Creating a new crypto currency is extremely easy. In less than 5 minutes you can create and deploy your very own ERC20 token on Ethereum or any other EVM compatible blockchain. Does it mean that your new token will be competing in market cap with the likes of AXS or GALA? Of course not, your new token is most likely worthless.
How do you make your token valuable? In the words of Peter Thiel, how do you go from 0 to 1? In this article we are going to explore 5 different mechanisms that could help provide value for your token.
Note: In this article I’ll be using the term “coin” to refer to the native currencies of different blockchains (BTC, ETH, AVAX, etc.) and the term “token” to refer to ERC20 tokens (AXS, GALA, UNI, etc.).
1) Utility
What is your token used for? The answer to this question is THE most important aspect of your token valuation as it creates buy pressure from the market. People buy GALA because it’s required to buy in-game NFTs from the Gala Games store. People buy Ethereum because they need it to pay gas fees for their transactions. People buy UNI because they want to participate in the governance process of Uniswap.
It is my experience that “governance” is not a strong enough incentive to give value to a token. If you are building a DAO you’ll need to create a secondary use case for your token that is not related to governance to influence its valuation.
2) Liquidity
To allow the market to define the fair value of your token you must find a way to provide liquidity to exchanges so people can buy and sell at different prices until a balance of supply and demand is found. Given that centralized exchanges don’t index new tokens you’ll have to focus on creating liquidity on decentralized exchanges (DEX) like Uniswap.
When providing liquidity to a DEX you’ll have to decide how much of the total supply of your new token you want make available, the other crypto you want people to be able to deposit in exchange of your token (most likely the native coin of the blockchain where your ERC20 token is deployed), how much of this crypto you are willing to pony up for the liquidity pool and the spread of this liquidity.
An alternative to provide liquidity yourself would be to sell your tokens directly using a smart contract or using a dapp like Juicebox and then incentivize the buyers to provide liquidity in a DEX through staking. Illuvium is a good example of this as they provide two staking pools, one for the ILV token and another for SushiSwap’s LP token that’s granted when providing liquidity on the DEX for the pair ILV/ETH. The LP pool has a much higher staking reward than the regular ILV pool to incentivize people to provide plenty of liquidity to a DEX. Paraphrasing The Mandalorian, this is the way.
3) Inflation
You probably know that low inflation is good and high inflation is bad. Sure, no inflation or even deflation would be even better but who are we kidding? At least in the early days (or years) of your token, inflation is inevitable. Minting and selling tokens creates inflation. The rewards for staking tokens creates inflation. Unlocking tokens over time creates inflation.
Inflation is acceptable as long as the utility of your token increases over time. If you are only counting on increasing network effects (more tokens in the hands of more people) to combat inflation you are basically creating a Ponzi scheme. Please don’t, we have plenty of those already.
4) Network Effect
According to economists, the value of a network is defined by the number of nodes and the number of connections between those nodes. This theory is known as the “network effect” or “Metcalfe’s law” and it’s often used to explain why a company like Facebook became so valuable: everyone you knew was there so you couldn’t afford not being there too.
We can extrapolate this definition to our token valuation problem by stating that, the more people have your token and the more they use it to trade among themselves, the more valuable it becomes. Although it’s clearer why this would apply to native coins like Bitcoin, Ethereum and Avax, its connection to ERC20 tokens is weaker but not insignificant. For ERC20 tokens I suspect the network effect is more about “brand awareness” than anything else.
A common approach at strengthening the network effect of a new token is to do a “token drop”. For example, if you are the creator of a new DeFi protocol that has its own token, you could set aside a percentage of the total supply to distribute freely to the token holders of a related DeFi project. This simple act will bring awareness to your project at a very low cost because people love token drops even if they don’t have any value (yet). Free t-shirts are usually of terrible quality but who doesn’t love to get one?
5) Distribution
You can have millions of token holders but if one of them controls a disproportionate amount of the total supply it would be seen as a red flag by the community and negatively impact its valuation. A “whale”, as large token holders are commonly known, has the power to exploit the rest of the community by manipulating the supply on exchanges to pump and dump the price of the token at will for a profit. If the token is used for governance, a whale will be able to control every decision even if it’s detrimental for the project as a whole.
How much is too much power? It depends on the market cap of your token. For a brand new token a maximum token supply of 5% might be acceptable but for a coin like Bitcoin is clearly not.
Conclusion
Creating a token is easy, making it valuable is hard. Utility is the most important factor when defining its valuation while the second most important factor changes depending on where you are on the life cycle of the token. Right after its creation liquidity is the second most important factor while long term inflation becomes the second most important factor.
Are there other important factors that I’m not listing here? Drop a line in the comment section below, I want to read different perspectives.