In exploring the underlying business model of a blockchain loyalty program, it is important to focus on a core fundamental difference between blockchain loyalty program and points and miles-based programs; currency scarcity.
A company running a loyalty program offering points and miles can create as many points and miles as they have demand for. Provided they’re able to cover the value of those points or miles when the member redeems them, the amount they can create is unlimited.
With cryptotoken loyalty programs, the strategy is to create a finite amount of cryptotokens. The program operator will declare in their whitepaper the total number of tokens which will be created (or pre-mined) and no more will ever be made. This creates the conditions for scarcity, the importance of which will be discussed throughout this chapter.
To understand the commercial differences between points and miles programs and cryptotoken loyalty programs, let’s compare the two using economic models.
Most people are surprised to learn that loyalty programs can actually be profitable for the business operating the program. They view loyalty programs as giving something to customers and automatically conclude they must therefore be a cost to the business. Certainly, many retail programs run this way but the big coalition loyalty programs can be hugely profitable, with their annual revenue in the billions and profits in the hundreds of millions. How can these sorts of profits manifest?
Let’s consider a frequent flyer program. Initially, they were created to reward the airline’s most loyal customers but soon after being created the airlines realised they had given birth to something very valuable: a highly desirable currency. Hotels and car rental firms quickly started partnering with the airlines and over time this expanded to banks, insurance companies, retailers and many other industries. These companies realised they could gain a competitive edge in their market by offering the frequent flyer program’s points or miles to their customers, who would choose to shop with them to increase their loyalty currency accumulation, moving their account balance more quickly towards a free flight.
The new opportunity for the airlines was twofold. Firstly, customers were more likely to remain loyal to the airline if they could gain free flights by accumulating the loyalty currency. Secondly, the airlines realised they could generate incremental profits by selling the points to their earn partners.
Consider this situation: a member of a frequent flyer program spends $1,000 with a participating retailer. They swipe their membership card and earn 1,000 points. The frequent flyer program will invoice the retailer for the cost of the points at a rate of 1.5 cents per point, costing the retailer $15. That’s right. The retailers who reward their customers with points from a frequent flyer program must pay the program for the points. While frequent flyer programs started as loyalty programs, they’ve now morphed into ‘points-selling’ businesses.
When the member chooses to redeem those points in the future, the frequent flyer program assigns a lower value to the points. Although they charged the retailer 1.5 cents per point, the value per point for the customer when they redeem them may be just 1 cent. Thus in our example, for each point sold and then redeemed, the frequent flyer program earns 0.5 cents. This may not sound like a lot but a big frequent flyer program can sell hundreds of billions of points each year, generating massive profits. In the case of our example, the frequent flyer program has sold the points for $15 but it has cost them $10 when they’re redeemed, earning them $5 profit on a single transaction.
If the member doesn’t use the points and they expire, the frequent flyer program banks the full 1.5 cents (or $15 in our example). Most frequent flyer programs have anywhere from 5 per cent to 20 per cent of their total points volume expire each year, contributing significantly to underlying profits.
The frequent flyer program also earns interest. When the points are sold the program operator must defer enough revenue to a holding account to cover the cost of the future reward (or liability). For example, if a member earns $50 of points, the operator must set aside $50 in a separate account, ensuring they have enough revenue allocated to cover the value of the reward when the member redeems them. The bank pays interest on this deferred revenue balance. A deferred revenue holding of several billion dollars is not unusual for a large coalition loyalty program.
From a pure economic modelling viewpoint, the supply and demand graph is defined by a perfectly horizontal supply line:
An increase in demand (from D1 to D2) for the loyalty currency translates directly into an increase in quantity (from Q1 to Q2), with no upward or downward pressure on the price. The frequent flyer program simply creates as much additional points or miles as required, deposits them into the members’ account and invoices the retail partner. They literally have a licence to print digital money.
This ignores the ability for the frequent flyer program to adjust the price and value of the currency to optimise their profit margin, which they do very effectively. Depending on what reward a member redeems their points on, the value they receive for their points is likely to be different. For example, points redeemed on a flight may deliver a value of 1 cent per point but if redeemed on a gift card they may deliver a value of 0.75 cents, while a toaster may give just 0.5 cents value. This pricing strategy is designed to both guide the member to redeem their loyalty currency on a reward which keeps the cash flow within the business (i.e. free flights) and take advantage of wholesale margins on third party products to boost profits.
The frequent flyer program will also try to sell their points for as much as possible. While our example uses the cost of 1.5 cents to the retailer, other retailers may pay 2 cents or 2.5 cents or even 3 cents, depending on their level of negotiating skills. Other retailers may agree to provide multiple points for each dollar spent by the member, so they end up spending 3 to 6 per cent of their total revenue on points or even more. The strategies used to maximise profits are incredibly sophisticated.
Now let us consider the model for a cryptotoken loyalty program.
The operator creates a finite amount of a loyalty cryptotoken; let’s call them Tokenz (TKZ) and let’s assume that one billion are created. A smart contract is set-up on the blockchain platform preventing any more TKZ ever being created. The loyalty company run an ICO and sell a percentage of them at a set price to anyone who wants to buy them; in our example, 200 million are sold at a set price of 10 cents per TKZ, generating $20 million of start-up capital. A further 100 million are distributed to the project team, business owners, early investors and advisors. This leaves 700 million TKZ as a company reserve.
At the end of the ICO, the loyalty company distributes the TKZ to the cryptocurrency wallets of the many ICO investors and floats TKZ on a digital trading exchange (or several). They can now be traded by participants of the ICO, as well as speculators who choose to buy and sell on the open market.
The operator then launches the loyalty program. With the right approach, they’ll have a network of retailers who participate in rewarding their customers with TKZ and accepting TKZ as a payment method. When a member of the program transacts with the retailer, the retailer will contribute a percentage of the transaction to cover the cost of the TKZ in exactly the same way as if they were buying points or miles from a frequent flyer program.
But here’s where things differ between the two models: rather than the loyalty company creating new points to provide to the member, the loyalty company takes the contribution from the retailer and purchases a TKZ allocation from the digital trading exchange. This creates on-market demand for TKZ and if there’s enough retailers and engaged members involved in the program, it will create strong and sustained demand. Following our example; a member spends $1,000 with a participating retailer. They swipe their membership card and earn $10 of TKZ, which are purchased at the market rate. If the market rate is $1, they’ll receive 10 TKZ and if the market rate is $2 they’ll receive 5 TKZ. Unlike the points model, the loyalty company doesn’t make a large margin on the transaction meaning a greater amount of value is transferred from the retailer to the member. The program operator can also charge a transaction fee on TKZ which are earned and redeemed to generate some revenue for the company. They should apply a fee to the transaction, although anything excessive is likely to be contentious from a retailer and member perspective. Once again the market will work to regulate the value structure.
This upfront transaction is very different to a points and miles program which requires the deferral of revenue to cover future liabilities. This will appeal to some companies, who don’t want to take on the complexity of deferred revenue loyalty program models. Other companies might prefer to defer the revenue, rather than wear the immediate cost of the reward upfront. It is something which needs consideration by companies when determining whether a cryptotoken loyalty program is right for them.
When a member redeems TKZ, the reverse applies. The loyalty company takes the amount of TKZ the member wants to redeem (or the dollar amount of TKZ they wish to redeem) and sells them on the exchange. They then provide the fiat currency to the retailer, less a transaction fee.
Here’s what the economic model looks like for a blockchain loyalty program:
The vertical supply curve is the exact opposite of the horizontal points and miles supply curve for a points and miles program. This is because the total supply of TKZ is finite (set at one billion TKZ) and no more will ever be created. Thus, if demand increases for TKZ (movement from D1 to D2) via growth in retailer participation, growth in the member base and/or member spend, or via an increase in speculative buying behaviour on the exchange, the price will subsequently rise (from P1 to P2).
Scarcity is the first lesson that economics students around the world learn. It’s why diamonds are worth more than dirt and is the fundamental economic theory underpinning a cryptotoken loyalty program.
Consider the profit potential of such a program: with 300 million TKZ in circulation at a launch value of $30 million, the operator’s reserve is valued at $70 million. This is $70 million that has been created from – essentially – nothing. TKZ didn’t exist until the operator created them and it cost them nothing. Now consider if the value of TKZ rises above 10 cents due to a demand increase. At 20 cents per TKZ, the reserve is worth $140 million. At 50 cents per TKZ, the reserve is worth $350 million. At $2 per TKZ, the reserve is worth $1.4 billion and the blockchain loyalty start-up is officially a “unicorn”. Managed wisely, the reserve can provide massive value akin to cash-in-bank which the loyalty company can draw on over many years to grow the program and build additional revenue streams.
Of course, the opposite is also true. If the value of TKZ drops to 5 cents, or 2 cents, or 0.01 cents, then the value of the reserve plummets. This is the actual reality facing most cryptotoken loyalty programs around the world today, because they’ve not been able to generate sufficient demand within the program to soak up the excess supply. That isn’t to say the model is flawed. The pure economics is still valid, but it will require an extensive retailer network and engaged member database to generate the level of demand required to grow the cryptotoken value in a sustained way, something very difficult for a start-up to achieve.
One advantage cryptotoken loyalty companies have over most other blockchain companies is the ability to generate most of the demand for the cryptotoken within the loyalty ecosystem rather than on trading exchanges. Most blockchain companies have created a cryptotoken as a way to raise funds via an ICO, without a genuine need to have their own cryptotoken. For example, there are many blockchain companies which force users to buy their cryptotoken to transact on their platform, even though it would be relatively easy to allow them to use fiat or other cryptocurrencies. It is an attempt to force the necessity of the existence of a currency which has no need to exist. Loyalty cryptotokens are necessary to the company’s operation; the program can’t run without them, and if the program operator is successful in signing up retailers and members, the demand created will build a solid foundation for the value which will be relatively impervious to market sentiment.
Outside of their cryptotoken reserve, the loyalty company can also generate revenue from transaction fees and a new revenue stream from blockchain marketing, which is covered in Chapter 15.
While most blockchain companies will do everything they can to send their cryptocurrency price ‘to the moon’ (a crypto term for a large price increase) as quickly as possible, this is not the right strategy for a cryptotoken loyalty program. A measured and consistent price rise is likely to be more effective in growing and maintaining member engagement. This is because too rapid a price rise will present the risk of a rapid decent which has the potential to generate disengagement. As discussed earlier, wild price fluctuations are arguably the single biggest challenge facing a cryptotoken loyalty program operator.
Imagine a scenario where the cryptotoken value quickly increases from 10 cents to $1 in value (as happened with Incent during the 2017-2018 bull market). For those members who have already earned a reasonable accumulation of the currency as part of their transactions with participating retailers this would be a fantastic event, particularly if they take the opportunity to redeem. However, for new members who are just starting to earn, the accumulation is at a high price versus historical averages. If the price suddenly declines, the value they have accumulated is reduced and they may not see any benefit in continuing their engagement with the program.
This may also be the case for long term members who maintain their holding in the hope the price will go even higher. If it rises too quickly it may trigger speculative sell behaviour, causing it to decline rapidly. Those members will be taken on the emotional rollercoaster known well by share traders the world over. This is a very different experience to earning points and miles and one that may be too much to bear for some members. Backlash and negative publicity may ensue which could damage the brand of the both the program and its retail partners.
So what can be done to help deliver a measured and consistent cryptotoken price rise?
The first step is getting the tokenomics right. According to Ennis et al, tokenomics covers ‘the set of all economic activity that has been generated through the creation of cryptotokens.’
As discussed, the biggest challenge many blockchain companies face regarding the value of their cryptotoken is that they don’t have an eco-system which is effective in generating sufficient demand for all the tokens in circulation. This is exacerbated by the fact they likely sold too many tokens at ICO in order to raise as much money as possible. As a result, most of the buy and sell activity for their cryptotoken takes place on exchanges which means the value of their token is almost entirely dependent on market sentiment. With a market as volatile as cryptocurrency trading, price swings have been seen to be considerable.
The recommended strategy for a cryptotoken loyalty company is to limit the amount of tokens held by investors and aim for the majority of buy and sell behaviour to occur within the program via earn and redemption transactions. Thus, if the speculative market pumps or dumps, the loyalty program token value is somewhat insulated because the average member isn’t trading, but accumulating for a future reward. As established earlier, a cryptotoken loyalty company has a greater chance of survival if most of the buy/sell behaviour happens within the program, not as speculative trading on exchanges. It is also critical that the demand for tokens within the program is greater than the supply held by active traders.
Quality commercial modelling will allow the loyalty company to ascertain the minimum amount of cash they need to raise via ICO to survive the first couple of years (of if they can avoid an ICO altogether), how many members they need to acquire, how much each member needs to spend per annum and what percentage of revenue retailers need to return to members in order to generate enough demand for tokens within the program. This will lead to a sustained and sustainable cryptotoken price rise and one which is resistant to downward price pressure from speculative selling.
The outcome from this should be a decision by the loyalty company to aim for a much smaller ICO raise (or none at all), so less cryptotokens are injected into the hands of investors/traders. The company always has the option to sell more cryptotokens if required. Another consideration is to try to direct most of the cryptotokens into the hands of a small number of investors who the company can work with to ensure they only sell at strategic times (difficult but still possible).
A further option is to delay the launch of the token on an exchange for 6-12 months after the conclusion of the ICO so the loyalty company can gain some traction with the program prior to the advent of speculative trading. This includes building a participating retailer network, recruiting the first wave of members, injecting cryptotokens into the accounts of members and generally building demand for cryptotokens through the program. Thus, when the cryptotoken does hit the exchange, the loyalty company has a fully working program with lots of small buy orders hitting the exchange to support the price. The downside of this approach is ICO investors will not appreciate a lag in the cryptotoken hitting exchanges, as their investment money is tied up in an asset they cannot sell.
It is also worth considering using loyalty theory to encourage investors to hold their cryptotoken allocation for as long as possible. This may be in the form of a time-based loyalty bonus. For example, if an ICO investor holds their cryptotokens for one year, they may receive an additional 5% of cryptotokens as a reward.
With the creation of a cryptotoken and the formation of a sizeable reserve, the loyalty company operator may also choose to maintain a cash and cryptotoken reserve, then use that reserve to smooth out the price fluctuations of their coin via strategic buy and sell behaviour. This approach can be compared to similar strategies used by a reserve bank or central bank managing the exchange rate of their country’s fiat currency. It can also be compared to a publicly listed company buying and selling their own shares to manage share price volatility. It is important to note that most countries have laws against market manipulation, which is a ‘deliberate attempt to interfere with the free and fair operation of the market and create artificial, false or misleading appearances with respect to the price of, or market for, a product, security, commodity or currency.’ Thus, any approach which involves buying or selling a reserve to affect the value of a cryptotoken needs to abide with the laws of the countries in which that cryptotoken is traded. An example of good practice in the crypto-markets is action taken by DeepBrainChain who, in March 2018, announced to the market they were intending to re-purchase 40 million DBC cryptotokens as a method to increase the value of non-repurchased tokens 
Suffice to say, this is not intended to be viewed as financial or commercial advice and any company planning to utilise this approach is advised to seek financial and legal guidance.
This is an excerpt from Blockchain Loyalty: Disrupting loyalty and reinventing marketing using cryptocurrencies (2nd Edition) by Philip Shelper.
Blockchain Loyalty is available at all good book stores. Buy it now.