Chapter Nine: Limited Supply Does Not Mean Increase In Value

[Comment: In the previous chapters we discussed how to avoid the Howey test, and some ways that people who plan initial coin offerings (or, as I call it sometimes, speculative cryptocurrency allotment methods, or SCAMs), may avoid being defined as  a security. During the last week, the Israeli Security and Exchange Authority issued a statement that pretty much repeats the conclusions set in my handbook (190 pages, Hebrew); the interim report states that if you're issuing a utility token that's meant for a distributed asset, or a private currency, then it's not a security; this will be reflected in the final version of the handbook, which I hope to publish sometime this year].

In this chapter, we'll discuss the presumption that affects people's decision to invest in an ICO, and that's the limited supply. The straw man argument is that because there is a limited supply of tokens, then when the network effect steps in, the people in the demand side will be willing to pay more for the token, therefore driving its price up.

That paragraph said quite a lot without explaining it, so let's rephrase it in layman's words. There is a limited amount of gold in the world: less than 200,000 tonnes; now gold has many uses: some people use it for jewelry, some for electricity and some as plain investments (keeping gold bars in their basement). The fact that a lot of people agree that gold is a mean of value, and that are willing to accept gold as a payment means that more people will use gold as a payment. 

Now, because of gold's limited supply, and the inherent need for gold in the world, the demand side will be willing to pay more as gold becomes scarce. Meaning, if there is less gold, and the value of the entire economy based on this gold increases, then the value of gold increases as well.

This might sound reasonable, and actually work in some cases: bitcoin is one example. The controlled supply of bitcoins means that there will never be more than 21 million bitcoins. This also means that when more people want to get into the bitcoin game, they will be willing to pay more per bitcoin in order to hold a bigger portion of the entire bitcoin cake. However, this does not work in all cases. 

The shopify blog gives a different example, relating to shopping: people are willing to make a transaction if they think that the supply of that product is limited, even if at first they were not inclined to purchase it. However, not all scarce merchandise is going to go up in value over time.

Let's explain. And I'll use Binance as an example.  Binance is an online cryptocurrency exchange that has its own internal currency, the Binance Coin. It has around 200M tokens, and they may be used for paying the fees when making transactions in Binance's service. Now, the fees in Binance's service fees are 0.1% per trade, meaning that if you trade 1BTC, you have to pay 0.001 as a fee. If you're willing to pay the fee with Binance coin, then it is reduced by 50%. How is Binanace coin's value calculated? according to the supply and demand rule: when people want a discount they will pay for this token. As long as Binance exists as a stock exchange, and as long as there will be a discount for Binance coin, people will have a use for Binance coin.

Now, let's say I'm agnostic to Binance coin's value and I'm not speculating on it, but just want to use the platform. What I'll do to get the discount is buy the amount of Binance coin I want just seconds before I enter into my transaction, and use its exchange rate at that moment. I get the same discount.

As the fees are calculated not in Binance coin, but in the currency I'm trading, I really don't care about Binance coin's value, but just on the discount I'm getting. Therefore, even if there's a limited supply and the Binance coin's value will be US$1M, I can buy just a fraction to pay the fees I need just before. I don't care whether there's a limited supply, as long as my use of the token/coin is just for the fees.

This explains why a limited supply, when the value is not intrinsic, is something that might not be a good rationale to have an ICO or to invest in one. If the token itself does not represent an actual asset or an actual stake in the project, then even if the project increases in value, there's no use for it going up.

The other example is my favorite coin, Doge. Dogecoin is a joke cryptocurrency; It began when Jackson Palmer, a cryptocurrency developer, wanted to ridicule the crypto-community and explain that people will invest in every shitcoin, even if it did not have a limited supply, and if it had ridiculous block times and block rewards. 

Dogecoin is an inflationary cryptocurrency; meaning that there is no limited supply, and the amount of coins grows all the time. It is also a joke-meme coin. It is meant to allow you to learn how cryptocurrency works.

However, in such case you would expect Dogecoin to be worth nothing. This is not really the case. Because  of an active community the currency did have some value. While it is nowhere near the 200 satoshis it was when just launched, it still holds a steady value of 40 satoshis, and a total market cap of around half billion dollars (and an all time high of US$2B). This is mostly because of the cool stuff doge provides people, that adds intrinsic value: dogecoin's community had some projects that were meant to make the world a better place; Pizza for the homeless, raising funds for the Jamaica bobsleigh team for the 2014 winter olympics, and a tipping bot, which is meant to allow people to tip others in online forums using this joke currency. This shows that an active community creates internal value, even if there is no limited supply.

So, will a limited supply ensure that an investment will go up if there are many users? the answer is "not really". The first thing to examine when you want to go for an ICO to raise funds, is to ask why will the value of your token will go up over time. If the token represents a portion of your company's revenues, then it's understood why: more profits mean more value. If the token represents a physical asset that is limited, like an acre of land or a gold bar, then when that asset goes up in value so will the token, but if your asset is just a mean to pay for the use of your network, there is no reason for prices to go up. If you're token represents 1GB of storage in a distributed storage system, then most likely that storage prices will go down over time. If your token  represents one hour of computing time, then likewise.

Before you go ICOing and state that the network effect and limited supply will make your token's value increase, please explain this.

I'm Jonathan Klinger, I'm a master of law, certified to practice in Israel. I've explored the blockchain, and now I'll be helping you in deciding on whether you should raise funds via a token generating event. I highly recommend you avoid it. Read my blog for more info.

Previous Chapters:

Preface
Chapter One: Other People's Money, an Introduction.
Chapter Two: Scams, or why do we need investor protection?
Chapter Three: The Investors, or who doesn't need protection.
Chapter Four: What is a security, or: the Howey test, simplified.
Chapter Five: Avoiding the Howey Test.
Chapter Six: Airdrops.
Chapter Seven: Valueless Tokens.
Chapter Eight: Token Burns; another way to avoid Howey.