Capital Stack Purgatory: Why exchange tokens sit somewhere between equity and an empty promise

“Given their position as aggregators of capital and their interest in building both traditional and crypto-native financial services, the exchanges are perfectly positioned to catalyze the adoption of Open Finance.” - Kyle Samani

Blurring the lines

Open Finance lacks a generally agreed upon unambiguous definition but most would agree that the core requirement is permissionless access. This means that no company can act as a gatekeeper for who can or can’t participate. Centralized exchanges fall outside this categorization since they have full control over who enters their platform. That being said, this may not always be the case as the exact degree to which these exchanges are “centralized” is changing.

This shift has been largely due to the introduction of native exchange tokens. These tokens have been used to raise money, not by offering any explicit rights as we see in debt or equity offerings, but rather a hodgepodge of “utility” functions on the exchange. Utility tokens exist in capital stack purgatory as there is no claim to cash flows, no liquidation rights in the event of bankruptcy, and no real legal obligation to do, well anything. Yet, exchange tokens have accrued over $5 billion in value.

So what’s going on here?

The underlying value in exchange tokens

Every exchange token is different in its own right, but there are some commonalities amongst them in that they can create tangible value for holders.

For example, tokens that offer trading discounts can save on fees. A trader would be willing to purchase a token at price x as long as the discounts outweigh the purchase cost of x. More specifically, x is the purchase price plus the opportunity cost of capital minus the price the token can be sold at in the future. As some have noted, there is precedent for this outside of crypto markets.

As Su mentioned, seats on the New York Mercantile Exchange enabled traders to trade on the exchange and receive discounted fees. Therefore, the price traders are willing to pay for a seat is in part derived from their expected savings on fees. As the market grows in size, so too does the total amount of savings, which is reflected in the price increase.

Another way exchange tokens have been able to provide value is through access to Initial Exchange Offerings (IEOs). Investors that wish to purchase an IEO typically need to hold an exchange's native token (for more details see our IEO report). In a similar vein, you will then be willing to pay a certain price for an exchange token if you believed that the profit from an IEO investment and the future sale price of the exchange token were higher than the purchase price.

In short, while exchange tokens don’t give you equity rights, they do provide holders a valuable seat at the table.

Does value accrue from burns?

There are various other ways exchanges look to provide value, but the point is that in doing so, they create a baseline of inherent value for those who use them. This brings us to arguably the most important and controversial aspect of these tokens - the burn mechanism. Exchanges typically burn some percent of revenue or trading fees in order to return "value" to token holders.

This looks and feels a lot like a corporate share buyback but as we established in a prior piece exchange tokens are not equity and burns are not buybacks since token holders do not receive a proportional increase to the claims on cash flows.

However, as we noted previously, these tokens do provide a “valuable seat,” so when a burn is introduced, it creates greater scarcity for a valuable asset. It’s unclear how much value accrues to the tokens as a result of the burns, especially as it pertains to exchanges burning from their own treasury. But all things equal, an exchange token that has a burn mechanism is more valuable than one without.

And exchanges know this so they put forth considerable resources towards these token burns. In 2019, the top five exchanges based on amount burned, burned over $300 million worth of tokens. While the respective numbers cannot be used to compare profitability on an apples to apples basis, it is interesting to see the gross amount spent by these companies on an unproven model.

Huobi spent the most money burning tokens in 2019, but after a massive Q2 burn, it decreased in the following two quarters. This compares to Binance’s burn which has increased every quarter since the end of 2018. Another interesting data point is Bitfinex’s LEO token which was used to raise $1 billion, yet only burned a fraction as much as its peers. It is worth noting that mechanisms differ for burns. While exchanges like Bitfinex use a portion of profits to buy tokens in the market and destroy them exchanges like Binance burn tokens already held in their treasury.

From exchanges to DAOs

The biggest takeaway here is the sheer amount of capital being "spent" on these burns. This serves to highlight an ongoing commitment to providing value to token holders. One rationale for this behavior is that exchanges view this new class of stakeholders as vital components to their long term success. With most exchanges rolling out their own native chains that will be secured by these tokens, it starts to look like exchanges are planning a gradual process of decentralization in which their end state is a DAO. If this is the case, then their ability to change token functionality on a whim is a valuable feature as new functions can be hardcoded to include staking and governance rights over the protocol.

Through this lens, the token’s malleable, pseudo-equity structure starts to make more sense with a path to becoming the dominant piece of a decentralized network remaining the end goal. This is an audacious undertaking, to say the least. Regulatory uncertainty will be a looming threat every step of the way. The various utility functions may prove to be less desired over time. Regulated, institutional-grade exchanges could eventually come to dominate the market. For these reasons or an array of others, exchanges may opt to remove their tokens altogether. Keeping this in mind, both the ambitious end goal and the plethora of risk along the way, the current state of exchange tokens sit somewhere in-between shares of equity in the exchange and a potentially empty promise.

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