Do Discount Tokens Have a Value Proposition?
In recent months, the blockchain community has becoming increasingly interested in token economics that will power new networks. Tokens 1.0 were proprietary medium-of-exchange tokens slapped onto any sort of business model. It was largely thought that these tokens could be used to bootstrap new communities and create a network effect. Various thought leaders were quick to recognize that these “payment” tokens would not capture much value, and numerous additional models have since been proposed. If we are to believe that tokens will ultimately power entire industries, it is important to also attempt to understand how tokens may create value and, equally importantly, capture value. A relatively newer token model known as “perpetual discount tokens” has garnered attention recently. In this post we analyze the value creation proposition of discount tokens.
The general description of perpetual discount tokens uses the following logic:
- If users own their relative shares of activity on the network, the fees they pay are offset by the discount they receive.
- Because the token is directly backed by the network usage in the form of future discounts, it captures value and puts it in the hands of people who actually use the network.
- This incentivizes network growth creating a more competitive and cooperative business model.
Value Creation
If the traditional definition of value is that it is created through work, what exactly is the work being done here? Discount tokens are frequently compared with loyalty reward programs. These are essentially marketing campaigns which aim to attract new customers and retain them through the offering of future discounts off the company’s products or services. This creates value because the cost of retaining an existing customer is far less than the cost of attracting a new one. Of the five primary activities in Porter’s Value Chain, loyalty reward programs create value under the umbrella of marketing and sales.
Indeed, this can prove to be a very effective marketing and sales tactic. The loyalty rewards industry is projected to grow to 4.59 billion by 2021. However, not all loyalty rewards programs are successful. According to one study, over 77% of loyalty reward programs fail. In order to yield a profit, the loyalty reward program’s marketing expenses must be less than the value created:
Value Created - Cost of Creating that Value = Margin
Market Efficiency
While there are many strategies within loyalty programs, loyalty rewards typically involve earning points which can be used to offset the cost of future purchases from the same entity. In this way, the reward points are a form of digital currency that is centrally-controlled and can only be used as cash-equivalent when purchasing from the central issuer. Loyalty reward programs rely on this unidirectional flow of value to secure their margins. While 83% of shoppers say loyalty rewards alter their purchasing behavior, far fewer actually redeem their earned points. The inherent inefficiency of this unidirectional flow of value allows the issuing company to asymmetrically alter consumer behavior at relatively low cost. As such, companies can retain customers while not actually providing a service, as most loyalty points will not be redeemed.
Discount tokens, however, are liquid cryptoassets and bidirectional. While they can certainly be used toward purchases from the underlying issuer, theoretically they can also be traded on third-party exchanges and redeemed for cash. Effectively, this means that a company issuing a discount token cannot leverage the inherent inefficiencies of loyalty points. That is to say, given the liquidity, all discount tokens would likely land in the hands of a purchaser who would act to redeem these tokens for a discount on an entity’s services.
A necessary component of the discount token model involves setting aside funds used to purchase services into a pool that may discount future use of the same service. There can only be 2 sources of the funds: the service users or the service providers. Both protocols are ultimately economically identical, but we will discuss them separately to deepen our understanding of the underlying economics.
Consumers fund the pool
When consumers fund the pool, there’s no actual global discount available. Rather, as shown below, the model discounts some consumers at the expense of others. Compare two businesses, one that uses a discount token and one that does not:
1) Token-free version: User pays $x for a service. $x goes to the service provider.
2) Discount token version: User pays $x * (1+d) for a service, where ‘d’ is a network fee. $x goes to the service provider, $d*x goes to the token-holders to subsidize their future purchase of the same service.
There are 3 types of users here:
i) User owns less % of the total supply of tokens than % usage of the network (call this ratio of owernship-to-usage, ‘y’). User pays $x + $dx * (1-y). In this scenario, 0 < y < 1 so the user pays more for the service even with the implied discount.
ii) User owns the same % of the total supply of tokens as % usage of the network, in this scenario y = 1, and user pays $x for the service. They break even if they continue to use the service.
iii) User owns a greater % of the total supply of tokens than % usage of the network. In this scenario 1 < y < (1 + 1/d). This user enjoys discounts at the expense of type i users, but only if their discount is <= $x.
Service providers stand to benefit from type i and iii users as this results in suboptimal usage of the total available discounts. The net effect may actually be a slight increase in the average price of the service. However, the discount tokens are liquid and in an efficient market they will be traded until everyone falls into category ii. That is to say, any asymmetry in favor of the service provider will be resolved on third-party markets.
Merchants fund the pool
A different way to construct the protocol is for the service provider themselves to fund the pool. Consider 2 competing airlines, both charge $100/flight, currently sell 1000 tickets a month, have baseline operating expenses of $50k, and profit $50/flight. Both are currently at $0 profits and are competing for a particular client that buys 500 tickets a month (250 from each):
Now, airline 1 decides to set aside 10% of it’s revenue in a typical discount token scheme, while airline 2 does not. If this does not change the behavior of their clients, airline 1 is now operating at a loss.
Now, what if the 10% discount token model does change customer behavior? Customer A decides to exclusively fly with airline 1 while the remaining customers do not change their preference. Airline 1 is now profitable and Airline 2 is in the red.
It’s easy to be drawn into this logic and conclude that discount tokens can create more competitive business models. But again, because of the liquidity of discount tokens and associated 3rd-party markets, the net-effect of a discount token in this case is essentially a price-reduction for consumers. This price-reduction, however, is achieved sub-optimally through disproportionate distribution of the discount tokens and subsequent re-distribution by the open-market. It would be far more efficient to simply reduce the price of the services!
Alex Felix summarizes a couple of his arguments in favor of discount tokens with the following observations:
- The discount (aggregate and user-level) is fundamentally linked to the adoption and growth of the network. The discount grows proportionately.
- The overall returns to the active token holders (users) outweigh the returns to passive token holders (investors).
But these arguments are true of price reduction! In fact, with price reduction, the discount is far more fundamentally linked to the active users of the network. We must not forget what economists and free-market proponents have known for quite some time: Price is the aggregate of all information available in the economy about how everyone values a good or service. A discount token merely serves to delay the price discovery mechanism of the free-market.
Decentralized Cryptonetworks
To round out the thesis, consider a platform for peer-to-peer cloud computation (such as Golem). On this network there is no central service provider. Rather, nodes offer cloud computing in exchange for the GNT token. As more nodes offer this service and compete, the fair market value for the service will ultimately emerge. Therefore, introducing a discount token in an efficiently priced peer-to-peer market, is effectively impossible. The price itself already reflects the value of the service.
Market Psychology
From an economic perspective, we have concluded that discount tokens just create inefficiencies in price discovery. However, we also have empiric evidence that humans don’t always make completely economically rational decisions. We began this post referencing the concept of using tokens to bootstrap new communities. While discount tokens effectively cause inefficient price discovery, perhaps this inefficiency can actually be used to bootstrap communities by incentivizing early adopters to evangelize the product.
In the table above, Airline 1 launches a discount token and Airline 2 simply lowers their prices. More than likely, in the early days of the network, the discount tokens will be unevenly distributed giving a small group of token holders large discounts and the incentive to market the network and drive widespread adoption. Airline 2 decides to simply lower prices in order to undercut competitors. Airline 2 has effectively evenly distributed the discount to 100% of the population (everyone is immediately a type ii user). No one is psychologically motivated to evangelize the network but everyone enjoys the discount.
It is not possible to objectively determine which network will prevail, but we can’t exclude the possibility that discount tokens can help bootstrap new networks in ways that optimal market prices do not. If this turns out to be the case, discount tokens would indeed have a marketing value proposition equivalent to the percentage of network discount that maximally drives network growth.
However, is this sustainable? Our early experience with medium-of-exchange tokens indicates that these tokens did bootstrap small, yet passionate, communities (just try to inform such a community on twitter that the token is useless and is tremendously overvalued). Unfortunately, because of the inherent price volatility and lack of liquidity in these tokens, the tokens ultimately thwart any meaningful network growth.
We suspect this may also be the case with discount tokens. While they may bootstrap small communities in the early days, these networks are now forever bound to a discount token model which will continue to create inefficiencies in market price discovery. Newcomers who simply wish to buy a product at a fair market price (user type ii), will first need to make the appropriate calculation and purchase a corresponding supply of the discount token. This will likely impede meaningful network growth.
In conclusion, because discount tokens are liquid, they offer a value proposition very different from the typical marketing strategy of loyalty rewards programs. Economically, discount tokens create inefficiencies in price discovery. However, this very inefficiency could potentially create marketing value in the form of evangelizing early adopters to drive network growth. While this early bootstrapping phenomenon may be successful, we feel that the long-term effect of price discovery inefficiencies will impede meaningful network growth.
Thanks John Todaro (Managing Partner) for stimulating discussion that led to this post.
