On Token Economics
Introduction
At a high level, blockchains are simple structures; they record transactions decentralized and transparently. The pseudo value to these structures is the transfer of value. After the realization occurred that blockchains can transfer value in a preferred way, the question of how that value should be optimally distributed, transferred, and allocated remained unforeseen. The investigation into this looming question spawned the creation of a micro subject of blockchain-based systems called Token Economics, or “Tokenomics.” In short, Token Economics is the study of value distribution through decentralized systems where the token is the value component, and the blockchain is the system that distributes said value.
When diving deeper into blockchain structures, significant fragilities that impact their efficiency are revealed. In particular, one fragile component is the token. Think of the token as the complete collection of data points on an X/Y graph, where the X-axis represents time and the Y-axis represents the value of each transaction.
Each recording on the blockchain represents an exchange of value between two parties, constituted by a token. For each transaction (i.e. exchange of value), the value associated with the token changes. Therefore, we can define a token as an exchangeable, digital account of value for an asset or utility on a decentralized infrastructure layer (i.e. blockchain). This definition is not perfect and within it lies a revealing limitation — its generalization as a whole restricts it in not considering the role of each particular asset and utility from which the token’s value is derived.
Without a clear understanding of the sources and flows of value, there is no way we can define the core purpose of a particular token. Consequently, we cannot build a framework to optimize its functionality in the system. To identify a solution to the token problem, we must first analyze token economic structures and then identify the token(s) objective in blockchain economies.
Analysis of a token economy
A token economic system (crypto economy) is an interlinked network of autonomous actors governed by predefined rules and policies built in a digital contract. The transfer of value occurs through a cryptocurrency (i.e. token). All else equal, in and of itself, a token has no intrinsic value. Value is created by the token holder’s belief, or lack thereof, for said asset or utility. Let’s analyze the role of the U.S. dollar (USD) to make this clear.
The U.S. dollar is not intrinsically valuable; however, throughout America’s history, humans have been made to believe that the dollar has value. In the past, the dollar represented the “gold standard” — each dollar was backed by an equivalent amount of gold held in the U.S. Treasury. As history ran its course, the U.S. government realized the gold standard could not be maintained because the Treasury could not accumulate enough for its reserves and transferring it was economically inefficient. The solution was to issue USD that primarily sources its value from the belief that it represents a medium of exchange, a unit of account, and a store of value. Note that USD is also backed by government securities and holdings, but the main point still stands. While this has worked out pretty well for the U.S, it is essential to understand that the USD acts as a medium to exchange and identifiable value for goods and services, but it has no inherent value. Here’s a helpful definition that supports this point: “Value in economics is essentially the same thing — it is generated by something, usually a good or a service that individuals, companies, or societies use or receive as a benefit.”
When comparing the token and USD, both are similar in that they facilitate the creation of more goods and services in the economy — tokens in the digital economy and USD in the physical economy. However, token ownership includes approval to affect the economy. In Foundations of Crypto economic systems:
Tokens are a representation of an individualized state of an economic system, including a specific right to change the system state.
Further, a crypto economy is not one central entity, as with the U.S. government, but a decentralized one that can build on or alongside other crypto economies. Thus, a specific token’s value is derived by an asset or utility (stock) and the underlying mechanism that enables the transferability of said utility (flow), i.e. blockchain or protocol.
A token’s purpose
Let’s get down to the core purpose of a token. The crypto economy is a system that needs to incentivize users, investors, and contributors. Diagnosing each actor’s meaning and value in the system will enlighten readers on a crypto economy’s (in)efficiency.
The user wants to use the system without any faults associated with the underlying mechanism facilitating the transfer of value; the investor wants to earn a return on investment (ROI); the contributor desires to earn an income. All these agents crave something out of the system, but they must give something to get it. The user pays a fee to use the system; the investor must provide capital to the system; the contributor must supply work to the system. Although these functions appear distinct, they interrelate through various micro-mechanisms that make up the totality of the crypto-economic system. For simplicity’s sake, we assume that these players and functions all come together for one purpose: to democratize the transfer and ownership of value in goods and services. Sound familiar? Again, we must break down this definition to reach a logical conclusion. Democratizing means everyone can access the goods or services, transfer refers to the movement of value from one party to another, and ownership implies complete control over those goods and services. The value baked in the crypto-economic system is the goods and services. So, what does a token have to do with all of this? The token is the vehicle that transfers the ownership of value.
By understanding each agent’s and component’s wants, needs, and purpose, we can devise a framework on which we can start to build an optimal crypto-economic system.
The optimal endpoint(s?)
We won’t go into it with this post, but some examples of effective tokenomics models exist. However, most are not effective, and those are the ones we are speaking of. The reason why most models don’t work is because they don’t identify the purpose of each actor in the system. The stocks and flows for each actor is inherently different, so each actor must only interact with the token that fits their purpose. The only system known thus far that fits this description is a multi-token economy, and I conclude by saying that this is the most efficient crypto-economic framework.
Let’s back up and further explain why a single-token economy does not work in a complex crypto-economic system. As explained previously, each actor in a token-based economy needs to be incentivized to participate consistently. A possible way to do this is to have one token utilized in every way possible, meaning one token represents all of the utility, goods, and flow of those utilities/goods for all agents. It would be a miracle to see an efficient tokenomics model that supports that vision with zero bounds or constraints.
Take the example of an Automated Market Maker (AMM) Decentralized Exchange (DEX) that operates as a Decentralized Autonomous Organization (DAO). The DEX has multiple actors: traders, liquidity Providers (LP), contributors, governing actors, and investors.
Note: I understand we can simplify the agent’s definitions to fit the system framework described above. But for the sake of simplicity please disregard that. Thank you.
Each actor wants something different and their wants and needs flow to the same stock (capital). This all sounds great, right? Not exactly. Each agent interacts with the stock differently and a token has one predefined role for each identical agent, so the purpose of a token for one agent cannot fit for another agent. If each nonidentical actor has a different purpose with a distinct token flow, they must have a discrete token. Therefore, a multi-token-based economy where each token serves only one specific impetus is the optimal token-based economy.
The valued token economy
Separating tokens based on their flow in contributing to capital diversifies the risk to each of the protocol’s mechanisms and creates a value-aligned economy. In this way, any user, contributor, governance holder, and investor will own a representable share of value in their independent micro crypto-economy and each micro economy synergizes with each other through its motivation to accumulate capital — inevitably leading to a (hopefully) competitive environment between agents in the protocol and between micro-crypto economies (i.e. protocol) in the macro-crypto economy (i.e. blockchain). These competitive games promote the project’s long-term success because through time, only the most invested actors who survived the trials and tribulations that occur throughout the project’s life cycle will remain. It is those actors who form a community and push the project forward.
Validation
In Designing Multi-token Economies, Matt Lockyer refers to an Infinite Game as the ideal multi-token economy. An Infinite Game creates a “virtuous circle of token minting, utilization, and value creation.” Compared to a finite game — a game played only to win — an infinite game is played solely to continue the game. Money-hungry players in the crypto-economic system are playing the finite game. However, contributors, governance holders, and any other agent acting selflessly to improve the game are playing the infinite game. Problems arise when the system design allows a finite player to play against an infinite player. According to Simon Sinek, “one player is playing to win, and the other is playing to keep playing.” Applying this to a crypto-economic system, it is apparent that a token that represents and exchanges value in the system similarly to a finite and infinite player can cause problems — further proving that multi-token economies must exist.
Aligning the incentives of all stakeholders in your vertical for infinite value generation can only be accomplished by pushing the limits of multi-token economies — (Matt Lockyer)
A necessity for better token design
Multi-token economies separate the components of the system, thus reducing the impact that one sub-system can have on another sub-system. Without multi-token economics, competition between ill-willed agents will negatively affect all other system participants. Although tokenomics may not be the most critical area of study in blockchain-based systems, a sustainable framework for developing a token and building a token economy is needed for the space to reach its full potential.
