A Graphical Analysis of SRC’s Price Mechanism
Introduction — Supply and Demand
Supply and demand is one of the core principles of economic theory and can be directly observed in every-day-life situations. A very illustrative example are markets where haggling is part of the process. A supplier offers his goods on the market, having an initial pricing scheme in mind. This pricing scheme is based on certain calculations and fundamental factors, such as production cost of the goods and labour cost, to ensure his expenses are covered. Additionally, it is assumed that individuals are profit seeking, so in this scenario he would try to charge a mark-up to get a little extra to build up wealth.
Customers enter the market with similar pricing schemes in mind, as in they have a reservation price for goods that is the maximal price they are willing to pay for any good. If the two parties have overlapping intervals of price expectations, an equilibrium is reached, they can close the deal and a transaction takes place. Increase in demand usually has a positive impact on prices, whereas an increase in supply has a negative one. One can observe this in the following example: A new product is introduced that is not really sought after in the beginning, with time, demand increases and prices rise. The rising prices signal other market participants that it might be a lucrative business to start providing said good themselves due to its scarcity. On medium-sized traditional markets, supply will be a function with discrete jumps.
In the case of SwissRealCoin (SRC), supply is a piecewise constant too, due to the fact that tokens are issued in discrete liquidity events. At the ICO between 30 million (mm) and 150mm SRCs, depending on the demand during the uprun to it, are minted and sold on the market. The price of the tokens will thereafter be determined by the participants in the secondary market analogous to other cryptocurrencies and traditional assets. In the following, we will examine the market mechanism and the SRC mechanism more closely and highlight certain features within graphs and explicit examples.
The SwissRealCoin
Some Characteristics of Asset linked tokens
In the case of SwissRealCoin, henceforth SRC, one has to distinguish between the price and the inner value, henceforth value, of a token. The value represents a characteristic of the token that has a tangible, non-digital counterpart in the economy. Up to 1971 legal tender was backed by gold, this was called the Gold-Standard or the Bretton-Woods system. Due to economic & political reasons this system was abandoned. In the case of SRC, it will be real estate, which has several traits that makes it, in our opinion, superior to gold.
First of all, real estate is a yield generating commodity as long as it is rented out. Constant cashflows help ensure operability and stability of business — it grants the ability to plan on a solid basis. There is a price risk, the same way as there is a price risk in any other good — even in everyday crops.
Secondly, real estate as an asset class depicts low volatility.
And last but not least, opposed to many other assets, real estate is something that everyone needs and understands — a place to live or to work in. Real estate surely constitutes a large part of worldwide asset holdings.
As a sidenote, above mentioned cashflows are not paid out as dividend but accumlated and reinvested into the portfolio. There are multiple reasons behind this decision and we will quickly summarise them here:
To begin, the funds raised with the ICO, altough a lot in terms, allow only for a small real estate portfolio — Switzerland is notorious for its high-price level. The 30 million CHF constitute a lower barrier to the feasibility of the project, simply due to the fact that acquisition of a geographically well diversified portfolio is not achievable with lower funding. Returns are reinvested to create potential for natural growth to strengthen the portfolio and the safe-haven traits of the token.
The SRC stands here in stark contrast to other cryptocurrencies where one cannot really disentangle the two: price and value.
We define the value of an SRC as a fraction of the liquidation proceeds of the real estate portfolio.
The liquidation proceeds at a point in time t, LP_t, are the uninvested liquid funds M_t plus the sum of the realized property prices at that given time, RE _{i,t}, after servicing liabilities (mortgage loans), L _{i,t }, as shown in the equation above.
In order to be able to sell under best conditions and prevent a firesale scenario, the devesting period is set to one year. Please note that the above definitions are preliminary and might be subject to change, the final ones will be put forward in the term-sheet and prospectus.
The token value, v_t , is then given as the liquidation proceeds divided by the number of outstanding coins, see the equation below.
The price of the token is decided by market forces, i.e. supply and demand, and might severely deviate from its value, depending on the expectations of the market participants. Since the token not only reflects the real estate value and its performance but also has a direct connection to the returns of the future software licensing., it is not only natural but also sustainable that the price that is above the value.
We define a price value combination as sustainable if the equation below holds.
Taking this ratio as a defining measure for the token, results in three scenarios one needs to examine.
pvr<1
The price of the token is below its value. There is either excess supply of tokens or no demand, thus the price dropped, or the value increased significantly, due to reinvestments, without the token being traded . This scenario should never materialize for an extended period of time due to the following reason:
Rational participants would use this arbitrage opportunity and start buying SRC on the market, thereby creating the demand that matches the supply causing a price increase up to a ratio of 1. This is an arbitrage opportunity since it allows the buyer to buy a claim to the liquidation proceeds below par without incuring risk, more explicitly said: buy real estate values at a discount. Should it against expectation be persistent, token holders can trigger the liquidation procedure by voting and realize the value of the token.
1<pvr <2
A ratio between one and two, should be the case in the medium to long run when the market has settled. The fact that it is above one would indicate the presence of a crypto stability premium next to the expectations of future software revenues.
2<pvr
The realization of the ratio above two is the case we expect to see repeatedly in the short run due to the fact that our market capitalization will increase, and especially in times of turmoil.
At the ICO, between 30mm and 150mm tokens will be issued for 1CHF per token, these tokens are freely tradeable on the secondary market, where supply and demand will determine the price. For illustrative purposes we assume a convex demand curve and the supply curve is fixed.
Note the shape of the demand curve is chosen to be convex, since demand usually displays the following features:
- For high prices, there is close to no shift in quantity that is demanded — highly inelastic.
- Demand is elastic in the medium range.
- A price of zero causes close to infinite demand,
The situation is depicted in figure (1). We start off with an initial observable demand curve D_0 and the fixed token supply S_1 which results in an equilibrium called Eq_0, the price being p_0. For reasons irrelevant to the story demand increases over time and would eventually reach D_1.
Since the supply is fixed at n_0 the price will be p* ,the market equilibrium that will be realized under the given setup is denoted by Eq*_1. To illustrate the mechanics, we now assume that the value of the token is v*, we denote the highest price we consider sustainable by p_bar. In this scenario, new tokens would be issued and sold at market price. As is stated in our term-sheet, the issuance lasts 72 hours and there will maximally be a doubling of tokens. Figure (2) illustrates this graphically.
The issuance of new tokens means that the supply curve moves outwards, the new supply curve is denoted by S_2.
The new market price will be p** and the equilibrium is denoted with Eq*_2. To get some intuition for the change in value, we bring forward the toy example below, see also table (1).
At some point in time, t, there are 100mm SRCs on the market with a market price of 1 Swiss Franc (CHF) and a value of 1 CHF. Due to increased demand and trading on the secondary market, the price at time t+s has risen to 2. New tokens will now be issued at market price, assuming all are sold, total outstanding tokens are 200mm, the price is still 2 but with the newly raised capital the value has changed
The lower bound of the SRC has increased and will do so continuously, since 80% of the real estate’s net profits and 50% of the licensing returns’ net profits will be reinvested into real estate. There is a second step done to further illustrate the mechanism.
For the sake of clarity, we will henceforth drop the initial demand curve.
One needs to mention that there exists a situation where not all the tokens will be sold, this naturally depends on the curvature of the demand curve. The logic behind it remains unchanged, therefore we do not analyze that case here but only reference the figure (4) and leave it up to the reader to adjust the toy example and check the fact.
David Haab is responsible for Research and Analytics at SwissRealCoin. He holds a B.A. in economics from the University of Zurich and is currently finishing his M.A. in banking & finance. He previously worked at Swiss National Bank.
