Why Economic Design is Essential for Security Tokens
Security tokens have many attractive properties: they can expand access to asset ownership, provide improved records of current and historical trades, improve efficiency of trade execution, increase liquidity, and can have more attractive fundraising economics than utility tokens. It is no wonder that they are garnering a great deal of interest from blockchain investors and founders.
StartEngine has been a leader in providing regulatory-compliant infrastructure for venture crowdfunding. I am looking forward to speaking at the StartEngine Summit on October 19 on the economics of security tokens. In this post, I discuss why economics is essential for security token design, and I outline some of the major economic issues that arise as platforms seek to create and launch security tokens.
What is economics and how does it relate to blockchain?
Economics is the study of how individuals make decisions under constraints and in strategic environments. Economists are called on to design economic systems as varied as school districts, labor markets, and spectrum auctions. Using their understanding of individual decision making, they engineer systems that function well and deliver the intended results to their users.
For this reason, economics is important to blockchain for more than tokenomics. Blockchain projects are economic systems written in code. Especially for decentralized projects that lack central authority to enforce behavior, the platform’s success depends on users independently making decisions that align with the platform’s goals. This includes both decisions about tokens — such as whether to hold or sell — and on-platform behavior, such as voting or staking. Careful economic design ensures the platform is a coherent system in which individual and system benefits align.
What can economics tell us about tokens, and security tokens in particular?
When we speak with clients about the economics of security token design, there are three points that we emphasize.
1. It is impossible to understand the economics of security tokens without understanding the economics of property rights.
The economic value of a token depends on the rights that it bestows on its holder. While utility tokens provide the rights to purchase goods and services on the platform, the rights bestowed by a security token can be more complex and can include ownership of shares of assets, dividends, or governance rights.
The rights that are assigned to token holders materially impact the value of a token. For example, a token that bestows a claim to only some specific uses of a commercial or residential property will be worth much less than a token that bestows ownership rights of that property. A blockchain founding team must think carefully about what drives value for token holders, and how the token can be designed to include the appropriate rights.
2. Not everything can or should be tokenized.
While tokenization is an attractive step forward for many asset markets, it cannot be applied universally. There are many ways in which the process of tokenization can fail. A simple but important point for security tokens is that whatever ownership rights the token bestows must be able to be traded using the blockchain protocol. For example, it would be impossible to turn university degrees into security tokens, as they cannot be bought and sold (or traded). The blockchain also needs to be a cost-effective way to transfer ownership of the asset. If the correspondence between physical and digital asset is weak, or the blockchain protocol is too costly to use, users will trade the asset without using the blockchain and the blockchain protocol becomes worthless.
3. Tokens must be designed as an integrated part of the blockchain platform’s overall economics.
The value of a token comes from one of two sources: it is either related to the value of the platform itself, or will be related to the value of an underlying asset. In either case, the economic structure by which token holders and other network participants interact will have an impact on token value. Tokens must be designed with this overall platform infrastructure in mind.
For example, if a token provides partial ownership (let’s say 1/1000) of a commercial real estate property, the token derives its value from the value of the underlying commercial real estate. But it also depends on whether the token holder has the rights to participate in the decision of whether to maintain the property, when to sell it and for how much and to whom, etc. These types of decisions are typically designed through governance, which is part of overall platform design.
Where does the economic design of security tokens go from here?
As token design continues to evolve, the industry will need to evolve and refine its approach to token economics. Security token creators will need to think carefully about what their token is to be used for, why it will have value, and how to design the surrounding ecosystem to deliver on that value. This will require cooperation and collaboration among business leaders, technologists, lawyers, and economists.
Join us on October 19th at StartEngine Summit as I further this discuss on the panel titled The Benefits of a Tokenized Economy, You can read more about blockchain economics and governance design Prysm Group’s Medium blog and through our contribution to the MIT Cryptoeconomics Lab.
Dr. Stephanie Hurder is Founding Economist at Prysm Group, an blockchain design firm assisting in the economic and governance design for mainstream market integration of crypto-related organizations around the world with a mission of bridging the knowledge gap between blockchain organizations and their users, accelerating the integration of these technologies into everyday life.
She is a Harvard-educated economist specializing in human capital, market design, and the future of work. Her speaking engagements on the economics of blockchain include the Federal Reserve, UC Berkeley, USC, the ZigZag podcast, StartEngine Summit, and other industry events. Previously, Dr. Hurder was at the Boston Consulting Group, where she was recognized as a firm-wide expert on organizational effectiveness and design and co-authored multiple publications on these topics.
Stephanie has held research positions at MIT, Microsoft Research, and Merrill Lynch, and has led seminars to faculty at a half dozen top research universities across the United States. She holds a PhD in Economics, an AM in Economics, and an AB in Mathematics from Harvard University.
Follow Stephanie on Twitter @shurder
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Legal disclaimer:
Partners of Prysm Group are not lawyers or broker-dealers. Any company seeking to design or sell a blockchain-based investment should engage a qualified securities lawyer, as well as an ICO advisor or investment bank, for advice on legal issues, regulation, marketing, advertising, and sales. The discussion here is based on economic models of blockchain platforms and tokens and does not reflect any legal or investment advice.
