Breaking Bad Brings Out Crypto’s True Potential
On the Road from Speculative Gain to Utility
This article is the first in a series covering what we at 1.2 Labs call THE NEW TOKENOMICS. Though shamefully, this article has nothing to say about Sam Bankman-Fried (as the photo above suggests). It’s just capitalizing on his image as the “bad boy” of crypto.
Ok, maybe just one quip in relation to Bankman-Fried. Forget his adopted philosophy of effective altruism! Let’s opt for Nietzsche instead.
If Nietzsche’s Zarathustra were a crypto pundit, he might proclaim:
“Crypto has burned itself with its own flame. The heights of uber financial speculation have been razed to the ground.”
Zarathustra might be right.
If the escapades of 2022 have shown us one thing, it’s that cryptocurrency and DeFi are far from ushering in an age of financial freedom . . . more like an age of financial free-for-all.
And this is because its innovative technology has been directed by the kinds of questionable financial behavior we hoped it might overcome.
So is cryptocurrency soon to die out through financial collapse or government regulation? Or, is some other path now becoming more apparent for the emergent technology?
I think there is reason for optimism about a new path. To get a sense of this, it’s worth bearing in mind a key distinction:
- There is financial utility (which is how the general idea of utility tends to be construed), which is about financial profit and speculation.
- Then there is real utility, which is about using technology to create use value to benefit our everyday lives.
I think that when we construct a more detailed picture of what lies behind the original idea of tokenomics, we’ll see that amongst much of the utility it purports to offer, it is drenched in and dominated by the motive for speculative gain. And this is where, as Zarathrustra might have it, tokenomics becomes consumed by its own flame.
The Idea of Tokenomics
“Tokenomics” is a term used to describe the way in which blockchain projects mint native tokens to raise capital and distribute rewards and earnings. Key to its method and structure is how tokens entice new users to invest in the native ecosystem.
As one would expect, tokenomics can be quite complex, so in this article we’re going to look at the typical way in which a token system is used to address specific obstacles.
Bootstrapping & the Cold Start Problem
Most tokenomic systems are designed in view of bootstrapping and the cold start problem. Both involve moving from a “zero” position to one of growth with respect to funding and users.
Bootstrapping describes how a project can raise capital with little resources. The cold start problem describes how a project can attract a critical mass of users with little to no marketing. Think here of “growth hacking”, which Ryan Holiday describes as,
“Throw[ing] out the playbook of traditional marketing and replac[ing] it with only what is testable, trackable, and scalable. While their marketing brethren chase vague notions like ‘branding’ and ‘mind share,’ growth hackers relentlessly pursue users and growth–and when they do it right, those users beget more users, who beget more users.”
Holiday later mentions that growth includes retention of users; otherwise, it’s not really growth. We’ll come back to the retention of users through utility in the next section. For now, let us focus on the narrow aim to get funding and the first wave of users.
The original design of tokenomics is motivated by the problem of critical mass. If the project can just overcome the initial dearth of funding and users, it will have enough activity ongoing within the ecosystem to create value and draw more users.
It sounds good in theory.
Use a coin or token launch for early and/or white-listed investors where the coin has a discounted price. This achieves two things:
- It raises capital; and
- It provides a bedrock of users who have incentives to grow the community; more users tends to equate to an increase in the value of the token.
With enough early investors, projects can bootstrap their way from no funds to thousands or even millions of dollars. It’s a sort of proof of concept process where a good project and value proposition can attract funds from the public. While this process seems like crowdfunding, it is not. This is because crowdfunding is a way to donate money without a stake in the project.
Token launches act like equity securities in so far as a project’s success is often tracked by the value of its tokens. The reasoning is simple: if you like the prospects of a project, you buy its tokens. Just like stock, the value of tokens will rise as the project does well. And so, this is a bit of the financial freedom idea: you don’t have to be an accredited investor to get in on the action. You, too, can be rich.
Coin launches no longer really work as they were once intended. I cover this elsewhere, so let’s focus on the issue of equity. Why is it always about equity????
Owning equity is a way to own a process of value creation without having to be very much involved in the value creating process itself. Own a token, let the platform do the work so you can reap the rewards in terms of the token’s rising price.
There are two questions we can ask here:
- Is there something wrong with equity in itself?
- Is there something wrong with equity in the picture of tokenomics I have sketched?
Let’s stay with the latter question since it’s more pertinent. (The former question is a really a philosophical problem about disambiguating different types of ownership and rights.)
The Key Problem with the Equity Approach for Tokenomics
There are at least two ways to describe the problems with the equity style approach to tokenomics:
- it creates a pyramid-type structure; and
- it focuses on distribution of value versus its creation.
The Pyramid
First problem: It does not clearly account for how the value of the project is going to grow beyond its initial bootstrapping phase. Great to raise money upfront and get those early adopters . . . but then what?
In a lot of tokencomic designs, there tends to be an assumption that the growth of users will translate to growth in value. But this relation breaks down rather quickly unless the project’s value proposition provides a real use case which will draw users beyond the initial boostrapping phase. Here’s why:
- Growth in value requires more users;
- Attracting more users requires growth in utility.
This relation is really circular since utility is a form of value. So what it’s saying is that in order to grow value as profit, the ecosystem must attract users by providing services or products they can really use and will want to continue to use. As as one of my favorite philosophers (no, not Marx) might put it:
“Real utility is logically prior to value.”
The relation seems straightforward?
However, the design of tokenomics over-emphasizes the growth in value part without really working out the long-term case for utility. In the worst case scenario, this is intentional with Ponzi schemes and rug pulls.
In the best case scenario, it’s one of mice and men. Best laid plans to have a decent tokenomic ecoystem fall apart.
More specifically, the circular relation between value and utility can become vicious if there is no utility provided. In this instance, the incentive for existing users is to get new users to buy into the system. And the way this vicious relation gets masked is in terms of celebrating growth for its own sake.
Unfortunately, simply getting more people involved has no real value in itself. After all, Metcalfe’s network value formula presupposes that the network has a real utility function! And once the pool of new users is exhausted, or once there is no incentive for new users to come on board, the project will stagnate or even spiral towards a flat line.
A shorthand for this weakness in a tokenomic structure is that its only value proposition is one of being a pyramid scheme. What tends to happen to pyramid schemes is that they die when the size of the community reaches its maximum limit where users decide it is best to cash out on their holdings.
The upshot: Where there is a lack of real utility in a tokenomic system, the equity aspect of a token becomes self-defeating because it tends towards a pyramid structure relying on late comers to help sustain and drive profit. Most pyramid schemes eventually come crashing down, or get razed (if we stick with Zarathustra’s flame metaphor).
Distribution v. Generation
(This is really re-hashing the absence of utility in a different way so that we can see how the initial design of tokenomics really has the wrong end of the stick.)
Second problem: Equity-based tokenomics focus on distribution of value and not its generation. The ubiquitous symbol for this problem is the tokenomics pie chart. If you’ve read a few white papers, you will have seen your fill of them.
As Sebastian Purcell once pointed out to me when we were thinking through a different tokenomics structure for a CharityFi project (I paraphrase):
“You know, those tokenomics pie charts really don’t say anything about how the tokens will be useful and why people will want to buy and spend them. So the charts don’t make sense unless the platform can deliver on use.”
And this comment illuminated the kernel of the problem.
The pie charts are saying something like “If we raise X amount of capital, here’s how were going to spend it. This will create value for the investors.” While the projects in question may have a value creation pathway, its often not clear how genuinely their respective (equity) tokens are necessary beyond raising money . . . and allowing early adopters to cash out.
The pie chart, in other words, assumes that there will be value beyond the capital raised to sustain the “pie-ing out”/distribution process. Yet, without a clear and explicit account of how the project ecosystem will generate value beyond simply relying on user growth (per above), the pie has no substance.
This is sort of like seeing a lovely picture of a slice of pie on a menu, only to get something remotely resembling it on your plate. A shadow of a shadow of the real thing.
So thinking of value as something that can be distributed (like equity) at the very least presumes the existence of a continous method of value creation. Otherwise . . .
. . . and here’s the rub . . .
What gets distributed or “pied out” is really nothing. Of course, the early adopters get the benefit of the amounts invested by later users. And many of us know what that looks like — the cash out!
Tokenomics pie charts used to be the hottest thing to get people in early with the hope of making a quick profit. Charts like this were a dime a dozen.
The upshot: Where most things go wrong for tokenomic ecosystems is in not being able to keep the value paid by users who buy coins locked in and recirculating in the system. Without real utility, users and wallets leave.
What Tokenomics in View?
“Become who you are!”
— Zarathustra
To be sure, I’ve not really explained how tokenomics dominated by financial utility connects to the really bad behavior of the likes of a Sam Bankman-Fried or a Do Kwon. I’ll have to rely in this article on conceptual associations. But at the same time, I think there is a connection that can be developed more fully:
Dominated by the purpose of speculative gain means the tokenomics system is at best a limited innovation; and at worst doomed to bring others down as it fails.
Given the change in the regulatory space, the broad world of cryptocurrency will realize that it can’t act like a wanton child trying to go around and collect as much candy as they can before the games are up.
Oh wait, that’s not Nieztsche, but more Plato on a limited conception of justice and Kierkegaard on wishful thinking confused as faith.
A so-called mature tokenomics will settle down with the idea of utility as a means to creating value, drawing users, and retaining users. In the subsequent parts of this series, I’ll be unpacking what might just be The New Tokenomics.
I’m the Director of Research at 1.2 Labs. We’re a blockchain consultancy that’s basically “philosophy meets finance”. I also write for the sister organization, The Art of the Bubble.
Although authored by me, many of the ideas have arisen in conversation with Sebastian Purcell, PhD, who is the real brains behind the scenes. Hey, I’m just a writer!
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