Tokens: winners and losers
By Vlad Centea on ALTCOIN MAGAZINE
Digital Tokens. Our casual, but not so casual relationship with the investor’s market. We have a fair-weather friendship with them. When they are up, we are proud to be invested in this amazing blockchain technology. When they plummet and take our investment down the drain with them, we wave them off as “a phase in our life”. This is what we truly call “an emotional market”. But let’s not forget, digital tokens are foremost a technology and stand to support innovation.
So what is a bond-worthy cryptocurrency? And, if you’re a developer planning on taking out the next life-altering decentralized technology, how do you tokenize it? Do you crowdfund via ICO? Do you burn tokens? How do you distribute them to investors? How do you monetize your blockchain-based project and what would a financial analyst tell you to do if you’re in it for the long-run, in a project based on the best of feelings?
SPOTTING GIANTS
Understanding token economy is an important factor in the process. It impacts profitability and survival of the project. We are not talking about the short-term speculation at this stage. We are talking about commitment and about supporting real-life tech with a bottled economy.
Yes, investors can choose whatever token has more hype. There are still hundreds of ICOs to pick and choose. Some are just pump-and-dumps meant to launder money and they might ride a wave to 10x ROI if they’re lucky, or just get swept away.
Yet, more involved investors save themselves a lot of headache when they choose projects that create real value (yes, brigh-eyed developer, I am looking at you) instead of financial models that facilitate short-term speculation. My base assumption is that blockchain projects are a cyberpunk step forward from the mechanisms that created the 2008 financial crash, not an updated version of it.
I will not cover Bitcoin, Ethereum or any other established token. Their value depends on a different set of criteria. My goal is to discover the 2009 Bitcoin today, or the Ethereum in the DAO era. What do they have in common? They offered a service in real demand, that is part of a real economy. They had two “unfair advantages”: first mover and amazing technology. And they covered a real need of the market.
Bitcoin and Ethereum are giants, and they gave all the signs of being in a separate class. If you spot one of those early, dive right in. Still, your portfolio will not brim with excitement if you’re looking for top-brass at all times. So let’s step down the ladder a little and look at smaller tokenized services.
UNDERSTANDING TOKEN ECONOMY
Tokenized services fulfill a real demand that is part of a real economy. Let’s say you’re working on a tokenized service for cloud storage. The service is sold in fixed units, like Gigabytes. Spot the value here? The token is linked to that bit of service and the value it provides.
When you put such a platform on a blockchain, the service units will be precisely linked to the token, at a sane value. Tokens like that are called utility tokens and are a digital representation of the service.
Some platforms generate tokens automatically when the service is produced, to reward contributors. Others issue a fixed supply of tokens in advance. Now here’s the secret. When you see contributors being rewarded from the fixed supply, know that there is more uncertainty and risk to the project economy. It leaves too much liberty to the developer team (investors don’t really like the whiff of that).
Pre-mined tokens represent a greater risk. They assume a certain capacity of the platform to deliver, and a certain market demand. Both are basically non-validated assumptions.
THE PRICE
The price of a utility token is (or should be) nothing else than the price of the service it provides. This makes an ICO a crowdfunding campaign in which adventurous users or investors would buy the service in advance at a discount.
Users are the ones that consume the service. They are not likely to hold large amounts of tokens. Investors on the other hand are not interested in the service and are willing to speculate on the price.
If the price of the service is denominated in tokens, the token price will vary with the market price for that service. If 1GB costs 1 token, that token price in USD should not exceed the market price from the competition.
If the price of the service is denominated in USD but paid in tokens, the price of the token is irrelevant to the users. They will simply buy them when they buy the service. This means the price of the token is not linked to the demand. It’s just linked to the availability of the token itself on the market or on the platform itself.
The catch is the following: if the price goes up means that there are more users wanting the buy the token and very few sellers and this means that the platform itself is hurt by this, because it could sell more services but users remain unserved because they cannot buy the token. In such cases if the platform would sell directly with USD would not have any barriers to grow. This way the HODLers will hurt the users and will suffocate the business of the platform.
Such a model is most often used in platforms providing financial services.
Some platforms will choose to burn all the tokens they receive when they deliver the service, others won’t. If they keep digital tokens, they compete with the investors on the market and are at risk of centralizing the economy, which in some cases might matter more than in others.
Burning instead, transfers the value of the profits to the remaining tokens, which protects their price. There is a lot of nuance here. If all investors speculate on that, they will all HODL and the platform might encounter liquidity problems. How will they then be able to supply the services, even if they have big demand? In the end, this will sabotage the business itself and users will migrate to competitors, where getting the service is more streamlined.
THE CASH FLOW — SUSTAINABILITY OF THE PLATFORM
Following the idea above, if a platform burns the tokens received in exchange for the service, it’s practically burning its profits. This might work for a while, because you might have some cash on hand from the initial sale. That will not even cover the cost of all the services sold in advance, because they were sold at a big discount. The platform might have some token reserves to sell from (which will of course bring the token price down) but when the reserve is over how will they cover operational expenses and cost of the services?
Also let’s not forget that most of the money from pre-sale was already used to cover the costs of building the platform and on customer acquisition.
So if all the money is gone, the platform will just have to issue new tokens and put them on the market in order to keep afloat. This puts downward pressure on the price.
Let me give you a real life example. Below you can see a cloud storage token (like the one in our example) variation in price. Both price in USD and in token are listed and plotted on the graph.
The USD price varies between 16$ and 0.7$.
Let’s compare it to the rest of the main-stream market, the established competitors.
Microsoft OneDrive — 2USD for 1 TB
Google Drive — 5USD for 1 TB
iCloud — 3.5USD for 1 TB.
Now let me show you another graphic example for the long-term outlook of the value distribution between equity and utility.
We can see utility prices are going down once we reach mass adoption. Companies instead are expanding, making big profits.
TAKE AWAY:
Utility tokens are a risky investment on the long-term when:
· There is no transfer of value mechanism from the company equity to the token
· The price is not directly linked to the price of your service. The price of service is always in USD and the token is just a medium of exchange.
· There is no economical reason to hold the token for actual users (this excludes investors). This will create high velocity of the token from the user’s perspective.
Velocity = Simply put, it’s the rate at which people spend money on good and services (speculation excluded) Velocity = total value of all services sold / number of all tokens
· The tokens are re-used by the platform after the service is delivered/consumed by the users.
· A large amount of utility tokens is held by the platform or founders and friends.
· The service doesn’t have an established market and no price to benchmark the token price against.
· The service has a market, but it’s crowded and large competitors push the price down.
One thing to remember is that utility tokens are not shares in the company. The owners don’t have dividend rights, even with the best of intentions. IF they do, they are securities and the company might be operating illegally.
There are a lot of bad projects with bad tokens
There are good projects with useless tokens
And there are a few good projects with good tokens. The last ones always pass the token economy test. Not all utility tokens are bad, but most of them are not a good investment.
My final thought is financing your blockchain project might prove harder than it looks, once the harsh realities of the market hits. You had a brilliant idea. Congratulations! Now you have a business. Treat it as such.
And keep in touch with me and with Morfin.io, write me your questions and tell me about your experience. Personally, I supported the growth of industrious projects and I know about the headache and the red eyes tearing up in front of the computer. And I am here to tell you all about it, hopefully saving you some time.
I will take a few hours to sift through all the info on security tokens if you show interest, so stay tuned.
References:
About token economics:
https://medium.com/@anshumanmehta/futility-tokens-6b8283c977a9
https://medium.com/@anshumanmehta/mv-p-que-love-and-circularity-in-the-time-of-crypto-db70c9d5c015
An interesting one about stable coins risks:
https://www.youtube.com/watch?v=EB7Bs-8WjQ4
A way of calculating Binance coin value, taking a lot of optimistic assumptions, and using discounted cash-flow method that normally applies to securities. However I put it just as an example to illustrate how easy one can play with assumptions to create a valuation. (it can be anything from $0.22 to $0.65 as utility value, and $1.95 or $7 using a valuation method for shares)
