This is Part 1 in a series (see Part 2 here).
Nearly 2000 startups in 2017 and 2018 have raised over 13 billion dollars using initial coin offerings (ICOs), selling crypto-tokens. A significant number of these raises sold what are most commonly called utility tokens (also known as usage or network-medium-of-exchange tokens). They are called utility tokens because the token derives its value from its utility in the functioning of the associated network or platform. Usually the main functions are to act as a medium-of-exchange for transactions on the network and to incentivize participation in support of the platform.
Unfortunately many, if not most, of these utility token raises have either already failed or are predicted to fail. Check out these posts for more detail: Why are So Many Icos Failing; 46% of Last Year’s ICOs Have Failed Already; Doubts about the Long Term Viability of Utility Cryptoassets; Why Most ICOs Will Fail: A Cold Hard Truth.
As the posts above explain, there are many reasons why a particular utility token platform might fail. To be successful, a platform has to do most things really well. To fail, it needs to do only one thing really poorly. I want to focus on the one thing that I believe is the reason most utility token platforms are eventually doomed to fail, even those that are doing most other things really well. Just as importantly, I want to explain how to fix that one thing.
This blog post is the first in a multi-part series on that one thing. This is explained in much greater depth in a recent white paper we published at Difuon’s website. Read the latest version of that white paper here.
Before we get to that one thing, we need to recall why ICOs were so popular in the first place. They were so popular because founders could raise capital for their startup without having to give up equity and investors could get a significant return on their investment in months instead of years. What a great idea! In other words ICOs provided a non-dilutive, highly liquid investment vehicle. That vehicle is the utility token which, when traded on a third party exchange, allowed investors to almost immediately profit from their investment. In many cases early investors could buy their tokens in a private pre-sale at substantial discounts. Once the public sale commenced, investors could sell them for positive returns, even as high as 100 times their investment.
A typical valuation approach to token price was to estimate the market cap for the platform and then divide by the number of tokens issued (ICO Valuations, Valuation Methods). For example, given such a valuation, a founder could sell to an early investor at an 80% discount to that price. The investor could then resell on an exchange at a 40% discount and immediately double their money. This might all happen before the platform has any meaningful activity or in many cases before the platform is actually live. Its valuation was entirely speculative.
Hype and promotion of the potential value of the network (pump) incentivized secondary buyers (greater fools) to acquire the token at a higher price, thus allowing the initial investors to liquidate their tokens at a profit. In most cases, the liquidation flooded the market with more tokens than the demand could absorb and the price dropped, thus incentivizing investors to liquidate even faster (dump), thus driving the price down to near zero. The price charts for the majority of utility tokens reflect this pattern.
For example the price chart of the crypto-token Tezos (XTZ) is shown below. The light green vertical line is the date that the Tezos was listed on exchanges and could be traded publicly. The price quickly dropped to a level below its early discounted pre-sale prices.
Utility Token Hypothesis
The hypothesis underlying a utility token is that if the token is required for anyone to access the platform or exchange products or services on the platform the token will then be in high demand. Moreover if the quantity of tokens is highly constrained (fixed cap or slow release) thus creating limited supply then the value of the token will appreciate as the network or platform increases in value because demand will continue to increase but the supply will not. This popular article included a list of 20 different uses for a single token. The hypothesis being that the more required uses of the token on the platform the better to force its value to appreciate as demand for those uses increase. Seems like a great idea.
Confusion of Concerns
A major flaw in the foregoing hypothesis is that a utility token cannot both be a good medium-of-exchange and an appreciating store-of-value. I call this a “confusion of concerns.” The second major flaw is that merely limiting supply while making the token required on a growing platform is not enough to drive the price upward. A utility token is designed to act much like a currency. A currency has three concerns, to act as a store-of-value, a medium-of-exchange, and a unit-of-account. If the utility token is used by participants on the platform to exchange value or to access the platform then the token is, acting as a medium-of-exchange and unit-of-account for the platform.
A good medium-of-exchange has low friction, high velocity, widespread access, high throughput, low latency, low average settlement cost, and stability. Low friction and high velocity means that its both convenient to use and there is no resistance to spending it in return for a product or service. Widespread access means that almost anyone can use it. High throughput and low latency mean that transactions are not impeded by the mechanics of using the token. Low average settlement cost means that the fees for a given transaction are very low relative to the value of that transaction. Finally, stability means that the change in price of a product due to volatility, appreciation, or depreciation of the token is insignificant relative to a product’s market life cycle.
On the other hand, from an investor’s perspective, a good store-of-value appreciates over time. The more appreciation the better. Appreciation, however, fundamentally and irreparably conflicts with some of the features that make a token a good medium-of-exchange. First, appreciation means the token price is not stable. This means that products or services priced in the token become increasingly uncompetitive relative to their competition as the prices rise. Expected appreciation also makes participants more reluctant to spend their tokens thereby increasing friction, lowering velocity, and further driving up prices. This stifles demand for the products and services and slows the platform’s growth. If on the other hand even a small number of participants expect the price to decrease then they will spend their tokens. If the platform’s token exchange mechanism provides high throughput and low latency then only a few tokens may ever need to be in circulation to meet demand, thus providing enough velocity to drive the price downward.
For example the price chart of the crypto-token EOS is shown below. The light green vertical line is the date that the EOS network went live. This is the date when the network started providing real utility and also the date when the token could be used as a true medium-of-exchange. Despite steadily increasing traffic at the level of millions of transactions per day, the price of the token steadily dropped.
The One Thing
A token can either be a good store-of-value or a good medium-of-exchange but not both. This is the one thing that all platforms based on single utility tokens do very poorly and hence why they are doomed to eventual failure. This bears restating, a single utility token cannot both be a good medium-of-exchange that facilitates and incentivizes activity on the platform and a good store-of-value that reward investors.
This confusion of concerns means that for any given utility token the founders must make a choice, either make the token act as a good store-of-value to reward investors or make the token act as a good medium-of-exchange to grow the platform (see Invest or MoE not Both, Value of Crypto Tokens). This poses a conundrum. If the platform doesn’t grow why would anyone invest? If the token does not appreciate why would anyone invest? So picking one or the other is not a solution either. The fix is the topic of the next post in this series. I will give you a hint: the fix requires at least two tokens.
Read the full whitepaper to see how to fix virtually any single utility tokenomics model. Go to our website here to see what we at Difuon are planning to do with our innovative dual utility tokenomics model. This is Part 1 in a series (see Part 2 here).