Tokens are a High-Risk Funding Mechanism

This is Part 1 of a series on token engineering, economics, and design. With this series of posts, I aim to contribute to the growing trove of literature in these fields, and to help educate those who are pursuing tokenization as a means to enhance their projects. Ultimately, my goal is to assist the community in encouraging the development of cryptoeconomic models whose tokens are sustainable, equitable, and credible economic tools for creating new types of networks.

Disclaimer: Any models I suggest or refer to are highly experimental in nature, and should be used with caution. Part of the aim of this series is to encourage people to test economic models more rigorously before releasing them into open markets. I present them here only as suggestions for avenues of exploration.

Preamble

This series of posts was inspired and informed by a number of great resources and think-pieces that I came across during my research. But I noticed a common trend across many of these posts: inaccessibility.

For anyone who doesn’t already understand the concepts, most of the wisdom imparted by token engineering resources online is largely incomprehensible (or at least inaccessible within the length of a few blog posts). It seems as though the authors are unwittingly writing for an audience of like-minded, equally informed token economists — rather than trying to educate newcomers to the space.

Yes, we get it, MV=PQ

These posts therefore aim to make the core concepts behind token engineering as understandable and accessible as possible. Let me know if I haven’t achieved this, and I’ll edit accordingly.

Utility Tokens as a Funding Mechanism

Token sales have become an increasingly popular funding mechanism (source)

For quite some time, tokens (and behind them, ICOs) have been hailed as a revolutionary new crowdfunding mechanism that will wrest the power of capital in the tech sector from the hands of Silicon Valley VCs and neatly distribute it to the creators and users of the platforms that are being funded. By disintermediating early-stage funding, tokenization has gained a powerful reputation among decentralists as a “good thing” in and of itself.

Disrupting current funding mechanisms is no doubt a noble goal, but placing utility tokens in the category of “crowdfunding” fundamentally misrepresents their substance and purpose. Whereas existing crowdfunding mechanisms essentially give the purchaser a “voucher” to be consumed once the platform or product is released, almost all tokens are designed to persist indefinitely, like a currency.

To clarify: here, I discuss what are termed “utility tokens” — tokens designed as a proprietary payment currency that provides access to products or services on a specific platform. Many but not all tokens are modelled this way.

The difference between the traditional voucher model of crowdfunding and the currency model of utility tokens is core to the problem:

  • A voucher is redeemed; a utility token is spent.
  • A voucher’s value is destroyed upon redemption; a utility token’s value is supposed to persist after spending.
  • A voucher is 1:1 backed by whatever it can be exchanged for; a utility token is backed only by its value as a medium of exchange as determined by the market.
  • A voucher is a temporary representation of future value yet to be created; a utility token is minted and unbacked value.

If utility tokens were burned (i.e. destroyed) upon redemption, they would truly be analogous to crowdfunding, and they would be economically sound. However, we seem to have instead arrived at a scenario where minting your own unbacked currency and hoping the market imbues it with value is an acceptable activity.

This is an activity previously restricted to nation states, and it is one of the crypto community’s greatest criticisms of fiat money. The irony here is not lost on me. How can we condemn fiat while campaigning for utility tokens, when they are based on the very same shaky foundations?

The fact that entire institutions of economists (in the form of Reserve Banks) are required to stabilize and legitimize unbacked currencies (in the form of fiat) illustrates just how irresponsible it is to mint tokens without proper economic considerations or constraints. Designing economies comes with its fair share of challenges…

Challenge 1: These Are Intricate Systems

There’s a reason governments don’t just print money whenever they need it: if it’s not backed by real world value, it dilutes the existing money supply, leading to inflation. Given that the crypto token market is relatively small, I don’t expect to see mass inflation within the wider economy as a result of this new money being minted out of thin air. But within these markets, I do expect to see a lot of perceived value plummet when people start to accept that much of it is baseless.

This is because economies are like natural ecosystems. They are intricate, finely balanced systems developed over long time spans, whose members all interact synergistically. When one or more of the members in the system deviates from normal behaviours, ecological (or economic) catastrophes often occur. Keeping these components in balance requires carefully designed incentive structures, and we are still figuring out how to get these right in the context of crypto tokens.

Challenge 2: Volatility and Vulnerability

Because economies are highly intricate systems, and because the market capitalization of token economies is small (usually less than $100 million), they will be highly vulnerable to external events.

Small markets can experience massive volatility even over the course of short time spans (anonymous token, source)

Consider the image of boats on the open ocean during a storm. The USD economy is a super tanker. It get battered around a bit by the wind and waves, but is ultimately sturdy. A token economy, on the other hand, is like a tiny yacht. It may be able to sail the open oceans, but even a moderate storm poses a grave threat to its survival.

How do you think a tiny yacht would fare in these conditions? (source)

This “storm” could be an unrelated economic or political event (massive crypto sell-off, global economic crisis, new legislation), or a direct attack on a specific token’s economy.

Even when conditions appear to be favourable, and the price is going up, this can affect the accessibility of your platform. People may not want to buy or spend your token when the price is too high. Liquidity may be too low due to hodling and other speculative behaviours, restricting supply and therefore access to your platform.

Ask yourself the question: would my platform be more stable, accessible, and frictionless if I used a larger, more established currency (e.g. USD, ETH, BTC)? If so, what is your token really for?

Challenge 3: Velocity

The underlying assumption of most utility token creators is that as adoption of their platform increases, the value of the token will go up. The reasoning is always the same: “There is a limited supply of tokens. As demand for the platform increases, more people will need to buy the token, so the price will increase.”

This may appear to be obviously true at first glance, but Kyle Samani neatly explains why this is not the case in “Understanding Token Velocity” (which is well worth the read). The problem of velocity is that despite delivering real, tangible benefits to marketplace participants, many tokens won’t actually capture the value the platform is creating. That is, the price of the token won’t reflect the true value of the network.

Even if there is high demand for the use of a platform, very few people will be incentivized to hold the platform’s tokens and risk losing money relative to the dollar. They will buy them when they need them, and spend them straight away, rarely holding them for more than a few minutes at a time. The counterparty also won’t want to hold onto the token, as they too would have to the incur price risk. Instead, they will sell the token back to the market, where it gets recycled again and again.

Samani illustrates the high-velocity flow of a fictional ticketing token, Karn (source)

This turns into a game of hot potato, where no one wants to hold onto the token for any considerable amount of time. In turn, the token will be too liquid, as people want to get rid of it. As a result, the price of the token will not materially appreciate relative to the value the network is providing.

There are several token models which combat the velocity problem by incentivizing people to hold tokens for longer periods of time. These are on the right path toward more sustainable token economies. However, as we have discussed, economies are intricate systems, and these types of models come with their own set of risks and challenges.

In short, tokenized economic systems are extremely hard to design and implement. So what is the rationale behind them? And why have they been so hyped in the market?

I’ll cover these questions in Part 2: Problems with Utility Token Economies.

Writer, growth strategist, analyst, product designer at @Glassnode