In defense of tokens

There is a lot of controversy in the cryptosphere about tokens. There are people think that Tokens are all scams. The “Tokens are scams” argument comes from from two groups

1. Bitcoin maximalists worried that “Bitcoin Dominance” is being threatened (Bitcoin dominance is the market cap of Bitcoin divided by the total cryptoasset marketcap)

2. Traditional VCs/professional investors that are worried that their profitable (but very inefficient) business model is being threatened by tokenization and the ICO trend.

The supporters of the concept of tokens have made many arguments as to why these pessimists are wrong. Smart very insightful entrepreneurs have written about what “tokens” are and how they function as well as the value they add (ref).

Instead of guessing who is right, let’s examine what tokens are, by examining the fundamental economics of tokenization.

What are tokens?

You can’t start to understand tokens without a first understanding of the thing that started them all, Bitcoin (Yes, Bitcoin is a token).

Tokens can essentially be two functions:

1. A reward for performing a function in a network
2. A voucher that can be exchanged for goods or services (value) in a network

The first crypto token, Bitcoin is a designed to be money, and rewards “mining”

In the case of Bitcoin, each bitcoin is created when a miner finds a new “block” by finding a block header that is the hash of the previous block, plus repeatedly solving a hash puzzle called the “partial hash preimage puzzle”, linking the chain of blocks and securing the ledger.

Because miners verify transactions and perform expensive computations to protect the network and continuously secure the blockchain, they are rewarded by getting Bitcoins.

Bitcoin satisfies the 1st definition of a token.

Now what are these other tokens?

The development of Bitcoin is an example of what Carlotta Perez refers to as a ‘highly visible attractor” in her book “Technological Revolutions and Financial Capital”, that started a new techno-economic paradigm.

The development of bitcoin is a fundamental breakthrough in technology, and , as Perez describes these cycles, “symbolized new potential and sparked the technological and business imagination of a cluster of pioneers”.

The success of Bitcoin created a wave of entrepreneurs who saw the applications of cryptography and distributed systems design in building many kinds of networks, (along with some scammers), leading to the recent ICO froth.

Most “cryptocurrencies” are not to be “money”, but vouchers for network value

This is a key distinction. Most “tokens” should not be called cryptocurrencies, but appropriately termed “cryptoassets”, as others have pointed out. They are not trying to be money, do not have monetary properties, and will not be money. But they do act as network currencies that have utility within specific networks.

These tokens created a revolutionary new way to accomplish the following

1. A new way of building and operating networks,
2. A new way for network effects to be distributed, and
3. A faster, more efficient way of coordinating networks

Lets examine these in detail.

1. Tokens provide a new way for building networks

The traditional Silicon Valley way of building network effects businesses,(which, by the way the only proven model that returned money to VCs in the last couple of decades), is being disrupted by tokens.

How were networks built before tokens?

Let’s say you are starting a company with a great idea, in a great market. The company is thought to have network effects. The VC’s you know or were able to get infront of, will give you a million dollars to go build your product, then when you show some traction, you get more millions even if you don’t have any revenue or profits. They do this because the VCs know that you are building a network effects business, and once your company gets to critical mass, you will be extremely hard to dislodge. From then on, you can sit back and mint money, grow fat and dominate your market while the investors benefit by selling their stock in an IPO or acquisition. However, until this liquidity event happens, the investors will only have “paper gains” of their portfolio, which are illiquid.

Nevertheless, in the above scenario, the people who benefit from the network effect are as follows:

1. Founders, who started the company
2. VCs who can write big checks and have access to the best deals because of their location, connections, history, branding etc
3. Early employees.

No one else gets to play in this space because they don’t have the “deal flow”. The bottleneck to deal flow is typically controlled by Sand Hill Road.

With tokens, (in jurisdictions that have a clear outline of utility tokens) anyone can compete with VCs in building the next generation of networks. Given the liquidity, the almost negligible minimum participation amounts and the 24/7 availability of exchanges, anyone can spare a small fraction of their discretionary income to contribute towards building the next generation of networks. This is the story of Ethereum, Cardano, Stellar etc. Moreover, their investment is liquid almost immediately. Sounds like all rainbows and unicorns right?

But what about the “risk’?. It’s not much greater than that of a typical VC portfolio. What is the average rate of success of VCs? 5% would be a good approximation. With globally available pool of capital contributing to high risk/high reward projects like new crypto assets, the success rate will probably be similar or lower. But given the fact that there is no 20% carry, no 2–3% management fee extracted by professional investors, etc, tokenization still beats the existing way of funding networks in terms of efficiency. We call this new global pool of capital “Adventure Capital”. This is true democratization of venture capital and will disrupt VC business model as we know it.

2. Tokens a new way of distributing network effects

The story of the internet is the story of great networks. Network effects have played a powerful role in building the giants of the internet economy. In fact, it can be argued that the internet economy is driven by network effects.

In a nutshell, network effects (also called ”network externalities” or” demand side economies of scale”) can be described as positive feedbacks where “the value of connecting to a network depends on the number of other users that are connected to that network”(Shapiro, Carl and Varian,Hal, Information Rules-A Strategic Guide to the Network Economy, Chapter 7: Networks and positive feedback).

Many important non-network industries also share many essential economic features with network industries. For example, a pair of vertically related industries is formally equivalent to a one way network (Economides, Nicholas, The economics of networks, International Journal of Industrial Organization, 03/1996).

There are two types of network effects. With direct network effects, the platform becomes more valuable as more users join and use the platform. This applies to the consumer side of social networks like Facebook and Instagram.

In an indirect network effect, as in a two sided marketplace, the platform becomes more useful to the consumers as more and more producers use the platform and vice versa (the producer and consumer sides are formally called “complementary goods”).

The Producers join the network because that is where the consumers are, and the consumers join the network because that is where the producers are. All two sided marketplaces are examples of this, including exchanges. In a two sided network, Ceteris Paribus, higher liquidity increases a participant’s utility.

Frequently, network effects companies have a combination of direct and indirect network effects. For example, Facebook is increasingly valuable to users because more and more of their friends join the network (direct network effect). But advertisers like facebook because there are more consumers there
(Indirect network effect).

Who benefits from network effects?

Currently, most marketplace models are centralized, in that the entire value of network effect is captured by the company (intermediary). The most powerful companies of the internet age are those that successfully intermediate these network effects. Examples include Microsoft (OS intermediates App developers on one side and users on the other), Apple (iOS intermediates App developers on one side and users on the other), Facebook (the platform intermediates users who connect with other users, as well as advertisers), Google (Search engine intermediates users on one side and advertisers on the other).

In all the above examples, the intermediaries have accumulated almost all of the benefits from the network effects, which has allowed them to grow rapidly, with extraordinary profitability, while the marketplace participants who drive the value of the network effect have a minimal share in it.

This also had the effect of concentrating too much censorship power in the hands of a few giant companies.

Enter the Blockchain

The blockchain created a new model for coordinating economic activity, along with firms and markets (Davidson, Sinclair and De Filippi, Primavera and Potts, Jason, Economics of Blockchain, March 8, 2016). When any asset can have its provenance verified by anyone, everyone is empowered to engage in trust disintermediated transactions. It also created a novel model for distributing network effects away from a centralized entity.

How tokens distribute network effects

A properly designed token structure captures the network effect in the value of the token. Since tokens are typically owned by a more distributed network of owners than the cap table of a typical startup before IPO, tokens are a better way to distribute network effects.

Let’s look at an example.

Let’s say that there is a network of people renting their cars to others. Let’s call it CarBnB. For someone to rent a car from someone, they need to pay in CARB tokens. People who rent their car gets pain in CARB tokens. Let’s say that there is a fixed supply of 10,000 carb tokens. Every transaction happens only when a pair of users exchange CARB tokens in return for the car that was rented. As more and more users rent cars on CarBnB, the demand for CARB tokens goes up and since CARB supply is fixed, the value of CARB tokens goes up. This directly captures the network effect in the tokens. However, since CarBnB does not hold all CARB tokens, anyone who holds a CARB token, and uses it benefits from the network effect captured in the value of CARB. (There are secondary effects where the increasing value of the token could dissuade the users from consuming CARBs, but there is a stable equilibrium where the value of consumption equals the need to save an appreciating asset, but we won’t go into that here.)

Tokens capture the value of network effects businesses because there is only a fixed supply of tokens, which represents the compressed lifetime utility of the network (lifetime network value). Since the tokens also are needed to derive utility or perform certain functions in the network, they enable holders of tokens to create the network effect as well as benefit from the network effect. By participating in the network, either on the consumer or producer side, users increase the network effect.

Tokens allow users to directly share in the externalities they themselves helped create. This way, tokens “internalize” and distribute the externalities amongst token holders. Token architecture allows the welfare maximizing effect of network effects to be decentralized and distributed among all network participants. This is perhaps the first model that allows the power of a network to be distributed without reducing the value of the network.

The exciting thing about tokenization is that this token architecture can be applied to disrupt any organization that has the dynamics of a network, starting from communication networks like social media platforms, advertising networks, insurance, and other financial products (where banks and other financial service providers centralize and capture a significant portion of a transaction value). Tokenization realizes the promise of blockchains as tools to distribute externalities out of centralized organizations and back to the decentralized market participants. In this way, tokenization will compete with centralized organizations of all kinds, and alter the boundaries of self organization as we’ve known it.

It’s a heady and dizzying world of tokens we are headed into.

By aligning the interests all the participants (the teams building the network, the users of the network, as well as any other holders of the tokens), the token model is superior to using VC/PE/public market funding models for building networks. Consequently, tokenization has provided liquidity for many decentralized applications and protocols in recent years.

Tokens are especially suited to build two-sided marketplaces, where the value of the platform is directly dependent on the aggregate value of transactions happening between the participants on either side of the platform. A decentralized marketplace, which distributes the network transaction fee amongst the tokens, aligns the aggregate value of the network equally between the tokens and preferentially rewards participants that strengthen the network effect.

3. Tokens Align incentives and coordinate activities of a decentralized organization

Since tokens represent the compressed lifetime utility of the network (lifetime network value), as the network grows in value, tokens grow in value as well. However, just the usage of tokens in the network means that the aggregate transaction value of the network is increasing. When a token holder uses tokens in the network to derive utility (aggregate transaction value increases), the network value increases, which in turn increases the token value.

Now let’s look at the way this disrupts the traditional “corporation structure:

1. Management, which has residual control of the corporation’s resources
2. Board, which can exercise control over management structure
3. Shareholders, who ultimately pay the price for the actions of the above

Managing the possible interactions between these various contingents and their activities is significant field of study, and is almost exclusively the domain of management science. The token model, however, promises to be dramatically different.

In a decentralized network (or DAO), the stakeholders are

1. Token holders (Developer/Founder team)
2. Token holders (Consumers who want to derive utilIty from the network)
3. Token holders (who speculate on the value of a token, thus providing liquidity)

Thus, tokens align the incentives of all the stakeholders much better than the incentive structures that corporations use to optimize their organizational structure and function.

Autonomous coordination in a decentralized network is a complex process because several distributed algorithms are required to interact to produce agile, cohesive and efficient coordinated behavior. There are many widely used coordination approaches such as auction based coordination, market based coordination and token-based coordination etc.

The information transmission costs are much lower in the second model. In a way, tokens can be thought of as “coordinators” of the various contingents of an autonomous organization. It can be argued that tokens reduce the operational costs, information risks, time and human activities involved in coordinating autonomous organizations, while increasing efficiency, flexibility and performance (Y.Xu, P.Scerri, B.Yu, S. Okamoto, M. Lewis, & K. Sycara, “An integrated Token-Based Algorithm for Scalable Coordination”, Y. Xu, P. Scerri, K. Sycara & M. Lewis, “Comparing Market and Token-Based Coordination”).

To Summarize,

Tokenization aligns the interests all the participants (the teams building the network, the users of the network, as well as any other holders of the tokens) more efficiently than other prevailing corporate structure and is therefore a much superior model for building networks than the established VC/PE/public market models.

Consequently, tokenization has provided liquidity for many decentralized applications and protocols in recent years, and it will continue to do so, once the existing legal and regulatory uncertainty has been minimized. 2018 and the next few years will prove to be an interesting time when the organizations as we know them all get disrupted by tokens.

If you have any thoughts, comments or suggestions, we’d love to hear them in the comments below or on our Telegram channel: https://t.me/getportal

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