Cryptocurrency supply and how to evaluate one

Token issuance relates to the creation of a digital asset and how its supply evolves over time.

One should expect of the supply dynamics and distribution of any reliable digital assets to be transparent, immutable and fair.

Furthermore, it is important to underline that the founding team backing and developing a novel cryptocurrency is the only economic agent that has the power to design the asset supply.

When purchasing a virtual currency, investors agree informally to the supply dynamics and distribution of the asset, as they have no power to change the initial set-up.

Total supply

The maximum amount of digital assets can either be fixed like Bitcoin or unlimited like Ether.

In other words, fixed supply has a ceiling limit - a maximum supply - while an unlimited supply indicates that there are no limitations to the amount of digital assets.
We can therefore differentiate:

  • Total supply: the maximum asset supply that can exist.
  • Circulating supply: the number of assets that have been released.

Pre-mining

Founder can pre-mine digital assets behind closed doors before introducing them for the first time to primary markets.
Depending on how it is operated, this practice can be controversial as founders decide to reward themselves, advisors or early investors in their own token.
The controversy is not whether or not to pre-mine tokens, but if the process is transparent.

In this sense, it is important to understand:

  • The proportion of digital assets that are pre-mined
  • The stakeholders that get access to these assets
  • Whether there is a vesting and lockup period.

Inflation rate

Once assets are issued, the inflation rate determines how the circulating amount evolves over time. A positive inflation rate means that the volume of tokens increases, while a negative one implies that assets are burned and the supply reduces over time.

The rate is usually annualised to give the supply volume change of an asset in a single year.

Inflation is a key metric that showcases the variation of total supply and indicates the future level of dilution of asset owners. Depending on supply dynamics (usually hardcoded on a smart contract), the token economy and dilution levels can vary drastically:

  • Limited supply with positive inflation rate: the circulating supply increases until it reaches the total supply
  • Limited supply with negative inflation rate: the circulating supply decreases until it reaches a threshold
  • Limited supply with constant inflation rate: the circulating supply is equal to the total supply
  • Unlimited supply with positive inflation: the circulating supply increases indefinitely
  • Unlimited supply with fluctuating inflation: the circulating supply increases at different rates

Indicators helps investors navigate through these different scenarios.

For instance, the present circulating rate shows the percentage of token currently available against its maximum, while the 5-year inflation rate estimates the supply change in the next five years:

  • Present circulating rate: circulating supply / total supply
  • 5-year inflation rate: circulating supply in 5 years / circulating supply

Smart contracts can accommodate various inflation rate dynamics. The rate does not have to be constant and can fluctuate based on the supply design.

For instance, inflation rate can be positive but decrease over time - less assets will be added every year - or on the other hand, inflation can stay positive but increase over time, meaning the incremental addition of assets increases year on year.

Distribution

Last but not least, cryptocurrency holders have to understand how the assets are distributed in the first place.
Distribution can get confusing, sometimes misleading, and fully comprehending how many assets are allocated to stakeholders involved in the project is vital to accurately assess the viability of a cryptocurrency.

Most of the time, these tokens and coins are introduced during an ICO but do not represent the entire supply: founders, advisors and early investors rewards differ from the assets sold during a token sale:

Total token supply = token sold to public investors + token sold to private investors + tokens allocated to the team and for future use.

Dividing the token sold during an ICO by they target sale capitalisation gives the maximum valuation of the project.

Initial valuation

The team behind the ICO decides the valuation of the token eco-system. In fact, they set the rules of the game: it’s their way or the highway.

The amount sought by the founding team in a token sale often holds a price ceiling and a price floor, called soft cap and hard cap respectively. More advanced sales can introduce refund mechanisms or personal capitalisations such as the reverse ICO or the interactive ale.
Under the hood, a smart contract automatically reimburses investments whenever the final capitalisation comes up outside of the pre-defined brackets.

In conventional sales, soft and hard capitalisation are not negotiated but solely decided by the founding team itself. Naturally, since founders evaluate their own work, there are considerable risks of over-valuation.

Finally, the initial valuation is often priced in cryptocurrency rather than in fiat.
In fact, many ICOs fundraise and fix their soft and hard market capitalisation with a cryptocurrency as unit of account.
For instance, if an ICO is up and running for a couple of weeks with Ether as a unit of account, a price fluctuation on the ETH/USD pair would have an impact on the market capitalisation of the ICO.

An increasing amount of ICOs are switching from a cryptocurrency unit of account to a fiat one, in order to reduce volatility risks for both investors and issuers.