What’s Driving the Crypto Token’s Value and How the SEC Could Act

FTX cryptocurrency exchange collapsed dramatically, and was followed by unprecedented bankruptcy filings with around one million creditors.

The media widely reported the alleged causes of FTX’s demise: there was an $8 billion balance sheet void. There was an incestuous business relationship with a commercial affiliate, Alameda Research. There was misappropriation of client funds and borrowing of funds against FTX’s own FTT token. And there was a bank run triggered by a competitor’s public threat of a massive FTT dump.

The fact that Alameda Research allegedly used the FTT as collateral to borrow funds suggests that lenders thought the FTT had value, which begs the question: how much is an FTT worth?

Understanding the value of any digital token requires understanding the key drivers of the token’s value: reserve, future cash flows, liquidity profile, and growth rate of token adoption.

Gary Gensler, Chairman of the Securities and Exchange Commission affirms that most tokens are securities and subject to existing securities registration requirements. But certain disclosure requirements, such as issuers’ audited financial statements, are in many cases not relevant to token investors.

Unlike stock prices which are anchored by the earnings and finances of the issuer, many token values ​​are created in the secondary market through usage and adoption.

Thus, for these digital assets, disclosures should instead be guided by token value factors.

Token Value Drivers

The token pool, if intended for trading, provides a floor price for a token. If a token was backed by an equal or greater amount of liquid assets, such as cash or Treasury securities, then it could be worth the amount of assets backing it or its face value, whichever is lower.

For tokens that generate cash flow from staking or utility i.e. loyalty rewards, their value can be estimated using the time discounted cash flow method immemorial. Some cash flows are predictable and are similar to dividends, which can be approximated using the Gordon’s growth model.

Both the liquidity profile and the adoption growth rate are tied to the secondary market value of the token. Many tokens differ from traditional securities in one crucial aspect in that they generally do not give holders a legal right to the assets of the issuer. Some tokens are non-refundable once struck – buyers can only earn a return if someone else is willing to pay more.

Therefore, token promoters in their marketing will often tout the potential liquidity of the secondary token market and their plan to increase token demand. The higher the adoption and growth rates, the more token buyers there are in the secondary market, leading to greater liquidity and a potentially higher price.

It is important to note that liquidity and adoption rate only matter if they arise from a viable token use case. Liquidity and growth fueled solely by secondary market speculation will eventually collapse.

Disclosure Framework

Based on the key drivers of token value, the SEC could standardize token offering disclosures. An issuer should discuss tokenomics – the supply and demand characteristics of crypto use cases, the level of developer activity, the volume of token transactions, and the consensus mechanism, among others.

In addition, a registration statement must include information regarding the reserve of the token – for example, cash, marketable securities or other tokens – if any, and whether it is intended to be redeemed.

If the reserve is partially backed by other liquid tokens, the registrant must provide a detailed assessment analysis of the value of these reserve tokens and a market stress analysis, i.e. whether the Reserve tokens have dropped by 10%, 50% or 90%.

Details regarding staking and other benefits – rebates or airdrops – must also be disclosed to enable investors to calculate cash flows. If liquid staking is allowed, this should be disclosed, as it will amplify leverage and the effects of a market downturn on the price of the token.

Periodic public reports for a token issuer, such as 10-Q and 10-K reports, should not require reporting of income and expenses applicable to a traditional public company. Instead, it should provide updates on reserve, network activity, transaction volume, developer activity, and adoption rates.

If a token is in the early stages of a project cycle and does not have an established use case, it should not be publicly offered to retail investors. Many of these tokens will not end up in a viable use case and will rely heavily on secondary market speculation and pose significant risks to retail investors.

These seed tokens can be offered to sophisticated investors in private markets, much like how startups raise capital in private markets today.

Most of the above can be incorporated into the current requirements, but the lack of standardized token-specific disclosures in token offerings hampers investor protection.

There are additional considerations to iron out, but this framework provides a foundation on which to potentially build. The registration of FTT probably would not have prevented the collapse of FTX given the alleged significant fraud and lack of corporate governance.

But it’s one step closer to more relevant disclosure and a necessary step to rebuilding crypto and regaining investor confidence, much like the enactment of post-Enron Sarbanes-Oxley and post-Lehman Brothers Dodd-Frank.

This article does not necessarily reflect the views of Bloomberg Industry Group, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.

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Author Information

Noah Qiao is a partner in Kirkland & Ellis’ Investment Funds Regulatory Group and a key member of the firm’s crypto advisory practice. He is also an adjunct professor at Cornell Law School, where he teaches a course on cryptography regulation.