Oh, shiny tokens! How much are they really worth?

Note: This article assumes familiarity with 0x. If you’re not familiar with the protocol or its purpose, please see Linda Xie’s excellent introduction.

0x is one of my favorite Ethereum projects: It’s elegant, serves a clear need, and has a nice ecosystem budding around it. However, is ZRX — the token powering it — a good investment? I will try to examine this below.

In this article, I will first briefly and informally review a few key factors that could contribute to 0x’s adoption or detract from it. Then I’ll spend some time trying to valuate the token assuming the project is generally successful.

Please note that valuation of tokens is far from a mature discipline as of this writing. I’m writing this not to present a thesis, but to share my thoughts and invite feedback and discussion. I will not be surprised if a year from now, this entire discussion seems absurd — consider yourself warned!

Adoption Drivers

Positive

Security concerns and increased legal scrutiny around tokens (which could cause some centralized exchanges to preemptively delist tokens) could push more token trading activity to decentralized exchanges Some dapps have a need to transparently exchange tokens for interacting with other dapps, making for an interesting use case that is not driven by human trading The project has some momentum around it, with a few relayers already operational and continued active development

Negative

The legal risks that drive adoption of decentralized exchanges could apply to 0x relayers as well (depending on the applicable jurisdiction), thereby weakening positive driver #1 above Exchanges could opt to use the 0x protocol but not the ZRX token. For instance, they can live off the spread, rendering the token unnecessary for fee payment Scalability issues of the Ethereum blockchain could hurt the trading UX at a level that deters mass adoption by users The governance aspects of the ZRX token may not be properly valued by the market (more on that below) Alternative generalized solutions to the same need could appear (e.g. distributed exchanges could be implemented via Plasma Cash or some other means)

Token Valuation Dynamics

For the following discussion, I’ll assume 0x is increasingly adopted and used in the field. If that’s not the case, this discussion doesn’t matter, as there’s no fundamental reason for the token to appreciate over time.

There is a fixed supply of 0x tokens. What are they used for? The white paper states (emphasis mine):

Protocol tokens will have two uses: for market participants to pay transaction fees to Relayers and for decentralized governance over updates to the protocol.

I will refrain from trying to value the token’s governance use, simply because I do not currently have intelligent insights to contribute on that aspect, nor am I aware of a good valuation framework for governance. I am probably not alone in this, as Will Warren, co-founder of 0x, stated in a recent interview on the Unchained podcast with Laura Shin that he feels the ecosystem does not currently appreciate the governance aspects of the token properly.

Time will tell and I’m looking forward to continued progress in valuation of governance aspects of tokens, but for now let’s consider the other use of the token — paying for fees.

First, note that we’ve touched above on the possibility that relayers and other players in the ecosystem would use the protocol without charging fees in ZRX. This is a very real possibility and my impression is that quite a few people in the 0x ecosystem believe that would ultimately be the case. If you’re considering investing in the token, you have to assign that outcome a non-zero probability and plan/size your bet accordingly. For that scenario, you will have to rely solely on the governance aspects of the token for your valuation.

For now, we’ll proceed with the discussion assuming the fee payment use case is becoming a long-term reality and we’ll try to value the token based on that.

For some background, there have been quite a few treatments of crypto-asset valuation. If this article is at all valuable, it is thanks to these prior works by Chris Burniske and others. Please see here, here, here and here.

Now, let’s consider the basic use case for ZRX: You’re using a distributed exchange (or “Relayer” in 0x terms) to perform a trade, and you’re paying fees in ZRX.

I postulate that even if the fees are nominally denominated in ZRX, in practice the pricing would be driven by USD (or whatever local fiat is applicable). The reason is that the relayer is competing with other exchanges, centralized or not, that price their commissions in USD or equivalents. (It doesn’t matter if an exchange’s commission is nominally priced in USD, some other fiat, BTC, or anything else, since the competitive pricing pressure is in USD terms.)

Let’s say (for simplicity’s sake) that a trade costs $1 over at GDAX or Binance. 0x-based exchanges must price their commissions competitively, so if one ZRX is $1, their commission would have to be around 1 ZRX, or if one ZRX is $100, their commissions would have to be around 0.01 ZRX.

Why does this matter? It matters because it means that even if you do not own ZRX and you’re only obtaining it to perform a trade, you know the USD-equivalent amount of ZRX you’d need to buy would always be the same, no matter the rate of the ZRX token. On the face of it, this gives the average user little incentive to stack up ZRX tokens: Trades will always essentially cost the same, so why bother?

Going further, one could suggest that trading costs are deflationary by nature, and we should expect crypto trading costs to trend lower with time. However, I will leave this for the reader’s consideration and will suffice with the assumption that the cost per trade in USD terms will be approximately the same over time.

Wait!, I hear you saying. As the volume of 0x-powered trading goes up , so does the demand for ZRX tokens. Even if they are bought on a need-to-use basis, if there’s a long-term secular trend of increasing trading volume (daily trading volume gyrations notwithstanding), then this increasing demand for ZRX should overall drive value appreciation, shouldn’t it?

To try and answer this question, let’s consider the valuation with the help of the quantity theory of money. Mind you, I will not attempt to arrive at a specific price; I’d rather focus on the dynamics of the token’s economy and arrive at an intuition that allows us to answer the question above. If we manage to get a solid understanding of these dynamics, then one could assign values and arrive at a specific number if one so chooses.

Let us apply the equation of exchange for 0x:

MV = PQ

M = fixed at 1B (the finite supply of ZRX tokens)

V = Velocity. The number of times ZRX tokens are spent in a period.

Q = Quantity of output in a period. In our case, that would be the number of transactions. (Must increase with trading activity.)

P is the price level — the amount of ZRX spent (as fees) per transaction

Remember, it’s important to denominate both P and M in ZRX terms (not USD/Ether)! Here’s why.

If we accept, as suggested above, that the price per transaction will always be roughly the same in USD terms, then our focus turns to determining the direction P will take over time. If P goes lower (lower prices in ZRX terms), then the USD value of ZRX is rising — and vice versa. (Confusing? Consider that if a trade always costs around $1 and you paid 1 ZRX for a trade today, but will pay 0.01 ZRX for a trade tomorrow, ZRX will have appreciated by 100x).

Let us isolate P then:

P = MV/Q

M is fixed and we’re assuming 0x is succeeding and its adoption is growing over time, hence Q is rising over time. The key factor to determine then is the token velocity - V. Can/will V increase over time in an unbounded manner, to match the increase in Q? If the answer is yes, then P will remain constant and ZRX will not appreciate. However, if V’s increase is somehow bounded, then at some point Q (trading volume) will “outpace” it, P will decrease and the ZRX token will appreciate.

Unfortunately, V is not easy to accurately predict (more reading about velocity in token economies here). Let us explore some assumptions to intuit about V:

Some amount of ZRX will always be hoarded (ugh, I mean hodled), thereby reducing the available supply of ZRX tokens for users/dapps who want to buy them and use them immediately for trading purposes. The velocity of these tokens is 0 and they’re essentially removed from circulation. Let’s call this H — the amount of hodled ZRX tokens. Some amount of ZRX tokens will always be made available for selling by the relayers/exchanges, because a) they need to sell ZRX to ultimately get something they can pay their bills with, and b) their interest is to provide liquidity in the market so users who need ZRX can immediately obtain it, maintaining the usability of the protocol. Therefore, there are actors in the market who are incentivized to provide liquidity — more so than for store-of-value type of assets. This means that the velocity V will generally grow to accommodate the market needs.

So, we have established that V will grow to accommodate the growth in Q. However, is this growth bounded in some way, or can it “infinitely” grow to match an increasing Q?

To answer that question, let us do a little thought experiment: If you “freeze” the 0x economy at a point in time T, there will always be a number of open trading orders N which is roughly proportional, but not identical, to Q (number of transactions). These orders have associated fees which must reside, at this particular moment T, in the accounts of the trading entities (the issuers of the orders).

The amount of tokens available for fee payment at moment T is approximately fixed at M— H (total supply minus the hodled amount). However, N is unbounded — it is proportional to Q which we’re assuming is on long-term secular growth. It follows then that V cannot grow to accommodate Q in an unbounded way. Which means that directionally, the USD value of the ZRX does ultimately grow with the growth of transactions. But there’s an obvious catch …

The (Obvious) Catch

Remember, my purpose above was to provide intuition about valuation dynamics of ZRX. For arriving at an actual number, you would need to assume some values for the trade volume, fees, hodled amount… and remember a key point for any investment: The starting point matters. Even if the ZRX token has dynamics that support price appreciation over time (and please remember, this is a big if — we don’t even know if ZRX will be used to pay fees at all!), its current price point could represent speculation that goes beyond the justifiable value for reasonable expected trading volumes. Remember, our discussion here was focused on dynamics and not on arriving to a specific price point.

While undoubtedly lacking and incomplete, I hope the above discussion was a useful exercise in evaluating the dynamics of the ZRX token’s economy. I believe many of the above ideas are applicable to other tokens as well. Either way, comments and insights are welcome. Thank you for reading!

Disclaimer: This is not investment advice, and I am not a financial advisor. Investing in crypto-assets is incredibly risky. If the phrasing used in the article did not make that clear, I am not certain about many things in life, and I am even less certain about the ideas expressed above. For all I know, this article could look absurdly misguided in the near future, or it may already be absurdly misguided as of this writing. Finally, if you take any sort of investment advice from People On The Internet, remember these wise words.