Notes on Utility Token design
TL;DR; Early contributors and project adopters often have conflicting aims to those of investors, leading to target audience dilemma. In this article we consider the opposing stakeholders of a token sale and how “value” is derived. What is velocity, why is it an important design factor and what are the evolving Token models addressing this issue?
The fact that Token Sales are becoming the dominant way of raising money for early stage technology projects has been already thoroughly covered (e.g. by Coindesk or Techcrunch). We see ever-increasing interest from entrepreneurs trying to take advantage of this new fundraising phenomenon. However from many teams, that are predominantly intending to build projects for the application layer, we often see little interest to understand the importance of the role the Token is supposed to play within their projects. Many see the Token as being a necessary evil, they need to forcefully sow into their project, in order to conduct a utility token ICO (Initial Coin Offering or less criticised term TGE — Token Generation Event), in the first place.
If there is no rationale for a Token to exist other than raising money for a startup without giving up equity — that can be a terrible deal for anyone buying such a Token. If the investors are offered equity, share of future revenues or other forms of dividend — such a Token would be considered a security, and this carries a widely discussed burden of compliance under the securities laws of different countries. This article does not intend to focus on security tokens although it is of course a key part of the future of Tokenomics — that is for another day.
So how do we design a utility Token, that is attractive to investors, but at the same time does not jeopardise the long term sustainability of the underlying project?
Utility Tokenomics 101
“The only Token that matters is the one being actually used”
As well summarized in William Mougayar’s Tokenomics — A Business Guide to Token Usage, Utility and Value,
“Token is a unit of value that an organization creates to self-govern its business model, and empower its users to interact with its products, while facilitating the distribution and sharing of rewards and benefits to all of its stakeholders.”
William’s article is a great starting point for understanding the emerging Crypto Economy and the role the Tokens play within a decentralised ecosystem — building blocks or Crypto-Economic primitives (by Jacob Horne, March 2018):
“Protocol based incentives systems that are uniquely enabled by Tokens. Also referred to as “Tokenized economic games”.
They enable the coordination and allocation of capital to achieve a shared goal via the use of various economic and cryptographic mechanisms.
A Crypto-Economic Primitive should be a self-sustaining system, and its intrinsic Token must be a necessary element of that system. In other words, it shouldn’t require anything other than itself to function and the removal of the Token would cause it to fail or work less effectively than the system with a Token.
A Crypto-Economic Primitive should result in the predictable coordination of a set of actors (whether it be humans or machines) towards some specific shared goal or outcome.”
While there are several frameworks, such as the Token classification framework by Thomas Euler, for evaluating the viability of a particular Token Design, the first and key question we should ask when considering an utility Token for investment is:
What will happen if we take the Token away?
If the answer is “not much” and the project continues to work without any significant loss of efficiency, there is very little reason for the Token’s existence.
Artificial barriers created to give an impression of Token necessity won’t help either, and will likely hurt the project in the long term. For example, forcing users to solely transact using the Token, will likely make the project less competitive than others (which may exist at the time or later), offering a similar service, allowing acceptance of mainstream currencies.
A good project facilitating utility Tokens builds its economic model around them, and does not try to forcefully attach the Token in order to qualify for an ICO/TGE.
Token value correlation
An investor in utility Tokens might naturally look for projects that meet at least the following 2 conditions of investability:
- Belief in the sustainable project future, where the Token is an indispensable component or at least is increasing efficiencies within the project’s ecosystem.
2. The Token value positively correlates with the project’s adoption.
There may be many great projects with amazing futures, but if there isn’t a clear case for the Token’s value appreciation with adoption, it would make a poor candidate for investment via the Token.
From many ICO promoters, we hear the following:
“There is a limited number of Tokens, more people will use the product leading to higher demand, therefore the Token price will raise!”
This “logic” however fails to account for the Velocity Problem.
The equation goes:
M*V = P*Q
M — Monetary base
V — Velocity (how often a Token changes hands)
P — Price of the digital asset being provisioned
Q — Quantity of the asset provisioned
The seminal article by the co-author of “CryptoAssets”, Chris Burniske on CryptoAsset Valuation is a comprehensive guide on how the equation can be used for valuing digital asset, as well as the detailed paper “An (Institutional) Investor’s Take on Cryptoassets” by John Pfeffer.
“A crypto asset valuation is largely comprised of solving for M, where M = PQ / V. M is the size of the monetary base necessary to support a crypto economy of size PQ, at velocity V.”
In a nutshell the thesis assumes, the lower the velocity, the greater the Token price with raising adoption, all other things being equal.
Great, so we’ve figured it out! If we create strong incentives for our network’s stakeholders to stake and hold their Tokens, fix the supply and we’ll have a deflationary Token that will increase in value with increased adoption!
Deflationary currencies work terribly in the real world when coupled also with the Circularity problem. The more adopted the project becomes, the more Tokens are staked and held, the more the Token appreciates in value, it suddenly creates incentives for speculators to hoard them, rather than being used within the network, leading to deflationary spirals and recession.
Arguably, the adoption of a decentralised network then works against its future success.
Brian Koralewski has well articulated:
“Clever crypto-architects can also monitor the health of a functioning distributed network by keeping tabs on velocity V. Low velocity, whether by design or misaligned investor, participant and customer incentives, may push up Token prices but render the networks commercially unviable.”
The TGE target audience ‘dilemma’
That presents us with an important question: Who is going to buy my Token? Ideally, it would be the end-users of the future platform, product or service. Not only am I raising required capital to build it, but I’m building a community of users and an important early adopter’s base for it .
Finding such an audience requires community building through frequent, and often long term communication. However, many (good) technology startups prefer to focus on building their products, rather than selling ideas through crypto or tech conferences — they contract companies specialising in organising Token sales (e.g. ICO agencies or factories). These companies are incentivised to make the Token issuance look attractive to investors with speculative motives, rather than the early adopters. Agency “success” is measured by a completed Token sale that achieves the minimum or target raise — they often have little or no incentive to support the sustainability of the Token economy once the project is live. And the more competition there is in marketing Tokens, the more of the pre Token-sale budget is spent on marketing in this way and the more disaligment there can be between those focused only on the Token sale and those who care about the sustainability of the project.
Aligning the incentives of project contributors, early adopters and TGE investors is not an easy task and requires thorough thought on both the Token design and issuance policy. We have to do so with the view, that we are still in an early experimentation phase and we are yet to see an established model, that would solve these challenges.
All things to all men?
Is it possible to package into one Token the sustainable incentives for participants/users as well as speculators/investors? Their conflicting aims may be irreconcilable in one Token. While the theory in utility Tokenomics continues to evolve, we foresee a strong case for the introduction of dual Token issuances during the TGE: utility Token for early contributors and adopters, and a separate Token carrying well known and understood properties of financial securities. These may happen at the same time or sequentially, but where they meet different needs and deliver different benefits.
Utility features (we like)
I include examples of Token utility functions, that we at Rockchain think represent the stronger models from a Tokenomics perspective.
Useful for early stage projects to incentivise meaningful coordination of early contributors to the project and aligning them with the goals of the core team.
Key concepts are well summarised in Leveraging the True Power of Tokens for Early Stage Projects article by the VariabL team.
These Tokens are not useful for early adopters or investors, and this model may be limited to the development stage of the projects. Once the network has been completed a new type of Token may be necessary, that will carry properties interesting to the users. Contribution Tokens may than be converted security Tokens, that may financial reward early contributors in similar way shares would in a startup.
Right to Work
In principle, the service provider willing to provide services to the decentralised network stakes Tokens to receive the right to be assigned work from the network customers. The probability that a service provider is awarded the next job increases with to the number of Tokens staked as a fraction of total Tokens staked by all service providers.
This model has low Token velocity, and absent any speculators, it’s value should positively correlate with the network adoption. The more customers seeking the services, the more potential service providers (network effect) will seek to stake larger amounts of Tokens.
Token-curated registries are decentrally-curated lists with intrinsic economic incentives for Token holders to curate the list’s contents judiciously.
The product or output of a Token-curated registry is a curated list of items adhering to certain definite conditions, for example a list of pubs serving Slovak beer.
Candidates, in this case pubs serving such beer, desire the attention of customers and wish to be included in the list. They must make a deposit denominated in the registry’s native Token to be considered for listing. If a candidate meets the list conditions and is accepted they keep the deposit, and may withdraw it at any time should they desire to terminate their listing. If a candidate is dishonest, his application may be challenged by Token holders the deposit is forfeited and divvied up as a reward amongst Token holders who participated in the challenge process.
Customers want quality information — they only want to visit pubs that genuinely serve that kind of beer.
Token holders desire to keep demand for the Token they hold high, as this increases its price.
“They may be otherwise disinterested in the contents of the list they are curating. To keep demand for their Token high, Token holders must keep candidates desirous of having listings in the registry by maintaining consumer interest in the registry by keeping the quality of listings high. Stated in reverse, if the quality of listings are high, then consumers will be interested in the registry such that candidates will desire to be listed in the registry. Token holders realize a direct financial benefit for curating the list in an expert manner, and the degree of their benefit increases proportionally to the quality of their curation as consumer and candidate interest rise in lockstep. (Mike Goldin, Sep 14, 2017)”
This model has low Token velocity and thus its value should in theory correlate with the growth of the list, as more list participants will keep higher amounts locked as deposits.
The basic premise of curved bonding as described by Simon de la Rouviere is as follows:
“A specific Token (eg ETH), you can buy a new Token (eg #projectToken) through a smart contract. The ETH is kept as deposit within the smart contract. It’s not disbursed to any particular person or team.
The buy price is determined by the current supply of the new Token (#projectToken). The buy price is hardcoded according to some algorithmic curve.
At any point in time, someone can sell back their #projectToken into the communal pool and get out an appropriate reward that is set by a sell curve.
The value derived from curved bonding is that it rewards participants for being early and buying Tokens in that project.”
This model can be used in curation markets, i.e. rating of assets, quality of data or work.
Furthermore, bonding curves may allow for better alignment between crowdfund investors and project teams. If the team misbehaves, the investors can exit and reduce the pool available to the teams. See 1Hive by District0x for more details.
The value of the project Token (in relation to benchmark, i.e. ETH in our example) directly correlates with its demand, making it an interesting vehicle for both investors and contributors.
Staked for Discount
The Discount Token model, where Tokens are staked in order to receive a discount to the services provided on the network, whereby the discount may be proportional to the amount of Tokens staked.
An interesting model, easy to understand and potentially catering to both users and investors. However, the value of the Token may be limited to the total nominal financial advantage it provides when applying to receive the discount.
We consider this to be better approach than a burned token when used for a discount because it may lead to a deflationary spiral as described earlier.
I recommend Understanding Discount Token Models for Blockchain Projects article by Clayton Roche for anyone interested to explore this model in depth.
Owning and staking the Token gives the right to use the system, perform a governance function, such as voting.
While a very simple model, one may question whether such limitation, unless coupled with another feature (e.g. Curation), isn’t putting projects into a disadvantage when compared to competitive projects, without these limitations.
Token Economics and their design is a fast evolving area in the Crypto Economy. It’s too early to establish which designs will become successful in the long run and whether any pure utility Token will be able to equally satisfy all stakeholders at once — investors, issuers, contributors and customers. However, considering the role and nature of the token and how it relates to your desired outcomes in the project at the start of the design of your project, is essential. Also, acknowledging that sustainable benefits for different user types may not be achievable, means you can prioritise them and address those that matter most.
Disclaimer: This document does not constitute legal or investment advice nor should be taken as such. You should not rely on it and if seeking to do an ICO or any other related activity you should seek separate professional counsel. It is for informational purposes only.