This article was initially be published on the Meritt blog. This is an instalment in a series of blog posts on crypto token design and economics, aka “Tokenonmics”.
When writing about different crypto tokens one should probably start with the most fundamental class, ie protocol tokens like Bitcoin and Ethereum. The drawback of this approach is that those protocols tokens — when seen as a class — are also the most difficult ones to describe, and their description naturally draws upon a lot of the observations and concepts that will only be developed throughout this series. The solution to this conundrum is that in this post we will only discuss basic protocol tokens, notably Bitcoin and Ethereum, and will leave the full discussion of protocol tokens to later.
In line with the other article in this series that are yet to come, we will here look at three distinct dimensions: token governance, token econonics (or tokenomics), and last but not least their legal status. Token governance is about governance in the wider sense — what rights can token holders exercise, what rights can be exercised against token holders, and how is the legal and technical environment in which the token exist governed. Token economicsor tokenomics is about value and price, but also about things like induced incentives. Finally the legal status discussion is about under which legal framework a token operates, and in particular whether it is more likely to be considered a securities token (and therefore subject to securities and investor protection legislation) or a utility token in which case a much more lenient legal framework applies.
Both Bitcoin and Ethereum are decentralised, and so is the token governance process. Also, both the code and the data are fully transparent, so in principle everyone can fork the chain and create a second one that is identical up to the fork point, but then will have its own unique history. At this stage there could in principle be a problem which of the competing chains is the original one. So the first governance issue with Bitcoin and Ethereum, especially when trying to use define “Bitcoin” and Ethereum in forward looking discussions, is which chain this moniker actually refers to. This is not an entirely theoretical issue: Bitcoin has been forked to Bitcoin Cash in 2017 and whilst the large majority recognise this as a fork there are from time to time arguments that Bitcoin Cash is the real Bitcoin, and any real-world documents referring to “Bitcoin” before that fork will have to be amended.
In case of Bitcoin and (mostly) Ethereum the governance process only relates to technology governance, ie decision what features should be added to the existing codebase. Other than that, “code is law”, meaning that any transactions that are legal as per the technical rules of the system (ie, they correspond to feasible operations, and are authorised with the right digital signatures) are considered genuine and will be executed, even if fraudulent eg because of a security breach affecting either the management of the private keys or the deployed smart-contracts.
The “mostly” qualification for Ethereum above relates to the DAO incidentwhere the Ethereum chain hard-forked to undo the effects of a hack that would have lead to a massive loss of funds for DAO investors. So far this was a one-off however; for example when there was an error in the code of the Parity wallet that lead to a loss of $300m, no action was taken.
For code development, both Bitcoin and Ethereum follow a process that is in line with other open source projects. In the Bitcoin world this works using Bitcoin Improvement Proposals or BIPs whose functioning is explained in BIP2. For Ethereum the equivalent documents are the called EIPs and ERCs where the latter are requests for comment that lead to a proposal.
Ultimately adoption of a proposal in both the Bitcoin and the Ethereum world depends on hashrate-weighted miner voting. For Bitcoin this process is explained in BIP2:
A soft-fork BIP strictly requires a clear miner majority expressed by blockchain voting (eg, using BIP 9). In addition, if the economy seems willing to make a “no confidence” hard-fork (such as a change in proof-of-work algorithm), the soft-fork does not become Final for as long as such a hard-fork might have majority support, or at most three months. Soft-fork BIPs may also set additional requirements for their adoption. […]
A hard-fork BIP requires adoption from the entire Bitcoin economy […]. Adoption must be expressed by de facto usage of the hard-fork in practice (ie, not merely expressing public support, although that is a good step to establish agreement before adoption of the BIP).
Peer services BIPs should be observed to be adopted by at least 1% of public listening nodes for one month.
API/RPC and application layer BIPs must be implemented by at least two independent and compatible software applications.
For Ethereum the process is similar.
Token economics and valuation
Price and Value
One of the first thing to learn in markets is that there is a difference between a price and a value:
the (fair) value is an estimate what an asset should be worth to the potential owner who values is most highly
the price of an asset is the value at which arms-length market participants are willing to trade the asset there and then
A price is an objective number, with the caveat that for every market participant the price they see depensd on whether they want to buy or to sell, as well as the desired transaction volume. The general rule is that if someone initiates a transaction the price they’ll see when they want to buy is higher than the one they’ll see if they want to sell. Moreover the difference increases the bigger the desired volume is, up to the point where there will be no one willing to take the other side in the market, and prices disappear. In some instances — highly illiquid assets, and/or extraordinary market conditions — there are no counterparties at all whatever the volume, so prices can disappear entirely.
A value is a subjective number because it depends on modelling that in turn relies on unobservable parameters and predictions. Depending on the asset in question however often the range of “reasonable subjectivity” is limited. For example, people might have different views on where the 3 months rate will be in 3 months time and therefore ascribe different values to the corresponding forward contract. However, if rates are currently at 1% then with virtual certainty it won’t go over 10%, and there will even be a pretty strong consensus that it won’t go over 2%. So whatever the value is, it is below 10%, and almost certainly below 2%.
Price and value are related: if market participants are reasonably confident in their valuation they should be willing to buy at a price below that valuation, and sell at a price above that valuation. In practice they will only be enticed to act on differences between (objectively available) prices and (their subjective estimate of) value if the differential is big enough, with the obvious relationship between the size of the differential, their confidence in the estimate, and the volume in which they are willing to transact.
Currency prices and valuations
Having this out of the way we can now look at prices and values of regular currencies like USD, GBP and EUR. Those markets are highly liquid, so price estimates tend to be easy: at any given moment there will be plenty of buyers and sellers, and even for fairly high volumes — millions of dollars, even hundred of millions for the major currency pairs — the market prices are well defined, with very little difference between buying and selling prices (typically a fraction of a percent).
Fundamental valuation of currencies on the other hand is much harder. Some people resort to technical analysis where they are trying to predict the future exchange values as a function of how it behaved in the past. Whilst this might or might not work at any given point in time, it ultimately is a turtles-all-the-way-down analysis: the valuation obtained in that manner is not fundamentallike say an equity valuation based on expected future earnings is.
The problem with fundamental currency valuation is that there is no anchor. To give an analogy, if one wanted to determine the “exchange rate” between a bowl of pasta and an piece of bread of similar nutritional value then the monetary value should be approximately the same as well. Similarly, the value of a car or a phone should be in line with the values of all the inputs used to producing it, plus a reasonable profit margin representing things like brands, patents, or a specific expertise that other producers find hard to match. Those “valuations” are not exact, but they should certainly be in a bracket of say 2x, or 5x or at worst 10x. For a currency however there is no such fundamental anchor: whether the value of a piece of bread is the same as that of 1 Thaler, or 10, or 100, or even 100,000 does not really matter as long as the values of all assets, move in parallel and therefore the exchange ratios of real assets (eg “this piece of bread is worth half an apple”; the exchange ratios real assets is the only realobservable in a currency system) are not affected.
In principle one can even dramatically change the “value” of a currency over time without changing what happens in the real world: for example, the value of 1 piece of bread could be 1 Thaler today, 100 tomorrow, and 10 the day after, and all other real-world prices follow the same path. Whilst this requires a certain amount of book-keeping — one must adjust all prices, all deposits, all loans, and literally all contracts accordingly — this is in principle possible. In fact, it is actually done from time to time: when a currency experiences inflation and accumulates too many zeroes, sometimes those zeroes are removed. This happened for example in 1960 in France. This was a major and costly operation, but in a world with all-electronic record keeping designed for frequent currency revaluations the cost effort of performing a revaluation would be substantially less.
Inflation is essentially this process in inverse: all prices go up, at the same time wages adjust, and importantly capital stocks are also impacted via inflation-dependent interest rates. Assuming perfect inflation that is acting uniformly everywhere, and ignoring the menu cost of physically adjusting price labels, economically it does not matter whether annual inflation is 1%, or 2%, or even 10% or 100%. Even deflation does not matter, provided that it is possibly to have negative interest rates.
What this shows is that currencies are not anchored through fundamental economic processes — rather they are (most of the time) kept approximately stable by a combination of central bank magic, a general belief that central bank magic works, and a certain friction that is caused by price increase being often hard to do. In this framework, the fundamental value of a currency is driven by the expectation in the differential between nominal interest rates and inflation, ie by what is known as expectations of what is known as real interest rates.
Crypto currency prices and valuations
After this lengthy detour into the world of classic finance we are finally ready to discuss the “fair value” of crypto currencies — the prices are like for every other asset in the world determined by supply and demand. If we want to use crypto currencies as means of payment it does not really matter how much they are worth. Often people prefer the unit of account to have a purchasing power of 1$, or 1£, or 1€, each subdivided into 100 cents or pence. Alternatively people account in the basic unit, eg in the case of 1¥, or. There are currencies that have smaller denominations like the Turkish Lira, but this is usually the case because of inflation.
There is a tendency in the crypto space to associate the big number with the unit of account — 1 Bitcoin, 1 Ether etc — but this is mostly pointless, because the big denomination in crypto currencies is meaningless. The developers of Ethereum understood this, and there are numerous other denominations other than Etherthat could be used as the unit of account which is in the human-friendly 1$ region. What does somewhat matter is the fundamental unit which in case of Ethereum is the Wei, and in case of Bitcoin the Satoshi. This smallest unit limits that maximum value that a currency that is used for every day payments can attain, simply because people need cent or at least 10-cent granularity for everyday payments. The upper boundary this sets however is unrealistically high, and in any case if this was to become an issue one could always add additional decimal using a technical fix.
One key difference between crypto and fiat currencies is that crypto currencies have a constant (or deterministic) supply: we know how many bitcoins will be eventually mined (21 million BTC or 2.1e15 Satoshi). With Ethereum this is a bit more complex: the idea is to keep a certain growth but keep that growth capped at 18m Ether per year. Provided this is adhered to — it might not, because Ethereum is a bit more lenient with respect to hard forking — this means that supply eventually will be almost constant, as the exponential growth in value that currencies typically experience will eventually dwarf the at-most linear growth in Ether supply. In the short to medium term however the linear growth coefficient is relatively high (25% of initial supply), leaving ample room for growth.
In order to really have a constant supply we must assume that in a crypto world the financial system will completely restructure. In particular we need to assume that there will be no banks that can create pseudo-money, eg in terms of sight deposits that are not 100% backed by actual currency, or tradeable certificates of deposit. This is an extremely problematic assumption — the modern banking system developed the way it is for a reason — but this discussion is out of scope here, so I simply posit that everyone who wants to hold crypto currency must hold the actual crypto asset, not a near-par-yet-not-fully-backed-liability representing said crypto asset.
In a world of constant supply we can run a few numbers to come up with a “valuation”. Say we use world savings: according to the world bank, gross domestic savings are 25% of GDP. World GDP in 2014 was about $80tn in PPP terms, so world savings are $20tn, give or take. Let’s call it $21tn for simplicity, so if we have 21m bitcoin and all world savings are in bitcoin this implies a “value” of $1m per bitcoin or 1c per Satoshi. Of course those are non-interest bearing “savings” and it is hard to see why people would want to keep their money under their “digital mattress” if they could invest it into interest-bearing deposits instead, but let’s not go down that particular rabbit hole. One could also take a much narrower view and assume that BTC will be used for payments only, and that people otherwise prefer to hold their wealth in other types of assets. World payment volume in 2015 was $433bn and let’s say people want to hold about 18 days worth of payments which corresponds to $21bn. With 21m BTC this leads us to a bitcoin price of $1000.
We could amuse ourselves by refining those estimates, but in my view this is not particularly meaningful, the main reason being that we are relying on some heroic assumptions with respect to future market structure. As already alluded to above, the presence of banks would completely change the picture. Also, the fact that bitcoin is by design not supported by any central banks makes it prone to boom-and-bust cycles: people might be happy to hodl on the way up, but at one point the dynamic might turn around and when large parts of the market are trying to get out and noone is there to buy this will not be pretty. So maybe hodling everyone’s savings in bitcoin is not the most healthy asset allocation from a global financial stability point of view.
The key takeaway here is that in order to support global payments the bitcoin market cap — or arguably the market cap of all crypto currencies used in the payment space — does not have to be particularly high. Moreover, given that the technology is open source, and that for payment purposes a stable price is much preferred as to not suffer major volatility in transit, there is a decent chance that either payments will be based on stable coins, or on a rebooted version of an existing coin that replicates everything but the pre-reboot property structure, ie everyone’s balance is reset to zero. So to conclude: whilst the price of crypto assets will be driven by supply and demand, there is no good way of determining their value, and there is a good chance that every crypto currency that is not closely tied to an eco system that is actively using it as opposed to just hodling will eventually fall to zero.
Security or utility token
I am not a lawyer, and if I was a lawyer I would still not be your lawer, and this is certainly not legal advice. Having got this out of the way, for Bitcoin and Ethereum the security vs utility token question is as advanced as it gets in that space. The mainstream opinion — mainstream being defined as the mainstream outside the crypto world, because ultimately it is real-world legislators and courts who will make this decision — on Bitcoin is that it is a utility token, and probably a currency or possibly a commodity. The opinion on Ethereum is similar, but with a twist: here the utility token / currency / commodity view holds now, but there has been a time in the past where it did not hold, notably immediately after Ethereum’s ICO when the development team had just raised funds by selling Ethereum, and those funds were used to kickstart the development of the network that at that point did not yet exist.
Without claiming to be complete, let’s have a look at where people are coming from. In the US, there is the Howey Test which is a test whether or not a contract is an investment contract and therefore whether a token associated to an (explicit or implicit) contract is a security or not. The Howey test is based on a court case from 1943, notably SEC v. Howey Co which in turn refers to two laws created in the 1930s, the 1933 Securities Act and the 1934 Securities Exchange Act. There are numerous pieces written on this subject in relation to crypto assets, for example here and here.
The key criteria in the Howey test are that the underlying contract is an investment contract which is in turn is influenced by whether there is a reasonable expectation of profits and whether those profits are derived from managerial efforts of others. In the current discussion this last point is important, as current thinking seems to be that the managerial effort of othersimplies something like a centrally managed development team working on it, as opposed to a loosely associated network of peers. This last point is an argument why Bitcoin and Ethereum are not investment contracts, because they are not managed by a team, but rather exist within a decentralised community of peers. This also explains why the Ethereum would have initially been a security, because at this stage there was a clearly defined team that had executed the fund-raising exercise and whose managerial efforts would ultimately create the network that would create value for the Ethereum token holders.
The Howey test is only relevant for investments linked to the US, for example because the issuer, the investor or an intermediary is legally resident in the US. Given that the new nature of crypto assets that does not always align with the characteristics of traditional assets current legislation often only applies with difficulties and is subject to interpretation. A good overview over the regional differences in regulation has been provided for example by Clifford Chance in May 2018 here, and by Whitecase in 2017 here. Interesting regulatory guidance has been for example provided by the German BaFin, by the European EBA in 2014, by the UK FCA in 2017, by the US SEC in 2017, by the Singporean MAS in 2017, by the Canadian CAS in 2017, and by the Hong Kong SFC in 2017.
To grossly oversimplify, the approach taken by regulators seems to be somewhere between reasonable-but-cautious and cautious-bordering-on-reasonble, depending on the regulator and whom you ask. Consensus however seems to be that the big established crypto-currencies are probably something akin to currencies.
This article has been a tour-de-force introduction into currency-like crypto tokens, in particular Bitcoin and Ethereum, looking at their governance structure, their economics, and their regulation. In the upcoming articles we will look at other token designs and analyse them according to those same dimensions. Once we have done that and have built up a more detailed framework we will come back to the types of tokens discussed here for a more detailed analysis.
Stefan Loesch is a partner at LexByte. He recently published “A Guide to Financial Regulation for Fintech Entrepreneurs”. He is a serial tech entrepreneur, and he previously worked at J.P. Morgan, McKinsey & Co, and Paribas.
(c) Copyright Stefan Loesch 2018