How the Behavior of Token “Hodlers” May Create Volatility

In my previous article, I touched on the problem of token holders, who consist of either actual users or investors. As shown, the activity of users determines the actual use of tokens and hence their utility value. But what about investors who act as passive holders? Do they increase or decrease network value?

The answer is not straightforward, and we need to understand how the relationship between users and investors can change. When there is an ICO, token holders act as investors, although a large part of them may become future users once the product is built. Initially, however, people buy tokens because they believe a project has a good chance of success and value appreciation. Once the product is built and has some users, we can determine token value with more certainty by analyzing fundamentals, such as the exchange of tokens by users to acquire a particular utility. In the long term, this will be the most important determinant of value for most of the tokens we see.

Even though a migration from investors to users eventually occurs, there will always be a certain share of token holders who act as investors, either active or passive. Even if these investors are passive in their behavior, do they really have no effect on a network at all? Interestingly, in the token economy an investor is someone who impacts the floating number of tokens that can be utilized. By having more “hodlers” or passive investors in the token ownership structure, they effectively take tokens out of circulation for use. Assuming velocity of tokens and total spending stay constant, the floating value per token must increase if more tokens are hoarded by investors. When passive holders liquidate their positions, this brings additional tokens in float, and their value drops because there is suddenly an abundance of them relative to their consumption. Only higher velocity or spending would offset such an event, but that is very unlikely to happen simultaneously.

This demonstrates how the behavior of investors has a monetary effect on network economy. They indirectly control the monetary base among users and can cause inflationary or deflationary effects. If investors in the traditional financial system can in a limited way impact stock fundamentals by electing a board of directors, in token networks they impact fundamentals by controlling the monetary base used between users. The situation is different because tokens are not equities but network currencies. In the traditional financial system, a token investor would be an entity who chooses not to participate in money flow, taking his cash out of the system and putting it under his bed.

In practice, this means that when a large fund suddenly finds a particular token attractive and accumulates a large position from the actual users, the token’s price is impacted upward not just because there is a positive effect on exchange order books and the news associated with such “acquisitions,” but also because the number of tokens available for exchange between users is indirectly decreased. And this is symmetrical: when prices deteriorate because of some negative fundamental event (i.e., the product is not attractive enough for use) and investors choose to abandon the token and liquidate their positions, a second-order effect follows when a larger pool of tokens floats and utilization per token drops. It can lead to a downward spiral in which investors’ decisions cause underutilization of tokens exchanged, leading to lower network value and causing additional investors to flee.

When the price starts rising due to some event, users may eventually start becoming investors, and in extreme cases the token economy may slow down its “production.” At some point, network token value may be determined by its effectiveness as a store of value instead of its utility. A tendency toward equilibrium is set when investors realize that a token’s use as a store of value is not properly associated with its utility function, and the price adapts. These exact dynamics may not necessarily hold for a currency such as Bitcoin, however, which has characteristics more like gold. As is well known, use as a store of value can be established even if there is no specific utility — money is about common belief (or religion, if you like).

This clearly shows that investors could bring additional volatility to token networks if the share of them changes drastically through time because they have an indirect impact on the monetary variables that determine network value. I think this is pretty intuitive when observing ICOs and their impact on large pools of ether being held by teams as a store of value. This can lead to very volatile events. Even if the utility of ether rises, this doesn’t necessarily offset the large amount of additional ether that may float between users because some teams may find better store of value alternatives and switch to them.

As we have seen, analyzing the token holder structure is very important. The best scenario for stable and predictive token dynamics is to have more actual users in the ownership structure, but this isn’t something that can really be controlled. Perhaps initially through some sort of targeted issuance to users of a working product or hard caps per investor, but you can’t control it in the longer term.

My point being is that when you see large investment fund holding a substantial share of tokens of a particular network, don’t get too excited: these investors control the network’s monetary base.

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