In an information sessions for Congress, Peter Van Valkenburgh used my favorite analogy comparing crypto tokens to tickets at a fair ground. And William Mougayar has a new post about tokens where he specifically refers to them as “privately issued currency.” No matter how you think about tokens, there is now a great interest in understanding why and how their prices are determined in the market. The trivial answer of course is: supply and demand. But what exactly is the supply?
As it turns out one critical determinant of supply, and hence of the price of a token today, is how many tokens there will be in the future. This is determined by the “monetary policy” of the token. To date all major tokens have either a fixed amount of tokens right away or eventually (e.g., BTC) or a rate of inflation that asymptotically goes to zero (e.g., ETH).
Philosophically this “no inflation” choice seems to be inspired by a deep rooted aversion to central banks and their policies of growing the money supply. Many people in the crypto currency community consider this as a kind of appropriation, or even theft, from those who already hold currency.
But the current approach has a severe drawback. It results in extremely rapid appreciation of tokens well ahead of their use value. Why is this? Without future inflation, the discount rate to be used in determining Net Present Value (NPV) of a token is quite low. And as anyone who has built an NPV or Discounted Cash Flow (DCF) model knows, NPV is extremely sensitive to changes in interest rate. In fact, as the discount rate approaches zero, the NPV explodes towards infinity as can be seen in the following chart
Now one might argue that I am confusing concepts here because you can sell a token only once in the future and not repeatedly. But think of it differently: in the future the tokens will be used again and again and again, each time have some use value (you can think of that use value multiplied by the number of tokens in the future as the value of the network as a whole). So each token today will reflect that discounted future stream of use values.
The future percentage rate of inflation is a key component of the discount rate. And for the majority of tokens today that component is ZERO! Now the other two components of the discount rate are the risk free rate of return, which is generally taken to be the return on some government backed asset. Well those rates are at historic lows and are essentially ZERO also because of a global glut of capital. The third and final component of the discount rate is the risk premium. Here I think many investors are currently vastly underestimating the risk they are taking on, largely because we are in the honeymoon phase with crypto tokens.
So here is a rough approximation of the discount rate as I see it
discount rate = inflation (ZERO by monetary policy of token) + risk free rate (ZERO because of glut of capital in the world) + risk premium (mistakenly near ZERO due to honeymoon phase)
Taken together this gives you discount rate that is way too small which in turn results in an NPV that’s way too high. I believe this explains much of what we are currently seeing in token prices.
Now you night say, why is an inflated NPV a problem? The answer is that it causes a wide divergence between the personal incentives of teams holding token sales from the socially desirable characteristics (Vitalik Buterin gets at this somewhat in his post on analyzing token sales models, but doesn’t draw the distinction clearly enough).
I will write a separate post (or several) addressing the incentive problems in token sales. Until then one lever you should consider is having a token with a fixed low percentage inflation rate to reduce NPV. Monetary policy matters.
PS One way to inflate is to issue new currency to lots of people which could form the basis of a future global basic income.
