Token Pricing in a Web3 Economy. Token pricing is more of an art than… | by Living Opera | March 2022
Token pricing is more of an art than a science. Here’s how.
There are more than 10,000 tokens in circulation, according to to Statista, but most of them probably aren’t worth much. While some tokens are blatant scams, others are more ambiguous – and others are interesting and very promising. To tell the truth, it is a disconcerting landscape.
How do you navigate to make informed decisions about what to invest in and what to think of all the stocks going on? While many have spoken of the red flags behind the scams, including my friend Henrique Centieiromuch less has been written about token pricing.
Like most activities, token pricing is more of an art than a science.
Explain Token Price Growth
Let’s start with the basics: risk and reward.
Cryptocurrencies have much more volatility than standard stock market securities. For example, Yukun Liu and Aleh Tsyvinski wrote a seminal research paper in 2020, finding that daily returns for coins are 0.46%, compared to 0.05% for stocks. Similarly, monthly returns are 20.44% for coins and 0.94% for stocks. These are glaring differences – not to mention differences in skewness and kurtosis, which tell us about the distribution.
It’s breathtaking. Even a simple chart showing the different dimensions of the distribution gives a lot of information about token volatility.
But how do we understand what drives all this variation?
Two of most often cited the factors are:
- Network usage (i.e. how many users are on the network)
- Cost of executing a transaction (i.e., what is the cost of the consensus mechanism)
Which of these factors matters the most? Interestingly, Liu and Tsyvinsky (2020) find that measures of the cost of production – such as the price of electricity or computing power – are uncorrelated with returns. “Overall, there is little evidence that IT factors are significant drivers of cryptocurrency returns.” They also find that macroeconomic and other currency fluctuations are also not significant factors in coin price growth.
“Overall, there is little evidence that IT factors are significant drivers of cryptocurrency returns.”
However, they find that network effects are important. The idea here is that the more users there are on a platform, the better off everyone is. It’s easy to see that in the case of Web2 technologies — if you’re the only one on Facebook, it’s worthless to you since you can’t communicate with others.
But this is not so clear, nor necessarily true, for Web3 technologies.
Yukun and Tsyvinski account for network effects by quantifying the number of users, active wallets, etc. They find that these variables are highly predictive of token price growth. However, this is not necessarily surprising: tokens that have more users likely have more because they also vary in many other unobserved (and positive) ways.
Indeed, a big advantage in the Web3 era is that interoperability between technologies is easier because individuals usually own the data, either explicitly or implicitly based on the consensus mechanism. This creates incentives for the formation of bridges between chains. Take, for example, Fibswapwhich offers users the ability to exchange tokens between chains.
Yukun and Tsyvinski (2020) also explore the role of investor attention to market events, concluding that it matters. That is, there are times when investors may be more watchful than others, especially around adverse events, like hacks. For example, they find that an additional one standard deviation increase in investor attention around searches for “Bitcoin hack” results in a 2% decrease in coin market returns over the next week.
(It’s no surprise that investor sentiment matters. They represent it using the ratio of positive to negative stories – positively correlated with price growth.)
However, when trying to dig deeper into the actual fundamentals behind the tokens, it’s really difficult. There is no “book value” for a token, like a standard physical asset. Here are five examples from Yukun and Tsyvinski.
- The Negative of the Cumulative Coin Market Return of the Past 100 Weeks
- User to market ratio
- (Portfolio) Address-to-market ratio
- Deal/market ratio
- Payment/market ratio
Each of these efforts strives to capture the “book value” of the crypto asset over a long period of time and scale it to the current market capitalization.
Interestingly, however, they find that these metrics do not predict coin growth. “Overall, there is a very weak relationship between future coin market returns and the current ratio of fundamental to cryptocurrency value.” Rather than taking this as proof that the fundamentals don’t matter – the fundamentals will ALWAYS matter, at least eventually, since the laws of physics cannot be circumvented – these results indicate that the way which we think about the symbolic fundamentals requires more work and that we are still largely in an “art form” in the community than a “scientific practice”.
How we think about symbolic fundamentals needs more work and that we are still largely an “art form” in the community than a “scientific practice”.
How Tokens Differ From Equity
Although tokens share many similarities with equity, they have important differences, namely the utility value they provide on the blockchain, which also adds additional layers of security depending on the consensus mechanism used by the blockchain. Let’s unpack this idea.
In a traditional startup, the founders and venture capitalists have equity. This means that decision-making remains fairly centralized. And it also means that few employees and participants feel like real shareholders.
In the Web3 economy, the notion of shareholder becomes much broader. As a result, anyone with a token can function as a shareholder of the underlying platform. In other words, when there is a transaction, token holders get a share of the overall transaction. Additionally, if the token also confers governance capabilities, token holders can vote on the development of the protocol, which means they can influence the fee structure.
Along with more widely released governance capabilities, tokens also provide unlimited ways to create utility for users. For example, in Living Opera, we’re building NFT collections around fine art that allow holders to use NFTs to access in-person concerts. Equity by itself only offers a portal to money, but utility tokens offer experience and money.
Equity by itself only offers a portal to money, but utility tokens offer experience and money.
That said, just as equity can be diluted, so can tokens. It is important to consider how a platform decides to take a more inflationary than deflationary approach to its token supply. This decision should be influenced by:
- What is the market for potential users?
- How is the composition of new users changing?
- How are the historical users?
Heuristic for pricing a token
Let’s make these ideas practical. It’s probably hard for anyone to claim that there’s an exact price for a token, but there are several questions to ask that can create a temporary valuation that functions as a benchmark.
- What is the purchase price of each token on the platform today?
- How much should the community grow, and at these different stages of growth, what is the fee structure?
- What is the discount rate and what are the comparable investments?
These are clearly not an exhaustive set of questions, but they are probing questions that you can couple with the broader context introduced throughout the article. There is still no complete evidence explaining the dispersion of token price growth, so the best we can do for now is to ask informed questions and use the initial price estimates as a guide.
This article was written by Christos A. MakridisChief Technology Officer and Head of Research at Living Opera. He is also a research affiliate with the Digital Economy Lab at Stanford University and the Chazen Institute at Columbia Business School, and holds a dual doctorate in economics and management science and engineering from Stanford University. Follow us on @living_opera!