The Argument for Security Tokens (Part 2 of 3)
Over the course of three posts, this thought experiment will lay out the problems that exist and will exist as long as utility tokens are seen as vehicles of speculation, and assert the reasons why security tokens will be the new standard for how crypto companies capitalize themselves.
This thought experiment is broken down into three scenarios:
The first two scenarios lay out the problem that exists in crypto today given the lack of security tokens, and the potential problems that may arise down the line if crypto companies do not adopt security tokens as the standard to raise capital.
The thought experiment will be easier to follow by taking an illustrative company as an example. For the purposes of this thought experiment, let’s use a made-up blockchain company with the following criteria:
· Company name: HouseChain
· Product: Provides short-term rentals through a decentralized network
· Utility Token: HouseCoin
· Security Token: HouseST
Let’s dive in.
Scenario 1 (Summary): Role of Utility Tokens in an Environment Where Security Tokens Do Not Exist and Blockchain Companies Have Yet to Develop Their Products
Currently, blockchain companies are distributing utility tokens in such a way that make their utility tokens not much more than a vehicle for speculation. For one, blockchain companies are first selling their tokens to early accredited investors who are buying and hodling them with the intent to resell them at a higher price. Furthermore, blockchain companies issue tokens to founders, developers, and to other members of their teams in order to compensate them for their time and efforts. Such a practice is akin to any company’s employee stock compensation program. Those awarded with tokens stand to gain if the price of the token appreciates just as those awarded with stock incentives stand to gain if the company’s stock price goes up. These individuals have the incentive to hold their tokens and resell them later to a third party for a gain.
The positive side of speculation is that it has given the crypto industry global recognition. The downside is that it has created a state of crazed hype that is analogous to the dot.com bubble or to the Tulip mania.
Read the first part: The Argument for Security Tokens (Part 1 of 3)
Scenario 2: Role of Utility Tokens in an Environment Where Security Tokens Do Not Exist and Blockchain Companies Have Developed Products
Fast-forwarding to the point when HouseChain has developed its decentralized short-term rental service, let’s analyze how purchasers of HouseCoins will use their tokens. This analysis assumes that HouseChain matured to a developed state without security tokens ever becoming the standard for raising capital (i.e., HouseChain issued HouseCoins, instead of HouseSTs, to raise capital).
The above assumption implies that a HouseCoin has two potential uses:
· Means for speculation
· Means of trade for goods or services
Crypto investors laud the theory that the value of a network increases as the network grows in user base. However, the assumption behind this statement is that users are actually “using” the network. If users are speculating on HouseCoins — as is the case for Group A of HouseCoin Holders in Exhibit 2 — they will hodl and resell the tokens through an exchange at some point in the future in hopes of making a profit instead of using the token within the network. These type of holders hodl, just as HouseChain founders, developers, and early accredited investors have been doing since they first received their HouseCoins. This is because their net worth and/or the value of their investment is directly dependent on HouseCoin’s price appreciating. The end result is these holders are not using the network, and thus not contributing any value to it.
Another type of holder (Group B in Exhibit 2) buys HouseCoins because they intend to pay for a short-term rental but do not have a pressing need to do so today. These buyers are also seeing that HouseCoin keeps appreciating in value, so what incentive do they have to pay for the short-term rental now vs later? To compare this to how consumers will react in a highly deflationary environment, these HouseCoin holders do not have an incentive to use their HouseCoins “today” since waiting for “tomorrow” will let them rent the same short-term rental with less tokens. Therefore, these type of HouseCoin holders will store their HouseCoins in their wallets and wait to use them.
A third type of HouseCoin holder (Group C in Exhibit 2) will buy the token from an exchange and immediately transact with the HouseChain network. This group of holders, which represents only a fraction of total HouseCoin holders, are the active network users. The fundamental value of the network ultimately depends on its active users and not on its speculators. Thinking about fundamental value of a crypto network makes me want to dive into cryptoasset valuation. I will refrain for the sake of staying on topic; however, I will leave you with this spectacular post on cryptoasset valuation by Chris Burniske and promise to discuss the topic further in a post soon.
Finally, what are HouseChain’s incentives? What will HouseChain do with the tokens it receives from its active users? HouseChain can do two things with the HouseCoin it receives from users transacting on the network: burn them or resell them. If the value of the HouseCoin is due to speculation, then HouseChain is incentivized to burn the coins. Why? Assuming that the demand for a HouseCoin remains constant, then basic principals of economics state that a reduction in the supply of HouseCoins (e.g., burning HouseCoins) will lead to an increase in the price users are willing to pay for a HouseCoin. If HouseChain resells the HouseCoins, then it is temporarily increasing the supply of HouseCoins in circulation at that point in time. Following the same logic, an increase in supply, assuming demand stays constant, will lead to a decrease in price. In this state of the world, founders, developers, and other members of the HouseChain team have been compensated in HouseCoins, and their net worth stands to gain when the price of a HouseCoin increases. Therefore, they will be incentivized to burn HouseCoins. From a long-term investor perspective, this is a problem because those in charge of HouseChain have an incentive to promote short-term price appreciation over taking actions to maximize the value of the network over the long-term.
All in all, if the majority of HouseCoin holders do not participate in the network, then HouseChain will have developed a “zombie network” — in other words, the network will be up-and-running but have a few to no active users. Therefore, in such a state, any HouseCoin price increase will be due to speculation and not from any increase in the network’s fundamental value.
Removing speculation as a reason to buy a utility token is key in order to have a functional macro cryptoeconomy with real commerce where there is trade between blockchain companies providing goods and services and consumers of those goods and services.
The third post will take a look at how such a state of the world can look like.