Tokenization: A Paradigm Shift
Blockchain Beyond Bitcoin | Lecture 7
Recap
In previous lectures, we’ve touched upon the shared protocols of which the internet is comprised: TCP/IP, SMTP, HTTP, etc. Private companies have built walled gardens on top of these open protocols which have produced an unfathomable amount of value for their shareholders, largely due to network effects and the monetization of user data.
Given the self-reinforcing nature of network effects, the majority of this value has been captured at the application layer of the internet stack. This view of the internet is best described in a notable piece by Union Square Ventures as having “thin” protocols and “fat” applications.
As Joel Monegro of USV mentions, these applications are designed to collect lots of state, lucrative data which software giants can transact and profit off of (via targeted online advertising, for example). State provides the ultimate competitive advantage, incentivizing companies to silo this data and providing limited access—as they see fit—to both users and application developers. In recent history, these permissions have been abused or circumvented to allow malicious parties to gain unauthorized access to personal data on applications such as Facebook. State is often non-transferrable to other applications, meaning that the switching costs of moving to another service or application for both users and developers ensure they have no choice but to stay.
Venture capitalists quickly realized that investing in applications yielded high returns, and that these returns could be reinvested into the research and development of proprietary protocols which would solidify competitive advantages via improvements in performance, usability, or interoperability.
With the advent of Ethereum—and more generally, the blockchain application stack—value is amassed at the shared protocol layer, and only a fraction is distributed to users at the application layer. This results in “fat protocols” and “thin applications”. As a defining example of this, Bitcoin has a ~$70B market cap, yet the largest companies built on top of it are (due to the speculative nature of the industry, likely over-) valued in the single-digit billions. Similarly, Ethereum has a market capitalization approaching ~$14B, yet we’re only now seeing breakout applications with sustained traction.
There are two key properties of open (permissionless) cryptonetworks: the first is a shared data layer which all applications have equal access to, and the second is a protocol token which grants a user access to the service(s) provided by the network (trustless payments infrastructure with Bitcoin, a decentralized & Turing-complete computing platform with Ethereum, decentralized file storage with Sia, etc.). Let’s unpack these two properties.
Shared Data Layer
The shared data layer exists to replicate and store user data in an open and decentralized manner, instead of siloing data inside individual ecosystems (think Google, Facebook, Apple’s iCloud, etc.). With this, the barrier to entry for new applications decreases, which results in a more level playing ground for application developers who have product advantages instead of data advantages. For more context into the motivations and properties of a shared data layer, read our previous lecture on Ethereum and “open state” here.
Protocol Token
As described by Will Warren—founder of 0x Protocol—a protocol is defined as the set of rules which maintains agreement among peers in peer-to-peer network. These rules exist to coordinate the action of rational agents participating in the network, and the token is used to incentivize actions that secure or create value for the network (such as mining). For a given blockchain, there is—almost always—a single protocol, and a native token associated with it. This native token, a protocol token, is acutely described as a unit of access to the service provided by the network. Thus, the value of the token is contextual to the protocol, and can serve functions such as governance (voting power for modifications to the monetary policy, consensus mechanisms, etc.), staking, lending, and more generally a form of equity in the protocol. As mentioned earlier, examples include payments infrastructure with Bitcoin, and a decentralized computing platform with Ethereum.
Examples of protocols with interesting token use cases include REP for Augur, BAT for Basic Attention Token, MANA for Decentraland, etc. These tokens have specific use cases defined by the protocol which allow users to (1) accrue/extract utility, and/or (2) transfer value within the context of the application. In the case of Basic Attention Token, this might include spending BAT to unlock premium content or view higher higher-resolution media.
Most importantly, tokens can also be used as a fundraising mechanism via a public crowdsale—as we will touch on shortly—if the token is designed to avoid classification as a security.
Protocol tokens play a crucial role in incentivizing both the development and adoption of cryptonetworks. Let’s begin with the feedback loop they create for protocol development.
Incentivizing Protocol Development with Tokens
The development and implementation of internet building blocks—such as TCP/IP—took place in the 70’s and early 80’s in research facilities, such as Xerox PARC, and networking research initiatives, including Vint Cerf’s group at Stanford. These initiatives were funded by the US Department of Defense (via DARPA), but researchers and scientists were not rewarded proportionally to the value created by the technologies they developed. In other words, researchers had no equity in the protocol, and could not capture asymmetric upsides if the tech were to catch on.
Fast forward almost forty years, and shareholders of businesses worth upwards of $500bn are earning fortunes from applications extracting rent from consumers and developers in the form of advertisements and fees. In contrast, the researchers who developed and implemented the underlying protocols gained no stake in the success of the applications built on top of them.
For this reason, both entrepreneurs and investors focused quickly on the application layer of the internet, where users would be captured and monetized. Consequently, changes to internet—which were incremental and infrequent, since they required the agreement of hundreds, if not thousands of individuals and organizations—happened in the private domain. Companies who profited from the success of internet applications reinvested into private protocol development and research, intending to help their own products and services scale to reach hundreds of millions of users with low latency, high performance, and functionality enhanced by network effects.
Tokens are a breakthrough in open network design that enable: 1) the creation of open, decentralized networks that combine the best architectural properties of open and proprietary networks, and 2) new ways to incentivize open network participants, including users, developers, investors, and service providers. By enabling the development of new open networks, tokens could help reverse the centralization of the internet, thereby keeping it accessible, vibrant and fair, and resulting in greater innovation. Chris Dixon
With the introduction of tokens, there are new economic incentives for the creation and development of protocols serving to transfer information & value over the internet. Developers of these protocols can pre-mine or pre-allocate the currency for reasons including:
- Receiving rewards proportional to the success of the protocol
- Creating an organization to sponsor developers, companies, and initiatives in the space
- Pre-sales to private investors, or early supporters & users
Preallocation of these scarce digital tokens—which due to the speculative nature of crypto could result in an exponential increase in price after being listed on retail exchanges such as Coinbase or Binance (“to the moon!”)—is contentious. While it allows for developers to possess a far more equitable stake in the market value of their technology, some public investors complain about the new terms. This piece on the “fairness” of a token sale provides more context into these contentious founder’s rewards:
Zcash and Beam both have a timelocked pre-mine (the founder’s reward), that was partially sold to accredited venture investors. With Dfinity (and many other ICOs), early investors paid 1/100 or less than later investors in the public offering. It can be argued that these discounts are justified because these investors lend needed credibility to projects and accept longer lockup/illiquidity periods than public investors. Whether the market agrees with this argument remains to be seen. Arjun Balaji & Hasu
Due to the supply inelasticity inherent to protocols with scarce tokens, we see that tokens are very responsive to market movements, and thus volatile. Thus, tokens held as equity will appreciate quickly if and when the protocol is adopted by users (often, application developers), providing a continuous incentive for protocol developers to improve functionality, performance, and design.
Tokenization is a paradigm shift. When investors recognize value in a network, a market grows around the token, and token prices rise (or fall) relative to the protocol’s abilities.
Previously, protocols were only monetizable by creating or hosting software on top of it. Thus, protocol development was never correlated with financial gains, resulting in perverse incentives to build closed-source networks and proprietary protocols.
Now, protocols can have economic value embedded into them, allowing the creators and early investors to reap rewards if it gains traction. The evolution of the protocols is largely in the hands of developers and token holders; if a competing protocol becomes more attractive, users will sell or trade their tokens to switch to the new protocol. This incentivizes an open and democratic process for making changes to protocols over time. For instance, Tezos allocates new coins to developers who submit improvements to the protocol (with a receipt that is included with the request for changes) if it is merged/approved.
Token Feedback Loops Drive Adoption
Token networks remove […] friction by aligning network participants to work together toward a common goal — the growth of the network and the appreciation of the token. Chris Dixon
As Dixon describes, tokenization is a powerful catalyst for network growth—speculation is the driving force behind adoption of new technology, which is especially apparent with cryptonetworks and their associated tokens.
When a protocol proposes valuable new functionality, developers and entrepreneurs are attracted to it. They invest time and capital, becoming invested in its success, which results in investors and speculators to place bets (short or long) on the future success of the protocol.
Hoping to ride the increase in the price of the token, retail investors seeking to make short-term profits invest capital and become token holders. Some of these users care about accessing the functionality of the protocol, while others view it purely as an investment play. Hedge funds also recognize investment opportunities and invest in tokens accordingly. Interest might grow faster than supply, leading to a bubble-style appreciation.
Since the value of the token is increased, more developers and entrepreneurs are motivated to build on top of the technology given access to both liquidity (important for financial applications) and high investor confidence (to raise capital for new ventures).
Tokenization is a significant paradigm shift in the evolution of the internet—peer-to-peer networks with embedded economics solve the bootstrapping problem of open networks, whereby financial incentives can be created to drive early user and developer adoption.
The combination of the shared data layer and an incentive system that exists to prevent natural monopolies & consolidation of power creates a new building block for applications which can operate under radically new business models.
Types of Tokens
Since tokens are highly emergent, it is difficult to define them durably. As described by Token Foundry — a platform for issuing and purchasing of digital assets — tokens can have highly differentiated use cases, issuance schedules, distribution mechanisms, and properties (including fungibility).
Fungibility
As we discussed in our previous article about the history of currencies, fungibility is a property of money which defines the ability of one unit of currency to be exchanged for another due to their identical value and meaning. The US Dollar is a great example of a fungible asset: you don’t care about the serial number associated with a dollar, and are willing to exchange it for someone else’s dollar without problem, since they will be accepted as equal if & when you try to pay with it.
Thus, fungible tokens can be exchanged interchangably with one another, making them particularly well suited for transactions or exchange of value in an application. On Ethereum, a fungible token can be represented by the ERC-20 smart contract [link], and are used within applications for staking on the outcomes of real-world events in prediction markets, making transactions with individuals and companies in exchange for services or products, as collaterals for loans, etc.
In contrast, a non-fungible token implies uniqueness. Train tickets, real estate deeds, and driver’s licenses are examples of unique documents which cannot be used or exchanged interchangeably. For instance, you cannot trade an airplane ticket with a friend and expect for them to be accepted as identical. These unique assets can be digitally represented as tokens as well, called “non-fungible tokens” (NFT’s). Each non-fungible token is unique, and possesses characteristics which distinguish them from others of the same type.
A popular example of NFT’s is Cryptokitties, a game built on Ethereum which allows users to breed and trade unique digital cats. Cryptokitties are examples of digitally native NFT’s, which exist purely in a digital sense in the ecosystem within which the application is built (in this case, Ethereum). Conversely, NFT’s can also exist as digital representations of real-world items including legal agreements (such as a real-estate deed), tickets, identifying documents, etc.
Consumer vs. Security
While the definition of a security, and whether a given token qualifies as a security, is still under consideration by the Securities and Exchange Commission, security tokens are blockchain-based assets which represent traditional securities such as equity or debt. For context, securities exist to convert assets (that otherwise could not be traded or exchanged, such as loans) into fungible financial instruments, often for the sake of fundraising by selling them to investors.
According to Token Foundry, tokenizing securities can yield two significant advantages: (1) more things can be securitized, and (2) the efficiency, trust, liquidity, and speed of execution will increase drastically over the traditional model due to the programmability of smart contracts.
On the other hand, “consumer tokens” are an entirely new asset class for which rules and regulations are still under development. These tokens allow a holder to access a protocol or application so that they can interact with the underlying technology, instead of mere speculation. Speculation results in inflated token prices which can make it prohibitively expensive for users and developers to interact with the protocol, increases its volatility, and does not contribute directly to the growth and adoption of a protocol.
ICOs vs. IPOs
In the last two years, initial coin offerings (ICOs) have taken the financial and regulatory worlds by storm. An initial coin offering can be described as a digital equivalent to an initial public offering, whereby companies can fundraise by offering investors a token (akin to a share). Let’s dive into details and differences between the two.
IPO
An initial public offering (IPO) is the process of “offering shares in a private corporation to the public for the first time”. Capital-intensive companies seeking to scale or expand will use an IPO to raise money from unaccredited investors. IPOs also provide a mechanism whereby investors and employees who have accrued shares in the company can liquidate their positions by selling shares on the public market, allowing them to _exit_ their investment position. In filing for an IPO, a company will invite underwriters or investment banks to aid in the process of securitization, conduct due diligence on the company on behalf of investors, determine an offering price, the number of shares offered, etc.
An IPO falls towards the end of a company’s fundraising lifecycle. Prior to an IPO, a company might raise seed capital across one or more rounds, which is used to hire initial employees, bootstrap growth, and execute go-to-market strategies. Raising seed capital is an indication of early growth, and might include friends, families, angel investors, and early-stage venture capital funds. Seed rounds usually range from $25k to $5m. In the process of scaling the company, it is common for employees, directors, etc. to be compensated with equity, where their reward will be proportional to the listing price & number of shares when filing for an IPO.
Seed rounds are followed by venture rounds, which are larger investments led by venture capital and wealth managements firms. These rounds are denoted by the series of the stock sold (e.g. Series A, Series B, etc.), suggestive of the stage, size, and growth trajectory of the company. When a company approaches their Series E round, it is likely that investments are on the order of hundreds of millions of dollars, and are referred to as “mezzanine rounds” (late-stage private funding). This investment is meant to carry the company until its public offering or a merger/acquisition.
When filing for an IPO, extensive documentation must be filed with the SEC such that the public can conduct due diligence on the company’s business fundamentals, accounting, burn rate, growth strategy, etc. A public company can still raise rounds after they have conducted their initial public offering via secondary offerings on the public market.
ICO
A reductive definition of an ICO might claim that it is a digital equivalent to an initial public offering, though there are many notable differences. An ICO functions as a fundraising mechanism for internet businesses seeking to develop a new application, service, protocol, etc. In exchange for capital (either in the form of fiat currencies or alternative digital currencies such as Ether), a coin offering will mint and distribute fungible, digitally native tokens which represents the investors’ stake in the company. In traditional terms, an ICO is akin to an IPO which offers options to the general public upon inception.
While an IPO occurs towards the end of a company’s fundraising lifecycle, an ICO happens before any building begins. Investors, based on the [mission, technology, team, story, approach, development timeline] outlined in the whitepaper, invest to either (1) short the token by capturing upside due to volatility (for instance, when the token is listed on exchanges), or (2) hold the tokens based on an investment thesis advancing that the token and underlying technology will create significant value in the future.
Since tokens represent stake in a venture, it is common for employees to either pre-mine or hold a large amount of this currency — this incentive structure is referred to as having “skin in the game”, since the developers will be act in the interest of the value of the currency and should be rewarded proportionally for the value created by their work.
Token Launches
As mentioned in an excellent piece on the dynamics of token launches [link], a “fair” ICO is transparent, providing equal opportunity to acquire a token at a relatively equal price over a long duration of time. Though, we have seen very few ICO’s which satisfy these properties; many sell out in seconds due to the offering taking place at a single point in time, some are private, and many pre-sell or pre-mine their tokens to (sometimes disproportionately) reward early adopters and developers.
To reiterate, ICO’s can be closed off to the public, similarly to a private equity raise; Telegram, a messaging application developed by the founders of Russia’s largest social media network, raised over $1.7bn across two private token sales involving 200 investors—more details here.
If the money raised during the designated timespan does not reach some minimum requirement, funds are returned to the backers and the ICO fails; otherwise, the money is deployed as purported in the whitepaper (ideally to build out the company and its technology).
Structure
There are many models for structuring an ICO, but some common themes include:
- a specific goal or limit for funding, where tokens have a pre-set price and the supply of tokens does not change,
- a dynamic funding goal, where the distribution of tokens is dependent on the amount of funds received, and
- a static token price with dynamic supply, where the length of issuance is constrained but virtually unlimited tokens could be minted.
Brief History
By subverting the rigorous and inefficient processes in place for traditional fundraising, ICOs became incredibly prevalent in 2017 as a strategic lever to raise capital. This resulted in a wide disparity of outcomes. On the upside, protocols like Ethereum and NEO launched via ICO’s and allowed developers and entrepreneurs the opportunity to leave their day jobs and build on top of the platform full-time. ICO’s also allowed projects from around the world fundraise with little concern for regulatory intervention, and connected engineers from around the world to work on decentralized protocols and applications.
On the other hand, many retail investors — who knew little about how to conduct diligence on a cryptocurrency — ended up losing fortunes in ICO scams. Many argue that raising an ICO based on the mission outlined in a whitepaper is simply too small of a burden, and that a company should have to demonstrate provable results in order to raise capital from unknowing retail investors. Moreover, especially in 2017, there were few barriers to entry resulting in founders bypassing legal, financial, or technical diligence from outside parties resulting in many projects failing to deliver on their promises.
The failure and lack of regulation surrounding many ICO’s led the People’s Bank of China to ban them, citing them as disruptive to economic and financial stability. As a result, cryptocurrency market capitalizations tumbled downwards, viewing it as a sign that regulatory intervention was looming. In early 2018, Facebook, Twitter, and Gogole banned advertisements for ICO’s.
A Possible Remedy
To remedy the lack of oversight into ICOs, investors and developers looked to blockchains for the solution: since there was little room for investors to secure the guarantee that the project would meet its deadlines, token sales are being designed within smart contracts on Ethereum and similar decentralized computing platforms. If the tokens are distributed entirely by logic implemented within verifiable code, certain guarantees can be made with regards to founders’ allocations, token minting, company governance, returning funds to investors, etc. For instance, the founders might not be able to withdraw their tokens for a certain amount of time to prevent them from colluding in pump-and-dump schemes. Tokens can also be implemented such that investors get a refund if certain project milestones are not met. This is similar to slock.it’s original idea with a decentralized autonomous organization (DAO) — shareholders can vote on the direction of the company after the ICO by leveraging their tokens as votes within a decentralized system of governance.
Closing Thoughts
Tokenization, and more specifically the initial coin offering as an investment vehicle, provides a revolutionary process for “kickstart” the development of an internet business, and helping to bootstrap both user and developer adoption to compete with the network effects of software monopolies. Though, since tokens exist within a regulatory grey area within many countries, their future remains uncertain.
Resources
If you’re interested in peer-reviewing our content, please feel free to make comments in the discussion or inline via Medium. We highly value feedback, and want to ensure that our content is accurate & meaningful — all help is appreciated. You can also reach out to us at blockchain@rice.edu with any private feedback.
