other tokens and currencies. Not a viable scenario.
- Staking or skin-in-the-game tokens are excluded from this analysis and will be subject to further examination in the future.
This post is divided thus:
- Clarifying the Nomenclature
- FaceLook and a utility token called ZUCK
- Tokens as Unit of Account
- Tokens as Medium of Exchange
- Tokens as Store of Value
- Your Tokens May Never Go ‘To The Moon’
- Re-stating MV = PQ and Implications
- The Future of Token Design and ‘Tokenomics’
- Let’s Stop Calling It Market Cap
- Special Bonus (if you read this far)
Let us begin.
1. Clarifying Nomenclature
For the purposes of this piece, we look at the actions and motivation of three distinct groups and one ‘thing’ -
- The decentralized service provider aka ‘startup’, ‘founding team’ or ‘foundation’ — a group of individuals (engineers, salespeople, account managers) that band together to create a ‘decentralized product or service’
- Token Investors — individuals or institutions external to group 1 and group 3, to whom utility tokens are sold
- End-users — the end-users of the decentralized service for whom the decentralized service is created
- ‘Utility Tokens’ — alpha-numeric strings that entitle the holder to use a ‘service’ or ‘product’
2. FaceLook and a utility token called ZUCK
Meet Mark, a young entrepreneur who wants to raise $1M to finance the development and growth of his new social network, The FaceLook, Inc.
Accordingly, the board of FaceLook authorizes the creation of 5M utility tokens called ZUCKs, each with a face value of $1.
FaceLook issues 4M to Mark as founder and sells 1M ZUCKs to you, an external investor, for $1 per token.
Et voila, the company has a ‘market cap’ of $5M. Each ZUCK is “worth” $1, the last traded price.
Armed with this cash injection, FaceLook starts acquiring users, reaches critical mass and lands its first paying customer, car giant NIKOLA. NIKOLA wants to advertise to 1000 potential customers of its electric cars, and it is willing to pay FaceLook’s asking price of $1 for 1000 impressions.Now let’s evaluate the three scenarios that arise –
In scenario A — the Unit of Account scenario — we live in a fiat-money-world. We use USD, GBP, EUR etc. to earn paychecks and pay bills. FaceLook quotes advertising rates in USD terms (e.g. $1 per 1000 impressions) but to run ads, NIKOLA needs to buy an equivalent amount of ZUCKs. The token is used merely to measure FaceLook’s success (“Hey, we sold a billion ZUCKs of ads!”)
In Scenario B — the Medium of Exchange Scenario — we still live in a fiat world, but FaceLook ads are now denominated in ZUCKs. So to reach 1000 customer, you need to buy 1 ZUCK.
In Scenario C — the Store of Value scenario — the entire world, all 200+ countries and 7BN+ people in them, have moved over to using ZUCKs and only ZUCKs for our daily lives. We earn our paychecks in ZUCKs, use them to buy milk, bread, electricity and yes, even FaceLook ads.
3. Tokens as Unit of Account
In Scenario A, FaceLook prices its services in fiat terms — NIKOLA needs to buy $1 equivalent of ZUCKs to reach 1000 customers.
Now, FaceLook doesn’t have any retained tokens of its own. It has sold all its authorized tokens to Mark and you. So the company sends the order for ZUCKS to the marketplace, where you await. NIKOLA checks the screens for the last traded price (FaceLook issued 1M tokens to you for $1) and bids at the same price. “$1 for 1 ZUCK, please.”
You are a HODLER. Naturally, you HODL.
NIKOLA is forced to raise the bid to $2 per ZUCK, then $10, and finally $100. At this price, your resolve finally weakens. You sell 0.01 ZUCKs to NIKOLA, who uses these ZUCKs to purchase ads on FaceLook.
Remember, we live in the fiat currency world in this scenario. So long as the price of FaceLook ads doesn’t change in fiat terms ($1 for 1000 impressions), all NIKOLA needs is enough ZUCKs to buy $1 of ads.
But it makes a world of difference to you because your wealth varies with the market price of ZUCKs. You make a 99c profit on the sale of that 0.01 ZUCK, and a $99.99M ‘paper’ profit on the rest of your holdings as the market cap of FaceLook jumps from $5M to $500M.
Now, two things can happen.
FaceLook can destroy this 0.01 ZUCK as ‘spent’. In theory, this leaves fewer tokens available to buy ads, pushing prices up even further. NIKOLA will need to come back to you to buy more ZUCKs, and pay the price at which you are happy to sell at least small amounts.
Or FaceLook can hold on to that 0.01 ZUCK for the next time NIKOLA wants to buy ads.
This is bad, very bad, for you the token holder. A new seller has now the market — FaceLook itself. Next time, NIKOLA can approach FaceLook directly to buy the tokens it needs to buy ads. Depending on the inventory FaceLook has accumulated, and speed with which its share of tokens are used and recycled, FaceLook’s can directly influence the buying interest you see in the open market.
Worse, if FaceLook and Nikola transact off-market, you could be deceived into thinking your ZUCKs are still worth $100 a pop when in reality there are no buyers at that price. Bad if you own the tokens, and worse if you are a new investor looking to buy into ZUCK.
Another important consequence is that the market price of ZUCK decouples from the ‘enterprise value’ generated by FaceLook.
Remember, we live in the fiat world. In this world, FaceLook’s value as a company is the sum of all the $1 ad sales it generates. Whether a ZUCK trades at $1, $100 or $1m, whether there exist 1m, 10m or 100m tokens, the economic value captured by the sum of all $1 ad-sales remains independent of token trading activity and unaffected by token price.
All that matters is NIKOLA find sufficient $ equivalent of ZUCKs with speed and predictability. And when determining the value generated by FaceLook, we simply look through the tokens to determine the fiat currency revenues generated by FaceLook’s services.
It is as if the tokens didn’t exist at all.
4. Tokens as Medium of Exchange
Things don’t get much better if we take this analysis a step further.
Let’s assume ZUCK is a true medium of exchange. FaceLook quotes ad rates in ZUCKs e.g. to reach 1000 potential customers, NIKOLA needs to buy 1 ZUCK of ads.
In and of itself, this is a meaningless price. Is 1 ZUCK too little for NIKOLA to pay? Is it too much?
Remember, NIKOLA exists in a fiat world — it manufacturers and sells cars, pays for expenses and earns revenues in USD, EUR etc. NIKOLA needs to convert 1 ZUCK into it’s fiat-currency equivalent, and compare this cost with its break-even cost for advertising before deciding to buy or pass. In the first instance, where only you offer ZUCKs in the market, this price is determined by you, a HODL-er.
What you do not know is that NIKOLA can walk away from FaceLook if it needs to pay more than $1 equivalent for 1000 impressions. Beyond this price, it may well choose to get CEO Musk Melon to tweet out their new fancy car.
Think about this for a moment.
The price ceiling to which a ZUCK ought to appreciate is determined by the interplay of a non-public piece of information — the maximum price that the NIKOLA’s of the world are willing to pay for social media advertising — and the speculative desires of token-hodlers. Not its own tech or user traction.
The more external investors HODL, the more the token’s economics start to resemble supply-limited deflationary commodity-backed currencies that the crypto world is so fond of. The price of ZUCK spikes upwards in a parabola, rendering the network all but useless for predictable and repeatable use.
FaceLook’s continuing survival is at the mercy of hodl-ers who may inadvertently sabotage their own investment.
And here’s another thought — could a tech-giant like search engine Boogle potentially drive a fledgling FaceLook out of business simply by acquiring free float tokens and pricing them out of commercial viability?
Not a great, or sustainable, way to build a business.
5. Utility Tokens as Store of Value
Let’s take ZUCK adoption one step further. Let’s say we live in a ZUCK world. For the first time in human history, all of mankind uses a single currency minted by a bit of computer code and operated by a group of private companies that happen to own large computer farms.
Yep, me neither.
This is an outlandish scenario that, whilst tempting for early speculators given the riches on offer, conveniently ignores the realities on the ground.
Political power is inter-twined in with monetary control and enforced with the full force of local law. Human societies are organized in nation states based on linguistic and cultural divides. Vast differentials in concentrations of wealth between the developed and emerging world cause the latter to put up trade and capital control barriers, as much to perpetuate regimes as shield the fortunes of the underdeveloped poor from ‘asset allocation’ choices of the cash rich.
A single world currency may well come to pass, but it is not likely to be minted and distributed by private hands.
We therefore ignore the crypto-utopian scenario in which crypto-tokens are superior to fiat merely because a small concentration of crypto holders bought these in a pre-sale.
6. Your Tokens May Never Go ‘To The Moon’
One final thought experiment — what if FaceLook becomes wildly successful?
Say over one particularly successful year, FaceLook racks up a record $20B of advertising revenues as the NIKOLAs of the world line up to buy ads. Surely this is good for token holders? Even a simplistic analysis shows that the price of each of those 5M tokens should soar to $20B / 5M = $4000 per token.
To the moon, right?
FaceLook may earn $20B of revenues per year but to earn this gross annual figure, it only needs to process c. $650 of ad purchases per second ($20B per year / 315M seconds per year). And here, ZUCKs act as LeadCoins described in theLead Pipe analogy piece — their purpose is merely the transmission of $650 of value per second from the pool of advertisers to FaceLook’s bank accounts. Superior user experience design links ad purchases to an internal purchase and sale of corresponding ZUCKs from FaceLook (see Figure 6 below, and also Figure 5).
Could we envisage a scenario where advertisers maintain token balances? To the contrary. Utility tokens hold no utility outside the narrow use case for which they are designed. The market may well nudge application design towards a seamless user experience where customers never need to interact with tokens at all.
7. Restating MV = PQ and Implications
Clearly, our findings thus far have significant implications for the continued misuse of the monetarist identity equation we analysed in our previous analysis of token valuation — MV=P…Que”.
Let’s revisit the monetarism equation as applied in crypto world:
M * V = P * Q
M is the monetary base (i.e. number of tokens outstanding),
V is the observed velocity
P * Q are the fiat-currency equivalent of products and services delivered by the network (i.e. the sum of all $1 ad sales generated by FaceLook).
First off, it’s obvious that equation is ‘misspelt’ — the units don’t balance. On the left, M is denominated in crypto terms. On the right, P*Q is denominated in fiat terms.
The equation should really read:
M * R * V = P * Q
R is the ZUCK / $ conversion rate, equivalent to the token’s trading price over a period of time.
Next, we realize that the revenues of a network (P*Q) are independent of token supply and trading prices.
The price at which a ZUCK trades, or how many ZUCKs are available for trading, does not determine NIKOLA’s willingness to purchase advertising on FaceLook. Similarly, the aggregate of end user demand for FaceLook’s services (i.e. the sum of all $1 ad spends from all customers) is independent of token price and velocity. Unlike the real economy, and the original application of the monetarism equation, P*Q cannot be increased merely by issuing more tokens or pumping up token price.
Next, as we’ve already seen, in a fiat-currency world, token trading prices are irrelevant. Per our example above, at a token price of $1 per ZUCK, you need 1 ZUCK. At $100, you need 0.01 ZUCKs.
We thus realize that neither token issuance volume or nor token price are important. The availability of P*Q fiat-currency equivalent of tokens is all that matters.
Here, the retained issuance base comes into play — it is incumbent upon FaceLook to make sure its customers (the advertisers) always have the amount of tokens required to conduct business on the platform.
This tranforms FaceLook’s post-activation network maintenance role into a central bank-like function of controlling token supply when necessary, NOT to support token price (which we have seen is irrelevant) but to ensure token availability at the point of need.
8. Implications for Token Design and Economics
As we peel the layers back, several other and equally significant implications become apparent.
- Decentralized Service Providers may determine that retained inventory of tokens is sufficient to service end user requirements. This would further delink token-trading markets with the process of purchasing tokens to utilize them.
- Poorly designed protocols fail to create an explicit economic and legal linkages between tokens and the value of products and services created over a decentralized network (no ownership rights, no dividend, interest or principal repayment obligations either). This is a very bad outcome for holders of such tokens.
- Token fractionalization will become important. It does not matter if a platform issues quadrillions of tokens if a user cannot purchase a small fiat-currency-equivalent amount of utility tokens. User adoption will likely suffer as users wait to aggregate enough demand to buy a higher unit, or seek fractionalization elsewhere. In our example, unless NIKOLA can purchase 0.01 ZUCK when its price skyrockets, it cannot do business with FaceLook.
- Speculative price appreciation of tokens will be of no relevance to end-users— so long as they can purchase the $-equivalent necessary to get their job done. Remember, NIKOLA is in the business of making and selling cars, not speculating on ZUCKs.
- Trading prices can and possibly will become completely de-linked with network economics — you can trade the price of a ZUCK to a trillion dollars, so long as you find the next ‘investor’ to buy it from you. FaceLook does not sell a trillion dollars of advertising to justify this token price, and nor will it need to. The price will be supported till greater fools enter the market after you.
- As a consequence, token trading prices could far outstrip ‘per-token’ revenue even when adjusted for ‘velocity’.
- Worse, this relationship is symmetric for price — i.e. a small issuance base and low price could support a very high revenue volume given sufficient efficiency of use. All that is required is the ease of recycling tokens and the understanding that annual revenue volumes, though seemingly large numbers, are earned over a prolonged periods of time.
- End-user UX will be significantly eased if tokens can be acquired directly from FaceLook instead of coordinating in an open (securities?) marketplace. We can foresee a scenario where tokens are acquired as part of purchase process of the decentralized service, not as a separate dialogue with ‘investors’ or ‘hodlers’.
- This will lead to the development of a two-pronged market — speculators and so-called crypto-funds frantically trading tokens at make-believe ‘intrinsic’ or ‘fair’ value with each other; and end-users directly interacting with FaceLook-like entities to get work done (see Figure 9).
- Ironically, service providers could end up becoming the last resort for fiat liquidity for token holders exiting token positions for fiat, becoming a single point of failure in token design.
- An extremely low barrier to entry for issuing tokens means there will be no reason not to issue tokens. Even as consumers, the prospect of buying UberToken, SubwayToken, StarbucksToken, ElevatorToken, SandwichToken etc. merely reinforces reluctance to move off fiat. Taken to its natural conclusion, if all the FaceLooks of the world tokenized their services, we could foresee deeply inefficient markets that gross up the amount of fiat-currency liquidity committed and sitting idle in individual tokens.
This is the price we pay for a token-maximalist’s vision of a tokenized world.
- Even so, end-users users may not over purchase tokens, electing to not build up reserves and provide early investors with the outsized returns they anticipate. There is a real opportunity cost of capital to over-buying tokens. End-users are not in the business of financing vendors with advances against otherwise unusable tokens. Enterprise clients even more so, they heavily optimize working capital requirement (negative accounts receivables, positive accounts payable)
- Currently, global corporates struggle to manage multiple reserves in multiple currencies to finance operations. Asset-liability matching and local currency liquidity management are a nightmare for any treasurer, necessitating cash management expertise and forecasting and multiple banking relationships. Add to that the need to maintain token balances for global vendors like FB, Twitter, eBay etc. and local tokens for local services, and the difficulty will go up several-fold. Expect push-back from enterprise users for yet more tokens.
Does this analysis merely reinforce the need for a so-called stablecoin to enable seamless transfer between such tokens?
Yes, and we already have stable coins in spades — fiat currencies.
The only problem for token ‘investors’ is they don’t hand out dollars for a dime in pre-sales. They never did.
Long may that continue.
9. Let’s Stop Calling It Market Cap
Whilst you’re here, let’s take a closer look at Market Cap, a metric commonly misquoted and misused in the crypto space.
Ostensibly, ‘market cap’ provides a relative measure for comparing crypto networks. By multiplying the number of tokens outstanding with traded price, the crypto universe is deemed to have a market cap of $345B (as of end-March, 2018). This figure gets compared with other large numbers such as equity or bond market caps or world GDP. Worse, illicit activity such as money laundering is expressed as a fraction of total market cap and deemed to be “not such a big deal”.
We can easily demonstrate that ‘market cap’ is a meaningless construct in the crypto-space.
Say I create 200M tokens. I sell you a single token for a $1. Does this mean the market cap of this particular project is $200M?
Worse, if I conspire with you to trade the same token back and forth between multiple pseudonymous addresses that both of us control, could we raise the ‘traded price’ to $2, $3 or even $5? Does this mean the market cap is now $1B?
The sum-product of token volumes and prices does not reflect aggregate demand for or utility of tokens, and is therefore a flawed measure.
There are still other arguments to sort through.
Crypto proponents argue that common stock capitalization (e.g. AAPL shares) is determined by the marginal trading activity of a handful of shares on any day, giving the company a multi-billion valuation. In reality, one couldn’t sell all AAPL shares at that price. So how’s that different from BTC or ETH’s market cap?
Very dissimilar, as it turns out.
A stock is essentially an ownership claim — when you buy an AAPL stock, you own part a large company with many billions of revenues. Each stock assigns to you a proportionate claim to the net earnings of AAPL adjusted for the time value of money. So whilst the price may be wrong for extended periods of time, and you may buy AAPL at too much of a premium or discount, AAPL’s net profits are available to make payments to ALL its shareholders in the form of dividends.
For utility tokens on the other hand, the entirety of returns derived by an owner is realized at the point of sale. These returns belong to the token holder only, and have no bearing to the returns accrued by subsequent sellers.
Once sold, there are no other returns due to the token holder.
Token trading may help in price discovery, but the customer demand for tokens is determined by the success of the protocol in earning real revenues ( P*Q) and not the ‘market cap’ of the tokens (M*R*V).
Another retort cites growth stocks with high stock prices that pay no dividends (e.g. AMZN) — surely zero-dividend paying stocks are similar to zero-returns utility tokens in that token holders rely on price appreciation?
Not quite — whilst AMZN doesn’t pay dividends at this time, at some point in the future when growth slows, it will be expected to transition to a ‘value’ stock with a dividend yield. If you were to tell AMZN shareholders they would never receive any dividends whatsoever, then the stock price would plummet as the relationship between AMZN’s financial performance and its owners’ rewards is severed.
10. Special Bonus — A Brief Introduction to ‘Principal Tokens’
We’ll break our promise at the beginning of this piece to briefly touch upon what I call Principal Tokens.
Principal Tokens are tokens designed to raise a certain amount of principal that is then invested in financial assets. Think of most asset-backed tokenization plays, property investments via REITs or even crypto-backed-loans.
All Principal Tokens require an adherence to The Law of Conservation of Principal.
Let’s see how this works.
Say an enterprising real estate developer creates 200M BUILD tokens and sells 75M for a dollar each, raising $75M. The remaining 125M are variously retained to pay for expenses, allotted to the founding team and advisors and kept in reserve.
Bearing in mind that this set-up only contains $75M in cash, what is the market cap of BUILD now?
If you said $75M, you’re close but not in line with market practice.
If you said $200M, then problems abound.
There are 200M tokens in existence, all claiming rights to $75M of assets. The ‘fair value’ or ‘book value’ of a BUILD token is now $0.375 per token. If you were lucky enough to buy BUILD in the initial offering, congratulations, you’ve already lost 62.5% of your investment.
It gets worse.
In order to recoup your investments, you will rely on the real estate developer to turn $75M of cash into $200M of assets. That is an almost 270% return just to break even on real-world assets. To make even a nominal 10% return over a holding period of 4–5 years, we’re talking a 400% return on invested capital.
It gets worse still.
If the token design is not subject to lock-up periods and a returns-allocation waterfall (e.g. external investors get their capital returned first, then profits split etc.), unscrupulous promoters dump their token positions out of turn to unsuspecting new entrants. This sale affects the transfers new money from late entrants to the founding team, leaving the former holding the bag for a woefully undercollateralized project, a variant of a ponzi scheme.
Principal Tokens reinforce an age-old principal that one cannot create real money out of thin air.
And of course market capital tables would list both ZUCK and BUILD tokens with comparable market cap numbers ($500M and $200M respectively).
In reality, neither is worth anywhere close to these figures.
[Note: Interested in discussing principal tokens further? Get in touch!]
So what have we learned from this (lengthy) examination of tokens?
- Utility tokens are lousy investment substitutes for common equity
- The price of a token does not matter — its availability does
- Token price can be delinked from network ‘value’ in either direction — very low token prices can support very high transaction volumes with sufficient efficiency of recycling
- Market capitalization is grossly mis-understood and mis-used in the crypto space. And leads to dangerous conclusions.
- The Law of Conservation of Principal cannot be violated.
The token space is quickly re-branding. Gone are explicit promises of quick returns, replaced by proclamations of SEC compliance and promises of ‘asset-backed tokenization’.
In future pieces, we will focus our attention on the the evolving eco system of securities-like tokens, enumerating best practices for token design and observing the interplay between fractionalization and liquidity.
Thank you for reading.