What is Tokenomics and Which School of Economics Would Crush It?
To understand the question “What is tokenomics?”, one should first understand how the field relates to existing schools of thought, both applied and academic, and then explore the specific problems tokenomic engineers are aiming to solve in the early stages of blockchain.
Of all of the various disciplines of economic study, the Austrian school has the most to offer in understanding tokenomics. The Austrian school of economics includes among its ranks great economists such as Ludwig Von Mises, Friedrich Hayek, and Murray Rothbard. They are notable both for their unique approach to the development of their economic theories as well as their view on sound money and the role of the state in the economy.
If the great economists of the Austrian school were active in 2018, I think token economies would be both a primary interest of theirs. The Austrians would be among the first to see that the sound money of the future is being pioneered before our eyes. Those who created Austrian business cycle theory would immediately see the potential for fungible sound money such as Bitcoin, Horizen, Beam, and Monero to promote human welfare. The Austrians may also find attractive the potential for economic design without economic coercion through the use of smart contracts. The present day economic experimentation through smart contracts, sidechains, and forks provides an arena for discovery without restricting individual rights.
What may be less obvious is the need for the Austrians praxeological approach to steer the first generation of blockchain projects to success. Praxeology is the study of human action, the purposeful behavior of humans to achieve their ends. Unlike the data driven Chicago school and the idealistic Keynesians, the Austrians would thrive in creating models using incentive based deduction. This is a fitting approach for an innovative but complex environment devoid of historical data, particularly for economies functioning at scale.
Tokenomics Is Praxeology + Technology
Theorizing about human action, how individuals respond to changing incentives, is not a new endeavour. Praxeology originates in ancient Greece, after all. Tokenomics isn’t a new field as much as it is an application of the study of human action to new technologies. For an example of such technologies, it isn’t clear Mises and Hayek would have considered how the forking of an economy with individuals able to participate in one, both, or neither of the resulting economies affects the costs of various stages of production in these economies. The technologies new to the study of human action include blockchain, smart contracts, and open source practice/forking. More broadly speaking, the speed of trusted, decentralized activity (we hope) serves as another wrinkle to existing models that the token economist must consider. Further, the ability for non-human autonomous, trusted entities acting in these economies opens possibilities for economic activity to be organized between parties with incentives that can’t align without these entities.
Other new technologies are really just reboots. Consider something like staking, a common feature of token economies. Token staking, whether it’s as a form of collateral or just a method of paying for certain privileges, is a practice that is facilitated by blockchain technology but is not unique to blockchain. Security deposits on a rental property is fairly analogous to token staking as collateral to insure against bad behavior. An Austrian economist could tell you that if the lessee suddenly finds the yellow shade of paint in the living room oppressive, they will decide whether to paint the room blue, the preferred color, if the value of repainting exceeds the value of receiving the security deposit at the end of the lease. The longer the end of the lease from the realization that yellow is an abhorrent hue, the more likely the room will be repainted. At Ezra, we feel that considerations such as the true economic cost of staking and the amount of staking necessary to discourage bad behavior are not given proper consideration by blockchain entrepreneurs more focused on glamorous technology and fundraising efforts.
Tokenomics Deals With Complexities in Decentralized Supply and Demand
The Austrians understand how producers are able to meet the demands of consumers in free market conditions. While blockchain unlocks the ability for certain previously unfeasible consumer demands to be met, the relationship between producers and consumers is often more complex in these networks. Experts in tokenomics must be able to see gaps between supply and demand in token economies and utilize blockchain solutions to connect these two sides in ways that allow both to prosper.
Consider the Metacert protocol, a tokenomics consulting client of the Ezra Fund. Among many other things, their platform seeks to connect consumers of a registry of crypto-scam URIs with a decentralized network of producers who can detect these crypto-scam URIs. In a traditional set-up, a centralized entity would be responsible for paying individual suppliers and selling the aggregated registry to consumers. This centralized entity, however, is antithetical to what Metacert is trying to accomplish with their decentralized model. The token economist’s objective, in this case, is to find a way to efficiently allocate the resources of the consumers to create a registry without inserting a centralized authority. The token economist must understand the incentives facing suppliers and consumers as well as the ethos of decentralization.
The Key Challenge of Tokenomics
While all of the above is highly relevant to tokenomics, the main reason the field emerged is to solve a very specific problem in blockchain. Blockchain entrepreneurs want to raise money by selling tokens to investors without those tokens being classified as securities. We believe the primary method for bypassing these security laws is to make sure the token has some sort of application on the network being built. While not all of these utility tokens were created with securities laws in mind, the fundraising advantages for this asset class are clear, and the lack of sound tokenomic modeling suggests that there was somewhat of a “raise money now, figure it out later” attitude during the ICO boom. Therefore, the token economist’s challenge is as follows: how can these networks using utility tokens be structured so that the token given to investors increases in value as the network generates more value to users?
This is a somewhat cynical view of tokenomics’ role in the current blockchain landscape, although the Austrian’s would likely point out that securities laws incentivize enterprises to invest resources in creating investment vehicles that aren’t securities. Perhaps token economists’ would be engaged in other endeavours were these laws not in place, but this is the political reality, and thus structuring the utility token as both an investment vehicle and as an essential component for use of the decentralized network is the primary goal of most applied tokenomics.
One can see how this is not always a simple matter. Constructing networks where the token appreciates as a result of network growth is challenging. Some common pitfalls include tying token value to some sort of network function that doesn’t require a valuable token for the network to be successful. Other projects have accidentally created token structures that are functioning as a ponzi scheme where only the earliest adopters will be able to see upside (feel free to email us for specific examples). Even when networks are constructed in a way where growth is possible and token appreciation is a result of that growth, competition from forks can limit the possible upside to investors who are looking to cash out with some of that accrued network value.
While use of utility tokens for fundraising may have initially been to find a way around securities law, the resulting creativity and innovation may result in a competitive advantage for projects well suited to this model of securing capital. We are already seeing new networks structuring their tokens such that the use of the token is leveraging incentive alignment and has the ability to capture more value than traditional equity. Ezra portfolio companies such as Metacert and Workcoin are examples of projects tying the utility token to many network functions so that demand for the network’s services is synonymous with demand for the network token. Both of these projects leverage staking to align incentives and increase token value. Metacert is particularly novel in that the decentralized network they have built is separate from but designed to help their existing centralized business. They have equity in the network via token ownership and that equity could far surpass the direct value to their centralized business since the network has the potential to be leveraged by a far broader audience. This innovative structure is unlocked by using a utility token rather than equity for network ownership. Additional tokenomic analysis will be necessary to see what works as these projects and the infrastructure they rely upon scales, but the evolution of these projects is already very clear and is a direct result of better tokenomic planning.
As the initial generations of blockchain mature, the question “What is tokenomics?” is likely to have a simpler answer; the difference between successful and unsuccessful projects. As the industry continues to develop its revolutionary technologies, tokenomic innovation will remain an essential component of creating networks that generate economic value in unprecedented manner and quantity. The Austrians praxeological method to understanding complex systems of human interaction and exchange will prove invaluable in pioneering the field of tokenomics. At Ezra, we are excited to make use of these techniques in our roles as investors and advisors.