Token Velocity Explained
Most token white papers proudly state their token supply is capped and conclude that if supply is fixed, then as demand increases so too will price.
This concept is flawed.
Many, if not most projects have utility tokens that a user only needs to hold for a few seconds. In fact as UI’s improve so “normal” people can use blockchain services, it’s quite likely users will not even need to know about the existence of an underlying token. Here’s an example.
I buy a concert ticket from a vendor that is blockchain enabled. I pay with my credit card, that fiat payment will be instantly converted, behind the scenes into a token, ticket is purchased, organizer gets tokens and instantly converts back into fiat. No one needs to hold the token for more than a few seconds. This will all be automated. The guys at 0x Project are working on it.
When those tokens are in play, I call that being in the pipe. In the example above, as blockchain infrastructure improves, time spent in the pipe will be shorter and shorter down to fractions of a second.
Now for many of these projects, token price is irrelevant for the mechanism to work as intended. All that is required is liquidity and that will be provided by market makers who live off a tiny spread, but hopefully, for them, with massive volumes.
Now in this example, where the token is only held for a very short time, we call this a high velocity token. High velocity is not good.
So let’s define velocity:
Velocity = Total Transaction Volume / Average Network Value
Average Network Value = Total Transaction Volume / Velocity
As you can see from this equation, the higher the velocity, the lower average network value.
Trading volume is a little tricky to calculate as it should include volume that occurs on exchanges plus any over-the-counter trades plus actual usage of the platform.
Although high velocity is bad you do need some velocity. If, over the course of a year, no one buys or sells a token then it has a velocity of 0. This lack of liquidity would destroy the asset price. Much like a stock with very low trading volume.
In the case of a proprietary payment token that nobody wants to hold, velocity will grow with transaction volume. If that’s the case you can see from the equation that network value will end up remaining somewhat constant or at the least it would not be very sensitive to a volume increase.
A majority of utility tokens suffer from this problem.
The key is therefore to find projects that have cleverly inserted ways into their protocol ecosystem, that slow velocity down. Here are some ways that might be achieved.
Profit Sharing. If a token yields a profit or dividend then its worth holding the asset. Even better, if the asset price falls the yield increases until investors buy the asset for its juicy yield and end up driving up the price.
Problem here is once your token starts paying dividends you get into the regulatory issues of looking a lot like a security.
Build staking functions into the protocol that lock up the asset. Another option is to build token staking into the ecosystem. This could include proof-of-stake mechanisms for achieving network-layer consensus or participation in governance and so on.
Token burning. Some protocols employ a token burn or deflationary strategy. I’m not a big fan of this strategy unless its baked into the ecosystem in a way that makes sense, outside of price management.
Gamification. Some protocols have been quite clever at giving users extra benefits when they hold tokens. SocialMedia.Market, the influencer platform, lets token holders participate in dispute resolutions where they can earn more tokens.
Reserve currency. Finally becoming a reserve currency certainly does the trick but by definition thats limited to the very few.
Most utility tokens don’t provide a rich enough token ecosystem that naturally weaves itself into the fabric of the protocol to slow down velocity. As you evaluate your token investment opportunities, you would be well served to focus on velocity as a major contributor to long term token appreciation. In conclusion, velocity is one of the key levers that will influence long-term, non-speculative value.