This is the second part of a two-part article. In the first part we explained what tokens and token economics are. We also discussed some legal issues and the relevance for lawyers. In this second part, we look at the value of tokens. Tokens are digital assets. Assets have a value. How is that value assessed? What are the factors in determining the value of tokens? And what are the most common value models for digital tokens?
Factors determining the value of tokens
The value of tokens is determined by a variety of factors, including supply and demand, market sentiment, and the underlying technology. Let’s have a look at those.
Supply and Demand: Like any other asset, the value of tokens is determined by the balance of supply and demand. If there is a high demand for a particular token and a limited supply, the price of the token will go up. Conversely, if there is a low demand and a high supply, the price of the token will go down.
Market Sentiment: The value of tokens is also influenced by market sentiment. If investors believe that a particular token has a strong future, they will be more likely to buy it, increasing its value. Conversely, if there are concerns about the future of a token, investors may sell their holdings, causing the value to drop.
Underlying Technology: The underlying technology of a token can also influence its value. If a token is built on a strong, reliable blockchain network, it may be seen as more valuable than a token built on a less secure network. Similarly, if a new technology is more environmentally friendly than its competitors, it will be considered more valuable.
The value of a token is largely determined by the token model. The term token model refers to the design and structure of a token, and how these aim to create a self-sustaining ecosystem that incentivizes network participation and rewards valuable contributions. These models typically include elements such as token distribution, inflation rate, governance mechanisms, and utility functions, among others.
There are several different value models of tokens, each with its own unique characteristics and potential benefits. But before we explain those, it is good to first familiarize ourselves with some of the terminology regarding these characteristics.
A hard cap is the maximum amount of funds that a token sale or initial coin offering (ICO) can raise. Once this cap is reached, no more tokens will be sold or created. A soft cap, on the other hand, is a lower funding threshold that must be met for the project to proceed. If the soft cap is not met, the project may be cancelled or delayed, and investors may receive a refund.
The total token supply is the total number of tokens that will ever be created for a given project. This includes both tokens that have already been distributed and tokens that have not yet been released. The circulating supply, on the other hand, is the number of tokens that are currently in circulation and available for trading. This excludes tokens that are locked up or held by the project team, for example.
The market cap, short for market capitalization, is the total value of all tokens in circulation. It is calculated by multiplying the current price of a token by the circulating supply of tokens. Market cap can be used as an indicator of the overall size and success of a project and is often used to compare different projects within the same industry or sector.
Token value models
There are basically four common types of token value models:
Deflationary tokens are designed to decrease in supply over time, either through burning tokens or reducing the rate of token issuance. In other words, there is a hard cap on the number of tokens created. which acts as a deflationary mechanism as demand increases over time, but supply does not. This creates scarcity and can lead to a rise in the value of the token as demand outstrips supply. The goal is to incentivize long-term holding of the token and discourage short-term speculation. However, there is a risk that the decreasing supply may make the token less attractive for use in transactions, reducing its utility. Examples of deflationary tokens are Bitcoin (BTC), Litecoin (LTC), and Bitcoin Cash (BCH).
Inflationary tokens are the opposite of deflationary tokens. They are designed to increase in supply over time, either through regular token issuance or through other mechanisms such as staking rewards. The goal is to encourage spending and discourage hoarding, as the value of the token may decrease over time due to increased supply. This can also incentivize network participation and development, as new tokens are issued to those who contribute to the network. In this model, there is no hard cap on the number of tokens created. Instead, there are various iterations of the tokens being issued. Some token issuers limit token creation to a yearly basis, while others stick to a set schedule, and some adjust the supply, based on demand data. Examples of inflationary tokens are Ethereum (ETH), Polkadot (DOT), and Solana (SOL).
In a dual-tokens model, there are two tokens: one that serves as a utility token for network access or use, and another that serves as a store of value or governance token. This can help separate the utility and speculative aspects of the token, and potentially provide more stable value for both. The utility token can be inflationary or deflationary depending on the specific model, while the store of value/governance token is typically designed to be more stable. Examples of this are VeChain (VET), VeChain Thor Energy (VTHO), NEO, GAS, Ontology Coin (ONT), Ontology Gas (ONG)
Asset-backed tokens are tokens that are backed by a physical asset or reserve, such as gold or fiat currency. This provides a degree of stability and confidence in the token’s value, as it is tied to a tangible asset. However, the value of the token may be limited by the value of the underlying asset, and there may be challenges in ensuring the proper reserve ratio and maintaining transparency. Examples are Pax Gold (PAXG), which is linked to the price of gold, as well as Tether (USDT) and USD Coin (USDC), which are both linked to the US Dollar.
It’s worth noting that these different value models are not mutually exclusive, and hybrid models may also be used to achieve specific goals. Ultimately, the choice of value model depends on the specific use case and goals of the token and its associated network. Overall, the deflationary utility token model is the most popular, with the inflationary token model in second place.
The design of token models plays a crucial role in determining the value of tokens within a given ecosystem. A well-designed token model can create a strong network effect and incentivize various stakeholders to participate in the network. This, in turn, can increase the demand for tokens.
For example, a token with a deflationary supply mechanism may see an increase in its value as the supply decreases over time. Similarly, a token with strong governance mechanisms that allow token holders to have a say in the network’s decision-making process may be more attractive to investors and users, increasing the demand for tokens.
On the other hand, poorly designed token models may lead to a lack of adoption, low network activity, and a decrease in the token’s value. For example, a token with excessive inflation or high transaction fees may discourage users from participating in the network, leading to a decrease in demand and a corresponding decrease in the token’s value.
The value of tokens is determined by a variety of factors, including supply and demand, market sentiment, and the underlying technology. Overall, the value of tokens is closely tied to the token model’s ability to incentivize network participation, promote adoption, and balance the supply and demand dynamics within the network. The success of a token model depends on its ability to provide clear value propositions, promote adoption and usage, and maintain a healthy balance between supply and demand dynamics.