On token economies as an evolution of multi-layered platforms

Key takeaways of today's Daily:

• Token economies have the potential to become the next evolution of multi-sided platforms.

• Token based exchange among all parties involved in token economies, is a multiplier to the overall value of the token economy. 

• Fragmentation leads to loss of the multiplier effect and sub-optimal incentives for the supply/infrastructure side.

Lately, I've been doing some thinking on token economies. In today's newsletter, I'll try to set the foundations for those thoughts as succinctly as I can. At a very high level, we can make a compelling case for token economies being the next evolution of multi-layered platforms, where multiple markets collide into a compelling ecosystem, bound by a quasi-sovereign currency for the micro-economy.

In that token economy, you have multiple parties involved, which can be distinguished in 3 main groups; the creator of the blockchain - the foundation that provides with the initial protocol as well as the follower contributors, the marketplace - where content creators and consumers meet to exchange goods and services, and the infrastructure providers - the miners, validators and other network service providers that secure the whole thing. I've taken my best shot (in the short time between last night and today) to map out how the flows in a well functioning token economy might work, and presenting you with it below;

The areas above represent the different groups and within them the different parties that bring value to the ecosystem. Notice that I have given roughly 80% of the notional value contribution (area size) to the consumers. They are the ones that eventually will bring the majority of the value ad to the ecosystem, allowing it to absorb value from the world outside it (via fiat money or other tokens - foreign investment of sorts) and ultimately enter maturity. The dark arrows represent the token flows, and the white represent the fiat flows (subject to revision). I think that an important underlying implication of those flows is that as in traditional economies, there is a multiplier effect to the value created once all activity on the ecosystem is facilitated by the native token. The more it circulates between all parties, the higher its value should be. Further, the more consumers come on the ecosystem the more fiat gets absorbed by the token economy and thus the token value inflates. Let's now briefly explore what happens when you allow fiat flows on the marketplace side of the ecosystem.

In a nutshell, the ecosystem becomes fragmented and as such the potential token value diminishes. Now does that mean that it will not be valuable at all? The answer here is probably no, as there are still flows between the infrastructure side and the creators on the marketplace side. However, those flows are smaller than in the case with consumer participation, the token value is capped and thus sub-optimal incentives are produced for the infrastructure side of the ecosystem. Ultimately, the multiplier effect never kicks in, as the main fiat bridge to the token economy is burned, and instead of a token economy, our thought experiment degrades to a platform.

In this case, the big question is whether the said token flows will produce strong enough incentives for the infrastructure side to join the platform in a meaningful way and stay there for the long haul...

The king is naked

The Diar has recently published some data on the treasury balances  of ~100 crypto projects' ICO wallets, and I thought it would be interesting to run a few analyses on the data and see what sort of insights (if any) we can elicit. Before we dive in, it's useful to note that the projects examined here only represent 5-10% of the whole. There is a multitude of other projects that are not included in this dataset - or any other publicly available dataset as far as I know. If you happen to know of a more comprehensive resource, do get in touch. Now without further ado, let's get to it;

The first figure shows the total ETH balances in the projects' wallets and how that figure has been shaped over the course of the year. The total wallet balance has decreased by 17.8%, while ETH's price has decreased by ~90% from January 2018. Putting two and two together, this amounts to a 92% decrease in the USD value of those holdings. In absolute terms, the average project's treasury, lost about $38M in potential value held, since January - see figure below.

Theis is a summary of the simple average size of a random project's treasury, accross 2018, expressed in USD terms. The dark area represents the actual value of the treasury, while the light shaded area, represents the value lost due to ETH's price depreciation. In order to highlight the degree of potential mismanagement, let's run a quick thought experiment; starting out in January 2018, project ABC has $55M in its treasury. Let's also assume that the optimal budget distribution for ABC, looks something like what's presented below. 

The above implies that ABC can hire approximately 60 professionals (engineers, ops, marketing), at Silicon Valley salaries (~$180k a year average), and keep them employed for 3 years. While I don't have concrete numbers on this, last time I checked, most projects that raised in  2017 are not on a hiring spree of that magnitude. Let's further assume that ABC actually consumed 17.8% of the $55M they raised (approx. $10M), out of which $5M is committed towards payroll (by the above assumptions). With that they hired 9 people, which sounds about right. Now, had they managed their finances optimally, they would still have enough money to hire another 50 people to help them build and ship. What the reality points to is that they can actually hire about 3 more people at SV salaries and keep them employed for 3 years. That's a tentative loss of 47 high quality professionals. Wow! Surely there was no CFO among those 9 hires that ABC went ahead with in 2018...Note that we are talking about are technology organizations that have raised money to deliver a product/network - not finance shops. As such I don't see how they can justify being long ETH.

Now let's have a quick look at how the total ETH liquidation activity relates to the price of ETH.

The correlations here are not very revealing;  there is a positive 30% correlation (relatively weak) between this month's ETH liquidation and next month's %D in the price of ETH and a negative 40% correlation between this month's ETH liquidation and this month's %D in the price of ETH . In other words, there is some correlation between projects selling ETH and the price of ETH dropping, but it seems to not be the most compelling reason why. Again, we are only tracking ~5% of all projects here, so there is a chance that the correlations would increase if we had a more complete picture.

To round off the analysis, let's take a look at how specific projects have managed their treasuries thus far.

The dark area signifies how much the project's treasury was worth in USD terms in January, while the the light area represents the % of the treasury that the project consumed (or liquidated to USD). There are a few key observations here; (i) the distribution between total value in January and amount consumed is random, (ii) the amount consumed has not impacted price overall (for most projects) - one would assume that better management would translate to the market pricing that in and (iii) some of the most hyped projects, like Tezos and Golem, have consumed none of their ETH holdings in 2018. 

There are a few conclusions that really stand out here; (i) the average project has no idea how to or low interest in managing their treasury and part of that lack of activity is most likely owing to the fact that (ii) in 2017 projects  raised way too much money, compared to what they needed to ship product. It would also appear that (iii) many of the teams succumbed to the whims of an anchoring bias, and while the USD value of their ETH holdings 2-5xed over the course of 2017, they didn't bother to liquidate some, as that was way over the amount that they initially asked for. Of course, this is something that we  already knew, but interesting to see how it has played out over time. This abundance of (notional) capital, surely did not create an optimal incentive structure for the teams. 

As the industry matures, the need for diverse skillsets is evident, as is the current lack of design and ops/finance people in crypto - despite the increasing flow. While there are many things wrong with the "real world" that crypto has the potential to improve, there are equally many things done right, that crypto would be better off adopting. 

It's raining stablecoins

The more stablecoins I see, the more conviction I get behind my original thesis of "if you don't participate in all/most, don't participate in any" - bar very high conviction in a specific version of the future. The idea here is simple; stablecoins are exceptionally risky business. Besides the fact that the architectures of stablecoins (not dollar backed coins, like the ones launched by Gemini and Paxos) are very likely to prove fickle and in the end faulty - Preston Byrne lays down some great arguments here, and that the value capture mechanisms that connect the stablecoin with the governance token (which is what the investor would hold) are oftentimes murky, the stablecoin market is highly competitive with very low barriers to entry. Since early-May, when the first conversation around stablecoins was had with me on board, the number of stablecoins launched or to-be-launched has more than doubled (check the stablecoinindex.com from Multicoin's Miles Snider for a comprehensive list of those projects). Effectively then, with every new project launched - or even announced, the future value of all others, bar the winner perhaps, is eroded. And I believe that this will be a winner takes most market.

Let's take the current de-facto market leader, Tether, for example. Many alternative models have come to challenge for Tether's market share in the year past, yet none are succeeding thus far. What is truly astounding here, is that Tether hasn't been trying very hard to keep their image polished, with a fully recognized audit still pending and many scathing op-eds and even outright accusations about their model being thrown left and right. Then again, when you totally dominate a market (as evidenced by the charts below), why would you care? What I suspect Tether really has going for it, is first mover advantage and with that, "eyeballs".

What the dot com era taught the world - drawing a parallel to yesterday's analogy of the current market state being similar to the post dot com bubble era - was that attention can be converted into revenue and thus claiming attention real estate first in an emerging industry/market, can really make or break your business. You could very well argue, that Tether's monopoly is one implosion away from deconstruction. Nevertheless, as time passes, we cannot discount the fact that the first mover amasses more resources, gets smarter, and prepares for the next stage of evolution. Without perfect information about what happens behind closed doors, we cannot discount how the Tether camp is evolving in structuring the dollar backed coin's offering in response to emerging competition.

However, for the sake of the example, let's examine some scenarios in which Tether is dethroned and who might take its place. Without having extensively scrutinized the subject, there are two scenarios that jump most prominently to mind; (i) Tether implodes after a reveal that only 10% of its value is backed by actual dollars locked up in a vault and (ii) a wall of institutional money (tens of billions) enters the market and flocks to the most transparent and regulated stablecoin, in which case Tether's market cap remaining at $2-$3B will deem it sidelined as a market follower. In both cases, it is highly likely that after a brief period of reshuffling, there will be a new stablecoin king that will devour over 95% of the market, with the main reason being attention and the second most important being interoperability between exchanges and other services, where a holder can move their stablecoin to store or spend. I suspect both of those reasons power the dollar as the global reserve currency and gold as the most widely accepted store of value. Probably the same reasons why in traditional markets, we don't deal with USD #1, USD #2 all the way down to USD #99; rather just USD.

With that in mind, if I were to make a prediction on who would claim the top spot in case either of the two scenarios above came to pass, I would be inclined to say that it would be the institutionally backed, fully regulated alternative. The reason why is that if we assume that as the market matures, more institutions join the dance, those very institutions would much rather entrust their capital to such a product, rather than an unproven technological solution. As those institutions then would populate the new ecosystem, the rest of the market would follow fairly quickly - due to positive signalling, crowning a new king and leaving the rest in the dust.

In any case, the announcement of Gemini Dollar and Paxos Standard is a positive development and a sign that the crypto market is making decisive steps to maturity.