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Token Economics: An Emerging Field

by internationalbanker

By Nicholas Larsen, International Banker

The proliferation of digital currencies over the last few years has led to a rapidly growing list of use cases for tokenised assets. Thanks in no small part to the development of blockchain technology, as well as the recognition and anticipation of what cryptocurrencies such as bitcoin and ethereum (ether) could achieve in the future, tokenised assets are hotly anticipated to deliver a variety of benefits to the world—from boosting specific industries such as banking and real estate to helping to solve global challenges such as supply-chain issues and financial inclusion.

Indeed, we are already seeing hundreds of projects issuing digital tokens with the intention of growing both user adoption and utilisation of the tokens as well as promoting the use of particular blockchain platforms. But given that these tokens now represent an increasing array of useful assets and functions, each one is exposed to numerous economic forces, including supply and demand, changes in the prices of competitor currencies, and inflation. And because each has an economic value that can change in response to such factors, it becomes crucially important to understand each token’s inherent utility. This ensures that both token users and investors are confident that they are buying an asset that is valued accurately. And it is also important for them to ensure that a token will be employed more extensively going forward, which in turn will mean that more people will demand to use the token, and thus its value should appreciate.

So, what is a token’s utility? This question has led to the early development of new economic models that aim to account for the forces that determine the value of digital tokens. As such, token economics seeks to analyse the various economic factors and mechanisms that are involved in the value-creation process of a tokenised ecosystem. It refers to how economic forces lead to the creation of sustained user adoption of both the token and the ecosystem as a whole, and it is thus ultimately used to determine whether tokenised assets can be useful in the real world over the long term, beyond merely functioning as a digital currency.

The methods through which cryptocurrencies are created and issued into circulation play a significant role. Whilst some are issued in a one-off manner, others are circulated more gradually. This has significant implications for the relative scarcity of the token at any point in time, which in turn influences how much each token is worth. Similar in manner to how real-world commodities such as gold derive much of their value from their relative scarcity and utility, the scarcity and utility of digital tokens such as ether also go a long way towards determining their value.

Token economics also deals with how robust blockchain systems can be designed to produce desirable outcomes for all network stakeholders, including token users and those responsible for validating transactions. With that in mind, one of the most important forces for which to account when designing such models is incentivisation. With blockchains invariably involving a decentralised architecture, there is no need for relevant parties within the ecosystem to trust or rely on an intermediary entity to maintain the integrity of the ledger of transactions (as is generally the case with centralised applications such as Facebook or Google). Instead, blockchain enables all validating nodes to maintain their own copies of the same ledger, which in turn greatly enhances the security of the data. But to ensure long-term sustainability, relevant stakeholders must be adequately incentivised to act in the best interests of the system as a whole. If this is achieved, it should instil confidence in the integrity of the system and thus facilitate greater user adoption of the system’s token.

Bitcoin, for instance, involves senders and recipients of the cryptocurrency, as well as miners who are responsible for validating transactions and adding the next block of transactions to the blockchain. This is done using cryptography, which provides irrefutable proof of all previous transactions within the system. Incentives are thus designed to ensure that the system continues to produce desirable outcomes. The miner receives bitcoins as a reward for validating transactions in accordance with the network rules. If, however, miners break the rules in one way or another, they can be penalised, typically through a loss of their tokens. This system incentivises miners not to behave nefariously and, as such, ensures individuals are acting to benefit the security of the system rather than for self-interest.

The world’s second-most valuable cryptocurrency project, ethereum, meanwhile, is designed principally to execute smart contracts that are employed for a variety of use cases, such as creating decentralised autonomous organisations (DAOs) and decentralised applications (DApps). The smart contract code is stored on ethereum’s blockchain. And while it is similar to bitcoin, in that miners validate new blocks and are rewarded with ether, the ethereum ecosystem also requires users to pay ethers if they want to execute smart contracts on the platform.

Similarly, the actual users of each ecosystem (such as the senders and recipients of coins in the case of bitcoin) must be suitably incentivised to ensure that their behaviour promotes the continued sustainability of the ecosystem. This means that issues such as the sustained growth in both the overall numbers of users adopting the token and the number of users actually using the token for its intended purpose are taken into account. As far as the latter is concerned, this is proving to be far from straightforward. Given the massive price swings that much of the cryptocurrency space experienced until 2018, the myriad of opportunities to benefit from short-term price appreciations has caused most users to date to hold their tokens as an investment that could generate potential substantial returns rather than actually use the tokens. Even today, many investors continue to hold on to their tokens in the hope of seeing bitcoin scale the heights it managed to achieve in late 2017.

Simply buying and holding is far from ideal from the perspective of the token issuer, especially given that such tokens have been created mainly to be used for a specific purpose within the ecosystem. Indeed, it is unlikely that violent price swings will even be considered desirable by token issuers, especially if those price swings are not reflective of the endogenous value of the token itself but instead of the trading activities conducted by investors looking to exploit opportunities for profit.

Nor will a static price over the long term incentivise users to hold on to their tokens. As the ecosystem grows and more users begin to adopt the token, one would reasonably assume that the increase in utility associated with this growth will induce a steady rise in the price of each token, which in turn will deliver at least respectable returns for token holders. The economics associated with designing such an ecosystem, therefore, is likely to prove challenging for token-project designers, especially for those projects for which the inherent value of each digital asset is not easy to calculate.

Some models have been posited to address some of these challenges. For instance, Factom, a system for securing millions of real-time records using blockchain, has tried to implement a “burn-and-mint” process, whereby users burn” their Factom (Factoid) tokens each month in order to use the Factom ecosystem, while the issuers separately mint 73,000 new tokens each month that are distributed to transaction validators. Should users end up burning less than this figure per month, therefore, Factom’s overall token supply in circulation increases, which should exert downward pressure on the Factoid price. But the total supply will fall if users end up burning more than the 73,000 tokens, which in turn should boost prices. As the usage of the Factom ecosystem grows over time, therefore, more tokens should hypothetically be burnt, which would help to progressively raise prices in direct proportion to network usage. But the burn mechanism should also incentivise token holders to actually use their tokens rather than simply hold them.

There may also be other issues that will have to be considered when ascertaining the token economics required for designing a suitably robust model, including the governance system, the mechanisms for revenue sharing and the ease of access for users. Ultimately, with each protocol likely to be different and dependent on the specific utility of the token, the approach to token valuation will also be different for each project. As such, designing the appropriate mechanisms and incentives to ensure that participant behaviours are always as desired will not be a standard process. And that makes token economics a challenging field for project designers to navigate during these early years of blockchain’s evolution.

 

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