There has been a lot discussion addressing the token velocity problem: Kyle Samani (Multicoin Capital) and Vitalik Buterin (Ethereum Co-Founder) have both written about the issue, and Ryan Selkis mentioned it recently as well. The general consensus is that for many tokens, the price goes towards zero in value over time because there’s no incentive to hold the token.
This problem specifically pertains to “proprietary payment tokens” — a class of utility tokens that exist to be exchanged for goods and services, or paid out as rewards. Generally any project that includes the concept “users will pay/receive the token for…” are exposed to this problem. Examples of these tokens include Filecoin, Golem, and Basic Attention Token, although I’d say that most tokens today are payment tokens.
Breaking Down The Problem
In a world where these platforms are mature and integrated into our daily lives, there would be hundreds and thousands of coins for everyone to manage. Most likely, people wouldn’t store the various coins they use. Rather, they would hold one (maybe more) general purpose currency. That way they would have flexibility on when and which coins they use, without having to worry about the price fluctuations.
In this situation, for any transaction on a platform, the buyer would go to an exchange and buy the exact number of tokens required. They might not even be exposed to the payment token throughout the process—an app might do all the conversions under the hood. The tokens would then be exchanged for platform goods, and the receiver of the tokens would immediately exchange them back into the general currency.
This is the main thesis proposed by Vitalik and Kyle: since no one needs to hold the token to use it, the only holders are speculators who want to sell the tokens to other, “greater fool” speculators. Eventually, there will be no more speculators to buy the tokens, the market collapses, and the price goes to zero.
Identifying the Holders
I’d like to disagree with the idea that only speculators hold the tokens. In payment token ecosystems, the holders are clear: the market makers. They take on the holding risk of the tokens in exchange for the right to charge fees for the liquidity they provide. In payment token ecosystems, liquidity is essential.
When tokens are the required means of payment on a platform, their velocity becomes a function of the network transaction volume. As the network grows in demand, so does the velocity of the token. As velocity grows, so does the need for liquidity. In other words, networks with payment tokens create liquidity premiums as they grow in adoption and usage. Market makers alleviate the liquidity problem for the token.
Going back to the fictional world of many payment coins, each time a transaction happens, a market maker collects a small fee. Market makers take a ‘spread’ by selling the token at a premium to the purchaser and buying it back from the receiver at a discount. Both parties are willing to pay the nominal fee so they don’t experience the price volatility of the token. Since the time from buy to sell happens for the token almost instantaneously, the market maker wouldn’t even have to take a position for very long either.
The valuation of the token becomes very simple: since the market making fees are paid in the general currency, the value of the tokens are the discounted cash flows from providing liquidity to the market. Those who can provide more liquidity earn more fees, and have a higher NPV for the tokens they hold.
…Creating Even Worse Problems
In this ecosystem, market makers are incentivized to speculate on the future transaction volume of the network. If a network grows in real demand the number of transactions increases — assuming a stable system, fees that market makers collect grow linearly with network usage.
In systems that involve payment tokens, the participants get nothing and the traders get everything. This is a serious security concern because it causes severe imbalances in the token distribution. As tokens are amassed by parties that can more effectively provide liquidity, larger concentrations of tokens appear in fewer wallets. This makes the tokens easily susceptible to things like market cornering and manipulation.
I can only think of a few exceptions for where a ‘medium-of-exchange’ token is necessary — general-purpose currencies like Dash, or systems where liquidity is the product, like Stellar Lumens. There is a clear understanding of why these products should be held, and providing liquidity actually contributes to the purpose of the platform, so the token model makes sense.
Conclusion
As a token model, I find payment tokens to be mostly unjustifiable. They introduce an entire ecosystem of complexities that doesn’t benefit the platform in any way. In fact, for most platforms, it would be a net positive for the removal of the native payment token and allowing users to pay in whatever currency they want. That way, unnecessary market makers wouldn’t be leeching off of each transaction.
To be clear, I don’t think that these platforms shouldn’t integrate a token — in fact, I think that tokens are an essential part of our next-generation applications. I just think that payment tokens aren’t the best use case for blockchain tokens, and projects should be looking to design with alternative models, and existing projects should consider redesigning their token. In the coming weeks, I’ll write about some alternative token systems and discuss how they work, and why they might be better use cases for utility tokens.
Edit: After doing some more thinking on the matter, I’m considering an alternative perspective that I’d like to explore further. Since there will always be an application layer built on top of the token’s protocol, developers might be able to monetize the apps they build by being the market maker. Maybe by providing a fiat bridge for the end user, they can monetize on the transactions in their apps by holding on to the token.
