17 Feb Token Velocity — Why it Matters for Initial Coin Offerings (ICOs)
Token velocity is a calculated measurement that is necessary to understand before successfully launching an Initial Coin Offering (ICO) or Token Generation Event (TGE). Velocity influences the long-term, non-speculative value of a token. Therefore, we must understand how velocity works, including the calculations and math behind token applications. By understanding key elements of token velocity token issuers are better prepared to implement strategies to manipulate token velocity for a healthy, long-term utility token marketplace.
What are tokens? Tokens vs. Coins (1,2,6,7)
The terms “coin” and “token” are often interchangeably used, despite their fundamental differences. A crypto coin, such as Bitcoin, Ethereum, Ripple, or Waves, possess its own independent distributed ledger or blockchain. Cryptocurrencies hold both similarities and many differences to their fiat brothers. Independently created cryptocoinage have limited functionality compared to tokens. Tokens have a much wider functionality.
Generating a token does not require creating a blockchain from scratch. In a much easier process, firms can follow a standard template on the blockchain to create their own tokens. Programmable computer codes called smart contacts allow tokens to operate without the need of third parties.
Just as a private company can go public and offer an Initial Price Offering (IPO), tokens can be created and distributed to the public through an Initial Coin Offering (ICO).
To create a successful token offering, there must be a reason for token holders to maintain token ownership for an extended period. Protocol designers must incorporate mechanisms to encourage token holding, not just usage. In other words, tokens with low velocity (we’ll look further into velocity below) will create true value. On the other hand, tokens with high velocity and high speculation both destroy long-term appreciation and elevate risk for token holders.
Most tokens offer a ‘get rich quick’ scheme where there is an increase or inflation at the beginning of the TGE, but as people sell their tokens into the token event, there is a bubble and the token loses value. But tokens that allow investors to vest for a certain period of time have low velocity, which decreases volatility and risk. In addition, tokens created under a typical exemption (e.g. Reg D, Reg A or Reg S) likely provide natural hold periods per Rule 144—creating an even better scenario for tampered velocity of the issued tokens.
The Math Behind Token Velocity (1,2,5)
The formula for token velocity is simple:
Velocity = Total Transactional Volume / Average Network Volume
Average Network Volume = Total Transaction Volume / Velocity
Token velocity is total transaction value divided by the average network value. This means the average network value is equal to the velocity divided by the total transaction value. Velocity is typically measured annually. If transactions are absent, then the token lacks liquidity and its velocity equals zero. Consequently, the asset will trade at a discounted rate. There must be some minimal velocity for a token to reach its full value.
With tokens that people do not hold, velocity increases linearly with transactional value. Even if transaction value grows tremendously, network value could remain unchanged. ICO and TGE developers should incorporate mechanisms that encourage holding to appreciate the long-term function of the token.
James Kilroe explains the math of token velocity as follows:
Burniske definition: MV=PQ
Where: M= size of the asset base, V= velocity of the asset (the number of times that an average coin changes hands every day), P= price of the digital resource being provisioned, Q= quantity of the digital resource being provisioned
Using the Burniske definition, valuations typically solve for M by rearranging the equation: M=PQ/V
In order to solve for token price, one must calculate M, by working out the size of the market in dollars (PQ), divide it by the velocity (V) and then divide M by the number of coins in supply.
Buterin definition: MC=TH
Where: M= total money supply (or total number of coins), C= price of the currency (or 1/P, with P being price level), T= transaction volume (the economic value of transactions per time), H= 1/V (the time that a user holds a coin before using it to make a transaction)
Using the Buterin definition, to solve for the token price, one must solve for C:
In either definition, one can see that the velocity of the 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. This is intuitive, because if the transactional activity of an economy is $100 billion (for the year) and coins circulate 10 times each over the course of the year, then the collective value of the coins is $10 billion. If they circulate 100 times, then the collective coins are worth $1 billion. Thus, understanding and calculating the velocity in any token economy is extremely important.
Why does token velocity matter in a token offering? (1,2)
Velocity is the speed at which transactions take place. Karn tokens have a high velocity because the cycle of buying and selling Karn tokens happens within seconds. Token velocity is important because it shows investors how volatile their money is in their choice cryptocurrency. Applying the laws of the market, a cryptocurrency can gain inflationary value. If the tokens increase at a rapid rate, investors will likely sell their tokens for cash. This causes the token’s value in the market to drop. Even though the market changes quickly in this example, the intrinsic value of the token remains the same. Token holders that participate in long-term investing will create less volatility and an increase in actual token value.
What are ways to slow token velocity? Why is this important? (1,2)
Here are a few methods for slowing token velocity:
- Introduce a profit-share (or buy-and burn) mechanism Creating a stock-bonus plan for employers. “If the market price of an asset decreases, its yield increases. If yield becomes too high, market participants seeking yield will buy and hold the asset, increasing price and reducing velocity” Buy and hold would mean that the value increases, and the volume of transactions would decrease.
- Build Staking functions into the protocol that lock up the asset Staking to achieve node consensus and to lock up a high percentage of tokens.
Proof-of-stake (PoS) mechanisms for achieving network-layer consensus: Proof-of-stake is an algorithm by which cryptocurrency blockchain network aims to achieve distributed consensus. In PoS-based cryptocurrencies, the creator of the next block is chosen via various combinations of random selection and wealth or age. These are the stakes.
Node Consensus: Consensus Nodes are elected by NEO holders and vote on validity of transactions. This node participates in the consensus activity. During a consensus activity, consensus nodes take turns assuming the roles of speaker and delegates.
- Balanced burn-and-mint mechanics This method addresses the problem of deflationary currencies and unnecessary volatility due to excessive speculation. There should be a linear relationship between the usage of protocol and price.
Example: Factom’s protocol mints 73,000 new tokens each month. If more than 73,000 are used, supply goes down and price goes up. If less than 73,000 are used, supply goes up and price goes down. There is a direct correlation. Factom works because it contains its own chain.
- Gamification to encourage holding Create incentives for customers to hold on to tokens. Customers can be prioritized based on the number of tokens they hold and the number of days the tokens are held.
Example: YouNow – live video tipping system. The longer they hold on to tokens, the higher their content is ranked. They try to hold on to more to create more viewers and tips.
- Become a store of value When people see real value in a token, they are more willing to hold on to excess tokens for longer rather than selling them. This one is the most difficult to achieve.
Token velocity plays a key role in the success of a TGE or ICO. The goal is to have long-term, healthy growth in token value. Seeing value in an ICO is looking at the token velocity and the duration investors will be able to hold the tokens. As stated above, understanding and calculating the velocity in any token economy is a critical factor in assessing long term sustainability and risk of any given token project.
Wesley Bosco, Austin Stradling and Colin Cole contributed to this report.