Decentralized networks can only be successful if the token design is sound — An analysis
Recently, more and more projects are realizing the importance of sound token design, however, often after the price of their own token went down tremendously. This article outlines why sound token design is absolutely crucial for decentralized networks to flourish.
For a network or project to become decentralized, people from outside of the initial project team must have an incentive to join the network and contribute to the further development or growth of the project. However, rational market participants are only interested to contribute their energy, time and work for a network if they receive something in return. Thanks to blockchain technology, it is now possible to create network ownership or access right representation. These are offered in return for valuable work, which is usually provided in the form of a digital token secured by a blockchain. The token is like a glue that holds all contributors together to facilitate the network goal. So two factors are necessary for market participants to contribute towards the network goal:
- a token that is of value and
- mechanisms that ensure receiving token in return for providing valuable work.
Both of these aspects are considered in token engineering, the practice of designing a token in a sound way.
Designing a valuable token as a basis for collaboration
To be clear: market participants are only willing to work for tokens if the token is valuable and can maintain its value over time somehow connected to the size of the network. A valuable token is the basis for interactions in the network, it is the fundament on which the network is built and through which the network functions. The value of a token is derived by demand through its utility and its relative scarcity.
The utility of a token is defined by several factors. First and foremost, the token allows the network participants to access the network and perform certain actions. More aspects that influence the utility of a token are: censorship-resistance (resilience against manipulation and misuse of the system), robustness (uptime), limited supply (limited inflation), network effects, competition and of course the specific utilities of a token in each network (e.g. access to secure blockspace). Censorship-resistance plays a superior role in decentral systems because data integrity has utmost priority.
The supply side of a token is usually predetermined in the protocol — at least this is how it should be for a well designed token because investors and users of the protocol need to know what they get themselves into. It is absolutely crucial to know if there is a limited amount of token and how many tokens are issued when because this greatly influences the supply of and token and therewith the price development — the higher the token supply, the lower the price assuming constant demand.
As soon as a solid basis for a valuable token is established, one can continue with designing the processes of interaction between market participants. The token then serves as a means for achieving the network goal which includes the alignment of all participants so they work seamlessly together. Thereby, the (financial) sustainability of the system must be guaranteed so it survives after the block rewards are fully distributed. These aspects are part of the macro perspective and discussed in another article with concrete examples which will be linked here as soon as it is published.
Designing proper reward and punishment mechanisms to incentivize the community
For proper incentivization, the reward and punishment mechanisms must be defined precisely. These mechanisms need to be defined in a way so that actions that are in alignment with the network goal are rewarded and vice versa. Essentially, the token design makes sure that every stakeholder is working in alignment with the overall network goal.
This is especially important when considering that there is no legal entity which could take legal actions against participants who cheat the system and other players by draining value without contributing value to unfairly enrich themselves. Additionally, participants are typically pseudonymous and can not be blocked to participate in an open, censorship-resistant and borderless environment.
In general, market participants receive a reward for providing valuable work to the network. When market participants abuse the network for personal gain, provide work of very low quality or try to strain the network unnecessarily (e.g. by spamming) then they are punished, e.g. by losing tokens. “Staking” is one means to achieve this: Before a participant may perform actions on the network, he has to pledge a financial commitment in the form of token (stake). In case of misbehavior, which is a behavior that is not in alignment with the network rules according to the protocol, the participant loses his stake.
State of token engineering in the blockchain scene
Through many conversations with entrepreneurs in the blockchain scene, I have realized that most projects focus on the technology without thinking about the utility of the token. Especially during the hype phase, quite often a token was issued for fundraising before there were precise ideas on how the token can be used. However, a token receives only value if it has a utility. Recently, more and more projects are realizing the importance of sound token design, however, often after the price of their own token went down tremendously. We at BlockKore support projects that require sound token design with our proven experience in token engineering.
For a further elaboration on token engineering, check out this article: https://medium.com/blockkore/token-engineering-the-design-of-decentral-marketplaces-with-bitcoin-as-example-57ce029c293a
