Cryptoasset Tokens: A Poor Capture of Economic Value
Thinking about cryptoasset value from first principles
If you’ve followed crypto in the last 12 months, you’ve likely come across initial coin offerings (ICOs). Huge amounts of capital have been raised through this new form of crowdfunding. The coins offered go by many names, including tokens, cryptocurrencies and cryptoassets.
I prefer to use the term “cryptoassets” in the context of investing. Yet, cryptocurrency is the most appropriate when thinking about function. The vast majority of current cryptoassets are cryptocurrencies (including “appcoins”) because they function as currencies inside of a micro-economy with specific goods, services or utility.
Cryptoassets may soon look more like traditional securities, with more robust economic value capture features (ownership, distributions, etc.). If that happens, we can start calling them something other than cryptocurrencies. In my view, that will be a positive development for investors.
Until then, cryptoassets’ lack of economic value capture pose a unique risk to investors. We’ll discuss some of those risks and ways to think about cryptoasset value in the meantime.
Cryptoasset valuation: We are getting there
There have been some good ideas and frameworks emerging in cryptoasset valuation. I’ve found the recent thoughts of Chris Burniske, Gregory DiPrisco, and Primoz Kordez to be useful in my own thinking.
But cryptoasset valuation is still difficult.
Some practical difficulties in determining value for cryptoassets include:
- ICOs and tokens lack standard economic features. They also have very poor data transparency relative to traditional securities
- Investors incorrectly apply traditional finance analogies (“it’s like a commodity”)
- There are huge price movements based on speculative, “dumb money” behavior. These movements may obscure real economic signals that drive longer term value capture
- The newness of the industry and emerging business models. There simply isn’t enough history to know what is a “normal” or “fair” valuation
I’m very supportive of efforts to create more detailed thinking about cryptoasset valuation. I hope to contribute in this area. However, many investors are not spending enough time on the most critical question:
Are most current cryptoassets even capable of capturing meaningful value?
To be worthy longer term investments, cryptoassets have to both:
- be issued on a network that has meaningful utility to users (“this idea works and lots of people use it” / “value is created”)
- be able to capture the created value, in the token, and transmit the value to the holder of the token. This value has to exceed the investment cost.
Most investors are spending time on #1.
Not enough time is spent on #2.
Tokens are offered like equity — as the primary investor incentive when raising capital. Yet, they have very poor value capture relative to equity (and other traditional investments).
The practical implication is:
Even if crypto-projects are successful networks, their tokens may still be bad investments over the long-term. Often, purely because of their poor economic design.
What is token value? Start with first principles
Instead of reasoning from analogy (“tokens are like X, X has Y trait, therefore tokens have Y”), I find it useful to start from first principles — at the most basic and fundamental level.
What then, are cryptoassets?
Cryptoassets (tokens) are digital units that represent economic value related to a set of defined utility in some application.
Going one more layer down: what is economic value?
The textbook definition of economic value is the measure of benefit provided by a good or service. To that, I will add “or utility” to get us to: “the measure of benefit provided by a good, service or utility”.
The purpose of a token is to capture some form of economic value. That value originates from a good, service or utility of the underlying protocol / network.
As investors, that leads us towards two critical questions. For a given token:
- What good, service or utility generates the value?
- How does the cryptoasset capture that value? (What are the economic value capture mechanisms?)
Economic Value Capture Mechanisms (EVCMs)
There are many forms of economic value and varying mechanisms to capture them. Let’s discuss some common ones:
- Rights: (legal) claims to valuable assets or cash flow. Ownership rights are a strong EVCM given that they legally entitle you to other forms of value capture. Stock is an example of an equity ownership right in a company. Bonds are an example of rights to payments.
- Distributions: distributions are a mechanism of directly transferring accumulated value. Dividends are an example, which provide distribution of value (accrued through earnings) back to owners of equities.
- Utility: the ability to access utility value. A ticket to a baseball game is an example of value captured by access to utility. Buying a baseball ticket doesn’t give you ownership in the baseball team. It doesn’t earn you the right to cash flow. But a ticket can still provide you utility value (enjoyment, hopefully).
- Price appreciation: the ability to gain value from selling an asset to someone who will pay more for it. Usually you are able to achieve a gain on sale when the price of an asset appreciates due to supply and demand factors.
We can take these mechanisms and compare them across different asset classes, as I’ve done in the below:
Traditional securities (e.g. stocks, bonds) have strong and well-known EVCMs. This makes them ideal candidates for long-term investment.
When you buy a traditional security, like a stock, you are able to know certain things about it:
- How the underlying entity generates value (goods, services, utility) and what form it takes (earnings)
- Which mechanisms allow value capture as an investor (rights, distributions, long-term price appreciation)
Consider an actual stock, like Boeing (NYSE:BA). Boeing creates value primarily through producing aircraft. I don’t need to be a buyer of aircraft or a pilot to realize BA’s value as an investment. This is because the value generated by Boeing is abstracted in several ways to a holder of BA stock.
Yet, unlike traditional securities, many current cryptoassets do not have strong EVCMs or value abstraction.
How tokens capture value
The only mechanisms available to most tokens for value capture are to use them for their assigned utility (which very few investors will) or by selling them to someone who will.
In other words, cryptoassets capture value much like fiat currencies.
Fiat currencies are poor as long term investments. This is usually because of value erosion related to inflationary monetary policy. Outside a handful of reserve currencies, most are rarely held as investment.
Cryptoassets may have advantages over fiat currencies, including potentially being less inflationary. Political decentralization is another valuable feature. Yet, they may have some notable disadvantages as well. Namely, most cryptoasset tokens are only usable in very small and unproven micro-economies.
We see the Dollar or Euro as being units of value able to provision utility in large, open economies.
Cryptoassets are a units of value to provision utility in a micro-economy akin to a vending machine. There are very few options, and the utility is specifically constrained by design.
Much like fiat currencies, units of cryptoassets are (usually) not consumed or destroyed during use. This infinite life increases the frequency at which single tokens are exchanged (velocity). Increased velocity can reduce a cryptoasset’s ability to store value.
If we exclude speculation and assume a constant velocity, investors make money from cryptoassets long term if:
the net demand for utility (“useful thing it does”) secured specifically by the token (not just the network) is growing faster than inflationary supply increases…
… AND that growth increases token value past the point of the initial entry valuation.
Gregory DiPrisco does a great job of articulating this non-intuitive idea that value in the network does not necessarily grow meaningfully just because there is value on the network.
Even if a cryptoasset network creates significant value, many tokens will not be able to actually capture it and return it to investors. For the tokens that actually manage to capture value, few will be able to do so in excess of their high initial valuations.
This is a grossly overlooked reality for many people investing in publicly trade-able tokens.
Tokens: Very Poor Captures of Economic Value… By Design
The majority of crypto-projects that ICO prefer to not be treated as securities. This “non-security” trait of tokens has been a greatest strength. It’s enabling huge fund raises from unaccredited investors at much-better-than-market valuations and terms.
Yet, the irony is that the greatest strength of current tokens is also the greatest weakness as a long term investment.
The lack of “security-like” features (EVCMs) strip many tokens of the ability to capture economic value over the long term.
Crypto-projects able to convince investors to buy these tokens often get an amazing deal. They ICO, receive huge sums of capital, all while committing to few-to-no legally binding rules. These teams build what are effectively un-saleable (cannot be acquired) open source projects.
For investors seeking venture equity-like risk / return on investment, these are unfavorable conditions. Token investors receive an asset that fundamentally has less mechanisms to provide a return fit for those high valuations.
In the future, I expect the worlds of economic feature-less cryptoassets and economic feature-rich traditional securities to converge. Driven by regulatory pressure and increased institutional interest, a new class of cryptoassets will likely emerge.
These “cryptoasset 2.0” tokens will (hopefully) retain many of the attractive traits of current cryptoassets while also developing mechanisms for real economic value capture seen in traditional securities.
The cryptoasset 2.0 tokens will be more suitable for raising capital, more robust as a long term incentive for founders, and better investments overall.
Takeaways for Investors and Teams
These conclusions don’t mean that there are zero current cryptoassets worthy of investment. In my view, there are multiple current cryptoassets worth longer-term consideration, because they have a logical economic design that pairs well with an attractive utility.
In the future, I’ll share my thoughts about which tokens I think fit that profile of a worthy cryptoasset investment, with supporting comments on which economic design features support that view.
For now, some closing thoughts:
- Right now investors are paying huge economic premiums to get into ICOs and cryptoasset tokens. In reality, these investors should be getting these assets at a discount valuation relative to traditional fundraising (e.g. equity), given the lack of economic value capture mechanisms (EVCMs) inherent to current tokens and significantly greater risk associated with a completely un-standardized, unregulated market.
- When you invest in a token, remember that you are investing in a currency assigned to specific utility within a micro-economy. Unless there is significant demand for that utility above-and-beyond available substitutes, at a level that surpasses your initial valuation, you will not make money long-term.
- Don’t conflate “a good idea for a network / use-case” and a good investment or token economic design. The two can be (and often are) mutually exclusive in the context of cryptoasset investing.
- A cryptoasset’s monetary policy (the rules around total and new supply) and overall economic design should be of supreme importance to any stakeholder. As important as the utility of the network itself.
- For cryptoassets to thrive as a major, investable asset class long-term, they need to provide greater economic value capture to investors. This is especially true for projects that don’t have enormous potential scale (i.e. most “appcoins”). I believe this will happen in a new class of cryptoassets.
- If you are running a crypto-project that is raising capital, you should be thinking deeply about these topics. For both your own incentive-based token holdings and external investors, generating AND retaining long-term economic value should be a key priority (not just immediate capital raise).
- We don’t have to choose tokens as our vehicle for raising capital or incentivizing investors for blockchain projects. As this wave of ICO hype fades and retail investors wise up to reality, more traditional looking economics might make more sense. Especially to create a saleable assets (i.e. monetize through being acquired — you know, how many startups exit and provide a return to investors).
