Decrypting the Crypto Economy

Making sense of the token categories and their investment value

One of the most common questions from crypto investors is how to differentiate one crypto asset from another. Among thousands of crypto assets currently available, it is a daunting task to understand all of their functions and purposes. This confusion can often keep investors from participating in this emerging asset class and cause them to miss out on the exponential growth potential in their investment portfolio.

There is no better time to conduct this analysis than in the middle of the bear market. As liquidity dried up, many crypto tokens struggled to stay afloat [1]. With the rise of so-called “zombie coins,” it is wise to ask: what are the use cases of these coins? And how do they possess any investment value? In this article, we aim to answer these two questions.

Technological advancement is fast-paced. We witnessed how the Internet has transformed our everyday lives in the past 30 years; it is not too difficult to imagine how blockchain technology, a value transfer protocol on top of the Internet infrastructure, can follow a similar innovation pattern. There might be thousands of crypto coins, just like the apps on your smartphone. We should not be confused once we understand each token’s purpose and choose the ones that can add value to our lives.

To provide a simple classification, we first divide all crypto assets into two types based on how their value is determined. Type A includes crypto coins whose value is mainly driven by utility and network effects, and Type B is crypto tokens with values linked to real-world assets.

Subsequently, each type can be divided into four categories:

Type A : Value driven by utility and adoption

1. Store of value
2. Smart contracts
3. Payment coins
4. Meme coins

1. Digital Store of Value

The digital store of value category winner goes to Bitcoin. As the first decentralized peer-to-peer cryptocurrency, Bitcoin runs on the most secure and widely distributed permissionless blockchain payment network. Like commodities, the value of Bitcoin is driven by supply and demand. Therefore, its value has a direct correlation to its adoption. Although critics often focus on Bitcoin’s high price volatility in the short term, its historical long-term price appreciation is not something to be ignored. Since its invention in 2008, Bitcoin has become an alternative digital asset class included in the CFA Institute curriculum. The latest study highlighted that a 5% allocation of Bitcoin in a traditional portfolio (from 2014 to 2020) could boost the total return by as much as 50%, while the risk-adjusted return (Sharpe ratio) can increase by 0.36 [2].

With inflation becoming a global concern in the post-pandemic economy, investors are looking for alternative assets to maintain their purchasing power. Wall Street leading bank Goldman Sachs predicted that Bitcoin would compete with gold as a digital store of value [3]. Bloomberg suggested that Bitcoin may be better than gold [4]. Many financial institutions, including pension funds, insurance companies, and sovereign wealth funds, reported increased allocation to this digital asset class in recent years [5].

The price of Bitcoin is expected to increase over time with its finite supply and growing demand. The assumption is that the advancement of the digital economy will drive more people to “hold” Bitcoin as a long-term investment and a digital store of value. Assuming the total value of Bitcoin reaches the market capitalization of gold at $11 trillion, one Bitcoin would be valued at $400,000. To learn more about the intrinsic value of Bitcoin, please refer to this article.

2. Smart Contracts

This is one of the largest categories, as many crypto assets aim to build decentralized solutions on distributed networks. As the second largest crypto asset, Ethereum is the category winner.

Ethereum is a decentralized software that supports smart contracts and allows various applications to be built on its network infrastructure. It functions like a global supercomputer and a giant app store. Ether, the native asset that powers all transactions on the Ethereum network, serves as programmable money that fuels the network engine and all of its applications.

Many decentralized projects, such as decentralized autonomous organizations (DAO), and decentralized finance (DeFi), are built on Ethereum infrastructure, including many NFT projects and stablecoins. These projects may also have their own blockchain infrastructure that promotes different consensus mechanisms, interoperability features, better data architecture, or faster transaction speed. The supply of these digital assets is usually unlimited, as the objective is to build scalable software solutions. Therefore, the investment value of these assets is based on how many people “use” them in the digital economy rather than simply “holding” them, as is the case for Bitcoin.

An overwhelming number of blockchain projects belong to this category. However, these new projects can take years and decades to achieve their ambitious objectives. Simply put, it is challenging enough to build a centralized business, let alone a decentralized one. Investors should look at this category of assets as early-stage tech ventures and pay special attention to the number of active developers on each chain [6]. In addition to Ethereum, Cardano, Solana, EOS, Cosmos, Polka Dot, MakerDAO, and Filecoin are some of the popular projects in this domain.

3. Payment Coins

The original Bitcoin whitepaper describes Bitcoin as a peer-to-peer electronic cash system. However, the current network can only handle seven transactions per second, which is insufficient compared to the Visa network’s 65,000 transactions per second output [7]. This limitation motivated early technologists to create alternative cryptocurrencies as better payment rails on the blockchain. They are faster than Bitcoin with lower transaction fees, and some even have privacy features to circumvent censorship and surveillance. The well-known payment-focused projects include Litecoin, Bitcoin Cash, Ripple, Stellar, Dash, Monero, and Zcash, among many others.

Comparing the transaction processing throughput of Bitcoin to Visa is not an apples-to-apples comparison because the bitcoin blockchain is a settlement layer. In contrast, Visa is a payment network on top of the conventional settlement layer. Similar solutions are being developed for Bitcoin, such as the Lightning Network (LN), a “layer 2” solution that sits on top of the original blockchain with a 1,000,000 transactions per second capacity, far surpassing the Visa network throughput.

The main argument, however, is beyond the transaction speed or processing capacity. Crypto asset prices are too volatile to be used as a settlement currency. Since the introduction of stablecoins in 2014, most crypto traders have preferred to use stablecoins as a settlement currency on the blockchain. Companies like Ripple and Stellar are focusing on building advanced payment rails for financial institutions to improve cross-border transaction efficiency. Their native coins, XRP and XLM, function as transaction receipts not designed to constitute investment value. Therefore, payment coin collectors might be disappointed if they merely hold these coins for investment purposes rather than using them to facilitate transactions.

4. Meme Coins

Memes are cultural expressions that are created and circulated on the Internet across social media platforms. It is not surprising to see their presence in the blockchain space. Meme coins are often humorous and do not represent any real-world value. It is popular among younger generations, who embrace them as a way to express opinions and new ideas. Dogecoin, the first meme coin created as a pure joke in 2013, has remained a popular coin supported by a large online community.

By default, memes come and go as they have short shelf lives. One example is a meme coin inspired by the Netflix megahit Squid Game — the SQUID coin traded up 30,000% in one day with over $11 million in volume and crashed to zero shortly after. It is hard to say whether the coin creators had ill intentions in the beginning, but the buyers should have learned the lesson that hype could disappear at any time [8].

More meme coins are expected to be created as the Internet culture continues to incubate creative ideas and trendy themes. As the purpose of memes is clear from the get-go, there is no investment value in these coins, and it is better to stay away from this category if you don’t want to lose money.

Type B : Value pegged to real-world (or virtual) assets

5. Stablecoins

6. Platform tokens

7. Non-Fungible Tokens (NFTs)

8. Security tokens

5. Stablecoins

Stablecoins are the tokenized values of specific fiat currencies. The most popular ones are U.S. Dollar stablecoins. They were first invented in 2014 to allow instant settlement on the blockchain for cryptocurrency traders because moving USD in and out of traditional banking systems was too cumbersome and time-consuming. Stablecoins are especially useful when it comes to cross-border or micro-payment transactions. It can settle in seconds with minimal fees, 24/7. This is the reason why stablecoins have become so popular. Tether, or USDT, is the most traded cryptocurrency, with an average of $50 billion daily trading volume, surpassing the volume of Bitcoin and Ethereum [9].

There are many versions of USD stablecoins. In addition to USDT, USDC, BUSD, and DAI are the most traded ones, with a combined market cap exceeding $150 billion and growing. We also see stablecoins that peg to other currencies, but none of them are significant enough at this point to compete with the popularity of USD stablecoins.

Governments worldwide are increasingly interested in the potential of central bank digital currency (CBDC). A recent survey from the Bank of International Settlements (BIS) showed that 9 out of 10 central banks are exploring CBDCs, and more than half are running implementation experiments [10]. Potentially, CBDCs may co-exist with private stablecoins and facilitate better international financial transactions. Recent discussions from U.S. Federal Reserve also hinted that the existence of stablecoins reinforces the importance of the U.S. dollar as a global reserve currency [11].

It is beneficial for crypto investors to keep some stablecoins in their portfolios for two main reasons. First, it is a convenient settlement currency to rebalance the crypto portfolio from time to time and switch between various crypto assets. Second, stablecoins provide a superior yield to bank deposits, as yields are supported by thriving borrowing and lending activities among crypto market participants. Since there is no central bank setting the benchmark interest rates, stablecoin yields are purely market-driven and can be as high as 8% to 10% per year for U.S. dollar stablecoins [12]. Keep in mind that counterparty risk will apply when placing a deposit with non-bank entities, as there is no Federally approved deposit insurance coverage.

6. Platform Tokens (Loyalty Points on Blockchain)

Platform tokens became popular during the initial coin offerings (ICO) era. During 2017–2018, ICO was an innovative way for startups to conduct crowdfunding easily, but it also drew many scammers and con artists that eventually popped the bubble [13]. Since equity crowdfunding involves security regulations, most ICOs pre-sell their project tokens as membership privileges, such as exclusive access or product discounts. It is similar to Kickstarter or Indigogo campaigns but in the form of blockchain tokens. In a way, these tokens are like loyalty points pre-issued for future companies.

Loyalty points are valuable because they can redeem specific goods and services according to the rules set by the issuers, but generally, they are not considered investments. Platform tokens function like discount coupons and are not as interchangeable with other platform tokens due to the lack of a standard measure of value. For instance, it would be difficult to figure out how many meal vouchers it takes to redeem an airline ticket, and that’s why the barter system was replaced by money centuries ago.

Tokenizing loyalty points is in its early experimental stage. Big crypto exchanges like Binance or FTX are making their platform tokens more transparent, limiting the total issuance, reducing circulating supply through buybacks, and increasing discount offerings to drive further adoption. Traditional companies like Starbucks and Reddit have also publicly announced their plans to tokenize their reward systems on the blockchain [14,15]. We will likely see accelerated growth for this token category, especially for gaming, Web3, and metaverse companies that take blockchain applications to the virtual reality world. However, investors should keep in mind that these tokens are not equities. Even if the token supplies may be limited, the scarcity is applied to the token itself, not what it represents. They can, at most, be seen as private vouchers or collectibles but not as investments.

With abundant platform tokens on the blockchain, interchangeability will be an ongoing issue. Therefore, we can predict that this phenomenon will further strengthen the use of Bitcoin, Ethereum, and stablecoins as a better universal measure of value.

7. Non-Fungible Tokens (NFTs)

A non-fungible token (NFT) was invented to certify authenticity and ownership on the blockchain. Unlike other groups of crypto tokens, each NFT is a unique digital identifier. In 2020, it became widely popular to represent specific artworks, music, or game characters. According to Dune Analytics, the total NFT transaction volume exceeded $146 billion in April 2022 at its peak [16]. Many artists, songwriters, designers, and collectors embrace this new trend as digitization of the creative industry takes place on the blockchain. The best-known NFT collections are Bored Ape Yacht Club (BAYC) and Crypto Punks.

In addition to its applications in artworks, NFTs could be used as digital identities for any physical objects, including individuals. Imagine a global digital identity network was in place; identity verification would become much easier, especially for cross-border or Web3 portal access authentication. Electronic voting could also be accomplished for more transparent election outcomes. However, it would take much coordination efforts from the public and private sectors to make this a reality. Privacy concerns, implementation risks, and technology integrations present just a few bigger challenges than the application itself.

The NFT hype started to show signs of decline in May 2022, and trading volume quickly diminished in the second half of 2022, showing a 97% decline from its peak [17]. Similar to the ICO bubble, this decline manifests the illiquid nature of the collectible market and validates that the blockchain-enabled trading solution cannot sustain or recreate additional trading volumes. Although digital authentication on the blockchain is a noteworthy innovation, investors should not get overly enthusiastic about its potential impact. The legal rights, including copyrights, commercial permissions, and intellectual property rights, conveyed by NFTs are still not linked to the legal system. For the time being, it might be safer to treat them as digital collectibles and not investment properties.

8. Security Tokens

Security tokens are the tokenization (or “securitization” in conventional terms) of real-world assets on the blockchain. These tokens represent ownership of investments like stocks, bonds, real estate, and valuable commodities such as gold, oil, or carbon credits. In the internet age, most of these assets already exist in digital form; therefore, the purpose for putting them on the blockchain has yet to be justified. Proponents of security tokens advocate that fractional ownership and decentralized accessibility are the potential benefits of this new asset category, but we have already seen evidence that invalidates such claims.

The concept of enabling fractional ownership is not new. The public stock market is an obvious example. Mutual funds in various asset classes or real estate investment trusts (REITs) are also forms of fractional ownership. The reasons why most private companies and properties are not securitized can be attributed to valuation difficulties and the illiquidity of these assets. Tokenizing them will not magically resolve these fundamental obstacles. Take timeshare, for example; the ability to resell or exchange fractional ownership of vacation properties has been proven difficult [18]. Blockchain technology will not enable sudden liquidity in an illiquid market.

Democratizing finance by having open access to all can also introduce instability to the financial system. The accredited investor’s rules initiated after the Great Depression in 1933 still have merit today because all investments have inherent risks, and not all participants, especially retail investors, can manage the complexity of these risks. The ICO phenomenon provided an excellent example; confusion and manipulations arise when everyone can freely participate in an open, low-entry barrier token market. Numerous scams flood the ecosystem with their cunning marketing campaigns that undermine legitimate companies seeking genuine growth capital. The result was devastating, and the victims will always be the retail investors.

Fortunately, there are already strict regulations in place for security offerings. Blockchain technology can certainly be applied to improve efficiency in the existing financial infrastructure (see Enterprise Blockchain section below), but not to issue more tokens for the public to trade. For the time being, it might be easier to keep your investments in conventional venues than invest in this token category.

Conclusion

The abovementioned categorization is by no means perfect, as many multi-purpose tokens can be classified into other categories. However, this article aims to simplify token group characters and analyze their investment value.

Categories one (store of value), two (smart contract), and five (stablecoins) should be considered core allocation to a crypto portfolio, whether holding them directly or through private fund vehicles. Categories six (platform tokens) and seven (NFTs) can be subject to investors’ personal preferences. Categories three (payment tokens) and four (meme coins) have no obvious investment value, and category eight (security tokens) is deemed redundant compared to what the traditional market already offers.

Holding crypto directly is not the only way to get investment exposure to this asset class. Traditional fund vehicles or exchange-traded products that track Bitcoin or major crypto asset groups are publicly available in many markets. Investing in public companies like Coinbase, Canaan (bitcoin mining), Tesla or MicroStrategy that holds Bitcoin as treasury assets can be another easy way to gain exposure [19]. Investors do not have to worry about self-custody or the hassle of transferring assets on the blockchain.

Appendix

Type C: No Token Category

Enterprise Blockchains

Enterprise blockchain is purely solution-driven without any speculations, as these projects do not have publicly available tokens to trade. Access to these blockchains is restricted to enterprise participants, so they are often referred to as “permissioned blockchains” or distributed ledger technology (DLT) projects.

The largest financial institution that is embracing DLT technology is J.P. Morgan. The bank has set up a business unit, Onyx, to oversee all blockchain development projects to improve the existing financial infrastructure. This includes cross-border payments, real-time FX and securities settlement, multi-currency liquidity management, digital identities, and tokenization of funds and securities. Liik, J.P. Morgan’s interbank information network, has more than 400 bank participants across 38 countries [20]. If proven successful, the project will be considered an upgrade to the legacy SWIFT system introduced almost 50 years ago.

Distributed ledger technology is beneficial not only for financial settlements. IBM and Microsoft are integrating enterprise blockchain solutions into business processes in the supply chain, data management, hotel booking, logistics, and freight tracking. Walmart is an early adopter of blockchain to improve food traceability [21]. It also uses DLT to unify its third-party freight tracking system and automated payments to achieve higher operational efficiencies [22].

In addition to IBM, Microsoft, and J.P. Morgan’s blockchain projects, other known enterprise blockchain players include the Enterprise Ethereum Alliance (EEA), Hyperledger, and R3. However, except for holding public shares of these large public companies, investors are not likely to get direct investment exposure from these enterprise technology upgrades.

Compared to the smart contract projects in category two mentioned above, enterprise blockchains are more likely to achieve the intended solutions due to their centralized nature and efficient implementation. It is worth paying close attention to enterprise blockchain developments to predict similar software solutions being implemented in a decentralized way.

About the author: Christian Hsieh is the co-founder and CEO of Tokenomy, a crypto financial services and investment management platform.

References:

1. Crypto slump leaves 12,100 coins trapped in zombie trading limbo, Bloomberg, 2022.
2. Crypto Assets: The guide to Bitcoin, Blockchain, and Cryptocurrency for investment professionals, CFA Institute, 2021.
3. Goldman Sachs says bitcoin will compete with gold as a “store of value,” Reuters, 2022.
4. Bloomberg Crypto Outlook, Bloomberg, 2021.
5. Crypto demand from institutions outstrips retail, Financial Review, 2022.
6. Tom Dunleavy, Messari Analyst, Twitter, 2022.
7. Visa Fact Sheet, Visa, 2018.
8. How a Squid Game Crypto Scam Got Away With Millions, Wired, 2022
9. The market capitalization of the 10 biggest stablecoins from January 2017 to June 19, 2022, Statista, 2022.
10. Visualized: The state of Central Bank Digital Currencies, Visual Capitalist, 2022.
11. The Fed’s Inaugural Conference on the International Roles of the U.S. Dollar, Federal Reserve, 2022.
12. LoanScan: Compare high-interest accounts, LinenApp, 2022.
13. 80% of ICOs are Scams, Investopedia, 2018.
14. Starbucks details its blockchain-based loyalty platform and NFT community, TechCrunch, 2022.
15. Reddit Community Points, Reddit, 2022.
16. NFT Market Overview, Dune Analytics, 2022.
17. NFT Trading Volumes Collapse 97% From January Peak, Bloomberg, 2022
18. US timeshare investors suffer buyer’s remorse as fees pile up, TheNationalNews, 2021.
19. Bitcoin Treasuries in publicly traded companies, BitcoinTreasuries.net, 2022.
20. Onyx by J.P.Morgan, J.P.Morgan, 2022.
21. Walmart Case Study, Hyperledger, 2018.
22. How Walmart Canada uses blockchain to solve supply-chain challenges, Harvard Business Review, 2022.

New to trading? Try crypto trading bots or copy trading