This 2 part series explains why TabooKey developed a new type of token economy. Part 1 explores the problem and what we want from a solution. Part 2 will propose a new type of token economic model (CREDO) that captures value in proportion to real economic growth and public confidence, without creating yet another strange and unusual form of volatile currency.
Utility tokens of math destruction
Are utility tokens necessarily doomed to fail?
“A house divided against itself cannot stand”
Imagine a bizarre world where startups only sold the goods and services they created in their own volatile stock. The standard token economy design has created something like that and it makes no sense.
Setting aside outright scams and nonsensical money grabs for centralized apps that don’t even need a blockchain, even some of the best dapps (decentralized apps) end up implementing minor variations on the theme of creating a limited supply of a new utility token which is sold to raise funding.
This is a problem for two reasons:
1. The big problem of small change
Why is every new dapp creating yet another form of volatile currency that is hard to obtain? Does this trend best serve users? Or can we expect increasing confusion and mental exhaustion from forcing them to keep track and exchange all of these different tokens?
Are dapp investors more or less likely to capture value when a poor user experience coupled with uncertainty and friction depress value creation in the first place?
2. Born in sin, living in a paradox
The design of a typical utility token economy is often an ugly hack that has more to do with supporting a free-for-all fundraising process that slips through the cracks than with maximizing value creation afterwards. Unfortunately the way most token economies bypass the usual laws regulating fundraising makes them more likely to conflict with the natural laws regulating economics. These can not be bypassed so easily.
By being shoehorned to serve a dual role as both currency for the dapp’s mini-economy and also de-facto investment instrument, a utility token ends up being good as neither. At best, this is harmful for its token economy. At worse, the flaw is fatal.
Utility tokens are inherently paradoxical because good currency doesn’t make for a good investment and vice versa. A good currency has a relatively stable value. Otherwise, it’s not good for business. Stability is desirable for a means of exchange and unit of account. By contrast, the value of an investment in anything new is speculative and highly volatile. For use as a currency high levels of volatility can be toxic and self-limiting. Even the perception of a potential future change in value can be damaging.
HODLers vs BUIDLers
If users expect a utility token to appreciate they are less likely to spend it. If they wait their purchasing power will increase. This depresses demand. In other words, the same belief that would drive up the value of a utility token would also drive down the very thing the value of the utility token is supposed to track.
Conversely, the perceived risk that a utility token may decrease in value can turn it into a hot potato that nobody wants to hold. It makes staking collateral riskier. Value depreciation amplifies volatility by creating self-reinforcing feedback loops. Increasing velocity further pushes down demand for the utility token, which further pushes down its price, which further increases velocity, ad nauseum.
Bad milk is bad for your baby
An economy thrives on good money as a baby thrives on good milk. You wouldn’t feed a baby bad milk, why would you do that to your economy? On a steady diet of good money, your economy will grow faster and healthier. You only use the cheap substitute if you can’t have the real thing or don’t know any better.
Utility token economics: decentralized failure or centralized manipulation
“The basic concept was allowed to remain unchallenged that man, in his infinite wisdom, can determine what the money supply should be more effectively that an unmanaged system responding to the law of supply and demand”
Left to its own devices a utility token economy trying to appease the conflicting desires of users and investors simultaneously with the same paradoxical token will naturally depress into nothingness or shake itself to pieces long before economic activity grows large enough to play a stabilizing role.
This creates a temptation to try and defer natural catastrophe through artificial manipulation. A sufficiently powerful entity, most likely the token economy developers or a cabal under their control, assuming the role of centralized monetary authority and implementing a policy that cycles between trading off the interests of investors for users or vice versa.
You shall know the tree from its fruits
The opening act would be a massive dump after fundraising to make the beast easier to control, followed by carefully engineered cycles of token price stability and turmoil, boom and bust. In the stable phase economic activity can grow relatively unmolested to maximize real value creation. In the unstable phase token price is shaken violently to wipe out less resourceful speculators, then restabilized at a new price.
Tinkering with the laws of supply and demand in an attempt to tame natural market forces is an expensive and risky proposition. It requires specialized knowledge and tools. Not to mention inordinate hubris. It is easier said than done. The financial graveyard is littered with the corpses of those who have dared to try.
Unfortunately, manipulation is necessarily required for the paradoxical utility token to appear to not contradict itself, at least temporarily between cycles.
Centralizing to decentralize?
Manipulation can only be successful to the degree that economic power is sufficiently centralized so that manipulators have practically cornered the market on utility tokens and have set aside liquidity reserves deep enough to resist market pressures.
The probability of staying in control rests on the relative resources of the manipulators vs the manipulated. This creates perverse incentives towards increased centralization, which may contradict the key value proposition that gave a token economy its reason for existence to begin with.
The dangerous art of token price manipulation
The easy part in controlling price is maintaining the ceiling. Just set aside a reserve of tokens, freshly created from nothing, that is large enough not to be exhausted by expected public demand.
The hard part is maintaining a price floor. That has to be backed with the willingness to essentially reverse the fundraising process by purchasing back tokens at the target price. The opportunity cost is high. Funds set aside for this purpose can not be invested into development that would otherwise drive value creation.
If you don’t know who the sucker is — it’s probably you
Investors beware! Decentralized application developers that are farsighted enough to realize stable utility token valuation is needed to maximize value creation may also realize it will be easier for them to control token price if it craters after fundraising. This creates a perverse incentive which if acted on guarantees to soon disappoint the early risk takers who subscribed to a utility token offering and are bankrolling this charade.
What would a sane tokenomic model look like and where do we look for it?
Mechanism design: To get what you want, reward what you want to get
Token engineering is economics in reverse, also known as mechanism design.
Economics starts with an existing economic system and tries to figure out its rules in order to create simplified models that can be analyzed using techniques such as game theory. The ultimate goal is to understand the system’s game theoretic equilibria and dominant strategies. These serve as strange attractors that pull the economy predictably from various circumstances towards outcomes that can be anticipated probabilistically.
Mechanism design is economics but in reverse: start with the desired outcomes and try to figure out what rules of rewards and penalties will lead to that. For practical purposes, certain simplifying assumptions are often made, such as participants being, on average, selfish rational actors that are capable of understanding their incentives and executing the dominant strategy that maximizes their utility.
The mechanism design genie is granting Aladdin three wishes
What will Alladin, our budding token engineer ask for?
- I wish to maximize GDP for my economy!
- I wish to maximize ROI for my investors!
- I wish my previous two wishes are granted in a way that doesn’t make me sorry I found this magic lamp!
That last wish is just in case the magic lamp is cursed, a malady more common afflicting monkey paws. When there’s magic involved, you can never be too careful.
Maximizing GDP means maximizing real value creation as measured in the growth of productive economic activity. Not a musical chairs game of speculation, but a rich and diverse marketplace of producers and consumers that maximizes utility & social surplus.
Our economy will be best served by a stable currency that increases predictability for all participants. Optimistic expectations for future growth should stimulate the economy and attract a greater range of producers competing for business, not depress it with the spectre of currency deflation.
Maximizing ROI means maximizing expected value capture for investors funding ecosystem development. The prospect for risk-adjusted returns has to be attractive enough to allow raising the funds needed to jumpstart a healthy, fast-growing economy.
Rewards should be proportional to risk exposure. Earlier risk takers should be appropriately compensated for not taking a wait and see approach.
Built to last: alignment of interests
Investors should be in the same boat with all other economic participants. Together they float, divided they sink.
To the degree that investors have governing powers, their incentives should compel them to be prudent stewards. It should be in their benefit to inspire the growth of confidence in the economy. They should expect to be rewarded handsomely for policies that maximize long-term gains, and penalized for short-term myopia.
A long-term greedy, stable hand, will be more likely achieved by minimizing investor turnover than encouraging flipping tokens from speculator to speculator. Rewarding time locked staking is good. Not only as a velocity sink. It gives stakers skin in the game and commits them to the success of the system. You don’t want the boat to sink when you can’t get off.
Built to last: defensibility through supremacy, not secrecy
In decentralized systems, maximizing value capture means maximizing defensibility against would be competitors that can easily copy your smart contracts.
Funding development that creates value isn’t an attractive prospect if the code is copied and the value captured elsewhere. There should be multiple lines of defense. These will mostly boil down to set up a token economy where would be competitors have more of an incentive to collaborate than set up shop on their own.
- Network effects: the best line of defense is a token economy that encourages strong network effects that can not be easily copied by functionally identical copycats. A functionally identical copy of Facebook is worthless when all your friends are on Facebook.
- A token is a bliss when it can’t be dismissed: tokens shouldn’t be forced where they don’t genuinely belong. If a token can be removed without breaking the token economy, there will be a fork and the fork will be better than the original.
- Unfair rent seeking: Avoiding burdensome rent seeking that redistributes wealth unfairly from one class of stakeholders such as consumers and producers to another class such as investors. If a mining or burn mechanism redistributes wealth this way, a slightly modified competitor could enjoy a competitive advantage.