If you have been around for a while in the blockchain space, you’ve seen the hype building up around tokenization in crypto circles, especially those concerning dApps and IDO participants. Undoubtedly, we have enough crypto literature at hand that talks in detail about the concept and constituents of tokenization. Also, almost every blockchain protocol has a whitepaper talking about the tokenomics of their native coin in pure supply and demand terms –
‘As the demand for the token increases in future, so must the price.’
‘As the circulation of the token increases, so does its value.’
‘A token’s value increases in proportion to the increase in the number of its use cases.’
And so on and so forth.
All these statements are partially true as their simplistic logic fails to take into account the associated ‘speed’ of the token, i.e., the number of times a token changes hands, which subsequently impacts the token price.
This concept is called the Velocity of the token.
A token’s velocity is an indicator of the token’s state of liquidity and the overall usage rate. Unfortunately, most crypto enthusiasts seem to be unaware of the existence of such a concept.
The concept of token velocity is highly underutilized in cryptocurrency valuation. However, the thumb rule goes like this – a coin is inversely proportional to the value of the token i.e., the longer people hold the token for, the higher the price of each token. (Nate Nead, Investment banker and principal at Deal Capital Partners LLC)
For instance, the token economy for a particular blockchain platform is $500 billion, while the yearly circulation is 10x for every token. This means the collective value of the tokens will be $50 billion. At 100x circulation, the collective worth of the tokens would be $5 billion, and at 500x, $1 billion.
For this very reason, in all probabilities, the tokens with high velocities and high Transactions Per Second (TPS) have less value. Conversely, cryptocurrencies such as BTC and ETH are valued higher for the in-built friction in the blockchain that prohibits a higher TPS. On the other hand, Litecoin has a TPS of 56, and the price of an individual LTC isn’t anywhere near BTC or ETH price.
But does this mean that high token velocity is harmful? Is zero velocity a feasible option, then? Before we find answers to these questions, let’s first understand the mathematics involved in the concept of the velocity of a token.
‘Figuring’ the Token Velocity Concept
Token velocity is the total volume of transactions in USD divided by the token’s market cap. The formula for the velocity of a token is derived from the equation of exchange:
M= Money supply
V= Velocity of money
P= Average price level of goods, and
T= The total number of economic transactions
The equation of token velocity is derived as follows:
M= Size of the Asset Base
V= Velocity of the Asset or the number of times the token changes hand every day
P= Price of the digital resource being provisioned, and
Q= Quantity of the digital resource being provisioned.
By rearranging the equation, we get:
This equation clearly brings out that the price of a token is inversely related to its velocity.
The Three Scenarios: V=0, V=1, 0<V<1
- V=0: Zero velocity for any token will result in the token getting deceased in due course of time for want of any transactional activity. One mustn’t forget that minimizing velocity cannot lead to the highest value for a token because velocity is correlated to transactional volume. A certain level of movement is necessary for a healthy economy. Think about the economic concept of depression in an economy. In such a situation, the volume of economic transactions declines rapidly, leading to the lower velocity of the currency. This lowered velocity leads to depreciation in the value of that particular currency. The same concept holds true for crypto tokens. If everyone holds the tokens, it will collapse the transaction volume due to zero demand.
- V=1: Let’s understand this with the example of a hypothetical coin ‘HairyApe’(HA). The HA tokens fuel the ticketing system in the Hairy Ape Zoo. Visitors coming to the zoo on a daily basis need to purchase the HA tokens using fiat. They would need to send the coins to the zookeeper to enter the zoo. The zookeeper quickly resells the coin for fiat. And the process goes on. No member of the visitor network wants to keep the coin after it has served the purpose, and the zookeeper doesn’t keep them either, for there is no incentive to hold the coin – all other transactions involve fiat. This arrangement helps to grow the transactional volume and, in turn, the velocity of the token. The network value remains constant, which means each token would now hold a lesser value as per the velocity equation.
- 0<V<1: Every token has a unique velocity at which its price will perform best. Deriving the optimal range for any token is a tricky task as conditions keep fluctuating, and every token serves a unique purpose. Ideally, any velocity within the too low – too high range can be a feasible velocity option for any token. There’s a need for more rigorous research on the velocity of token metrics in the coming days.
The Goldilocks Zone of Token Velocity: Use Case+Token Velocity=100
Vitalik Buterin, in his velocity concept, talks succinctly about the current crypto-economy being speculation-driven because the system suffers from positive feedback effects. If the price of a token is rising, people start holding the coin because its perceived yield is now higher than an alternative token. As speculation sets in, it drives the prices further up, and a new equilibrium is achieved. This process operates in reverse, too, deriving lower equilibrium levels as people start selling tokens with falling prices.
Fundamentally, because there is no need to hold the token, the price is only linked to speculation.
How to attain the Goldilocks zone of use case+token velocity arrangement then? The answer is pretty simple: Reducing the velocity of the tokens organically by attaching a viable spectrum of use cases to the token. The logic is thus – people will have better reasons to hold the crypto tokens rather than just speculation. Let’s discuss a few of these ways:
- By having a profit-sharing network in place, the protocol can incentivize the user to hold more tokens, thereby reducing velocity. This can be done in an arrangement where the token holders are given a share in the profits for doing work for the platform, provided they hold the required number of tokens for a specific period. As the price of the token falls, its profit share yield increases.
- The regular staking function helps reduce the velocity of the token significantly as the staked assets are frozen for a fixed tenure.
- HODLers often acquire and hold tokens for the belief that a particular cryptocurrency, such as BTC, would become a currency in the future. Building on the same belief, user trust in the stability of a token as a future alternative currency could be ‘periodized,’ i.e., a holding period may be introduced to contain the velocity of a token for a larger period of time.
- The concept of gamification in dApps is another way to make users hold tokens for a fixed tenure. This can be done by introducing a condition on the platform that users who hold the cryptocurrency for n number of days would have access to higher rewards.
Velocity will be a significant influencer in the price dynamics of any token in the long run. Most utility tokens hold no additional lure to make users hold the token beyond the utility they serve, which brings speculation into play. Minus the speculation, they hold barely any possibility for speculation. The incorporation of utility mechanisms within the protocol will not only optimize velocity but also lead to considerable price appreciation.Disclaimer: Cryptocurrency is not a legal tender and is currently unregulated. Kindly ensure that you undertake sufficient risk assessment when trading cryptocurrencies as they are often subject to high price volatility. The information provided in this section doesn't represent any investment advice or WazirX's official position. WazirX reserves the right in its sole discretion to amend or change this blog post at any time and for any reasons without prior notice.