Why utility tokens will not make you rich

One of the more tricky parts of crypto investing comes to light with certain types of utility tokens. Utility tokens are tokens that have the sole purpose of being used within a closed (payment) system. As stated in the previous article about Ethereum, utility tokens are at their core not a good investment.

A common misunderstanding is that when more people are using a utility token, the token value will rise. While in fact this is not the case. The value of a utility token goes up when the relative demand rises compared to the supply.

This has nothing to do with the usage of the token.

There are several crypto exchanges like Binance, Next and Blockport that use a utility token as an internal payment system. These tokens are distributed during an ICO to collect funds to build the exchange, and resultant is an expectation that token holders will use those tokens to pay for the exchange fee of that specific exchange. The exchange later sells the token back to the user to create revenue in fiat currency. This business model works for exchanges because they collect funds that they can use to pay for services outside of this closed environment. This model does not benefit the users of the exchange because they have no right to any of these funds. The only thing that gives the token a certain value is the willingness to pay of the user, the willingness to pay for exchange fees. If these fees exceed the fees of other exchanges, users will go to another exchange.

You can compare it with tickets for rides at an amusement park. The tickets have a certain value because guests have a willingness to pay for the rides. When the price to buy the tickets increases the demand for the tickets will decrease, due to basic economics for supply and demand.

So, are all utility tokens a bad investment?

The simple answer is no. A relatively fair way of redistributing the profit towards tokenholders is by ‘burning’ tokens. This is a process in which the company buys tokens back through exchanges. From there, the tokens are transferred to a wallet that doesn’t have a private code to access it. The idea is that no one can access the wallet and therefor the token supply decreases. When the supply decreases but the demand is stable, the price per token increases. The exchange will need to adjust their fees to the current price of the token to prevent a difference in pricing with other exchanges.

At the time of writing, only Binance has announced that they will start burning tokens to redistribute profit to tokenholders. Other exchanges have not shown any proof of moving towards a token burning initiative.

The three questions investors should ask themselves before investing in a utility token are:

1. How will this token make me money?

2. What is the chance of it doing so?

3. Is the amount of potential profit worth the risk?

Taking the case of cryptocurrency exchanges, investors will make money because the exchange will burn tokens. This decreases the supply and therefor increases the price of the token. The chance of doing so is tied to the profit that the exchange makes and so the amount of users of the exchange. The amount of potential profit is also tied to these metrics and gets divided by the amount of distributed tokens.

So to round this up, the only way an investor can make money on utility tokens is when the company behind the utility token has a way of distributing their profit to the token holders. The potentially distributed profit, divided by the amount of tokens, is the return on investment an investor is able to make.

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