Sustainable network effects and public blockchains — the role of utility tokens
1. The current problem with networks
Social networking, transport and vacation rentals are now done via platforms. Platforms connect supply and demand within double-sided markets and grow through network effects.
In some instances, these platforms have shown themselves to be exploitative wielders of monopoly power. With social networking, your privacy gets stolen — with direct consequences for democracy. In transport, drivers work under competitive pressure without pensions. Vacation rental platforms are changing the social composition and the living experience of whole cities. These events, combined with the rising awareness of privacy issues and the downstream effects of these networks, puts a question mark on the future sustainability of these business models.
To explain these events our first instinct is to point towards the personal ethics of the owners of these networks. This is too simplistic. It is important to take the creation of these networks into account and how these processes lead to the above-mentioned outcomes.
Using regulation to break these networks up have always been the go-to approach. The issue is the destruction of the achieved network effect. In this article, we explore how tokenised public distributed ledgers (DLs) could lead to a way to build more sustainable platforms.
2. What role can utility tokens play in more sustainable network generation for public DLs?
Utility tokens (a tokenised claim for future use of a network) provides an interesting alternative for the (1) creation, (2) monetisation and (3) growth of more sustainable and fair networks. The general use of utility tokens does not guarantee success. Some basic pre-conditions should be met:
· Limited utility token supply
· The utility token is the only means to gain access to the service of the network
· The utility token is also the only means of payment to service deliverers
· Convenient exchange of tokens for fiat currency
With this setup, as the demand for the service of the network grows the price of a token goes up. This is relative basic supply and demand economics but it does have interesting implications.
2.1 Creation — addressing the cold-start problem
Growing a network from scratch so that network effects are activated is very challenging. It is called the cold-start problem.
The usual way to address the cold-start problem is to subsidise the demand and supply side of the network. For example, mobility platforms will temporarily pay drivers more than the market rate to give customers discounted rides. This, in addition to a marketing campaign, is very expensive and requires a large amount of outside capital.
Before this capital is given the start-up needs to be able to display a willingness to generate a return on this large investment. This leads to the prioritisation of short term profitability above long term sustainability from the very beginning of the project.
Utility tokens offer an interesting fundraising alternative. On the demand side, money can be raised by pre-selling the tokens to future customers. Pre-selling the service has its challenges. Nevertheless, the token can go up in value if the network succeeds so there is an added incentive to take part in these token offerings. On the supply side, a limited amount of utility tokens can also be given to suppliers to the network — making them co-owners in the success of the network.
2.2 Monetisation — tapping into value at the network level
Until now networks didn’t have a built-in monetisation mechanism. To monetise a network an intermediary step is needed. When this intermediary step is taken too far then these powerful networks have negative consequences for society at large. In the previous section, we noted that the financial incentive to overdo this intermediary step is already ingrained into the network during fundraising.
Utility tokens enable monetisation directly at the source of the network’s value. The original Metcalfe’s Law says that the value of a network is proportional to the number of connected users of the system. In other words, the number of possible transactions that can be made. For peer-to-peer networks where the connected users are humans and not machines, this can arguably be substituted for the number of transactions being made.
If utility tokens are used to pay for a transaction fee on the network they thus provide a way to monetise the network at the point where the value is generated. This means that the need for the intermediary monetisation step is taken away.
2.3 Growth — the creation of a local economy
One thing that conventional networks lack is the ability to create mutually beneficial relationships between users, suppliers and network owners. The status quo is rather the flow of value to the owners of the network. This has the potential to stunt the growth of the network forcing network owners into even more extractive/abusive activities.
Given a functional network with some users and suppliers a tokenised public DL can create mutually beneficial relationships as well as organically grow the network through the creation of a local economy.
The local economy is powered by a currency native to the network. As the network grows one unit of this currency becomes more valuable. This mechanism attracts early movers on the supply and demand side. Within these local economies, the line between user and supplier is also blurred to the point that one person can play both roles as long as the network is diverse enough to support it.
The native currency also enables the recirculation of value within the network when the native currency is earned but also spent in the network again on services within the network.
This recirculating value attracts more suppliers as the value of the local currency goes up and with an increase in supply, quality and diversity of services more demand is generated. If the network becomes more successful suppliers are also set to benefit. Usually, network growth would generate competitive pressures that would force suppliers to sell their services at lower prices. In the example of a local economy, ownership of this local currency has made it possible to own a part of the increase in shared value.
2.4 Why can’t you use security tokens or even use fiat currency for it?
The creation of a network’s own local economy and the recirculation of value is the reason why security tokens and fiat currencies are not good alternatives to utility tokens.
Security tokens cannot be spent on the services of the network and there are also legal limitations to who the security tokens can be distributed to as well as the minimum amount they can receive. Another issue is that security token exchanges currently have low amounts of volume. With a proper utility token structure, the use of the network is also the volume because investors can always sell to users eager to use the service.
Fiat currency, is reflective of the state of the overall economy, not of the specific network. As with Bitcoin or Ethereum, the fluctuation in the value of the native currency plays an important role in how the network functions by equalising supply and demand forces. Apart from that fiat currency also does not have the type of good friction that is needed for the recirculation of value within a network.
3. Conclusion
As a society, we also tend to look at these platform in awe. Being almost forced to use them it is difficult for us to imagine an alternative. To merely think things simply are the way they become an easy mistake to make. Especially because their rise has been so fast and their impact so broad.
We simply take for granted that these platforms can be different. Different in a better way. Not only different through regulation. Not only different through design. Rather different through the very nature of how their network effects are created and maintained.
Tokenised public DLs is a powerful technology that provides the possibility to change the fundamental dynamics of network effect creation. These platforms impact billions of lives each day. This arguably makes any real and honest effort at better understanding how to use tokenised public DLs to make networks more equitable and sustainable a good environmental, social and governance (ESG) investment.
In the last article of this series, we will look into the challenges utility tokens face and how these issues are being addressed.
