It all started back in 2017, when the digital world went nuts about crypto tokens. Sadly enough, it didn’t have to do anything with the underlying sweeping innovation, but rather with speculative proceeds. Well, not surprising. With thousands of ICOs run and tons of actual white paper used for useless Whitepapers that were thrown down the trashcan the first second after raising a soft cap, quite a few could actually give an articulate answer to this one itchy question.
Why do you need a token used in the ecosystem?
Indeed, the answer is not as simple as it seems at first glance. Whenever we asked founders a question like ‘okay, so how does your token work in the system, and what’s the economic logic behind it?’, the answer would go along the lines of “Our token will be used everywhere in our ecosystem, it’s the core part of our system. And…mmm…. You can also use it for discount!”. Okay, guys, cut that, please, cause that’s bullsh*t. How about we stop hiding the elephant in the room — the fact that your token is useless? How about we stop treating our partners / advisors / community like the village idiots trying to sell them the digital void?
This is probably the only reasonable way to bootstrap a maturing crypto industry. Crafting an economic model for a protocol or a dApp is essential to succeed in building a token ecosystem, since it’s the economics that defines the governance, not the other way round. Look at the history of the modern world, and how a country’s economic systems sets the political course of a nation. The world of tokens is no different, and success stories of #Web3 projects are built upon their underlying economic value, meaningful incentives and interactions.
How about we start educating one another explaining how crypto-economic concepts work, and come up with ways we could improve an otherwise useless token?
WTF IS TOKEN UNDERGROUND?
We took the courage to start The Token Underground to analyze some existing dApps and protocols to educate by virtue of concrete examples. Token Underground is a series dedicated specifically to collecting knowledge about fundamentals of token economy and system design, and sharing this with the community on a weekly basis. In the very first issue we are going to cover some core concepts that lay the groundwork for understanding decentralized economic systems. Since we’re strong advocates for profound understanding ecosystem’s/project’s economy as the crucial point of token engineering, we will start with economic basics. Does that sound boring already? Let us prove you wrong.
The fresh start
Economics might look like a boring science about numbers, however its true scope and potential is greatly underestimated. Economics is basically a science about distributing limited resources. Now, let’s consider a token from the perspective of this definition of economics to understand its value for a decentralized ecosystem. A token is a unit that is used to get access to some limited resource. Here a more savvy reader could think ‘hey, but that’s what money is! money is the key to limited economic resources, like goods and services, no?’ Well, not exactly. Money is just one example of such a unit, or a basic element of an economic unit set. Or course, there exist much more economic units, such as:
- Share — used for access to a limited resource such as company profit and voting.
- Option — used for access to a limited resource such as an issuer’s obligation to buy or sell assets at a specified price.
- A key — used for access to a limited resource such as your house, a car, or a postbox. This one might look an odd-one-out in this list, however it is aligned with the logic of a limited resource concept. Another find is that token’s definition is comprehensive, and can cover almost all cases of economic units used for access to a limited resource.
Now, if we combine definitions of economics and a token, we will figure that token economy is a system (or a game with a ruleset, if you will) that regulates access to some limited resource in line with the defined goals of this system, using native token to regulate that access. How do we approach analyzing a crypto-economic system with this in mind? First of all, we have to understand how this system works, and what the primary goals and economic limitations are. We have to ask ourselves these three questions:
- What resources are limited?
- Which of them are the most important, and how does access to them affect the operation of the whole system?
- How can the access to the system lead to the achievement of system goals in the right way?
If we connect these dots — purposes, limitations, and the access mechanics — we will understand what functions our token should be endowed with.
Take for instance Bitcoin and Ethereum economic systems. How does the principle of limited resource work applied to in crypto? These two are mostly seen as systems designed to transfer money without the middleman. It is partially true, since BTC and ETH do perform the value transfer function in their network (just like any other digital native asset of any crypto-economic system). But it is only the tip of the iceberg. Note that blocks are finite (otherwise it will be not possible to store a complete backup copy of transactions), and adding a transaction to the block is an act of using a limited resource. The block size is measured in bytes. If a large number of users want to add their transactions, they won’t be able to do so due to the size limit. How is this achieved? By virtue of a token: you have to pay commissions in this particular token, so only transactions with highest commissions are included in a block, while the rest are not. This simple logic works as an economic barrier that also prevents the spam problem — if you do want to spam the network, you’d have to pay commissions and lose your money at every transaction.
However, there’s one question we have not considered yet: who has the right to form a new block? This is decided by the consensus of miners (in PoW), validators in PoS, and various approaches in other consensus algorithms. The right to form a block is definitely a limited resource access to which can be regulated by a token (PoS) or otherwise (PoW). Does it look like a token is not really needed here? It does on the surface, yet, if you dig deeper, you’ll figure that there’s a need to motivate agents who are the part of consensus to act honestly, and compensate them for this work. Hence, an economic incentive is born. It is not really necessary in some particular cases such as PoA (Proof-Of-Authority), but more broadly an economic incentive is a crucial part to bootstrap any network. So don’t bail on incentives, when launching your own.
Alright, time to wrap up. In a typical blockchain protocol, we have at least three functions of a token, and each of them can be stripped down to gaining access to some limited resource:
- Regulating the access to include information into a block. Can be executed in the form of transactional commissions or holding a token to receive the part of network’s capabilities.
- An economic incentive to participate in consensys and support the network.
- Value transfer.
It doesn’t matter what consensus mechanism we choose. For both PoW and PoS, a token will need these three functions economically.
What is the basic algorithm for building a token economy / analyzing an existing one?
- Understand the system. Down to the smallest details: why is it created? who are the participants? what’s the business model? how does it work?
- Understand the goals. Think if those goals are aligned with customer needs. Can the achievement of that goal facilitate the usage or enhance the performance of your system?
- Find economic limitations. In simple terms, what valuable resources are there in a system and why are they valuable?
- Link the goals achievement with the scenario of access to a limited resource.
- Congratulations, you’ve made it!
- No, just kidding. This is where the nitty-gritty starts. Mathematical modeling to prove that such token functionality achieves the system goals in most predictable cases.
- If 6 works, a great journey starts. Now you have to deploy your dApp on a testnet and start to draw in the community.
Understanding economics is not easy, but thinking of it as a science of limited resource simplifies the task greatly. This algorithm “the system → a limited resource → the goals and goals access alignment” can be used to analyze any token economy and blockchain system.
Okay, that’s it for now, folks. Up next is the analysis of one of the hot crypto projects of the space according to the workflow outlined above.
Disclaimer: We will be featuring the projects based on our choice only stemming from the relevance of their token design, and we promise that there will be no bullshit whatsoever. If you’d love to contribute in any way, please reach out to firstname.lastname@example.org.