The Foundation of Successful Cryptoasset Investing
When starting the process of evaluating a cryptoassets investment potential. Focus on its cryptoeconomics. Absent robust cryptoeconomics a project is unlikely to deliver value to you as an investor no matter how interesting it might be.
Five components of cryptoeconomic evaluation:
- The project requires a token to work
- Properly aligns incentives across stakeholders
- Mechanism to maintain scarcity
- Mechanism to generate value
- Mechanism to generate network effects
The first question to ask when evaluating a projects cryptoeconomics is does this project require its own token to work? If a project doesn’t require a token to work then why did it issue one? Since it did, do you really want to invest if a token isn’t critical to its functioning?
Defensible Tokenization requires meeting the following three criteria:
- The token incentivizes user adoption.
- The project requires its own token to work
- The project requires its own token to incentivize certain behaviors or
- The project requires its own token to disincentivize certain behaviors
Ethereum requires its own token to work because to leverage Ethereum’ s computing resources requires ETH. The token disincentives wasting these resources because it is used to pay for the gas required to power computations across the network using it.
Kin, the KIK messaging service token, is not catalyzing user adoption. KIK wanted to raise money and decided to do it via an ICO versus seeking out equity investors.
The Kin token is not a foundational element of its product. Kik works just fine without the Kin token for users who choose not to adopt it.
Additionally, Kin does not impact user behavior. It is just one of many payment options on the platform.
If a project incorporates one of the following mechanisms it indicates tokenization is critical to project success.
- Proof of Work
- Proof of Stake
- Decentralized oracles
- Token Curated Registries
Projects implementing these mechanisms require a token to align incentives between the various stakeholders needed for a functional economic model to evolve. Ensuring all agents behave honestly in the best interest of the network, whether or not they happen to be virtuous.
Agents behaving honestly is critical to inducing the positive feedback loop required for a cryptoasset to generate network effects.
A network effect is generated when each new user increases the value of the platform exponentially. When someone opens a Bitcoin wallet and uses it to obtain and send Bitcoin across the network, the value of the Bitcoin network increases exponentially because existing users can now potentially connect with the new user.
If a network is able to reach a critical mass of users the value it provides new users begins to exceed the costs of joining. Prompting explosive growth as new user growth becomes self-sustaining as a result of the value the network is providing.
Fundamentally, most cryptoassets are networks and need to generate network effects to succeed. Projects need to identify at least one and hopefully multiple avenues to leverage network effects to grow their user base. These include:
Setting a Communication Standard – Typically the focus of payment networks, creating a standard for users to broadcast and conduct transactions across the network.
Monetary – Increasing the value of a cryptoasset by expanding the potential investor base. The most common example of this is obtaining a listing on one of the major exchanges such as Binance or Poloniex. If users can’t obtain a token, they can’t use a token. Accessibility is the foundation of usage.
Listings on exchanges are also important because they provide market depth. Allowing you to move into and out of a position in a cryptoasset with minimal price impact due to the larger volume of liquidity available on the larger exchanges.
Usage – Power users can drive the success of cryptoasset projects. A small cohort of dedicated users can drive the adoption of the protocol forward through technical contributions and evangelism. Daily usage continuously trending up is more significant than absolute address growth.
Identity – Cryptoassets giving users the ability to maintain a reputation tied to their identity are the natural destination for future activity from users once they’ve established their identity in a positive way.
Platform – Generally the tool builders of the cryptosphere. Drawing in developers to build applications using the platforms tools. Leading to user growth as more people access the platform to access the applications.
Information – The more information flowing into, out of, and around a project the more likely people are to be aware of it, use it, and come back to it.
Catalyzing network effects is vital because generally they are the foundation for the mechanism cryptoassets employ to generate value.
Mechanism to Generate Value
For cryptoassets producing network effects, governance is an effective mechanism to generate value. As 0x continues to build out its partnership network. Partners will naturally gravitate towards obtaining the ZRX token so they have a say its ongoing development because eventually, ZRX holders will be determining the protocol’s future.
Volume is another mechanism to generate value. The more things able to take place on a blockchain the more value it could potentially have. Why? The more things taking place the more records a blockchain generates. Generally, changes to these records require a transaction so a high volume of records is often a precursor to transactional activity.
Ethereum is a good example of a platform supporting a variety of activities leading to high volumes of records. The downside of volume is at times the network can get congested. But, I’d rather have the problem of too many records changing than nothing going on.
Transactions do not have to be the result of record keeping to have value. Privacy coins actually generate value with as minimal records as possible, seeking to minimize record keeping to preserve anonymity.
Superior censorship resistance is their value capture mechanism, attracting usage from individuals who prioritize anonymity when conducting transactions.
Mechanism to Maintain Scarcity
As an investor, you need to feel confident a coin won’t endlessly proliferate via a high level of continued issuance driving down the value of existing coins. For native tokens employing proof of work, you can feel reasonably confident scarcity will be maintained. As long as the supply schedule is conservative and the total anticipated supply is reasonable. Bitcoin is the prototypical example of this approach. Total issuance of 21 million released over a 136-year timeframe.
For other cryptoassets like Ethereum, you will need to be comfortable with the initial inflation rate. Monitoring them on an ongoing basis to ensure issuance continues in a way that doesn’t severely dilute existing holders. Currently, Ethereum’s inflation rate hovers around 5.5%. To ensure the network has enough tokens available to continue to expand its user base.
Over time as Ethereum migrates to a proof of stake model, it’s expected the inflation rate will drop to around 2%. Reasonable given Ethereum’s existing supply is burned to support transactions. Meaning Ethereum’s outstanding supply should remain relatively fixed, helping to maintain its value, as long as a decent volume of transactions is flowing across the network.
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