Thoughts on Token Mechanics
Public blockchains and their use of incentive-based models will be a driving force in reshaping the use of currency in the digital age. Part of this shift will be removing or diminishing the role of third part service providers. In removing these third parties, cryptographic networks will form far more efficient markets than we have today. There will be a lot less friction. The businesses of tomorrow will take advantage of strong incentive models that haven’t been possible until now.
Application-specific tokens should be fundamental in building, and maintaining decentralized autonomous organizations. In these organizations, users, service providers, and developers should be appropriately incentivized to drive network usage. We’ve only begun to see projects that appropriately integrate tokens into their ecosystems.
There are projects today that have sustainable incentive models with positive feedback loops. As network utility increases so too will the price/demand for the underlying asset. A prime example is Augur which uses the work token model. In this model, the probability a service provider is awarded work is proportional to the number of tokens the provider stakes. The more tokens a provider stakes, the more revenue the provider can earn relative to the rest of the network. Another model that promotes linear price growth with network utility is burn and mint equilibrium. The work token model and burn and mint equilibrium are detailed in Kyle Samani’s New Models for Utility Tokens.
Most projects built on smart contract platforms rely on the “pay for service” model where an application requires a native token in order to pay for service. This model depends on token speculation and high friction of exchange to sustain price. The argument is that as a service becomes more popular, more users will require the service’s token and demand will drive a price increase. This speculative view overlooks the future interoperability of decentralized applications and networks.
Most agree that as decentralized exchanges become more functional and liquid, the friction of trading between tokens/currencies will be largely eliminated. It doesn’t seem reasonable to hold 20 different tokens for various applications. Instead, I would hold my preferred store of value, ether for example. Using the pay for service model, my ether would automatically be exchanged for the appropriate application token, and I would pay a fee for service. In this scenario, I might own a token for small fraction of a second and there is zero incentive to hold that token any longer than is necessary to execute the transaction. This results in what is referred to as “the infinite velocity problem.”
It’s useful to consider the “equation of exchange,” where MV=PQ. M = money supply in an application, V = velocity of circulation, P = price of services, and Q = quantity of services. In the scenario described above, V has the potential to increase indefinitely, allowing M in M = PQ/V to approach 0.
Most ICOs are raising money under the pay for service model and my forecast is that most of these custom tokens will become worthless over time. Some argue that worrying about token economics now is analogous to worrying that Facebook didn’t have a revenue model in 2004. I think that in most cases, this is flawed logic because token economics should be integral in how a decentralized application functions. The most successful businesses and applications will form around new economic models rather than trying to force an old business model into a new set of rules and supporting technologies. These sorts of things were tried when the Web was new in the late 1990’s. The big winners in the early Web were not the business that tried to replicate an old model in a new medium, but those who saw the promise of a new and globally-connected system.
Jeff Bezos knew that the internet was uniquely suited for selling books opposed to other goods. What are decentralized networks uniquely suited for?
I’m looking forward to ICOs that lead with their token model and then follow with their use case. After all, it is an investment in the token. Investors should know how the token fits into the system. In the current environment, projects aren’t incentivized to do this. Why? Because in most cases it would result in dramatically less funding for the ICO.
As the space matures, I expect token mechanics to become not only a greater area of focus for investors, but the essential foundation of the value proposition.