The Wrong Way To Do Cryptocurrency

Posted: Mar 22, 2018 12:32 PM
The Wrong Way To Do Cryptocurrency

The Cryptocurrency Explosion

Cryptocurrency has slowly crept into the public eye after it’s explosive growth in 2017. Over the past year, from January 2017 to January 2018, the total cryptocurrency market capitalization grew over 3,300% from $17.68 billion to over $610 billion. While the market has pulled back since  the end of 2017, the growth rate still far outpaces that of any other market.  

Attempting to Bring Cryptocurrency To Mainstream Transactions

One of the premier cryptocurrencies to rise is Ripple, which looks to extend financial services and credit to individuals without access to traditional banking which is a challenge that individuals and companies have been attempting to tackle for decades. To do this, Ripple is creating a platform to facilitate near-instantaneous (3-5 seconds) transactions between asset or currency pairs.

However, Ripple is not unique in its mission, as there are a number of rival cryptocurrencies that are trying to accomplish the same goal. Stellar is an example of this. It's looking to create a global exchange on the same scale as Ripple. Both cryptocurrencies are looking to create a real-time protocol that facilitates any sort of cross-asset exchange, essentially allowing cryptocurrency to enter mainstream transactions. 

Interestingly, one of the prime differences between Stellar and Ripple are the backers: Stellar is backed by a cast of start-up veterans such as the creator of WordPress Matt Mullenweg and Y Combinator President Sam Altman. On the other hand, Ripple is backed by a number of ex-bankers and a board of financial institutions. Most recently, IBM has entered the ring by backing Stellar.

Over the past year, the price of Stellar has risen from 0.0018 to .3397 from March 2017 to March 2018 – a growth rate of over 18,700%. Ripple, on the other hand, had its price rise from 0.0055 to 0.8906 in the same timeline, a much larger growth rate of 17,729%. The reasons for steller's growth are mainly that new tokens have been released to the public and that there has been an increase in the price of existing tokens. The combination of both of these has resulted in an explosive growth rate. The short-term growth is clearly fueled largely by the huge amounts of capital flowing into the crypto market as a whole, but the long-term prospects differ between Stellar and Ripple due to the way Stellar has oversaturated its own token market. While the idea behind Stellar has tremendous potential, the team’s approach to distributing XLM is shortsighted and will have repercussions in the future. 

Stellar and Its Mission

To facilitate its platform, Stellar uses a network of Anchors, which are entities that issue assets within the Stellar Network. Much like banks, Anchors can lend out credits to the network which can be held by individuals as assets. In other words, exchanges within the Stellar Network are conducted using credits instead of the actual asset. It’s important to note that actual assets are not being exchanged, but rather a token representing the assets. Essentially, Stellar allows users to store money in whatever type of asset they like, such as Apple stock, and they can cash out of the asset anytime they need to make a purchase.

At first blush, an investor could be led to believe that Stellar would enable small cryptocurrencies to become “spendable” with cross-asset transactions, effectively allowing users to harness the long tail of crypto, which consists of small-cap cryptocurrencies that collectively make up a larger market share than top performers.

Currently, the largest barrier to cryptocurrency’s long tail’s value is the fact that it’s incredibly difficult to spend many of the smaller cryptocurrencies – because few if any merchants are buying the 500th largest cryptocurrency. In fact, the cryptocurrency long tail with Stellar’s price included is valued at hundreds of billions of dollars. It’s important to realize that tapping into the long tail of crypto means that the Stellar network will have to handle a tremendous amount of transactions. 

Recognizing the Value of Tokens

The entirety of Stellar’s platform is fueled by its XLM token, which is used to run all operations on the network. Any operation on Stellar requires a fee of 0.00001 XLM to run, effectively making the token an anti-spam measure. In order to make the network widely accessible, the Stellar team released the majority of XLM tokens for free. The price of an XLM token is low today, but not zero. This means that the cost of accessing and using Stellar’s network is near zero, which makes sense as Stellar wishes to keep the network free for those without access to traditional banking.

However, the drawback here is that XLM tokens are limited in use. Users hold XLM tokens to either run operations required on Stellar’s network or as a store of value. This means that ignoring returns associated with XLM’s price appreciation, which nearly all crypto tokens are experiencing, the only ways to add value to the token is through increasing demand for XLM tokens throughout the Stellar network.

XLM’s Value Based on Stellar Usage

Austere Capital, a hedge fund, found that only entities that function within Stellar’s network would be incentivized to hold XLM. This means that Anchors who purchase XLM to maintain trading reserves would be the best source of revenue to token holders. The price of XLM will increase as more Anchors join the platform because XLM becomes more valuable as the user base grows due to supply and demand. 

However, while increased usage of Stellar’s network makes XLM more valuable, there is a hard cap on the impact of increased demand. It is a common fallacy to assume the value of XLM will be equal to the total value of transactions going through Stellar’s network, based on a cryptocurrency hypothesis from 2015.

In reality, it is important to understand that Stellar’s network is only worth whatever assets are being transferred at the moment. Once the transaction has occured, assets on both ends of the pipe are exchanged out of the Stellar ecosystem. This means that the total value of Stellar’s network can be reduced to a simple equation: 

Price of XLM x Throughput of Network

Stellar’s development team has a throughput estimate of about 1,000 operations per second, which translates to 315,000 XLM being required to run the network at max capacity. Based on this, Stellar’s total value would be $0.35.

$0.35 x 315,000= $110,250

Through this measure, even if Stellar has hundreds of billions of dollars of volume through the network, the maximum risk at any point is a small amount. Great for the network, but horrible for the token – these numbers imply that the volume of XLM tokens required to support the network is in the low millions. Stellar plans to release 100 billion tokens.

More Tokens, More Problems

At max capacity, only 0.000315% of all tokens will be utilized, which means that supply far outstrips demand for XLM tokens. In addition, the only true use for XLM tokens is to facilitate asset exchanges, and so there is no incentive to hold XLM tokens for the long term other than as a store of value. At this time, it does not seem likely that demand will require 1 billion tokens, much less 100 billion. 

The long-term prospects for Stellar are cloudy due to the way the team has oversaturated its token market and the fact that there are multiple competitors in the same space whose tokens can do more. While Stellar prides itself on its liquidity and therefore, on its usefulness to small-cap cryptocurrencies, Ripple can be used for the same function.

The long-term prospects are dependent on the value of holding a cryptocurrency’s token, and holding Stellar’s token brings very little value to the token holder at this time.  Outside of its use as a store of wealth, the only other use is to facilitate asset transfers, but the supply of tokens is so high that it can take years before major entities use up their XLM stockpile and have to purchase more, resulting in a very illiquid market for XLM. Fortunately, Stellar is still in fairly early stages of development, so there is ample opportunity for its tokens to be utilized in other capacities in the future.