How to Create Token Value

Level 2 - Value Investor

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In the world of equities, it’s fair to say that drivers of equity value need to have some flow through to cash flow.

Meaning, if you’re the CEO of a public company whose compensation is tied to the performance of your stock, you’re going to focus on what your investors care about (which, in the *long-run* should be cash flows).

Drivers of performance can include things like:

1. More customers and revenue

2. Better operations and lower costs

3. Efficient use of capital

4. Improved defensibility (moats)

5. Generally more attention and credibility

6. Improved governance

These are the key factors that increase the value of a company’s equity.

Companies typically have to generate value for someone else in order for their equity to be valuable. To generate revenues, you have to sell things that people find worth paying for. These revenues translate to future expected cash flows which translate to equity value for a company, which in turn generates returns for investors and executives.

Basically, we have a defined set of rules, laws and norms that allow for this ethereal concept known as “equity” to capture and represent “value” which you can exchange for cold hard dollars.

As we’ve been saying for years, crypto tokens are not equity, as they do not confer ownership.

Ownership is primarily a legal right that something is your property. Tokens do not give you any legal right over the direction of a protocol. That means the traditional form of capturing value is a tad broken.

Think about it – why should you care about the revenue and cost structure of a protocol if there’s no way for you to enforce your rights in the distribution of the resulting cash flows? You probably shouldn’t.

It’s only natural to then ask the question of “what should you care about?"

Crypto tokens are digital assets that are issued on a blockchain. They can represent various rights or assets, such as:

• A stake in a project (utility tokens)

• A claim on future profits (security tokens)

• Real world assets like financial contracts or real estate (asset-backed tokens)

It’s more accurate to compare crypto tokens to the legal infrastructure that supports financial contracts rather than the financial contracts themselves.

The legal infrastructure for financial assets establishes the framework within which the asset operates (e.g. debt, equity), defining the relationships between holders, their rights, and the company. Similarly, crypto tokens are more like assets or tools within a defined system (the blockchain ecosystem) that can be used for various purposes (e.g., as a currency, a means of access, or a token of value).

The rights are just different, and backed by code instead of law.

That means you should assume that if it is not coded, you have no real rights as a token holder.

If you’re a long-time DeFi Ed paid subscriber, this should not be news to you.

A Framework for Token Value Creation

Today we would like to pull back the curtains and unveil the secrets of token value creation. You might think it’s a function of “revenues” and cash flows, but there is far more than meets the eye to creating token value (some of which you would likely never expect).

Despite many of the same tactics and tricks used in TradFi, the “by the book” personalities in much of the industry will have a hard time wrapping their heads around why people actually buy.

At the end of the day, assets go up in price because they become more desirable. Desirability is a function of the market you’re in.

• Breakthrough in consumer AI means AI exposure becomes desired

• US Bitcoin buyers may differ from those in oppressed countries

• Milk demand is based on consumption trends

• Growing population means more demand for homes

Regardless of the asset, desirability is the only thing that matters.

By identifying what makes crypto assets desirable, we can develop a framework that drives token value creation.

Pay to Hold

The "Pay to Hold" strategy is about giving out tokens to holders for their loyalty, thereby influencing market perception and token valuation. Airdrops, token farming, and staking are the key components of this strategy.

Airdrops serve as a direct incentive for investors to maintain or increase their holdings in a particular token. By distributing additional tokens to current holders, projects not only reward loyalty but also potentially enhance the demand for the token. Future expected airdrops have been a clear meta for token value creation in recent months.

• Pudgy Penguins have received multiple airdrops (including over $6K per Pudgy in the Dymension $DYM airdrop)

• Bad Kids NFT on Cosmos has received several Cosmos drops

• Celestia ($TIA) stakers have received ongoing airdrops

The expectation of future airdrops is typically enough to convince people to hold or buy regardless of valuations.

Token farming is another such example where users will receive tokens in exchange for using the protocol in some form (such as trading), providing liquidity, or staking/locking up tokens.

By now it should be obvious that if you pay people to hold tokens, they’ll hold it.

From an investor perspective, the potential for enhanced returns through airdrops and staking rewards has to be balanced against the risks of dilution and the valuation of the token you’re buying in light of these incentives.

You should anticipate that any expectation of recurring token drops/farms will have a positive price impact. That also means when the expectation is that these token drops will be going away or be less valuable, the staked token could lose value..

Sure, it never hurts to pull out the spreadsheet and run calculations on the expected value of airdrops and farmed tokens relative to the cost of the asset. However, many market participants in crypto will never do this. Conclusion? Prices can get irrational and stay there for a long time.

Utility

Rather than being independent of the product/service like stocks are to companies, tokens can become an *essential component* of a crypto application. Tokens can serve as a valuable inputs to protocols. For example, Ethereum has multi-sided utility. Users need ETH to pay for gas, and stakers need ETH to secure the network.

So long as there is a reason to use Ethereum, there will be a reason to hold ETH. The same thought process can be applied to other L1s.

Attention

Research shows that more attention on a company increases the trading volume of its stock. This effect is amplified for crypto tokens given low liquidity and capital invested (amount of capital invested in stocks, bonds, and real estate is in the hundreds of trillions) as well as a primarily retail investor base. It doesn’t take a lot of attention to move most crypto tokens.

However, crypto projects need the right kind of attention - attention that converts into token purchases.

This includes:

• Adoption narratives

• Category creation

• Major announcements

• Talked about by reputable influencers/traders

• Breakthrough technology

• Token distribution (fair launch, airdrop, etc)

• Growth metrics (hint: try telling the market what is important instead of letting people decide)

Of course, a skyrocketing token or stock price is the best attention grabber there is. Who better to help with that then market makers.

Market Makers

A market maker deploys infrastructure, expertise and sometimes its own capital to provide a service: pricing markets efficiently and providing liquidity.

Market making is quoting a two-way market, providing liquidity to other market participants

A two way market means being willing to either buy or sell the token. This means a market maker will maintain bid and offer prices which other participants can trade on. Providing liquidity means making an two-sided inventory (token and USD) available to fulfill orders in the marketplace.

Without a market maker, traders will need to rely on coincidence of wants - waiting for another trader to sell tokens when they want to buy, and vice versa. This leads to trading delays and high transaction costs.

Transaction costs would be high because the market is not efficiently priced. The owner of a token is biased to believe in a higher valuation, even when selling the asset. This is due to the endowment effect and other cognitive biases. A buyer may also be cautious about overpaying for an asset.

This could lead to a market where a token owner wants to sell for no less than $5.00 and a the most eager buyer will only offer $4.50. This implies a 10% cost to trade the asset, a significant headwind. High trading costs deter investors and speculators, whereas low trading costs encourage more frequent trading activity.

Why Do Projects Hire A Market Maker?

Hiring a market maker will result in tighter spreads and higher displayed liquidity, whether on CEX or on DEX, giving investors additional confidence to buy the token. Market makers also offer additional services, including strategy for obtaining the coveted token listing on centralized exchanges.

CEX are responsible for the user experience of their customers and will be reluctant to list illiquid and therefore excessively volatile tokens. CEX are in business to make money from fees; a token supported by a reputable market making firm is likely to generate far greater volume and therefore revenue for the exchange.

Protocols can choose between two models when hiring a market maker:

• agency model

• proprietary model

In the agency model, the protocol provides all the capital (two-sided inventory, both their native token and USDC). They pay the market maker a monthly fee in USD for the use of their infrastructure and skills, but the project is responsible for any profits and losses incurred in market making activities. Commonly the market maker is entitled to a performance fee representing some percentage of any profits earned.

The agency model gives the protocol the most control. They can dictate the KPIs:

• uptime: market makers are contractually obliged to have quotes in the market for a high percentage of time, e.g. 99% of the time 24 hours a day 365 days a year in crypto. The remainder of the time they may be conducting maintenance of their infrastructure or removing their quotes to manage risk in highly volatile times.

• spread %: market makers agree to provide a minimum spread for the token, for example 0.5% - this ensures that investors can always transact without incurring too much slippage. The market maker may choose to quote a tighter spread in profitable conditions to take more market share (market making is competitive).

• depth: it’s not useful to quote a tight spread in a size which is too small for average deal sizes, so market making contracts specify how much inventory - tokens or dollars - must be available at certain distances from the market price

This model is most attractive to protocols who can afford to provide two sided inventory. Most protocols in the bootstrapping stage lack sufficient USD.

In the proprietary model, the market maker provides its own capital at its own risk and therefore has a greater influence on the deal terms and KPIs. The project will provide a loan of a significant share of tokens, typically at least 5% of supply. And the project will grant the market maker options over the tokens.

This optionality allows the market maker to elect to either repay the loan in tokens, or substitute a pre-agreed sum in USD (strike price). These agreements are long term, e.g. 1 year or more. During this time the token price could have changed significantly.

If the token price has soared, the market maker will repay USD and profit from any tokens still held in inventory.

If the project is a flop, the market maker will return the borrowed tokens.

How Do Market Makers Profit?

Market making is not necessarily a profitable activity on newer tokens and so the firm will be looking to make the bulk of its profit on the optionality in a proprietary agreement, or the fees in an agency agreement.

Proprietary KPIs should be drafted loosely enough that the market maker can limit its exposure to tokens which fail. If prices decline, the firm will reduce the size of its USD bids and skew them towards lower prices, while trying to sell any accumulated inventory as quickly as possible to any willing buyer.

A large token loan leads to the market maker controlling a high percentage of the circulating supply at launch. This typically allows the firm to both satisfy initial investor demand, and as a consequence put an initial cap on price. The market marker can therefore start by “selling high” with borrowed tokens.

Later, as investors sell to take profit (or losses) and the price declines, the market maker can re-accumulate their token inventory, without being exposed to the risk of the token price declining further (as they aim to purchase only sufficient tokens to repay the loan). In some cases the firm will need to spend USD to fill additional sell orders from investors, but they’ll try to manage their risk.

If at the expiry of the agreement the firm finds itself without sufficient tokens to repay the loan, it will exercise the option to acquire the tokens below market price locking in a profit. The firm therefore faces no risk if investor demand is unexpectedly strong, leading to depletion of their token inventory.

Summary

• projects engage market makers to:

  • improve their odds of listing on a CEX

  • make their token more attractive to investors

  • provide expertise and consulting e.g. tokenomics design, help with fundraising

• deals are negotiated based on who is providing the capital and taking the risk

• market making isn’t always profitable; the firm seeks to control risk while profiting from either fees or options

• in a loan + option deal, the firm can sell short without risk (which gives it capacity to buy tokens without risk)

Financing Tool

Traditional businesses have access to equity and debt financing, whereas crypto protocols have access to token financing. The term “token equity” is thrown around the ecosystem, but tokens have the power to represent all kinds of agreements on value exchange, not just equity.

When combined with a regulatory framework, tokens can be designed to mimic equity. A token standard could be developed that receives support from lawmakers and is recognized as equity.

Debt instruments are no different. A bond issuer could easily use smart contracts to manage payments to bondholders without the need for middlemen. Bondholders can buy and sell bonds seamlessly with tokenized bonds. Just like equity, a token standard could be developed to create a set of rules that allow tokenized bonds to be legally recognized.

Equity is a representation of value. Bonds are an agreement to transfer value. Tokens are units of value that can represent either of these traditional “legal tokens” and much more.

Tokens can be used for value exchanges ranging from borrowing/lending to paying team salaries and vendors. These activities serve to create value for the underlying protocol, which can then translate to additional value for the token.

We’ll be diving into more specific alts and coins again for our paid subs so we wanted to provide this framework around how we think about tokens.

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Disclaimer: None of this is to be deemed legal or financial advice of any kind. These are opinions from an anonymous group of cartoon animals with Wall Street and Software backgrounds.

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