In the midst of the ICO boom, investors, blockchain entrepreneurs, and a growing class of token economists became aware of what is sometimes referred to as the velocity problem.
The token velocity problem is confusing because it emerged as a critique of an already confusing business model. The velocity problem would likely be better understood were it called the “no one wants this token problem” or the “low market cap problem”. The business models that can easily encounter concerns about the velocity problem are platforms which sell tokens for fundraising purposes with the idea that the product on the platform must be purchased with the token sold to investors. For example, a company that sells distributed server space sells CloudToken to raise money and then mandates that CloudToken must be used for purchase of distributed server space through the platform. This type of token is sometimes called a medium-of-exchange token or a platform token. The naive thought process is that if one must pay for products/services on the platform using the platform token, then as more products/services are sold on the platform, the more valuable the token becomes. This intuition is correct, but it paints a much rosier picture than when one also considers the velocity problem.
The velocity problem occurs when the only reason most or all users would want to own the token is to purchase the goods on the platform. If any buyer would prefer to acquire the tokens right at the point of purchase and any seller would prefer to sell those tokens as soon as they are received from the buyer, then the tokens are unlikely to be valuable.
In late 2018, a team-member of Basic Attention Token (BAT), a platform seeking to disrupt online advertising by leveraging blockchain technology, wrote a paper titled “Token Economics: Considering ‘Token Velocity’”. This paper appears to claim that the velocity problem is rooted in faulty economics and is therefore non-existent and/or irrelevant. While the paper is useful insofar as it critiques some poor explanations of the velocity problem, I will show that the velocity problem is still something to take seriously. It will help to start with an explanation of the velocity problem in slightly different terms than it is typically explained. Then, I’ll show that the arguments outlined in “Token Economics: Considering ‘Token Velocity’” do not disprove the existence of the velocity problem.
People in the crypto space have often tried to explain the velocity problem using an equation many of us learned in high school economics, MV=PQ. The author of the BAT paper was very concerned with using the formal definitions of the variables in this equation, but I’ll define these terms as they are used more colloquially. The redefinition of terms is just a way to make the equation more intuitive to those in the crypto space.
M = The market cap of all tokens in dollars (assume constant over the defined time period)
V = The token velocity, the average number of times a token changes hands in the defined time period
P = The average the price in dollars of things bought in the defined time period
Q = The number of things bought in the defined time period
Put together, MV is the total dollar price of tokens spent in the given time period, and PQ is the total price of things bought in the given time period. Money spent = money received.
The equation is not profound. It is an accounting tautology. The insight comes from understanding that as PQ, the things bought, increases, the market cap does not necessarily increase. PQ does not tell us M without also knowing V. At fixed PQ, as V increases M decreases. As an investor, high M is my main priority, so if a project has a good pitch on high PQ, I want to be sure V isn’t high. Let’s create an example to understand an extreme case.
Fictional company Blocks “R” Us sets up a marketplace for blockchain themed toys in an online marketplace where buyers and sellers must transact using a platform token. There are 1 million tokens and the market price for all toys is $10. Neither buyer nor seller has any interest in holding tokens other than for purchases and it is frictionless to exchange tokens for dollars. 100,000 toys are sold in a month, but as no one wants to hold the token for longer than is needed, an average token changes hands 500 times in that month. PQ = $1,000,000, V = 500, so M = $2,000.
For those who are optimistic about blockchain scaling, imagining a token changing hands hundreds of times in a month is easy. While this toy problem isn’t the end of the story, it should be concerning for those expecting the market cap of a medium-of-exchange token to be at a similar or higher order of magnitude to monthly platform sales.
So why would V be high? Like I said before, high velocity is a result of most market participants not wanting to hold the token other than at the time of purchase. If most token holders would prefer not to hold the token, that means they would rather hold some other asset and will look to sell the token for that asset. In other words, there is low demand for these tokens. Low demand results in a low price. This low price is what is necessary for most token holders to be willing to hold tokens rather than immediately exchange them and continue putting downwards pressure on price.
So velocity is less the cause than the mechanism and low market cap is the problem. Without understanding how velocity and market cap combine to pay for goods and services, it isn’t clear how a token with a relatively low market cap could be sufficient to facilitate exchanges in a thriving marketplace. The low token price is a function of supply and demand for the token, but the ability for tokens to be used at high velocity allows the market to function.
Now that we understand the velocity problem, we can see that solutions to the velocity problem involve creating tokens that have more economic value to holders. A way to restrict supply and increase token price is to create an economic incentive to hold the token. We can revisit our toy problem and imagine that staking tokens gave preferential search results. Vendors were willing to stake $50,000 worth of tokens throughout the month for these preferential results. We can see already that the market cap has drastically increased since the market cap must be at least $50,000 to satisfy demand for the token. The demand for tokens driven by the need to use them in purchases will now result in M>$50,000, at least 25 times higher without increasing the total platform sales. Cleary, mandating that a token is used for transactions is a poor way to endow economic value relative to other means.
Now I don’t blame anyone for thinking this seems unrealistic. It certainly isn’t coherent with the current set of valuations in the crypto space. However, it is worth recognizing that many of these medium-of-exchange tokens depend on an ecosystem where high velocity is possible. If transacting and exchanging tokens is expensive, then many of these platforms are unlikely to succeed. If exchanging tokens is cheap, then tokens will be in direct competition with other assets as a mechanism for storing one’s wealth over time. One could imagine a wallet with the ability to convert one asset for another for any necessary transaction in the background and then rebalance to the desired asset allocation whenever some undesirable token was necessarily received.
The BAT paper was first brought to my attention by some of my colleagues at the Unbounded Capital. As a fund that often considers the velocity problem in the context of investment decisions, any legitimate attempt at refuting the velocity problem is of great interest to us. While the article did not prove to be particularly useful in improving our understanding of the economic forces affecting token price, I did find the content, tone, and placement of the article such that it is worth addressing publicly. Naturally, for full context I’d recommend reading the paper before continuing in this article.
Before diving into the content of the article, I want to comment on the tone and placement of the piece. While the Latex typeset gives the document a scientific veneer, this is really a marketing document. This isn’t a condemnation of the contents, but the articles placement just below BAT whitepaper on their homepage is evidence that the document serves some marketing purpose.
To me, what is more dubious is the condescending tone of the article. It seems as though the author is attempting to ridicule those that are concerned about the velocity problem. While there is a time and place for ridicule in public discourse, I see it used most often to supplement suspect arguments and dispel dissent from those who are suspicious but lack the knowledge to speak out without fear of being shamed. A big part of my motivation for writing this article is to embolden those who are aware of the velocity problem to speak out about it with confidence. An insufficient understanding is likely to cost the crypto community a lot of money, something I’d like to avoid as someone who would like to expedite and not retard crypto’s disruption.
Let us move onto the contents of the article. In truth, there isn’t much to refute. The majority of the paper is focused on incorrect definitions of the equation of exchange found in two articles concerning token velocity written by Ethereum’s Vitalek Buterin and Multicoin Capital’s Kyle Samani. While these errors should be concerning to those whose only knowledge of the velocity problem comes from these papers, the fact that these errors exist is not a refutation of the velocity problem.
There were also some more concrete refutations of the velocity problem. After doing some transformations of the equation of exchange and then telling readers they shouldn’t be worried about velocity, the author dives into toy problems to illustrate his point.
This initial toy problem provides us with very little insight. We are told M, P, and Q and then calculate V. We then are told a dollar exchange rate, although we don’t consider the impact on overall prices from someone showing up with what is essentially a lot more seashells in the form of a large amount of dollars. The author concludes that the fundamental insight of the equation of exchange is that increasing the supply of seashells lowers the value of an individual seashell and that increasing the quantity of goods bought and sold will make seashells worth more. While these statements are basically accurate, what isn’t addressed is the tenuous valuation of seashells. We were given an equilibrium price of seashells, but there wasn’t much consideration of how that was reached. We certainly understand how the market could clear even if seashells were priced much lower. It’s also non-trivial when extrapolating to crypto that direct exchanges without seashells are likely possible, and if someone showed up with dollars which seemed preferable, seashells could go to zero! I’m being silly, but I want to be clear that the insights from the equation of exchange explains how high PQ and relatively low M can co-exist.
The article then tries to apply the same limited set of insights to concerns expressed by Vitalik Buterin. The section in bold is a quotation from Buterin’s article. Buterin uses appcoin to refer to a platform token.
The fallacy comes in the second to last sentence. A decrease in the value of money relative to the goods in the economy would also increase token velocity. This is the flaw with the toy problem, we have assumed prices. If one looked through the history of money, this is a big mistake. Money of all types, from commodity money to fiat money, have seen their values change substantially as the market’s preference shifts or its confidence wavers.
The only other substantial argument in the piece is made in two places, the second to last paragraph of section 2 and the third paragraph of section 4. To paraphrase the argument, the author postulates that because lowering velocity is not a way to reliably increase token price, the velocity problem does not exist. He is right that lowering velocity is not a reliable way to increase token price. His suggestions for ways to lower velocity, typically to cap on-blockchain velocity at 1 for a given time period, are methods that would drastically reduce economic output and lower PQ. Clearly, lowering velocity while subsequently lowering PQ is much less likely to increase token value than lowering velocity with constant PQ. What the author fails to recognize is that most efforts to reduce velocity fall in the second bucket. If velocity is reduced but PQ stays constant, then the token must appreciate to clear the market. If we go back to the seashell problem and now one person on the island likes to wear a necklace of 5 seashells, then either the velocity of the remaining seashells must increase, the value of the remaining seashells must increase, or both.
At the New Economy Fund, we not only recognize the existence of the velocity problem, but we also factor it in strongly into investment decisions. Lots of interesting projects come onto our radar where everything looks good except for the token. Tokens can be an excellent investment vehicle and can give projects that utilize them well a competitive advantage. However, many tokens were conceived as a way to raise funds without dealing with securities laws rather than as an essential component of the business that naturally lent itself as an investment.
Further, in my role helping projects design and implement Tokenomics, I understand that creating a token with real economic value isn’t as simple as necessitating it at the point of sale. Because creating a token with value is difficult, I often advise blockchain startups to fund-raise through traditional means such as equity, even if their business uses a token. Not all tokens need to appreciate rapidly with platform growth or at all.
Even though there are a lot of positive things to say about businesses who have raised funds with a platform token, the investors holding these tokens which are subject to the velocity problem and other related issues are likely to see disappointing returns relative to platform adoption in the long run. Instead, tokens that are structured to capture a significant portion of the economic value generated by the network will reward both the investors who took on early stage risk as well as the platforms who can continue to fund development through the retention of now valuable tokens.