The Elasticity of Velocity

This article briefly reviews demand for and supply of utility tokens. It touches on the much-discussed topic of token velocity and considers the impact on token price over time, presupposing that velocity is not a constant but, rather, elastic in nature.

Textbook demand and supply

Traditional demand supply economics informs us that, all other things being equal, a commodity’s price will increase as demand increases, assuming a finite supply of the commodity. As price increases, speculators will tend to purchase the commodity, in anticipation of further increases. This increased demand will initially be satisfied both from the finite supply and from sales by those seeking to take profit from upward price movement. In the near term, though, price will tend to continue to increase. Over time, new suppliers of the commodity will be attracted by higher prices and this additional capacity will exert a downward influence on price.

Textbook utility tokens?

So how does this apply to tokens? Well, let’s say you have bought some tokens in a project that you believe has a good idea. You support the project team and hope to make a decent return on your investment. Let’s be honest, your altruistic commitment falls somewhat short of your pecuniary ambitions. The story goes something like this:

The project is addressing a big problem for many, in a manner that is innovative and better than existing solutions; there is therefore going to be huge demand for the token; token supply is capped, so the price is going to rise dramatically.

Seems fair, doesn’t it, if we consider the first paragraph. But is a token a commodity in the same sense?

An example

Let’s take an example of a token that affords access to a platform. This might be a blockchain or a web site portal. Once on the platform you can use your token to transact. It’s effectively a means of payment for a service or facility. For example, Filecoin allows access to data storage, Golem allows access to compute power. This is the utility provided by the token.

Once you’ve handed over your token, you no longer have an interest in it. That interest passes to the recipient. They will then decide whether to retain the token or sell it. Retaining a token makes sense if it can be used to access further desired utility on the platform. However, most platforms have quite limited utility. Alternatively, the token might be retained in the hope of further appreciation in its price.

More likely, though, is that it will be sold for another currency that has broader acceptance as a means of payment (e.g. fiat or some yet to be determined general purpose cryptocurrency payment coin). After all, we all have bills to pay!

What does it mean?

In short, a commodity is consumed over time, whether it is a tangible product or a service. A token, on the other hand, more accurately represents the right to access a commodity or service. The token itself may only need to be held fleetingly, whereas the underlying commodity or service may be owned or hired for a much longer duration.

Commodity prices increase due to scarcity as demand increases. Tokens will experience less scarcity if there is little or no reason to hold them post transacting on the platform. Constant recirculating of tokens will maintain supply that may be sufficient to satisfy a much-increased level of demand, without any significant change in token price. This is due to what is termed ‘velocity’. Put simply, the tokens turn over at an increasingly rapid rate.

This is made more likely given the intention to substantially increase blockchain transaction speeds, together with the emergence of atomic swaps and sophisticated P2P decentralised exchanges. It is even hypothesised that at some future point end users may not even be aware that they have transacted in a certain token. This does not bode well in terms of velocity.

What’s the remedy?

So, if token velocity is the real enemy of token price appreciation, what can be done to mitigate its effects? This is an interesting debate. Some say that increasing the reasons to hold a token is one beneficial strategy that can be adopted. Staking is a good example of this. For example, where tokens must be ‘staked’ or held to participate in the ecosystem (such as might be required to run a node and gain mining credits).

How is this beneficial? Well, staked tokens are effectively removed from the free float of tokens in circulation, thereby reducing the free float and creating scarcity. The velocity of staked tokens is zero. This has the effect of reducing the aggregate velocity of all tokens in circulation. Or so the theory goes.

However, think about a token where demand is increasing. If the free float is reduced then this might lead to a higher token price but it might also simply cause an increase in the velocity of those tokens in the reduced free float. If so, this would stunt the beneficial impact of staking. Velocity would need to already be at its maximum for any reduction in free float to have a beneficial impact upon token price.

Here is one of the great unknowns. What is, or will be, the maximum velocity of a specific token? That’s one that not even Einstein or Hawkins could likely answer with confidence, were they still with us.

Conclusion

A token that has limited utility and lack of incentive to encourage holding of the token is likely to have a high velocity. In turn, this will reduce the opportunity for token price appreciation. Strategies that encourage token holding (e.g. staking) or that are deflationary (e.g. burning) may promote token price appreciation. However, this may have limited effect should velocity not already have reached its ceiling.

Devotees of many utility tokens may need to steel themselves for disappointment, given that there may turn out to be little positive correlation between token demand and token price, contrary to popular belief.

Disclaimer: This article expresses my personal views on the subject matter and is not intended as investment advice of any kind or a recommendation to buy or sell any cryptocurrency.


The Elasticity of Velocity was originally published in Data Driven Investor on Medium, where people are continuing the conversation by highlighting and responding to this story.