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Investing in Smart Contract Coins

2022-11-11, Michael Thompson

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Investing in Smart Contract Coins

The intent of this article is to explore the case for investing in coins on smart contract platforms. Specifically, we focus on the potential market for smart contracts, token economics and staking. Media hype has been a major influence on coin prices historically (e.g. a positive Elon Musk tweet about a coin often results in a substantial price rise), but we exclude that topic here.

We feel the topics covered are relevant to creating real long-term value for the coins. A real market appetite for a smart contract platform, coupled with token economics that increase token value with usage, can provide a good long-term investing opportunity. Media hype, on the other hand, can be unpredictable, cause wild price fluctuations in both directions, and have little impact on the long-term price trajectory.

The article is organized as follows.

Potential Market

In this section, we discuss the potential market for smart contracts. The intent is to evaluate how much usage any particular smart contract platform will receive. Some questions that we will consider are below.

  • How big do researchers think the market will be?
  • Will traditional contracts become obsolete in favor of smart contracts?
  • What traditional contracts will switch to smart contracts?
  • How many new applications are enabled by smart contracts (applications that were not even possible with traditional contracts)?
  • What are the advantages of smart contracts over traditional ones?
  • Even if smart contracts prove to have high utility, is it possible that decentralized platforms like Ethereum are not used?

How big do researchers think the market will be?

Estimates vary significantly, even about the current and past market. The Verified Market Research group estimates the market for smart contracts was about 150M USD in 2021 and expects it to reach 821M USD by 2030. Valuates, on the other hand, estimates the market at 315M USD in 2021 and over 1.4T USD by 2028. Future Market Insights estimates the market to be 183M USD in 2022 and 1.5T USD in 2032.

Will traditional contracts become obsolete in favor of smart contracts?

Traditional contracts will likely stick around for many applications. First, most people are not programmers. Such people cannot simply write up a smart contract “on a whim” if they have an agreement over dinner (yes, contracts written on napkins over dinner have been deemed valid).

For non programmers, a smart contract could be about as clear as a traditional contract written in a foreign language. Entering a smart contract will require a great deal of trust in 3rd party translators and coders. For common types of contracts, this is resolved by template smart contracts with thorough explanations, but this won’t cover every case.

This issue manifests in another way in traditional business-to-customer contracts: e.g. when you subscribe to Netflix. You’d be able to sue Netflix for almost anything not spelled out clearly in natural language—courts typically rule in your favor if a business didn’t clearly state the terms, in a way that you can understand. For this reason, such smart contracts would likely need to be coupled with a natural language traditional contract. Of course, unless the contract is extremely simple, terms won’t be identical. Perceived differences between the smart contract and its natural language explanation could create further legal issues.

Some researchers have claimed that smart contracts are not feasible when ambiguity is desired within a contract. According to “An Introduction to Smart Contracts and Their Potential and Inherent Limitations” (Levi, et al.), traditional contracts may include one or more ambiguous provisions when the parties involved cannot agree on a precise form. This may not be a valid concern. Smart contracts can include conditionals based on multi-signature actions, e.g. based on a committee’s decision at a later time.

What traditional contracts will switch to smart contracts?

For this topic we don’t need to speculate, we have real examples. Most are very simple contracts related to finance (deFi) and non-fungible tokens (NFTs). At the end of 2021, decentralized finance (deFi) had 94 billion USD locked. For example, the lending protocol AAVE has almost 9 billion USD locked at the time of this writing. Opyn is building DeFi-native derivatives and options infrastructure with over 89 million USD locked as of the time of this writing.

NFTs have also been used as a claim to ownership of items off the blockchain. While NFTs for digital art may have been overhyped in 2021, the NFT concept shouldn’t be dismissed. For example, consider a group of investors purchasing an apartment building. Ownership fractions can be represented by tokens on a blockchain, similar to NFTs. Among other things, this allows smart contracts to automatically pay out profits and claim costs proportional to ownership. It simplifies the process of selling / buying portions of the property, relative to the status quo. For more information about NFTs, see “NFTs for Art and Collectables: Primer and Outlook.”

The list of examples goes on. Fizzy used smart contracts to handle flight delay insurance. B3i is being used by major global insurers for reinsurance. The healthcare industry and gaming industries have already used smart contracts for various applications. For the most part, smart contracts are currently being used for the simplest contracts.

What are the advantages of smart contracts over traditional ones?

Here’s a short list.

  • Speed. A contract can execute as soon as a condition is met. Traditional contracts often have to wait for human inputs and actions, perhaps days. This facilitates the use of contracts in high speed operations that were infeasible previously.
  • No biased middlemen. A party in a traditional contract may feel he has been wronged and go to court, where a potentially biased judge makes the ultimate decision. This is particularly problematic when a judge has a financial interest in the
  • Precise definition. Traditional contracts are written in often ambiguous language. While this is leveraged in rare cases, many times it’s accidental and results in costly litigation and broken relationships. In many cases, programmers will find ill-defined conditions and notify the parties to clarify those conditions up front.
  • Cost. For many applications, a smart contract will be cheaper to create and execute than a traditional one. This could open the door for new applications, ones that weren’t cost-feasible with traditional contracts.

How many new applications are enabled by smart contracts (applications that were not even possible with traditional contracts)?

Most new applications enabled by smart contracts are associated with speed and cost improvements—things that were doable but impractical with traditional contracts. However, there are applications that were not even doable with traditional contracts. For example, flash loans facilitate loans without collateral or risk. It's hard to imagine such a loan with only traditional contracts.

Other such applications may be developed, but it's hard to quantify how much market this will obtain at this point.

Even if smart contracts prove to have high utility, is it possible that platforms like Ethereum don’t benefit?

This seems like an important question, yet it’s rarely discussed. Even if smart contracts are wildly successful, it’s possible investing in tokens won’t be lucrative. For one, there are so many platforms competing to provide smart contracts, it’s difficult to know which one(s) will end up with which pieces of the market. Consider the following example Warren Buffett pointed out in a Berkshire shareholder’s meeting.

Suppose it was 1903, and you foresaw the enormous growth of automobiles in the USA and invested accordingly. At least 2000 companies entered this business and, by 2009, only 3 survived (and two of those have since gone bankrupt). Your investment in automobiles, while based on a correct foresight of growth, would most likely have resulted in a large loss.

Another reason is that token-based systems may not dominate the market. For example, most of the insurance applications are currently being investigated on Hyperledger Fabric, a system that doesn’t even have a cryptocurrency. Other such systems include Quorum and R3 Corda.

Coin Economics

Let’s say a particular platform like Ethereum ends up with an enormous market. Will the platform’s coins (e.g. Ether) increase in value with the market?

There are fundamental reasons why blockchain coins may increase in value. The coins are typically the currency used to pay for smart contracts and have a limited supply or issuance rate (some have burning mechanisms that can even make them deflationary). Hence, if demand for these contracts (or dapps) increases faster than supply, you can expect coins to increase in value.

It may appear that the coin price is limited (relative to, say, USD). If a smart contract is only worth 100 USD to users, then they won’t be willing to pay over 100 USD for the necessary coins. Fortunately, the cost for a contract (per unit work) is typically not fixed.

In the case of Ethereum, a user pays an amount of Ether proportional to the complexity of the operation (the gas units required) and a gas fee:
total fee = gas units x gas fee.
The gas fee includes a base fee set by the network, plus a user-chosen priority fee (or tip) which is paid to the validator, to incentivize validating the operations.

Critically, the gas fee fluctuates. Let’s say an Ether today is worth 2,000 USD, but tomorrow it rises to 3,000 USD. Smart contract usage would essentially stop if the total fee (converted to USD) was now too high. Ethereum automatically handles this. Two things happen when the token price increases: (1) usage drops and (2) more people are willing to validate. Both things result in a lowered gas fee—less Ether will be required, per unit work done on the blockchain. This frees the value of Ether to increase (relative to USD) without discouraging usage.

For more information about Ethereum transaction fees, see Gas and Fees.

Coin Supply

Smart contract platforms have algorithms to enlarge and reduce their supply of coins. Creating new coins is called minting, while removing coins from circulation is called burning. The net effect of these two processes can result in an increased or decreased supply of coins over time, and should be a concern for investors.

If coins are minted too fast, a surplus supply of coins can drive down the price and penalize the investor. If coins are burned quickly, on the other hand, a reduced supply could increase the price per coin.

Minting

Minting is the process in which new coins are created. Coins are typically minted when a new block is proposed, and distributed amongst the miners / validators who supported the process (in addition to the tips described above). The cost of minting a coin is relevant to investors because it competes with the market price of the coin. It makes little sense to pay 2,000 USD for an Ether if one can be mined for much less.

For more information about minting coins on Ethereum, see Intro to Ether.

Burning

Burning is the process by which coins are removed from the supply. This is typically done via a transaction that moves the coins paid to the network (fees) to a “dead” address that no one owns. Since this decreases the supply of coins it places an upward pressure on the price per coin.

With each block added to Ethereum’s chain, all base fees paid in that block are burned. (The base fee is computed by the network depending on demand in recent blocks.) When there are more users, block sizes increase, which cause base fees to increase. Therefore, the burn rate (amount of Ether burned per unit time) increases with network users / traffic (the “mint rate” also increases with usage, but potentially not as fast).

With enough usage, the net effect of burning and minting on some platforms can actually be deflationary. For example, see "The Merge: Supercharging Ethereum.”

Staking

Many smart contract platforms allow you to earn interest on your coins. It’s called staking, and we’ll explain it briefly below. In short, it’s like buying a treasury bond with fiat in that your coins will be locked up for a period of time, but you’ll be rewarded with "interest payments." Also, like treasury bonds, this has the potential to increase demand (and hence price) for the coin—people will want to buy it just to earn staking rewards.

Staking may be done only on platforms that validate transactions via a method called proof-of-stake. People provide tokens as collateral (a “stake”) when they verify transactions that enter the ledger. This allows bad actors, who try to push invalid transactions, to be punished by losing their stake. Good actors are rewarded by receiving a small percentage of their stake when a block (set of transactions) is added to the chain. A downside is that tokens are temporarily unusable (locked up) when staked.

Directly staking coins is not practical for many people. It requires a minimum amount of coins (e.g. 32 Ether), and a computer running special software with 24/7 connectivity to process transactions.

Pool

If solo staking is not feasible, you can join a “pool”—a group of people pool their coins together and a 3rd party computer will perform the validation and distribute the interest amongst the pool participants. Of course, you must be careful to join a trustworthy pool, and they’ll charge a fee / reduce your reward slightly. Many exchanges provide staking as a service as well.

For more information about staking on Ethereum, see Ethereum Staking.

Reward amounts

Major platforms like Ethereum, Cardano, and Solana are currently paying out the equivalent of 3.5 to 5.5% per year for staking. See the Staking Reward website for current estimates. As you might expect, staking rewards are larger on less reputable platforms. Of course, these rewards compound on top of coin appreciation. If you earn 4% Ether via staking, but Ether appreciates 50% relative to USD, then you effectively earned 6% by staking (in USD).

Conclusion

The market for smart contracts is growing and likely to expand significantly in the coming decade, primarily due to the reduced cost and speed at which they can execute. Many researchers in the field expect over 5x growth by 2031.

If usage of a particular blockchain grows fast enough, its coin could appreciate substantially relative to other currencies (e.g. fiat). On some networks, coins can actually be burned (destroyed) faster than they are created, further boosting coin price with usage. An investor can also increase coin holdings by roughly 4% per year (current estimate) by staking.

Even if smart contract usage grows over 5x, a big question is where this usage will take place. Will most of these execute on Ethereum, Solana, Hyperledger or some other platform we’re not even aware of now? Unfortunately, we don’t have a good answer for this. We can make predictions based on metrics like current usage, number of developers, and current cost per unit work. However, the youth of the technology combined with the huge number of competing platforms makes these predictions highly uncertain.

Given the uncertainty of where smart contracts will execute (Hyperledger, Ethereum, ...), I won't invest a large percent of my money in any of these coins. I consider it similar to the 1903 auto industry scenario described by Warren Buffett. I can appreciate that a smart contract expert may have superior insight to foresee that a certain platform, say Ethereum, will likely dominate the market. However, I'm not even in a position to understand if they are correct. (With most investments, 90+% of the "experts" making such predictions are actually phonies, trying to trick you into buying something or reading their article.)

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