Why Do We Need Tokens, Anyway?

Avtar Sehra
Aug 9, 2017 · 5 min read

Avtar Sehra

This is an extract from this paper, providing an in-depth analysis on the structural and dynamic economic properties of Initial Coin Offerings.

Executing an Initial Coin Offering (ICO), issuing tokens and managing the micro/macro-economic impacts on a product, business, key stakeholders and the market will mean companies in the future may not only need a CFO but likely also a Chief Economist, as running such a firm will be akin to running a small country!

This will be more of a problem for a startup or a fledgling company, but maybe not so for an ICO executed by a larger firm with a more established product or service. But I guess that just misses the point of tokens right… Anyway, lets pretend that’s not an issue and everyone starts to issue their own tokens, does that mean we will start paying each other in private money?

“I’ll give you 2 laundry tokens for 1 haircut token.”

Very unlikely!

Barter Exchange : Fruit and grain merchants in the marketplace. GETTY IMAGES

Money was invented because bartering isn’t a particularly efficient means of paying for goods and services. While this should be obvious it hasn’t stopped idealists and opportunists trying to bring back the concept through “new and revolutionary” business models — some of which scarily resemble the current token/appcoin hype!

With the growth of the internet in the 1990s and 2000s there was a sporadic resurgence in the concept of bartering. But many platforms that attempted such models disappeared as quickly as they emerged.

An example of one that launched in 2005 and persevered for a number of years was PeerFlix, which was a platform that enabled users to exchange DVDs. CNET summed it up nicely [1]:

“Essentially, it’s Netflix with no centralized processing center. Actually, that’s not true. It’s more like an open-source version of Netflix, with users sending their own DVDs to other members instead of everyone borrowing from the company’s massive library of movies. The idea is that collectively, users have the movies that everyone wants. So, if one user has a copy of “Pulp Fiction” and another member wants to borrow it, the first sends it off to the second. ”

Peerflix tried to overcome the limitations of bartering. One of the key issues was associated with the “Coincidence of Wants” i.e. not having exactly what someone wants with whom you want to barter [2]. Peerflix attempted to solve this problem by introducing their own token called “Peerbux”, with which users could pay for DVDs rather than doing an outright exchange. This native token was used as a medium of exchange on the platform and could be bought for fiat currency or earned by sending DVDs to other users. Before you say how contrived, reflect on how you stand with ICOs/tokens first!

By early 2008 Peerflix shut down, apparently as people realised that [3]:

“when you have to trade DVDs straight up, there are going to be a lot of crappy DVDs available, and not many good ones. It doesn’t take an advanced economics degree to figure out why” .

One of the key lessons we can learn from this is that having a native digital token is senseless when the economic structure of the underlying market is fundamentally flawed. In the case of Peerflix the flaw is simple, and is one Ebay knew very well. Ebay realised it could not fulfil user demand with the highly limited supply of used goods.

The inelastic supply of used goods meant that as demand for a product increased the auction prices increased to a new equilibrium, however there is a limit to how much a user is willing to pay for a used item i.e. there is a point where a user would rather buy a new item than pay above a certain threshold for a used item. Ebay’s original model works well for antiques, where there is no more supply of new items, but it does not work well for generic mass market items.

Ebay knew it needed to expand into a wider marketplace model that also offered new goods; this way it could fulfil user demand and compete effectively with the likes of Amazon [4].

Peerflix did not fulfill its market’s fundamental needs, instead it focussed on simplistic ideas of solving problems that people really didn’t care about. Which resulted in Peerflix being eaten alive by Netflix!

So while native digital infrastructure assets, such as bitcoin or ether, are fundamental innovations as a decentralised store of value, medium of exchange and potentially a unit of account, their value can also be seen to stem from the frictionless markets they enable to be developed atop of their decentralised networks.

Leveraging the core benefits of these native digital assets means that developers and entrepreneurs can focus on solving the real problems of inefficient markets they are trying to tackle.

By adding contrived secondary tokens, merely for the purposes of fundraising through regulatory arbitrage, is a potential sign that the market model being deployed may be contrived and of no extra value at best and potentially ineffective and destroy value at worst.

However, such complexities are not easy for token investors to assess, in particular where projects are marketed as “infrastructure layers” and or “open source technology”, and accompanied by a high-level white paper with little or no technical specs or economic analysis (qualitative or quantitative) that demonstrates an understanding of the market.

This lack of depth and structure would be equivalent to a startup or even a non-profit raising traditional financing/donations without providing a viable business/operating model and a deep understanding of their market’s economic structure and dynamics.

Interesting question is, while many people would not accept such a level of inadequacy in a “normal” funding processes, why are they willing to turn a blind eye when it comes to an ICO process?

But then again, who cares about answering such questions when there’s money to be made in the short term… as long as you’re not the last one left holding the lemon!

Thanks to Vic Arulchandran for his contributions to the refinement of this and upcoming work.

Avtar Sehra

CEO and Product Architect @Nivaura, previously a Financial Engineer and Theoretical Physicist Fascinated with the Group Theory of Rubix Cubes

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