As part of the senior analyst team at AmaZix I spend a large part of my time reading through hundreds of projects’ whitepapers. I do in-depth due diligence to determine whether or not their tokens will be good investments. In doing this, one of the most important factors we look at is the project’s token economic model. This is to discern how much of the value created by the project is being captured by the token.

This is extremely important. The value captured by a token is essentially its utility or intrinsic value. This ensures that the token’s price grows alongside adoption/success of the underlying project. A token lacking utility will see its price supported only by speculation. It is very likely to fail in the long-run. For more on this, see my earlier blog, in which I discussed the importance of token economic models in ensuring a token’s long-term value.

In this blog and the next, I’ll discuss the two most common problems we see with token economic models. I will also explain why they matter and also some of the solutions we recommend to our clients.

What is a token economic model and why does it matter?

If you’re a seasoned crypto investor or understand what a token economic model is, feel free to skip this part.

Before we start talking about token economic models, it may be wise to start at the very beginning. What is a token and what makes up its value?

A token is a crypto-economic unit of account that represents or interacts with an underlying value-generating asset. A token’s value is made up of its intrinsic value and its speculative value. The intrinsic value is the percentage of the token’s value that derives from demand for the underlying asset. The speculative value is the percentage of the value of the token that derives from demand due to an expectation of future price increases.

While speculation is nice, it is hard to control/predict. It puts projects at the mercy of short-term-oriented investors, like our friend below:

Rather than focus on speculative value, we recommend investors focus on intrinsic value. A token’s intrinsic value is dependent on two factors: the value created by the underlying asset and the percentage of this value which is captured by the token.

The token economic model is what determines the latter — how much of the value created by the platform is captured by the token. As such, it’s one of the primary determinants of a project’s utility value and long-term success.

Problem 1: Projects where equity is “stealing” value from the token

In my earlier blog, I suggested that there was an inverse relationship between the value of a project’s equity and the value of its token. They are effectively competing to capture the value created by the project.

This is because a company/protocol generates a fixed number of value/cashflows. This can be distributed to equity holders in the form of a dividend. It can also be distributed to token-holders in the form of a token burn/profit-share mechanism.

As such, ignoring speculation, if a project’s equity is valuable, then it’s capturing value for shareholders at the expense of token-holders. If a project’s token is valuable, then it’s capturing value for token-holders at the expense of shareholders.

Most of the biggest projects such as Bitcoin and Ethereum aren’t companies. They do not have shareholders. They only have token-holders instead. As such, there is no conflict of interest. Their token economic models seek to maximize value for token-holders.

However, this is not the case for many ICO’s which are limited companies, often with investors. They possess both shareholders (venture capitalists and founders) as well as token-holders (ICO investors and founders).

This creates a moral hazard. The founders of these projects will also possess both equity and tokens. They will often possess a higher percentage of the total equity than of total tokens. (A traditional seed round is 10–25% whereas an ICO is generally 40–60%).

More importantly, founders have a legally enforceable fiduciary duty to their investors. They are obligated to act on behalf of their shareholders (read: maximize value for their shareholders) without a conflict of interest.

Together, these factors create a perverse set of incentives. Founders are encouraged to prioritize the interests of shareholders over token-holders. They distribute the value created by their platforms to shareholders rather than token holders. (For an example of this, see my earlier piece on Ripple.)

This is a serious and overlooked issue, especially when ICO’s are making capital investments that benefit shareholders using the millions of dollars they raised in an ICO but then distributing the returns on those investments to shareholders rather than token-holders.

The way this most commonly manifests is through projects charging their customers some kind of fee (either in FIAT or in the project’s native token). Then using the revenue generated by this fee “to pay for the maintenance of the project”.

The word “maintenance” implies salaries and operational costs. There is nothing to prevent these fees being paid out as dividends to the company’s shareholders. (And the fact that investors continue to invest in blockchain companies’ equity indicates they believe these cash flows are or will eventually be paid out as dividends).

Bitcoin cash maintenance funds being put to good use

Another way in which this manifests is in companies using ICO proceeds to purchase cash flow generating assets which are however not legally owned by token-holders, leaving them with little downside protection.

For instance, most blockchain real-estate fund tokens use ICO proceeds to purchase real estate pay token-holders a given yield on these assets. Shockingly, this yield is generally comparable to the yield received on purchasing equity or bonds in similar publicly listed real estate funds. However, the yield on the token should actually be much higher than the yield on equity/bonds as token-holders, unlike equity and bond holders, have no downside protection.

Indeed, it’s worth remembering that these funds are legally owned by their shareholders. In many cases, these funds will also take on additional debt to finance purchases and will therefore also have obligations to bondholders. Thus, in a scenario in which these companies are facing bankruptcy and go into liquidation, bondholders and equity-holders will be paid first with token-holders either being paid last (in which case they will receive pennies on the dollar) or not being paid at all.

Many of these funds tout themselves as being “real estate backed”. But unless they are a structured security token offering which specifies the legal status of token-holders, investors in these funds’ token would be better off investing in real estate bonds or equities where they can enjoy similar upside with added downside protection.

This doesn’t only apply to real estate funds but also to cloud mining projects, projects developing commercial IP, and generally any projects using funds from an ICO to make capital investments into assets which will be legally owned by shareholders rather than token-holders.

Solutions

Solutions here all involve tweaking the token model such that value is transferred from the company’s equity to its token and aligning incentives between founders and token-holders. This can be done in several ways:

(1) Add a buy-and-burn or profit share mechanism

Both of these involve giving the token a “yield” and transferring value from the equity to the token.

In the case of the token “buy-and-burn”, this was initially suggested by Vitalik and has been widely adopted since. Basically, it involves designing token models with “buy-and-burn” mechanisms in which the project uses some or all of the cash flows generated by its platform to purchase its own tokens and destroy them. The decrease in supply raises the value of all remaining tokens by the percentage of total supply destroyed.

Effectively, the project is distributing its cash flows to its token-holders, very similar to how an equity distributes cashflows to its stockholders through a dividend.

An example of this is Iconomi, a digital asset management platform which burns preset percentages of all fees collected and also produces quarterly reports outlining the number of tokens burned (crypto quarterly earnings reports).

A profit-share is very similar in spirit to the “buy-and-burn” in that it is providing the token with a yield and turning it into an asset that generates cash flows. This was initially suggested by Kyle Samani of Multicoin.

An example of this is Augur which pays REP holders for performing work for the network. REP tokens are like taxi medallions: you must pay for the right to work for the network. Specifically, REP holders must report event outcomes to resolve prediction markets.

Ideally, token models should ensure that companies burn/profit share as high a percentage as possible of the cash flow they’re generating in fees in order to ensure the value they’re creating accrues to the token.

(2) Founders should be paid alongside token-holders

Projects raising money in ICO’s should not be paying dividends to shareholders, as this poses a significant conflict of interest.

In an ideal scenario, founders of a crypto project should not receive salaries either but rather be paid through the yield generated by their token ownership.

This is the case with Rialto, for instance, in which both team members and token-holders are paid through a bi-yearly dividend. While this is ideal as it maximally aligns incentives between founders and token-holders, it’s not always possible. Some crypto projects, like startups, will take time to reach profitability and the team must be able to survive in the meanwhile. In this case, transparency becomes paramount, which brings me to my next point.

(3) Transparency

Companies that raise money through ICO’s should be extremely transparent about all aspects of their project, including investors associated with the project, whether these investors received equity or tokens, how much they received, salaries they intend to pay themselves and any other operational costs they’ll be paying out.

For an example of this done well, check out page 26–30 of Essentia’s whitepaper. It’s worth remembering that all costs must be deducted from the cash flows generated by the platform in order to arrive at the value which actually accrues to the token. After all, cashflows going towards paying salaries/rent are cash flows that are not being distributed to token-holders through a token burn/profit share.

This information should be provided in the whitepaper (similar to the information a VC would expect in a seed/series A round) and should also be updated regularly once the ICO is completed.

Hopefully, in the future, a standard will emerge for ICO’s, similar to the GAAP accounting standards for quarterly earnings reports that govern public companies. In them, ICO’s would be forced to update investors in a given format on key aspects of the project’s performance.

Until that time comes, we must self-regulate this by voting with our money and rewarding projects with better transparency with higher valuations. For an example of a project doing it right, check out Iconomi’s quarterly reports.

In the case of real estate funds and other security type offerings, these should be avoided unless they’re legally recognized security token offerings that clearly specify the token-holders’ legal status. This is particularly true in the case of bankruptcy or liquidation and as relates to other stakeholders such as bond and equity holders. Investors should also demand additional transparency from these types of projects, such as regular balance sheet updates.

(4) Good governance models

Many of these issues can also be resolved by having good governance models built into the token that allows token-holders to vote on key issues, including asset allocation.

For instance, a project’s assets can be held in escrow in a smart contract allowing token-holders to vote to liquidate and distribute all assets pro-rata to token-holders.

While this is currently impossible for assets other than cryptocurrencies, there are many projects working on registering and “tokenizing” real estate, gold, intellectual property and all sorts of other assets which will then be able to be placed into smart contracts.

Conclusion

The token economic model design is an extremely important and underrated area for both investors and founders of cryptocurrency projects to think about. A project with a weak token economic model may see its token price fail, even as the project itself succeeds, simply because the token is not capturing any of the value created by the project.

Stay tuned for my next blog where I’ll cover the other biggest problem with token models: high velocity.

If you’re interested in having your project’s token economics audited or discussing this further, feel free to get in touch with me through here or on Twitter.

The amount of engagement in the crypto investment space needs no introduction. With market caps, volumes, and public awareness on the rise, I thought I’d put together a simple Jupyter notebook to get a clearer and broader viewpoint into the investment activities within my own crypto portfolio.

TL;DR here’s the code ;)

Why Should We Analyze Our Portfolios?

Because we’re definitely missing important details about our investments by only looking at the total value of our (potentially fat) wallets — even though I enjoy looking at Blockfolio from time to time. Because seeing our Ripple go to the moon and overshadow the rest of our investments is likely increasing our financial risk substantially. Because we all want our money to grow, but achieving this by picking a diverse set of cryptos is easier and safer than picking a moonshot that could end up a dud (and make us broke).

And let’s face it, the market gains are just too big for us to be left in the dark on the true characteristics of our investment portfolios.

Important Portfolio Characteristics

Now there are several characteristics of our portfolio that we should take a good look at, including return and risk. But a lot of the time we’re fixated on one and not the other.

We can look at return in several ways: the amount of money we’ve made from the beginning to the current date, the average rate of money we’ve made over specific time periods (e.g., annual returns), how much better our investments did when compared to several characteristics of a benchmark (e.g., alpha), and even the annual compound rate it would have taken to get to our current investment based on our starting point (i.e., CAGR).

As important, if not more, is how we look at risk and its effect on return. I don’t know about you, but I want to make sure I’m making a good return based on an amount of risk I feel comfortable with. If we take on a huge amount of risk to make one particular return when we could have taken much less risk to make that very same return, the path to take for a more efficient investment is clear.

This is where understanding volatility, correlations, and risk-adjusted returns come into play by computing statistics such as standard deviation of returns (or volatility), beta, the Sharpe ratio, and the Sortino ratio.

And while we can compute all the statistics under the sun to measure our portfolio’s performance, it doesn’t do much good if we don’t include a reference point to see how well we’re doing in comparison. This is called a benchmark, and we’ll be using the golden boy of cryptocurrencies: Bitcoin.

Notebook Walk-Through

So I don’t want to display a bunch of code here because I think you should go through the notebook yourself and get a feel for things. Don’t be afraid, the notebook includes some clear explanations and the code is commented! It’ll also help in better understanding this post. If you want, clone the repo and give it a whirl first. However, I will show you results through some statistics and nice visualizations.

To start, we need to create a tradesheet that emulates how we invested our portfolio. The one below is included in the repo. These are actually the same cryptos I invested in and the times I bought and sold them up until now, but the amount of money and the allocations (i.e., the amount I bought and sold) are not ;)

You can think of the tradesheet as our investment strategy. These are the trades we decided to take based on our wizardry powers or what an algorithm told us.

_Source: [Playstarbound](https://community.playstarbound.com/threads/glitch-ship-ai-feedback.80652/page-11" rel="noopener" target="blank" title=")

Along with the tradesheet, we also need historical market data. I chose to go with something simple: download some CSVs from CoinGecko and throw them into a data folder. Pulling data from an API would be better though!

Now we want to run a backtest on our investment strategy. Simply put, running a backtest allows us to go back in time to our first trade, walk forward in time, and simulate the trading activity that occurred in our portfolio up until today. A backtester can be very sophisticated and can be used in a lot of different scenarios (to the finance geeks: pun intended), but in our case it’s rather straightforward.

Based on the statistics above, it’s clear that our portfolio did fairly well when compared to our benchmark. The returns are better, volatility is only slightly worse, and our beta is surprisingly below 100%. And look at that alpha!

OK. Numbers are nice, but I want to see some charts.

Well that’s intimidating. The above chart shows how the USD value of our portfolio evolved over time including all of our cash flows (i.e., deposits and withdrawals). While it’s nice to visualize this, it’s hard to get a clear idea of how our portfolio did in true performance when cash flows are included. For example, if I deposited $1 million (I wish), the portfolio would appear to have a HUGE spike!

Now that’s better. By removing the daily returns when cash flows were witnessed, we have a more accurate representation of the true performance of our portfolio. Fortunately, we have a very small number of cash flows, so this method is acceptable. As you can see, it took us some time to catch up to Bitcoin, but it did and eventually surpassed it (thanks Golem and NEO).

Actually, you can see that after the crazy Bitcoin, Ethereum, and Litecoin boom (aka the Coinbase boom), our portfolio became more diversified. This surely had a lot to do with the dampening of the upcoming Bitcoin drawdowns and the likely larger returns experienced among the newly added assets.

Well there you have it. Clearly, our portfolio experienced much less volatility (i.e., risk) after diversifying. Diversification (and luck) for the win!

For me, this is the most interesting plot. This is a matrix that represents the correlations between all of the assets in our portfolio. While a lot of assets had a medium to high correlation with one another, Bitcoin Cash had a very low correlation to every single asset. You can even see that it was negatively correlated with OmiseGO! Correlations do change over time, but it’s nonetheless interesting to see these types of relationships within our portfolio.

Again, go ahead and clone the repo and play around a bit so you can understand in more detail how we went about analyzing our portfolio. You can even add your own tradesheet to get a glimpse into yours. And if you find bugs, let me know!

Summing It All Up

I hope you’ve gained a better appreciation for why it’s important to look at your portfolio through various lenses. It’s hard to get a clear understanding from just visualizing asset price movements, especially with all that’s been going on lately in the crypto space. Also, it’s not always clear how much risk we’re taking on over time, and how those risks will evolve when we invest.

What is clear is that diversification in such a market is important, because none of us knows where this market is going. With that in mind, best to keep an eye on your ship while weathering the storms and HODL.

By the way, none of this should be treated as investment advice and same goes for the code. Whichever investments you pursue are purely at your own discretion.

Full disclosure: At the time of writing this article I was invested in BCH, BTC, ETH, GNT, LTC, NEO, and OMG.

I’m Grant and I’m a freelance SEO and content professional. If you’re looking to grow your brand's organic search traffic, I can help with your fintech SEO. Cheers!

“No one can see a bubble. That’s what makes it a bubble.” — The Big Short

You must be familiar with the above quote if you’ve watched the Christian Bale movie The Big Short. Does that mean the Bitcoin is a bubble waiting to burst? Maybe. The truth is no one knows just yet. It’s difficult to assess whether something is a bubble by simply reading the news or following the market. So, let’s begin by understanding what is a Bitcoin?

Bitcoin is a decentralized, digital cryptocurrency. Confused? Let’s take an example. Let’s say that you are ordering headphones from Amazon via a seller and you want to know exactly where they’ve been before they were shipped to you. How do you find out? The answer is, you cannot. You can’t know the exact source of the product and you definitely cannot find out all the transactions related to those specific headphones.

Imagine if there was some sort of a digital ledger that could tell you all that and more? There is. Blockchain is a distributed digital ledger that stores all transactions related to a specific product or asset. But then what is a Bitcoin? Blockchain technology is what makes the Bitcoin possible.

Bitcoin is a peer to peer decentralized digital currency that is used to buy and sell products online. Decentralized means that the Bitcoin is not managed or issued by a company, government or financial institution. Bitcoin uses blockchain to store all transactions in a digital ledger which is then accessible to everyone globally using their computers. Now that you understand the basics, let’s understand why there is so much hype surrounding the Bitcoin.

coindesk.com

1 Bitcoin costs $10,886.85 at the time of writing this article. Crazy, right? Bitcoin was worth $1 in April 2011 and now, 6 years down the line, it’s worth more than 10,000 times its original value. But, why is the price of the Bitcoin so high? Bitcoin’s growing demand and the awareness amongst the public about cryptocurrencies is causing the price of the Bitcoin to rise.

The price of the Bitcoin has been fluctuating a lot recently but some are betting that the price of the Bitcoin will rise to $40,000 by the end of 2018. People are even purchasing 5% of 1 Bitcoin so that they can sell it off and earn a profit when the price rises again. Various Bitcoin exchanges like Coinome, Zebpay, Unocoin and several others in India are currently allowing the public to purchase and sell Bitcoin also known as BTC. So, should you invest in Bitcoin? I hope I can help you answer that question by the end of this article.

Warren Buffett, one of the world’s wealthiest individuals and a person who is widely regarded as one of the best investors of his time had this to say about the Bitcoin: “It’s a mirage.”

Several others share his thoughts but does that mean that they are right? Well, they could be but it’s quite difficult to assess something like this and who knows what could happen in the future. Let’s take a look at some important points:

1. Volatility: The price of the Bitcoin has been fluctuating a lot and although it has been termed as a currency, a 15% change in price in a single day is concerning. Although, you wouldn’t be thinking about this today if you had invested in Bitcoin a few years ago because you would have been a millionaire by now.
2. Regulatory problems: Various countries such as China have imposed various restrictions to try and regulate Bitcoin and some countries have even banned the use of Bitcoin completely. Some believe that a few countries are working on their own cryptocurrency which means more regulations.
3. Bubble: Bitcoin has drawn several comparisons to other bubbles in the past specially due to the fluctuations in price and the massive hype surrounding it.
4. Legality: Although, buying or selling a Bitcoin is considered neither legal or illegal in India but the Reserve Bank of India has not declared it a currency yet.
5. Fraud: Various individuals and companies are contacting the public to ask them to invest in Bitcoin through them but because Bitcoin investments are not regulated, if you are cheated by someone you can’t do much about it.
6. Price: The golden rule of investment is to not invest an amount that you cannot afford to lose. If you want to invest in a Bitcoin then purchase a small portion of 1 BTC but do not purchase a large amount if you do not fully understand the market. Also, it would be a good idea to buy it when the price is lower than usual.
7. Future: The market cap of the Bitcoin is much higher than any currency or stock. It is used throughout the world and is truly international.
8. Wallet: After you purchase a Bitcoin online, they are stored in a virtual wallet but they are not entirely secure as the company that owns the wallet might get hacked. It’s important to remember that if you decide to buy bitcoin, do not store it with an online coin exchange platform. Instead, withdraw it and store it on a hardware or offline wallet so that it is secure.
9. Supply: The number of Bitcoin in existence is not expected to exceed 21 million and because there is a finite number, the demand continues to grow.
10. Futures trading: Anyone who has invested in stocks before understands the meaning of futures. Futures are contracts to buy or sell something after a set period of time at a predetermined price. Why am I mentioning this here? It’s because Bitcoin futures could be a reality, in fact US regulators have given the green signal to a few companies to allow Bitcoin futures trading.

Hopefully, some of these points helped you make a decision whether you should or should not currently invest in Bitcoin. Invest wisely and only invest in something you truly understand and believe in.

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