Token valuation: The misunderstood importance of token economics (or why XRP is worthless)
Looking at the terminology used to understand and value tokens, a large part of it is lifted directly from the stock market/equity valuation, despite the fact that equities and tokens are fundamentally different kinds of assets. Indeed, while we may refer to both a token and an equity’s “market cap” as the number of shares or tokens in circulation multiplied by the share or token’s price, this apparent similarity only serves to obfuscate the fundamental difference between these types of assets and leads to misunderstandings and mistakes in the valuations of cryptoassets.
Note: For the sake of this article, I’ll be referring to utility rather than security tokens. Security tokens function in a very similar way to equities and are not really subject to the same distinctions and problems (i.e. they aren’t as interesting).
Equities represent legal ownership of an underlying company, whereas tokens represent the currency used to pay for a certain utility in an underlying protocol, platform or ecosystem. As such, when valuing an equity we need only analyse the underlying company and its ability to generate cashflows as we are assured to possess a legal ownership claim on the company’s cashflows. On the other hand, when valuing a token we must look not just at supply and demand for the underlying protocol, but also at the token’s economic model to ensure the price of the token is correlated to demand for the underlying protocol.
In this article I’ll cover this fundamental difference between equities and tokens in more depth before going over some real world examples of how this applies in practice when valuing tokens.
The difference between equities and tokens
What is an equity
Owning an equity (also known as stock or share) is effectively equivalent to owning a percentage of the underlying company represented by that stock. This ownership itself is a legal construction in that the legal system recognises certain rights for equity holders which are enforceable in court. Effectively, an equity gives its owner a legal claim to a proportionate amount of a company’s cashflows, whether that be in the form of actual cashflows such as dividends or “frozen” cashflows in the form of assets.
Valuing an equity
Since an equity represents ownership which the legal system defines as giving right to a claim on a company’s cashflows, its no wonder that equity valuation is based primarily on a company’s ability to produce cashflows. Indeed, if a company is making a profit or in other words has positive earnings, investors may look at a company’s Price to Earnings ratio which is simply the price paid for a company’s cashflows. In case a company doesn’t have earnings or has negative earnings, investors may speculate on the probabilities and magnitudes of the company’s future cashflows (as venture capitalists and other early stage investors do) or otherwise look at a company’s assets (as value investors do), which can be seen as “frozen” cashflows to be unlocked either willingly or forcefully in the case of liquidation. In every case, investors are focussed on the ability of the company to produce cashflows as the primary valuation metric.
While investors may also look at revenues, they are only of interest alongside an analysis of the company’s ongoing cost structure such that investors can determine whether the company will be able to earn a profit on those revenues at some point in the future and generate cashflows for shareholders. As Peter Thiel famously said: a company creates X dollars of value and captures Y% of that value. X and Y are independent variables. As such, revenues can be seen as the value created by a company whereas earnings/profits can be seen as the value captured by the company.
What is a token?
A token, on the other hand, doesn’t represent any ownership in an underlying company. In fact, a token may not even necessarily have an underlying company or legal entity. So what are tokens? Most broadly, tokens can be seen to represent currency used to pay for a certain utility in an underlying protocol, platform or ecosystem which they power. Specifically, tokens either have a certain use case in the protocol (i.e. Steem’s token used to stake in order to be able to work for the network) or otherwise serve as medium of exchange in the project’s ecosystem (i.e. Powerledger’s POWR token used to buy and sell energy on the platform).
Valuing a token
Since a token represents utility or currency in the protocol, token valuation must be based on the supply and demand for that particular protocol. However, this alone isn’t enough. Because, unlike an equity, a token doesn’t entitle its owner to any legal ownership of the underlying protocol (and the protocol itself may not even generate cashflow) but is rather simply the currency used to pay for a certain utility in the protocol, a token’s value must depend not just on demand for the protocol but also on the degree of correlation between demand for the protocol and demand for the token itself.
To put this in different terms, we can say that a given protocol creates X dollars of value but only Y% of X is captured through its token. X and Y are independent variables. Effectively, we can think of the value created by the protocol as the “revenue” and the value captured by the token as “profits”. Just as with equities, it’s not enough to merely look at X, the value created by the protocol but we must also to look at Y, the value created by the protocol which is captured by the token.
In order to determine what Y is for an equity, we must look at it the underlying company’s cost structure. To determine what Y is for a token, we must look at the token’s economic model (more on this later).
Practical consequences and examples
This may all seem slightly arcane and theoretical so I’ll now give some examples of how this distinction applies in practice, using particular projects as examples. Specifically, I’ll be looking for projects in which the correlation between demand for the protocol and demand for the token is weak or in other words the protocol creates $X of value but only a small % of that X is captured by the token.
Example 1: Ripple
The best example of this is probably Ripple. Ripple Labs (i.e. the company behind the XRP token) has invented a blockchain-based protocol called Ripple Network which aims to replace the SWIFT protocol in bank to bank transfers. Given SWIFT currently processes $5T a day in trans-country currency exchange or over a quadrillion dollars a year, Ripple’s total addressable market is huge. Ripple Labs has already signed partnerships with over 100 financial institutions worldwide who pay it to use its Ripple Network service. By all accounts, Ripple Labs seems like an extremely promising and successful company.
However, as we’ve discussed, while the success of Ripple Labs the company raises the value of its equity, it doesn’t necessarily raise the value of its token XRP. XRP doesn’t represent any ownership stake in Ripple Labs and indeed all the evidence seems to indicate that demand for the XRP token is extremely uncorrelated to demand for the Ripple protocol.
XRP serves three main purposes: (1) it can be used as a bridge currency for banks to settle international transactions with (2) it is burned to pay for transaction fees and (3) it is required as a small reserve for any address using the network. Of these, only (1) would provide any significant demand for XRP as the latter two serve primarily as anti-spam measures and long-term supply constraints. However, Ripple Labs doesn’t force banks to use XRP as a bridge currency and as a result almost none of them do as they use digital IOUs instead. In fact, some sources indicate that Ripple’s xRAPID system (the only one that uses the XRP token) currently only has one small user and one pilot.
As a result, only (2) and (3) are left which provide minimal value to XRP. For (3), while each account is required to hold a small reserve, thus constraining supply and increasing price of XRP, this reserve is currently only 20XRP (~$17 as of 29/04/2018) per account. Even with 10M accounts (8x the current amount), this would only lock up 200,000,000XRP or 0.02% of total supply; a tiny deflationary force. For (2), while some XRP is burned to pay for transaction fees, thus constraining supply and increasing the price of XRP, the current transaction fee is only 0.00001 XRP which means that only 10XRP tokens need to be destroyed if a bank wants to settle 1M transactions in a year. In fact, only 0.00526% has been burned in transaction fees so far and daily destruction rate is an average of ~8K XRP. At this rate, even in 100 years only 0.29% of total supply of XRP will be burned. Even if we assumed a 100K daily destruction rate (10x more than the current daily destruction rate), in 100 years only 3.65% of total supply of XRP would be destroyed. Once again, a tiny deflationary force.
As a result, this is a clear case in which demand for the protocol (i.e. Ripple Network) is only very weakly correlated to demand for the XRP token. Whereas Ripple Labs may create immense value for its customers, almost none of this value seems to be captured by the XRP token.
Example 2: Celsius Network
Celsius Network is a crypto-collateralised lending platform. For those who don’t know, these platforms allow users to deposit cryptocurrency as collateral, let’s say $150 of ETH, and receive loans paid into their bank account, let’s say $100. If ETH drops in value such that it comes within X% of leaving me undercollateralised, the platform automatically sells my ETH, pays off the loan and sends me any leftovers. This loan model allows much lower interest rates on loans than than the credit check model as there’s virtually no due diligence required which reduces costs and since collateral is provided and automatically sold through smart contracts the risk of default is also far lower. Also, once other assets (i.e. houses or cars) are registered onto the blockchain and possess liquid markets, these can be used as collateral in the same way.
While this is a very promising space and I believe the platforms and protocols in it will create significant value, given the current token economics only a small percentage of this value will actually be captured by the token. This is because loans on the platform are issued and paid off in FIAT and, in the case of Celsius, only the interest rate and fees are paid in the CEL token. As such, even if Celsius is extremely successful, demand for the protocol is high and $1B worth of loans are processed through it every year, only a small percentage of this (equivalent to the 5–7% paid in interest rates and the 0.5% paid in fees) will actually comprise demand for the token. This is a case in which demand for the token is weakly correlated with demand for the platform and as such demand for the token is always likely to lag significantly behind demand for the platform.
Example 3: Coinseed
Coinseed is a service which allows users to make micro-investments in cryptocurrencies by connecting to their credit cards and automatically collecting the “spare change” on their purchases, rounding them up to the nearest dollars. For instance, a user connects his credit card to CoinSeed and purchases a coffee for $2.30, his purchase is automatically rounded up to $3 and the $0.7 remainder is invested onto the platform. In addition, the platform also has a portfolio leaderboard showing the portfolios with the best returns and allows users to instantly convert their existing portfolio to any other on the leaderboard, charging a 1% fee for doing this. I’ll refer to this as the “portfolio conversion” feature.
While this is an interesting idea with many companies already successfully offering this service for the stockmarket (i.e. Acorns, Stash, Clink and Moneybox), the token economics ensure that only a small percentage of the value created by the platform will be captured by the token. The CSD token serves no purpose on the platform and will entitle holders to 50% of the revenues from the fees captured from the portfolio conversion feature. Leaving aside the fact that this token not pass the Howey test and almost certainly qualifies as a security, the token’s value will rely solely on how often users actually use the portfolio conversion feature. Even if the platform becomes successful and a significant number of users sign up for the core service of micro-investing their spare change, there’s no guarantee they will also want to use the portfolio conversion feature. As such, demand for the protocol itself (i.e. investing spare change into cryptocurrencies) is only very weakly correlated to demand for the CSD token. Indeed, the token’s value doesn’t rely on the success of the platform but rather on the success of the specific portfolio conversion fee.
Example 4: Swiss Alps Mining
Swiss Alps Mining is seeking, among other things, to build a P2P marketplace for the purchase of energy. However, the whitepaper mentions that its token SAM is not the sole currency used on the platform as purchasers will also be able to use FIAT to purchase energy on the marketplace. This means growth in demand for the purchase of energy on the platform will not necessarily correlate to increased demand for the SAM token as these services could be paid for in FIAT instead.
In general, any project whose native token is not the sole currency on the platform/protocol creates serious problems for the token’s value as users do not need the token in order to use the platform.
Tokens and equity as competing value capture mechanisms
An interesting corollary of this is that equities and tokens are effectively competing for the fixed amount of value created by a company, entity or protocol. Since they are both value capture mechanisms, a company that has valuable equity will necessarily have a less valuable token and vice versa.
For instance, let’s take the example of Ripple vs Ethereum. Ripple Labs has valuable equity since it owns ~60 % of all Ripple in existence (worth around $18B at time of writing) and also generates significant (albeit undisclosed) revenues by charging banks to use its protocol. As a result, XRP token is necessarily less valuable since much of the value created by Ripple Network is being captured through cashflows by Ripple Labs’s equity. The Ethereum foundation on the other hand owns around 1% of all ETH in circulation (worth around $457M at time of writing) and does not generate any cashflows. As a result, its equity is not nearly as valuable as Ripple Labs but the Ether token is worth much more since all the value created by it captured by the token.
There are some mechanisms that can be put in place in order to increase the value of the token compared to the equity. For instance, a company can charge for its services in FIAT and use its earnings/cashflows to purchase tokens and burn them (thus reducing the supply of the token and putting upward pressure on the price), effectively transferring value from the equity to the token. Alternatively, a company could charge for its services in the native token, then sell that token on the market and distribute that money to shareholders in a dividend. This would lower the value of the token by increasing supply and putting downward pressure on price, effectively transferring value from the token to the equity.
The key here is that given a limited amount of value created by a service, tokens and equity are competing to capture as much of that value as possible. As such, we can think of the token used on a protocol and the equity of the company developing the protocol as being inversely correlated, the more value is being captured by cashflows, the more the equity will be worth and the less the token will be worth, and vice versa.
This is why the news of Facebook looking into cryptocurrencies is so interesting. If Facebook were to launch a utility token, unless this token created additional value or captured value that Facebook’s equity could not reach, it would necessarily cannibalise the value of Facebook’s equity as the token’s price would effectively be absorbing potential cashflows to Facebook. This begs the question of whether fiduciary duties to shareholders would even render such a move legal.
I started by describing the differences between equities which imply ownership and a legal claim on cashflows, and tokens which are a currency used to pay for a certain utility on a protocol or platform. I then showed, using the examples of Celsius, Ripple, Coinvest and Swiss Alps Mining, that it’s not enough to simply look at the demand for the protocol or platform itself as we must also consider the token economics to see how much of the value created by the protocol is captured by the token. Finally I showed that tokens and equity can be seen as being in some sense inversely correlated.