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.
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 for investment 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 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.
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.
Here are a few methods for slowing token velocity:
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.
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.
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.
There is a fairly strong consensus among some leading venture capitalists arguing for safe harbors for utility tokens. The arguments are very sound and timely, given that the SEC seems to be moving toward regulating utility tokens as securities. Doing so would certainly create major fail-safes for investors but would also greatly restrict the innovation that will inevitably come from developers using coins and tokens to perform crowdsales for their next decentralized venture.
There is an unfortunate paradox in token crowdsales. It can be summed-up simply:
So, the question is how do we concurrently encourage slow token velocity, which is natural in a crowdsale that assumes a standard regulated environment while at the same time balance with the liquidity promised in a token crowdsale? This is not an easy question. Personally I believe in a balanced approach that somewhat marries the two. In some cases, token velocity is not as much of a factor for the long-term success of a viable token economy within the token being offering. While rare, such a company would spurn the fact that they might have to abide by Rule 144 restrictions on their utility token.
The more pressing current question in everyone’s mind is how can ensure the Howey Test can still apply to utility token sales with an exemption for companies under a particular size?
Forcing every company to assume a token or coin is a security will protect certain investors at the expense of a great deal of innovation. I will be the first to say that regulation is most certainly needed, but the current framework is a square peg in a round hole dilemma.
We need a framework that still protects smaller investors while not shutting them out (e.g. Reg CF), but which could still provide the liquidity promised by token crowdsales without the need for the stringent Rule 144 restrictions. In most cases, we will want a balanced approach to token velocity (likely step-wise over a period and on a smart contract–not as cliff-wise as current Rule 144), a regulatory framework that protects investors (like Reg D or Reg A+), but which still provides for an active secondary market that does not include many of the same restrictions we currently see in private securities offerings.
I am sure the market will figure out a solution which is hopefully a mix of both the current tech and regulation, but that allows for innovation to continue to blossom.
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.