Token Velocity and Why You Should Care - A humorous breakdown of a concept in token design

If you have been following the cryptocurrency craze for long enough, you would know that tokenization is a hot topic that gets easily brought up in most Blockchain conversations. There is plenty of literature surrounding this subject, and many more written about its constituting elements. This article will break down a concept called token velocity in layman's terms. This concept plays a key role in token design and should be a subject of interest to all token, dApp and ICO participants–especially those who are investing in ICOs and those who are presently preparing for their own.
With this in mind, let's start with constructing an example for a typical token project.

The Setup

Now… (Drumroll) (Stereotypical ICO pitch ahead)

This ICO is one of a kind…
It has a token with never before seen utility…
It is going to make you rich…
Very rich…
As per rough estimates (discounting gravity), you will be soon driving a Lambo to the moon
This powerful concept is soon to be a household name (like literally)
The ICO is called The Dubey ICO
And the token is The Dubey Token
And Dubey stands for Decentralized Uber for Laundry

For the purpose of our example consider the following:

1. We have 4 actors: Alice, Bob, Charlie, and Dave.
2. We have 3 'decentralized' washing machine cars in the Dubey ecosystem that can be called for washing clothes. They are driven by Bob, Charlie, and Dave. A piece of clothing costs $1 to wash. Each car has the capacity to wash up to 100 items of laundry a day. This would put the overall value that can be generated from the network in one day at - 3 cars x 100 items x 1$ = $300 in a day.
3. Dubey token is used to make payments in the ecosystem. Hence, one wash would transact a varying amount of Dubey token based on its current price. For example, if one wash has 50 pieces of laundry (each worth $1, totaling $50) and Dubey token is priced at $5, this transaction will cost the customer 10 tokens.
4. There exists a total supply of 300 Dubey tokens in the ecosystem, and all are owned by Alice.

Consider the three types of transaction scenarios described below:

Scenario 1

In one day, Alice hires 3 Dubey drivers, spending 100 tokens on each Dubey car. Each wash is worth $100 in value; therefore, Alice generated $300 worth of Dubey tokens, in a single day, in the ecosystem.

The point to note here is that every Dubey token has 'changed hands' or has been 'spent' exactly once. The number of times a token changes hands during a period of time is known as the token velocity. Hence for Scenario 1, the velocity of Dubey token for this one day is 1.

Scenario 2

Remember, Dubey tokens can only be used within the Dubey platform. This implies that there is a high chance that token holders would spend or cash out all of it the moment they receive it. This phenomenon is fairly common in the token economy, for which many reasons will be explained in the next section.

In the diagram, we have a scenario that describes this behavior. First, Alice hires Dubey driver Bob and spends all her tokens on washing 100 items of laundry. Bob then hires driver Charlie, spending his tokens washing 100 items. Finally, Charlie hires Dave and spends all his tokens similarly. Each wash is worth $100 in value, and the network again generates a total of $300 in value.

In this case, we can see that every Dubey token has changed hands three times in that one day. Hence the token velocity of Dubey token for this one day is 3.

Fun fact: The average velocity of the US dollar in a year is around 7, meaning a dollar bill changes hands on average seven times in a year.

Scenario 3

Here is a slightly different scenario. Alice knows about a little-known benefit of holding (or HODLing) Dubey tokens. If she holds 150 tokens in her wallet for one week, she gets a free massage (presumably from one of the drivers! #OnlySlightlyCreepy). With this in mind, she is more economical in spending her Dubey. She spends half of her tokens (150 Dubey tokens) for two washes (worth $200 in value) and saves the rest to get her free massage.

In this scenario, half the tokens have changed hands exactly once, while another half has not been spent at all. Therefore, in this case, the token velocity is 0.5.

Valuing Tokens by Utility

Quantity theory of money is a theory in economics which attempts to build a relationship between the quantity of money in an economy and the level of prices of goods and services sold. In token economics this relationship can be represented as:

Token velocity x Market cap = Total transaction value

Or in layman's terms, respectively:

No. of times a token changes hands x Value of the network (represented in fiat currency) = Total value generated from all transactions in the network (represented in fiat currency)

So how do we measure the value of a network?

The value of a network or the market cap is simply the total value in fiat currency of all circulating tokens. Utility price is simply this value divided by the number of circulating tokens.

Let's break that down according to the three scenarios:

Scenario 1:

All tokens were spent once to generate $300 in value.
This means that the network is worth a value of $300.
300 tokens generating $300 in value would mean that the utility price of 1 token would be $1

Scenario 2:

All tokens were spent 3 times to generate $300 in value.
On average, for each spend, $100 worth of value was created, and this is the value of the network.
300 tokens generating $100 worth of value would put the utility price of the token at $0.33 or 33 cents.

Scenario 3:

Only half the tokens were spent, generating $200 in value.
If all tokens were spent once, $400 worth of value would have been created. This would then put the value of the network at $400.
300 tokens generating $400 worth of value would this time put the utility price of the token at $1.33 or $1 and 33 cents.

See the problem yet? No? Read on.

The Token Velocity Problem

Most utility token economies designed today follow a pattern similar to that of Scenario 2, wherein the natural inclination of token holders is to immediately spend (or sell) all tokens.

This increases the velocity of the token, but the value generated in the network largely remains the same. When the 'number of times a token changes hands' increases, generating nearly the same amount of value, the token will have a lower price as exemplified in scenario 2.

Why would token holders wish to sell their tokens immediately rather than holding them?

1. There are no incentives for holding these tokens beyond its use inside the platform.
2. The volatility of the token might lead them to sell it for another coin like ether (or other altcoins), which may be a slightly better store of value derived from its utility in multiple other platforms.

Reducing Velocity

Scenario 3 describes a possible solution to this problem, although it may not be the best. Adding an incentive for users to hold tokens will reduce token velocity and have a positive impact on token price.

Reducing velocity can be done via other means:

1. Add a staking function that locks tokens in a user's wallet for a specific period of time.
2. Game your tokens (say by introducing user reputation) to give more benefit to users who have held them for longer
3. Introduce a profit-share mechanism to share profits with token holders (if possible, along with regulatory compliance)

Utility Value vs Speculative Value

However, valuing tokens purely based on their utility might not apply to the token ecosystem at present. This is because most utility tokens today ride on speculative interest rather than a value based on pure utility.

This means that the Dubey tokens in scenarios 1, 2 or 3, will probably not have the prices they were assigned, but instead, would have a price determined by what others are willing to pay for.

Therefore, ignoring its utility value, Alice, Bob, Charlie, and Dave will buy and sell Dubey at much higher prices in USD that its original utility price. This is because they believe in the grand vision of Dubey - a completely decentralized, stain-removing, massage-provisioning, fully-mobile washing machine ecosystem. Or they might just want to buy low, sell high and make a profit (which is usually the case). In either case, Dubey token is going to be traded at much higher values, and might even get you that Lambo to the moon.

As cryptocurrencies and tokens attract more institutional interest, we can expect speculative valuations to reduce. Institutional firms (such as the big banks, brokers, asset management companies, etc.) will be more keen on valuing tokens with respect to their real-world utility rather than valuing them highly for their golden promise of decentralization. This would make token velocity a crucial factor to consider while designing tokens for all future Blockchain projects.

Hope you had a good read, and feel free to hit me up if you have any queries.