Crypto tokens and coins: What drives performance?

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Source: CoinMarketCap, FactorResearch

Token financing

Crypto start-ups are financed through equity and tokens. Raising capital via equity means issuing shares that are privately held by angel investors, venture capitalists, and the like. These shares represent an ownership stake that entitles the recipients to dividends and proceeds when the company is sold.

Token financing is very different: It gives investors no legal claim to the underlying business. As a consequence, token and equity investing are not really comparable.

Naturally, start-ups pursuing token financing need to convince investors there is value to be gained by participating in the token sale. The typical pitch is that the start-up’s product requires the use of tokens. This can create rather complex ecosystems that resemble small economies with their assorted stakeholders: The start-up is the equivalent of the government, the product a stand-in for goods, the users for consumers, and the token for the currency or medium of exchange .

Since each token represents a currency, demand and supply should determine its price. Token and coin issuers can influence supply: Bitcoin, for example, limits the total number of tokens to 21 million, and Ethereum has bought back ETH tokens and “burned” them. Since the tokens represent cryptocurrencies, their demand should be influenced by their popularity.

Correlations of token prices and token volumes

The relationship between the product of the start-up and the underlying token is not straightforward, however, and is thus hard to evaluate. Stockholders would love to own shares in a booming, revenue-generating business. But token investors have no claim on such cash flows.

Worse, token investors face an information deficit since start-ups release little to no financial data on the underlying business. This puts them at a major disadvantage relative to equity investors.

The best way for token investors to understand the value of their holding is to interpret the change in token volume as a proxy for the demand of the associated product. The more popular the product, the higher the demand for the token, which should reflect an increasing volume of the token on the exchange.

But that relationship doesn’t hold up under scrutiny. The rolling correlation between changes in token volume and token price across all tokens between 2014 and 2022, on both a monthly and annual basis, is close to zero. This indicates that there is no positive relationship between the business of the start-up and the price of its token.

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