Monero (XMR) is the best-in-class privacy coin and continues to gain adoption in real-world transactions.
Monero’s relative anonymity makes it ideal for transactions where privacy is required. Recently though, it’s come to the attention of XMR users that this anonymity comes with hidden costs.
According to the Monero community, exchanges are using Monero’s anonymity to conceal their trading of ‘paper contracts’.
In short, exchanges are accused of selling Monero they don’t have, which suppresses price.
On April 18th, Monero users coordinated to withdraw their XMR from exchanges to create a bank run, forcing exchanges to buy XMR on the market, increasing its price.
This financial sleight of hand happens with cash, too. It’s called fractional reserve banking. Banks are permitted by the Federal Reserve to lend 5 to 10 times more than they hold in cash, thus creating money out of thin air – inflation.
If exchanges are doing the same thing with XMR, inflation doesn’t occur because these paper contracts aren’t circulating in the XMR economy, but speculation is not being priced into the coin.
Hidden benefits of rehypothecation
Caitlin Long warned of this phenomenon as a threat to Bitcoin in 2018, calling it “rehypothecation.”
In #TradFi, rehypothecation is to the reuse of the same underlying collateral in multiple financial contracts.
In the private sector, rehypothecation is illegal, as it can leave its beneficiaries on the hook for more than they’re able to pay.
Proponents in all sectors argue that done carefully, it enables liquidity.
This is ostensibly also the accused exchanges’ argument.
Accusations of rehypothecation may just be a convenient explanation for Monero (XMR)’s stagnant price, but it wouldn’t be the first time exchanges acted unethically to make a buck.
Most coins get their price primarily from speculation, and rehypothecation would decimate many of them.
Monero (XMR), on the other hand, is used primarily for real-world purchases. Because of this, it actually stands to benefit from rehypothecation.
MV = PQ
ESC Investor Series valuation models are based on the equation of exchange.
The Equation of Exchange, MV = PQ is the standard way to value a currency. In short, it says a currency is as valuable as the things it’s used to pay for.
We use it to find cryptocurrency price floors given a set of assumptions.
To use Monero as an example, the price of all circulating XMR must be at least enough to facilitate commerce.
If the price isn’t high enough to meet demand for payments with it, XMR will be bought – and importantly, withdrawn and used to buy things.
Because they’re not circulating, paper contracts don’t affect XMR’s price floor – given Monero’s use profile, it’s unlikely much is sent within exchanges as payment.
“Printing” contracts, though, still suppresses price as speculation is absorbed.
Takeaways
#1) Rehypothecation of XMR has mixed implications.
On the one hand, users miss out on speculative swings due to price suppression.
On the other, XMR gains price stability, arguably Monero’s greatest obstacle in the way of adoption.
#2) Monerun is unlikely to have lasting effects.
5/2/22 editor’s note: XMR’s price is down ~25% since recent highs on 4/18 during Monerun.
Exchanges lose no face by simply refusing withdrawals.
5/2/22 editor’s note 2: Binance withdrawals were suspended on 4/17, ahead of Monerun.
Furthermore, nothing stops exchanges from continuing to rehypothecate XMR.
#3) XMR has major upside.
If the XMR price was purely speculative, rehypothecation would be cause for concern.
But it’s not.
Monero best fits the main use case of cryptocurrencies – private, uncensorable payments.
Regardless of whether Monerun sustainably raises price, XMR has 100x growth ahead of it.
It won’t be long before the world realizes the importance of financial privacy.
All else equal, a cryptocurrency or token with a larger Total Addressable Market, following the principles of tokenomics, will have a higher price.
Components of Total Addressable Market
A currency’s TAM and its components come from each of its use cases.For example, Ethereum’s native token, ETH has multiple Total Addressable Markets.
ETH is used to pay fees for all of the applications running on the Ethereum network. Demand for payment of ETH fees is one component of its Total Addressable Market.
ETH also used to collateralize other tokens – Dai, for example. So another of ETH’s Total Addressable Market is use as collateral.
This in turn comes from demand for Dai (a stablecoin with many uses) and varies with Dai’s capture of its Total Addressable Market.
To maximize ETH’s fundamental value or price floor, these two use cases must be maximized.
When seeking to maximize a token’s price, TAM should be made large.
This is generally done by having a token transfer large amounts of value, or giving it many uses.
Fundamentally, cryptocurrencies get their value through use as a medium of exchange. This includes cryptocurrencies paid for goods and services, and tokens paid for fees, collateral, and other tokenomic levers within a protocol.
Most cryptocurrencies and tokens are best valued using the equation of exchange.
The equation of exchange was first derived by John Stuart Mill, referenced by Adam Smith, and popularized by Milton Friedman.
For example, if CashCoin is used to buy $1,000,000 worth of products per year, and each CSH is used an average of 5 times, the variables are as follows:
Coins which are lost, locked up, or in cold storage are not part of an economy – they’re not subject to supply and demand.
Stored coins may be relevant to speculators, but speculation is not priced in directly; the price floor of a cryptocurrency and its speculative price premium are different.
Price floor vs speculative price premium
A cryptocurrency’s price reflects:
Fundamental value, price floor
Speculative price premium
Cryptocurrency price floors
Fundamental value reflects supply and demand for a cryptocurrency as a medium of exchange.
This fundamental value is a price floor – a price a currency will not sustainably trade below.
When a currency trades at its price floor, volatility will naturally cause it to dip below, but buying pressure from aggregate demand brings the price back up.
A currency might trade below its price floor, but not for long.
Speculative price premium
The rest of a cryptocurrency’s price is speculative.
It may be rational to price in future returns (see Burniske’s DEUV), but it makes sense to distinguish speculative premium from fundamental value.
Price/price floor ratio is a meaningful measure of risk/reward – the closest
Most cryptocurrencies’ price floor can be extrapolated from on-chain data.
Identifying price floors using on-chain data
Dune Analytics is a free, open-source chain analytics platform.
Price floors can be worked out using on-chain analytics.
The components of price floors – circulating supply, velocity, and total purchases are all found on-chain.
Some on-chain data, like ERC-20 token data is easy to interpret. ERC-20 transactions are easy to reconstruct from blockchain analysis.
Commercial transactions on medium-of-exchange currencies are harder to distinguish from speculative trading, self-transfers, mixing, but it can be done.
Determining which transactions are speculative, self-transfers, part of mixers using just metadata requires getting creative.
Conclusion
This cryptocurrency valuation framework is used to identify and take advantage of price floors, calculate risk/reward ratios, and engineer tokens with price floors using the principles of tokenomics.
Tokenomic levers are features of a protocol which capture value.
The degree to which a tokenomic lever affects value capture is called tokenomic leverage.
The three types of tokenomic levers act on corresponding components of the equation of exchange.
Supply levers capture value by decreasing circulating supply.
Demand levers increase demand for tokens, raising PQ, Total Purchase Amount in the equation of exchange.
Velocity levers capture value by decreasing a token’s velocity.
Velocity levers are only hypothetical. Discerning coins based on velocity (e.g. coin age) would destroy a their fungibility, one of the key properties of money.
Tokenomic levers’ effects on value capture are proportional to their input.
A cryptocurrency’s utility value or price floor is proportional to its use as a medium of exchange. The total value of all circulating coins, called monetary base, M is solved for in the equation of exchange.
All else equal, less coins circulating makes each one more valuable.
Tokenomic mechanisms which decrease circulating supply in this way include:
Cryptocurrencies capture value through use as a medium of exchange.
Other kinds of tokens capture value differently.
Examples of demand levers include:
Fees
Collateral
Dividends
Velocity Levers
Velocity levers must be hard coded into the protocol, which affects user experience, but limited examples exist.
Velocity levers can be justifiably imposed when gas costs are a concern – e.g. implementing a bi-weekly “paycheck” in a protocol where payments are accrued, in order to distribute tokens, rather than forcing users to pay for their own withdrawals.
A slowing of velocity can be measured in other components of the equation of exchange.
For example, a coin age scheme which incentivizes holders of a token to hold funds for longer periods of time will tend to split their coins between “old” and “new,” increasing the velocity of “new” coins and taking the “old” coins out of circulating supply. [[Valuation Methods; Determining Coin Age]] schemes are one example of tokenomic mechanisms which affect velocity.
“Give me a lever long enough, and a place to stand, and I will move the Earth.” – Archimedes
In the physical world, mechanical leverage multiplies the force of a given input. Similarly, tokenomic leverage multiplies value capture by affecting supply and demand.
Currency-like tokens capture value when used as a medium of exchange.
Adding leverage through tokenomic mechanisms in a protocol increases supply and/or demand pressure for a token, specific to the type of mechanism in use, by increasing the value exchanged through that token.
For example, staking decreases circulating supply by the amount staked; fee increases for an application increase the demand for the token used to pay fees.
Illustrating Tokenomic Leverage
first-class lever
Tokenomic leverage mirrors mechanical leverage. Using the analogy of a first-class lever, we can say that:
Value captured is the output of force from on the other end.
Tokenomic leverage is the ratio of the distances of each force from the fulcrum.
Tokenomic leverage example
The ratio of value captured to value created or transferred is called tokenomic leverage.
Higher tokenomic leverage in a mechanism or protocol overall is analogous to higher profit margins in a traditional business.
Tokenomic mechanisms further up the hierarchy of value capture have higher leverage. And it’s possible to have a tokenomic leverage greater than 1 – indicating more value is being captured than created.
Synthetix’s tokenomics are an example of high tokenomic leverage.
Users of Synthetix can create sAssets – synthetic TradFi assets collateralized by several times their dollar value in SNX tokens.
Synthetix governance decides this collateralization requirement, but it generally stays between 300% and 500%.
This means that SNX will necessarily be worth 3-5 times the value of all necessary sAssets.
So the tokenomic leverage of this mechanism in the protocol is between 3 and 5, depending on the current collateral requirement.
This is only possible because the protocol has a monopoly; higher tokenomic leverage requires extreme defensibility.
Synthetix’s collateralization mechanism introduces economic security issues only mitigated by active management of the c-ratio, and heavy inflation. As a result, Synthetix has begun to pivot its design toward other tokenomic mechanisms with lower value capture, illustrating tradeoffs between the principles of tokenomics.
Conclusion
Archimedes’s assertion – that simple mechanical leverage at scale was sufficient to move the Earth – was a bold and groundbreaking claim.
Tokenomic leverage is just as powerful, yet it’s highly underappreciated. It’s a key component of value capture – one of the three principles of tokenomics.
Even those with a deep understanding of tokenomics miss opportunities to apply leverage to their token. Others go But adding leverage to a token is one of the simplest, yet most effective ways to increase its price floor.
If you or a project you support is in need of tweaks to its design to increase leverage and maximize its value, reach out to us for a free consult.
In a talk at Stanford, Peter Thiel called value capture the “most important, yet least understood” aspect of business.
Value is captured by a business by taking profit. Value captured is the percentage of a product’s total value taken as profit.
In his book Zero to One, Thiel describes the problem of inadequate value capture.
Examples of inadequate value capture include a business selling widgets valued at $10 for $5 (undercharging), or another business selling a widget for $10 which costs them $5.
A business may have inadequate value capture because either it doesn’t charge enough, or costs incurred are too great a percentage of revenue.
In both cases, less value is captured than is created, and at a certain point, inadequate value capture leaves a business economically unviable.
Similarly, inadequate tokenomic value capture allows price to stagnate with adoption and leaves a blockchain vulnerable to economic exploits.
Value capture in tokenomics
Tokens and cryptocurrencies miss opportunities to capture value when they are either not used in ways that raise their price floors, or used in insufficient quantities.
Cryptocurrencies primarily derive value proportional to their use as a medium of exchange (see How to Value Cryptocurrency).
So, a currency that is used to pay fees in a protocol is valuable proportional to the value of fees paid. If such a currency is only used for fees, it is only as valuable as the total amount paid in fees.
Inadequate tokenomic value capture becomes a security problem when a blockchain’s native asset (e.g. Ethereum’s ETH) is used exclusively for paying fees when that chain is securing other valuable assets.
Valuing cryptocurrencies is much different than valuing companies, but the concept is the same – inadequate value capture dampens the value proposition of a business; ditto for a token or cryptocurrency.
Why value capture matters
Without adequate value capture, cryptocurrencies and tokens are vulnerable to massive price crashes, and if the tokenomics of a blockchain’s native asset is not considered by developers of token protocols, those protocols may incentivize economic exploits through perverse incentives.
When a token’s value capture and other tokenomic components are properly considered, a token’s price increases steadily with its use in applications, and it strengthens the blockchain network on which it’s built.
If you or a project you know need help designing a protocol or would like input on your project’s tokenomics, reach out to us for a free consult.
Tokenomics describe how a token’s use affects its price.
Good tokenomics increase a cryptocurrency or token’s price and prevent bad actors from destroying or weakening a network.
Poor tokenomics leave tokens and blockchain networks vulnerable to economic exploits which arise from a lower-than-possible price of a token, disappointing users and investors.
When considering tokenomics, incentives are everything.
Charlie Munger is Warren Buffett’s business partner.
Munger also famously said in regards to management practices: “show me the incentives, and I will show you the outcome.”
What you incentivize is what will happen – even more so for blockchains.
In management, incentives are malleable. In decentralized protocols, changing analogous incentives requires a complete overhaul. Changing tokenomics requires consensus to avoid fracturing network effects.
Token economists design protocols to be maximally secure, and maximize token value by applying tokenomic leverage and value capture according to the principles of tokenomics.
Many projects leave tokenomics to chance, relying on speculation to create price support. This leaves them vulnerable and all but ensures 95% drawdowns, and subsequent abandonment by users.
Good tokenomics give cryptocurrencies and tokens a price floor – a price at which they can’t sustainably trade below.
For more on price floors, follow Eat Sleep Crypto on Twitter, and stay tuned for the release of Cryptocurrency Price Floors.
