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Why Token Velocity Matters

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These are still the early days in understanding token based crypto-economies. Whilst many of the principles of economics used aren’t new; the ability to hardcode rules into a system offer unparalleled opportunities to experiment with behavioural economics and game theory to try to make markets behave in certain ways.

At Outlier Ventures, we work with our partners at Imperial College London’s Business School and computer science department, to assist the open source projects we invest in, to design sustainable, efficient and orderly digital economies. This is the first in a series of regular posts where I, as Head of Cryptoeconomics, and the wider Outlier team will share with you some of the principles and learnings from this work.

Whether it’s designing token economies for implementation or evaluating cryptoassets for investment, token velocity is a key factor in guiding our thinking on the future value of tokens. This post aims to introduce token velocity as a principle and discuss some of its implications for economic design and valuation.

The Basics: MV = PT

Today, most tokens aim to represent a network-based medium of exchange. This means a network is created whereby sellers can offer digital services to buyers interested in acquiring them. A token is issued as a means of value in this digital economy and is required in order to facilitate the exchange of these services.

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To begin understanding token velocity, we must refer to traditional economic concepts like the velocity of money and the equation of exchange:

The velocity of money, is the number of times money is exchanged from one transaction to another over a period of time, or in other words, how often money is turned over. This is important because velocity is useful for assessing the health of an economy.

The equation of exchange, is used to demonstrate the relationship between money supply, velocity of money, price levels and an index of real expenditures on newly produced goods and services. It is expressed as:

MV = PT

where:

M = money supply

V = velocity of money

P = average price level of goods

T = index of expenditures (such as the total number of economic transactions) Note: As this is usually difficult to measure. it’s often substituted by Y=national income.

Connecting Token Velocity & Token Value

Likewise, for token economies, the velocity of a token offers us insight into the economic health of a network. Token velocity can inform the level of hoarding within a system, speculative trading, utility value of a token and the broad efficiency of the digital economy. For cryptoeconomies, token velocity can be determined through modifications of the equation of exchange (courtesy of Chris Burniske and Vitalik Buterin respectively).

Burniske has applied the equation of exchange for cryptoassets as such:

MV = PQ

where:

M = size of the asset base,

V = velocity of the asset

P = price of the digital resource being provisioned,

Q = quantity of the digital resource being provisioned

The token value would be determined by solving for M and dividing by the number of tokens in supply.

Meanwhile, Vitalik has his alternate modification of the equation of exchange for medium of exchange tokens:

MC = TH

Where:

M = total money supply (or total number of tokens),

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 token before using it to make a transaction)

To determine token value, one must solve for C in this case.

The implied takeaway from these different equations is that token velocity has an inverse relationship with the value of a token. More succinctly, the longer participants hold onto their tokens, the higher the price of their tokens.

Layered Economics

When examining token economies, we essentially look for the merged optimization of two sets of economics:

  • ledger layer economics
  • market layer economics

As the market exchanges digital services, the ledger layer is where key attributes of each transaction need to be verified and simple contracts need to be executed. The main goal of the ledger layer is to drive costs of verification to as low a level as possible, ideally as near to costless as possible. Cost reduction and disintermediation is the primary advantage of blockchain based services over traditional intermediary or audit based economies where substantial value is lost in the process. Common examples of where a token is used to facilitate low cost transactions for digital resources in payments, computation, and data storage are Bitcoin, Ethereum and Filecoin, respectively. We can associate this layer of economics more closely to protocol tokens.

Source: ‘Some Simple Economics of the Blockchain’ – https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2874598

Christian Catalini, MIT & Joshua Gans, University of Toronto – Rotman School of Management

At the market layer, economics are designed to realign the distribution of value to achieve a more efficient market that also leverages powerful network effects. The token is used as an incentive or disincentive to participants to behave both in their best interest and the greater good of the economy at large. This layer is generally exhibited as an app token.

An example of market layer economics is illustrated below by the Basic Attention Token (BAT), where users, publishers and advertisers are re-aligned to disintermediate middlemen, eliminate the economic waste and generate new value. In this blockchain based digital advertising market, the Brave browser blocks ads to the user and records where users spend their time.

Meanwhile, BAT is used as a unit of account between advertisers, publishers and users and to directly measure, exchange and verify attention.

The result is a system that is transparent and efficient. Publishers generate more revenue because middlemen are removed. Users that opt in receive fewer, better targeted ads (with far less malware). Lastly, advertisers receive better data for their spend.

Basic Attention Token (BAT)

Basic Attention Token: https://basicattentiontoken.org/BasicAttentionTokenWhitePaper-4.pdf

Economic Implications of Token Velocity

Velocity can have significant impact on the economics layers of a token economy, based on  the following:

Ledger Performance: If a ledger is suboptimal in facilitating exchange because of low throughput, latency, etc, this can cause service providers to become unmotivated to leverage  the ledger for their offerings. Such problems can be particularly exacerbated, when transaction volumes are high but token holders are also hoarding for speculative purposes. This results in transaction verifiers suffering by being required to  complete more costly work at a slower pace, thereby limiting their economic gains. We’ve seen the Bitcoin network attempting to deal with these important scalability issues for some time now. As shown below, Bitcoin hasn’t really

Source: http://woobull.com/determining-the-ideal-block-size-for-bitcoin-a-story-of-three-graphs/

Speculative Holding: When too many tokens are held by purely speculative investors (otherwise known as Hodlers), tokens generally do not get utilized within the market for their designed purpose. Instead, investors are simply waiting for the right time to sell off tokens for profits, and this causes low velocity in the system. Furthermore, speculative holding affects the system’s throughput, latency, etc putting pressures on the ledger layer as less tokens are available to facilitate transactions.

Note: Early on, a healthy amount of speculation is often advantageous in generating network effects and rewarding early adopters and contributors. In fact, what makes token economies so ripe with potential, is that they combine the two most powerful examples of network effects, financial exchanges and software, within a new digital economy.

New Equilibrium: As token economies progress or regress, new price equilibriums are set through behavioral feedback loops that are ultimately driven by token price itself. As Ethereum’s Vitalik points out, when the token price starts to increase, crypto traders begin to acquire and hold tokens based on expected returns, which are assumed to be higher than other cryptoassets. This increases the price of token and often closely resembles Elliott’s Wave Theory (a form of technical analysis) in setting a new token price equilibrium.

Provided the ledger layer can efficiently verify transactions, a price increase could also greatly benefit the market layer economics by making fees cheaper and further stimulating the economy. Both of the above positive feedback loops create a new token price equilibrium.

This chart of Monero illustrates new equilibriums in July ‘17 and again in October ‘17.

Source: https://coinmarketcap.com/currencies/monero/

Conversely, if the token price starts to decline, the token suffers as an opportunity cost to other seemingly more attractive tokens investments. As the sell off continues, the further the token price decreases, this time suffering from a negative feedback loop.

Stagnant Utility: Early adopters of a token will often hold the belief that a given decentralized market will be able to offer unique value propositions for digital services yet to be developed. If these services are too limited, tokens will be exchanged at a substandard velocity. Although the equations above suggest lower velocity would increase the value of the token, in this case, declining transaction volumes will lead to economic collapse and token price crash.

Another scenario derived from lack of utility, is when a token serves as an optimal medium of exchange for a dominant, high-demand service between a buyer and seller, where neither party has any motivation or incentive to keep the token for further use. Instead, opting to convert into a more desirable speculative or usable currency (like fiat). In these cases, velocity of a token would be high and drive down the price of the token, which further reinforces this behavior.

Featured image courtesy of Shutterstock.

Important: Never invest (trade with) money you can't afford to comfortably lose. Always do your own research and due diligence before placing a trade. Read our Terms & Conditions here. Trade recommendations and analysis are written by our analysts which might have different opinions. Read my 6 Golden Steps to Financial Freedom here. Best regards, Jonas Borchgrevink.

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Understanding the Lightning Network: Where We Stand

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The scaling of bitcoin’s network has long been a source of strife among supporters and detractors alike. As the network gained momentum over the last few years, users have seen both the transaction fees and wait times increase significantly.

Other cryptocurrencies have spawned based on this weakness, but bitcoin’s development community is hard at work on the scalability problem. The most promising project at the moment is the Lightning Network.

The Shortcomings of Bitcoin

Bitcoin’s original promise of being able to create a trustless network that enabled immutable financial transactions is still true to this day. With the implementation of SegWit on August 24th, 2017, it was hoped that the issues could be solved by finding a roundabout way to increase the block size. However, the protocol has not been widely adopted, and as such, a new solution is required.

This is where the need for the Lightning Network arose from, and it has been in development since 2015. The simplest way to understand the network is that it helps manage bitcoin transactions without executing them directly on the Bitcoin blockchain.

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The Basics of the Technology

The core idea behind the Lightning Network is that you can create small “bidirectional payment channels” that act as a running tab between two accounts. The smart contracts determine how much is owed to who, but none of this is stored directly on the blockchain until a payment is rendered. Basically, it is a running tab system that allows for microtransactions. Allocations are made between parties off-blockchain, with all the confidence of performing commerce on-blockchain.

Multi-signature wallets are the connecting force that acts as a running tab in a safety deposit box for the two parties. Their cryptocurrency sits in the wallet and is debited and credited according to the pre-existing agreement.

The result is that all of the different payment channels connect multi-sig wallets to create a network of two-party ledger entries. This means you don’t need to have a wallet between every duo that wishes to do transfer money. The connections can occur across a network of users with the same effect.

The Benefits of Lightning

The most salient benefit of the Lightning Network are the faster payments at a lower cost. The presence of instant payments will increase the usability of the entire network, and the smart contracts used will still be secure enough to prevent tampering.

As we mentioned before, the Bitcoin network was previously limited by its lack of scalability, so on a meta-level, the lightning network is enabling the network to continue its expansion.

The presence of the Lightning Network will also enable cross blockchain transactions (also known as atomic swaps), even with heterogeneous blockchain consensus rules. The enablement of these instant transactions between blockchains will eliminate the need for third party custodians and change the way the networks interact.

Where We Are Now

In order for Bitcoin to be a viable payment option in the future, something like the lightning network is absolutely essential. Scaling requires the ability for small payments to be made quickly, otherwise it will never be feasible to make everyday purchases like coffee or lunch with bitcoin.

Looking at all the potential benefits listed above, it is clear that the lightning network will have a drastic effect not only on the Bitcoin network, but the entire cryptocurrency ecosystem. As such, the protocol is not only being developed for the Bitcoin network, but many other of the top cryptocurrencies (Litecoin, Stellar, zcash, Ethereum, and Ripple). The test results are starting to come in, however, none of the implementations are ready for launch yet. Lightning Labs has released a beta version, but before this technology can change the industry, a lot more work must be done.

Featured image courtesy of Shutterstock. 

Important: Never invest (trade with) money you can't afford to comfortably lose. Always do your own research and due diligence before placing a trade. Read our Terms & Conditions here. Trade recommendations and analysis are written by our analysts which might have different opinions. Read my 6 Golden Steps to Financial Freedom here. Best regards, Jonas Borchgrevink.

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What is Proof of Stake?

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Newbies to the cryptocurrency space often struggle to understand how the mining mechanism works. The idea of having a cryptographic algorithm that mints new coins to reward those who help maintain the blockchain isn’t exactly a natural one, and a long explanation is usually required.

But once this group understands how the traditional proof of work theorem functions, they often find out that there are algorithms different than the one implemented by Satoshi in the beginning.

Where Proof of Work Falls Short

News stories keep surfacing about the growing energy requirements of networks using proof of work algorithms. The enforced scarcity of coins means that as more miners join the network, the amount of computation required continues to increase. Not only is this not sustainable in the future, but it also prices out smaller mining pools that don’t have the capital required, leaving a market structure similar to the oligopoly of the banking industry.

Additionally, from an economic standpoint, the proof of work theorem is vulnerable to the tragedy of the commons. This is an economic scenario where users are incentivized to act in accordance with what is best for them, rather than what is best for the group. Profitability on mining coins like Bitcoin will begin to fall, and that will drive miners out of the market, hurting the whole network.

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Proof of Stake as an Alternative

So if proof of work rewards you for the amount of work you do, proof of stake will reward you for the amount of coins you hold. You will mine coins in proportion to the amount you hold, which is much like the traditional interest rate structure.

Our previously described tragedy of the commons issue is solved, because people now have reason to continue holding the coin and are rewarded for it. Additionally, the centralization risks are minimized, as those with the most mining power or capital are no longer in control.

51% attacks are hardly a worry on the Bitcoin network, because you’d need to gain access to more than 51% of the computing power of the network. However, with PoS there is an even smaller risk because of how expensive it would be to buy 51% of a coin, only to devalue it.

Many Cryptocurrencies Using It

Since the incentives are different, proof of stake algorithms essentially change the entire structure of the market for a cryptocurrency. The fact you can earn coins just by holding cryptocurrency would be very appealing as an alternative to using tons of electricity.

Dash, or digital cash, may be the best known cryptocurrency using PoS, but NEO, PIVX, and many more are currently using it. The incentives change when you use these coins, because of all the additional benefits of just holding them. Often the only way to gain this interest is by joining a masternode or having a significant amount of coins yourself, but it is still something worth looking into.

Finally, we are finally starting to see larger cryptocurrencies like Ethereum considering a move to a hybrid algorithm that uses proof of stake as well, it is clear the consensus method will finally get tested at scale.

The Risks of PoS

As with any solution, there are risks involved with the potential implementation of proof of stake algorithms. The biggest risk inherent in a proof of stake system is that the bad actors aren’t pruned out in the same way as with a proof of work system. They can continue to collect “interest” while they vote for “invalid” blocks, and not be harmed in any way. For the proof of stake system to work, this problem will eventually need to be solved, but at the same time, it shows a lot of potential.

Featured image courtesy of Shutterstock. 

Important: Never invest (trade with) money you can't afford to comfortably lose. Always do your own research and due diligence before placing a trade. Read our Terms & Conditions here. Trade recommendations and analysis are written by our analysts which might have different opinions. Read my 6 Golden Steps to Financial Freedom here. Best regards, Jonas Borchgrevink.

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How to Convert Your Cryptocurrency Back to Fiat Currency

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It is possible that at some point in your cryptocurrency investing journey, you feel the need to sell off some of your crypto. Most of the time, this means you are just converting it back into the USD of cryptocurrency, bitcoin, but you could also be trying to get your money out of cryptocurrency entirely.

If your goal is to convert back into fiat currency, then there are a few paths you can take. As you might remember when you were first putting your money into cryptocurrency, it isn’t nearly as simple as using a regular brokerage account, but it is getting easier.

Simplest Possible Method

This sort of goes without saying, but if you did acquire your cryptocurrency on an exchange that allows for fiat deposits, you are likely going to be able to convert your money back into fiat with that same exchange. Exchanges known to do this are Gemini, Coinbase, Kraken, and Coinmama, although there are many others that do and it is worth checking yourself.

Exchanges are generally motivated to increase their revenue, and as a result, they tend to have fees set for withdrawal. Not only does this make them money when you withdraw your money, but it also makes it more likely you will keep your money in the exchange and continue trade it, which will also make them more money.

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The final thing you should realize here are that the exchanges may put actual limits on the amount you can withdraw or the time period you must wait before withdrawing. Both of these serve to the same effect as high withdrawal fees, and help them control their liquidity in a way very similar to a bank.

Using Services and Vendors

It is possible you have already moved your money to a separate hardware or software wallet, in which case, it might not make sense to move it back to an exchange, just to pay fees on the withdrawal. There are other ways of getting your cryptocurrency back into fiat, and some of them work out to be quite a bit cheaper.

In fact, websites like LocalBitcoins.com make it possible you to actually sell your cryptocurrency at a premium because of the extra effort. LocalBitcoins does take a fee, but it still works out quite nicely for the seller in the end.

Another option you may find appealing is using your money to directly pay for goods or services. There are an increasing amount of companies that accept cryptocurrency, and this saves you a lot of hassle, as it is working very similarly to LocalBitcoins.com. You are bartering with each other rather than have a third party act as market maker, and the costs are reduced as a result.

Similar to this is the idea of using your cryptocurrency to purchase a prepaid debit card. Services like Monaco and Tenx are making this easier than ever, and it minimized the number of times your money needs to change hands before it is spent.

What to Do About Your Altcoins

If you are trying to convert your altcoins back into cryptocurrency, you will have one extra step. Since most altcoins transact on a different exchange than those that convert into fiat, you will need to sell your altcoin for a more well-known cryptocurrency, and then convert it to fiat.

Generally, users choose to do this using Ethereum, because of the significantly lower network fee. You would sell your altcoin for Ethereum, transfer that Ethereum to your fiat exchange, and then sell back to your fiat currency.

No matter why you’re choosing to convert your crypto back to fiat, it is even nice to know how you would if you were in a pinch or were worried about potential crashes. The best way to think of it is having an escape plan, just in case.

Featured image courtesy of Shutterstock.

Important: Never invest (trade with) money you can't afford to comfortably lose. Always do your own research and due diligence before placing a trade. Read our Terms & Conditions here. Trade recommendations and analysis are written by our analysts which might have different opinions. Read my 6 Golden Steps to Financial Freedom here. Best regards, Jonas Borchgrevink.

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