How to Understand Tokens, Blockchains, and Cryptocurrencies — using a Drink Token

With all the buzz around blockchain and cryptocurrencies, it is easy to have conversations with folk nodding their heads frantically in agreement, whilst having wildly varying ideas of what the terms and concepts actually mean. So I decided to spend some time thinking through an example, one we can all imagine, that walks through the key points and gives a grounding in what is really going on — and why it is super interesting going forward.

I was invited to an Internations event in Berlin in July. Internations is a community site for people to meet up, go to events, etc — free to join with premium members getting a free drink for each event as part of their monthly membership fee.

House of Weekend — Berlin

So off to House of Weekend in Berlin, Mitte. At the door I was given a small square piece of thick paper, one side black and the other bright green, with the word ‘Weekend’ written on one side. I was told that this was my ‘drink token’ and then I could hand it over at the bar to get a drink.

Now how much is this ‘token’ worth?

Is it worth just the cost of the paper? Of course not! I have been told it is worth one drink, I believe it is worth one drink, and if the bartender accepts it and gives me a drink then it has the value of one drink. Already we can see we have a blockchain of trust — a sequence of people believing that the token has value. And we have the concept of a token, in this case a piece of paper, that has value. First two concepts nailed!

Next we work out what we can do with the token. If we try to use it in another bar it will be worthless. If we present it at the same bar on another night it may also be worthless. If we go to the supermarket there is no way they are going to accept this token. And if we keep the token for a month or a year it is not going to be a store of value, savings for a rainy day. There are many aspects of a typical currency that this token does not have, and still we do have token properties that make it unique to this business at this moment in time.

Moreover it turns out that there are rules on which drink you can get. The lady in front of me was deeply upset when she could not get a gin and tonic with her Weekend token — “wine or soft drinks” was her only choice. This, and the rules beforehand, turn out to be key concepts to understand the term “smart contracts” which apply in the blockchain / crypto world. They add rules to the token. In the case of our drinks token they determine where and when they are accepted, and what you get.

Now we can add additional aspects to this token. It turns out that I could gather the drinks tokens from my friends and order on their behalf. This means that the tokens could be used by another person apart from their owner to make an exchange. Someone might decide that they don’t want to use the token (perhaps paying for the G&T) and give the token to someone else, hence allowing transfer of ownership.

One aspect of the token which I didn’t try at the bar is divisibility, cutting down the paper into pieces and seeing if it still had value, as either the sum of the pieces or with each small piece having some relative value. It turns out that if I were to have cut the token into 10 pieces I could not get 10 x a 10th of a drink. Divisibility was denied for this token, but in the world of digital tokens this feature is easy to build in.

We now go back to how much is the token worth. It turns out that a glass of wine is €7 and a bottle of water was €3 — as defined in Euros or what crypto-folk like to call fiat currency. To help the non-initiated, fiat currency is legal tender whose value is backed by the government that issued it. There is no pot of gold or other store of value that is there to back up the currency, just a belief that the government must be ok enough to issue money.

So with a range of values possible for our drink token, back to the question of what it is worth. The unused token should be worth a maximum of €7 and a minimum of €0, if given away for free. We could therefore imagine some point in the evening where people with a token to spare might try to sell it to someone in the drinks queue. A Euro for a drink with €7? Sure!

Next we could imagine two people with tokens who want to sell them at the bar, quietly so the bartender does not hear them and stop the transaction. Perhaps one sets a price of €2 and the other a price of €4. We now have somewhat of a market and if the prices are shared we have a form of price discovery mechanism. In this case the market would likely clear at the lower price of €2 — why pay more for a drink? However maybe the person with the lower price has 1 token and the one with the higher price has 10 tokens. Then the price might start at €2 and then quickly move to the higher price where there is supply.

Heck, the person who bought the drink at €2 might decide to not use the token for buying a drink but trade it himself, maybe offering €3.75 to undercut the market and clear his stock. Sure he would miss out on a drink but he would have a cool profit of €1.75 made in just a few minutes!

But it is now the end of the evening and time to go home. Unused tokens have a value set to zero and the ones that were consumed will have somehow been accounted for by the bar and the party organizer. Maybe there was a deal for the organizer to get them at €1 to give some value to its members, but more likely the organizer used the presence of a few hundred people as leverage to get one free drink token for everyone in the bar’s expectation that people would spend money on full priced drinks later. Somehow real fiat money was converted into tokens and then back again. A medium of exchange created out of a square piece of paper.

The Drink Token example hopefully gives you a feel for the key concepts of this cryptocurrency world. Let me know what you think and if I have missed a trick in any of the aspects. Thanks!