Analyzing Utility Token Value Capture in Blockchain
Token economics is the rapidly expanding study of new economic models brought on by the proliferation of digital tokens. The plethora of use cases for blockchain technology has only added to the complexity and importance of these new token-based economic models.
While project quality, team competency, and market viability remain the critical questions to consider before investing in any token, an understanding of the token economics behind a digital asset is an essential and often overlooked element in determining strong, high yield token investments in the blockchain space. Analyzing how the token model interacts with the overarching business model of a project can corroborate technologic value and reveal key details about network and investment potential. After identifying a high quality project, the token’s purpose within the blockchain ecosystem should be addressed to determine its ability to capture value created by the project.
In this analysis, I will discuss:
- How do utility tokens accrue value in blockchain
- Utility token features and their relation to network value capture
- Mechanics of token economy models as they affect token value
- Current issues with utility token economies
- Concluding thoughts
For the purposes of this analysis, I will specifically focus on utility tokens, or digital tokens granting access to blockchain-based products or services within a project(s), rather than security tokens (digitally-securitized real-world assets), as they require separate analysis.
How Do Blockchain Utility Tokens Capture Value?
What Is Token Value?
Before delving into how a token can capture value, it is pertinent to first define what token value is. Due to the nature of utility tokens as representing access to services within a certain blockchain, the value of a token corresponds directly to the value of the underlying blockchain.
However, there is an important distinction to be made between this underlying value and a token’s actual traded value. In the blockchain space, coordination between networks of buyers and sellers is required to arrive at the token’s traded value, which can deviate greatly from underlying value in the current market as a result of high speculation and low usage rates. As markets mature, traded value and underlying value should converge.
In this analysis, I will focus on a framework for evaluating underlying token value.
Token Value vs. Network Value
Although the analogy is often made, tokens are unlike equities in that they do not represent ownership in a company or entity. This means equity-based valuation models cannot be blindly applied to token valuation. As stated above, a utility token represents utility within a project’s blockchain network. Thus, the values of these tokens are based on their project’s network effects, but also the degree of correlation between demand for the blockchain services and demand for the token.
Determining Network Value
Most leading blockchain network valuations are based on Metcalfe’s Law. The law suggests that for n users, the value of a network increases by approximately n2. In plain terms, each additional user increases network effects exponentially. Variations of the law, which account for nuances in specific tokens and the blockchain market, are also being tested, such as one proposed by Andrew Odlyzko, et al. which employs more conservative assumptions and suggests that for large values of n, the value of a network grows more closely in proportion to n*log(n).
Determining Correlation Between Network Value and Token Value
The other piece of the puzzle involves analyzing a token’s features and economic model to determine its correlation to the underlying network value. The underlying value of a token, and ultimately the success of the blockchain project, depend heavily on the economic and incentive structures of the token. An investigation into a token’s features and economic design is key to understanding the relation between demand for the token and network value.
Utility Token Features
Product Access/Contribution
Perhaps the most obvious feature for a utility token is its ability to access or contribute to its native blockchain’s product or service. This feature correlates most directly to value — and therefore allows the token to capture more network value — when the native token is the only accepted form of payment for the blockchain’s services.
Work Rewards (Mining/Staking)
Token models providing rewards for work done within the blockchain network, particularly for verifying transactions, have become some of the most widespread practices in the space. The consensus model for a token can determine the nature of the rewards for doing work on the native blockchain. Two of the most common consensus models used in the space today are Proof-of-Work and Proof-of-Stake.
In the Proof-of-Work (PoW) consensus model, miners are rewarded with tokens for solving complex math equations to verify transactions and create new blocks. Well-known examples include Bitcoin and Zcash. PoW provides security against attacks, however its high energy consumption rate can make mining cost-prohibitive for average users, and mining specialization can lead to the centralization of nodes.
In the Proof-of-Stake (PoS) model, token holders are incentivized to stake token to validate transactions, with larger stakers (known as “forgers”) awarded proportionally. Examples of Proof-of-Stake tokens include DASH and NEO. Although, the main issue facing the PoS model is the “nothing-at-stake” problem, where in the case of a fork, forgers are incentivized to validate both chains, preventing consensus and increasing the double spending problem.
In both consensus models, higher demand for the protocol results in a larger network value which incentivizes users, whether miners or forgers, to perform work on their blockchain, thus increasing token demand. Hybrid models also have been introduced to combat the problems facing these popular consensus models, while maintaining the interconnectedness of the token’s incentive structures and the value of the network.
Profit Sharing and Usage Incentives
Some tokens are designed to redistribute the cash flows of the network among users. KuCoin is a leading example of this, as their native KuCoinShares token (KCS) entitles holders to 50% of the exchange’s transaction fees. The share of profits is then distributed proportionally based on users’ holdings. KuCoin also offers up to a 30% discount on trading fees based on a user’s KCS holding. These incentives work to not only increase demand for KCS, but also allow the token to capture a larger share of the network value.
By contrast, Binance, one of the largest cryptocurrency exchanges, does not have a profit sharing mechanism in their native Binance Coin (BNB) model. To incentivize BNB use, trading fees are discounted by 50% when paid in BNB. However, because BNB does not have additional rewards to incentivize users to hold the token and the Binance exchange allows for trading fees to be paid in popular tokens such as Bitcoin and Ethereum, the token fails to capture a sizable portion of the network value. This highlights the importance of strong token incentive structures in network value capture, as well as the potential pitfalls when allowing payment in multiple currencies on a single platform.
Governance
Although it would seem that a token meriting governance or voting rights on a blockchain would be a significant value add for a token, prospective token buyers must be careful in weighing this feature as it relates to token value.
A study by Saman Adhami, et al., which analyzed data from 253 ICOs between 2014 and 2017, found second-market success of ICOs to be relatively unaffected by granting network governance to token holders, implying a low correlation between demand for the network and demand for the token. Although, their findings did reveal a strong relationship between second-market success and both the token providing product or service access and profit-sharing structures, corroborating the claims in the preceding sections.
In addition to overestimating the value of token-based governance, prospective token holders must be careful of the token’s possible classification as a security. Decentralized Autonomous Organizations, or DAOs, exemplify blockchain ecosystems with token-based governance. However, in July 2017, the SEC published a report stating that all DAO tokens are to be considered securities, posing difficult legal situations for both token holders and the entities themselves. I will further discuss concerns regarding utility token regulation later in the analysis.
Token Economy Models
Supply
A token’s supply and distribution details are very important when considering potential token value capture, as well as a project’s overall success.
Token supplies can be capped or allow issuing additional coin. Bitcoin, for example, is capped at 21,000,000 coins, and with approximate circulating supply data and mining rate data publicly available, valuation can be done with relatively more certainty than tokens that risk dilution through additional coin generation.
Another model tokens can pursue is the burn and mint equilibrium. In this model, the native token must be the only token accepted for payment on the network. When paying a service provider, rather than sending the actual token to the provider, the user burns the token and the network mints and awards the service provider with the appropriate of token amount when the network is running in equilibrium. Kyle Samani of Multicoin Capital notes that this token design creates a model where network growth causes linear, non-speculative growth in token value, making it a stronger alternative in the long-run to tokens whose economic model involves explicit deflationary burning without minting new tokens.
Single- vs. Multi-Token Economy
Another differentiator between token economic structures is the number of different tokens within the network. While single-token models are the most common and typically enable the native token to capture more network value, multi-token economies can be designed to effectively capture network value within the tokens.
NEO is an example of a two-token economy, consisting of NEO and GAS tokens. NEO tokens represent shares in the NEO market and provide voting rights for the NEO blockchain. GAS is distributed to NEO holders as a dividend and can be used to pay network transaction fees. In this example, demand for the NEO protocol correlates directly to demand for the NEO token, and token owners are incentivized to hold their NEO to capture profit from network growth and the dividend.
The main problem facing multi-token economies in blockchain is, again, the threat of regulation and classification as a security. In most multi-token designs, one token’s value is typically based directly on network growth and future earnings, making them prime targets for SEC regulation against mislabeled utility tokens in the blockchain space.
Current Issues with Utility Token Economies
Regulation
As blockchain technology has gained massive support in the United States, government organizations are reviewing and amending their policies to regulate blockchain investments. Among the hottest topic for regulators in the blockchain space is the classification of token sales as true utility token sale events or disguised security offerings. This is important to consider, especially during ICO and raise events, as they can affect the legality of the entire sale. The financially-savvy may be familiar with the Howey Test and understand its potential application to blockchain tokens.
For those unfamiliar, a general rule of thumb as it pertains to blockchain: tokens sold without a minimum viable product to exercise the token’s utility are likely to be considered securities in the eyes of lawmakers. In this case where the token is sold without a launched product or service, it can also be expected that even if the project’s demand is correlated to demand for the token itself, the network’s underlying value and token’s traded value would vary considerably due to the lack of token utility.
Network Usage vs Investment/Speculation
Another major issue facing token economies today is the significant disparity between actual network usage and investment speculation. Most token holders in the current blockchain market do not use their tokens for their intended utility, whether as a unit of payment and store of wealth or for a blockchain-based product or service, but for monetary gain. This inflates user data and can disrupt growth in network activity, slowing the maturation of these economies and manipulating the traded value of the tokens.
The velocity problem — the macroeconomic concept of exchange rate being driven by both transaction volume and currency velocity — also skews traded currency value from its underlying value. While velocity is incredibly difficult to accurately predict in the blockchain space and lost tokens or wallets remain issues affecting true circulation measures, token economics can still assist investors in determining tokens that enable maximal value capture from their network.
Concluding Thoughts
Medium- to long-term price prediction in the current blockchain market is a fruitless endeavor, but using a theoretical framework to analyze value in token structures can help identify strong, high yield blockchain investments. Technical quality and market viability are still the first and most important elements to consider when evaluating a project. With that said, a look into the features and economic design can determine how effectively a strong project’s token captures the value of its network.
