0x token review

Combination of potentially large utility and lack of a good network business model makes us follow the coin, but not invest.

The 0x protocol, which recently concluded a crowd-sale for its protocol governance token, is a basic building block to enable p2p over-the-counter ERC20 token trades and custodian-risk free ERC20 exchanges. This video gives a good high level description of the protocol.

Commercial utility and addressable market

The primary utility of the 0x protocol is it enables ERC20 token exchanges with no custodian-risk. Token traders today need to hand over custody of their ERC20 tokens to a centralised exchange such as Poloniex prior to trades and are exposed to the risk of such exchanges being hacked while trades are in progress. 0x removes this risks by having Ethereum — based smart contracts take over the custodian role. This is a large enough advantage to entice a significant percentage of crypto-traders to switch over to exchanges based on the 0x protocol (if and when the technology works satisfactorily). We are quite confident that the protocol solves a tangible pain point.

A secondary utility might arise in case of regulatory clampdown on crypto exchanges. 0x protocol could presumably allow the creation of un-censorable p2p OTC exchanges.

The addressable market can be estimated from historical data and projecting a growth rate for the foreseeable future. Currently, $1 billion of daily trade volume exists for crypto -to- crypto market pairs, and this number can grow at a CAGR of 120%–220% annually over the next 5 years. Historical growth in the past 2 years has clocked in at a healthy 400% annually. Conservatively, the 0x project could act as a pipe for 1%–5% of these exchanges and therefore has a large total addressable market in front of it.

Technology review

A working version of the OTC trade technology can be tried at portal, and development updates followed from the blog. The technology is sound and tractable to build, and we are confident of seeing it integrated into commercial products over the next 6–12 months.

There are some technology risks that investors need to be aware of:

Problem of front running: The process of order creation and fill in the 0x protocol allows miners to front-run trades. There does not appear to be a satisfactory resolution to this problem and it can stunt protocol adoption. Denial of smooth trading experience through co-ordinated 'taker-griefing' attacks: 0x protocol might have its own version of a DoS attack where token purchasers attempt to fill orders only to be thwarted by order creators en-masse. If such attacks happen on a co-ordinated fashion, it could impact user experience on a large enough scale to affect protocol adoption. Exposure to scalability bottlenecks of Ethereum: 0x trades require one of the trading parties to submit a transaction to the Ethereum blockchain. Therefore, the utility of the protocol is dependent on gas costs. If gas costs spike up due to high transactional demand from ICOs or other applications, performance of the 0x protocol would degrade. As 0x competes with other centralised exchanges that are unaffected by gas cost considerations, this could be a roadblock in the medium term.

Nature of the token

0x is a 'governance token' acting as permission rights to participate in the protocol upgrade process. The process has not been specified, but we shall assume it involves voting on upgrades. The token design is where this, otherwise excellent project, leaves us with unresolved questions.

First and foremost, there doesn't appear to be any research on governance challenges faced by previous open source projects, and why a token could solve these challenges. This is a critical omission from the whitepaper.

Second, consider the costs to participate in the governance process imposed on interested parties via the 0x token. Assume the reader wants their voice to count in the process and for it to have 1% of the weight in decision making. This would necessitate them to purchase 1% of the token supply. At the total market cap of $220 million, a cost of $2.2 million to purchase enough tokens is imposed. Further assume that major upgrades are done twice a year and that protocol life is 10 years. This would value the "privilege" to participate in one major upgrade, with 1% weight, at $110k [$2.2 million / (10 * 2)]. Who, exactly, would pay $110k for the privilege of participating in one 0x protocol upgrade? Why would they pay this money? Why would the number of paying parties grow over time? Important questions for 0x speculators since holding a coin is a bet on growth of paying parties.

One might posit that exchange businesses using the protocol would partake in the process by shelling out funds. This leads to an enquiry about what kinds of conflict would entice exchange businesses to take an active role in the process. Prospective investors should wait for the emergence of protocol upgrade conflicts before buying into the 0x governance token.

Further, any governance process benefits by putting the right parties on the table. Does the cost-imposing governance token really help identify the right parties? Would the exclusion of cash strapped entrepreneurs, academic researchers & open source activists (who cannot pay $110k per decision) be a good thing for the protocol?

Finally, wouldn't a token-based governance structure can create a conflict between speculators seeking a return, and the right parties to involve in governance? The better a return speculators get, via appreciation of token value, the more exclusionary and corporate-controlled the governance process might become. Imagine a 0x market cap of $2 billion. Having 1% of the say in token upgrades costs $1 million per decision, worsening the governance process.

Given current information, we are not convinced of the governance token idea from both an investor's hat and that of a party genuinely motivated to make a better protocol.

What 0x lacks — a sound network business model

From past technological history, we know that good technologies do not necessarily make good investments. Many influential technologies lack a method for technology creators to route some of the real value created to themselves and their early backers. TCP-IP and HTTP are immensely important technologies, but lack a direct method by which we, a user of both, end up routing some value to the creators of these technologies. 0x risks having a similar outcome down the line. The governance token attempts to monetise protocol upgrade conflicts, and this may not prove rewarding to its investors in the long term.

The feature of great internet technology investments is the presence of a method that directly links technology usage with returns to investors. Consider Google — whenever a visitor searches, the sale of advertisements on results displayed enriches Google investors. What is the equivalent route of enrichment for 0x investors? How does value flow to them, as a collective, every-time ERC20 tokens are exchanged using the 0x protocol?

Answering this question successfully will mean that the 0x network develops a sound business model. Wait for that moment before investing.

Conclusion

The 0x protocol and coin gets many thing rights — it solves a problem with large commercial utility, has a tractable technology target, sound development plans, an able team and famous backers.

Concurrently, there appears to have been sparse thought invested into business models, and actual designs of governance tokens. This combination makes us follow the project, but not invest. We watch out for the following catalysts before purchasing 0x coins:

Market Proof: 0x protocol usage numbers that are growing faster than the industry average. The industry average can be considered to be ShapeShift, Poloniex and the existing centralised exchanges. Here's an interesting video about tracking market metrics for 0x. Development of a business model: Presence of a method where growing volumes of 0x protocol usage directly translate into larger returns for coin holders is key. The governance token idea is probably too weak a link between usage and returns to investors, and should be superseded by something else. Removal of technology risks: Discovery of methods to address front-running and large scale denial of good UX would de-risk the technology further.

Disclaimer: this article constitutes our opinions and is for information purposes only. It is not intended to be an investment advice. Seek a duly licensed professional for investment advice.

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