Should I be using the blockchain?

Before deciding the properties of a system’s token and its sale, we must first ensure that a project should be undertaken using the blockchain. Solving this first quandary requires an understanding of the most important qualities of your envisioned system and asking if these qualities can be provided best by the blockchain.

In the case of Topl, we identified open access, transparency, resiliency, and the ability to eschew bias towards any particular jurisdiction as key properties of our system. Based on our understanding of and previous experience working with the technology, we were confident that these qualities could be best provided to us by the blockchain.

What will my token be used for?

Having established that a project should be built using the blockchain, we now determine whether we need a token and, if so, answer the questions: “What does this token do? What value am I really selling here?” There are different answers to these questions, so before looking at how to make this decision, let’s just recall some of what’s already been done by various blockchain projects.

Looking at each of these four examples, we notice a similarity: all of these tokens have a clearly defined function. These tokens enable anyone holding them to perform some action that they would not be able to otherwise and are willing to pay for. Broadly speaking, this functionality can be divided into two classes — allowing holders access to a valuable service (information, computing power, storage, etc) and enabling holders to produce and subsequently extract some value from the system (through the creation of new blocks to collect associated transaction fees or correctly resolving prediction markets to earn market fees). While both of these approaches to functionality are commonly used in token design, I believe that the second is preferable from both perspectives of design and legality.

One way of looking at the difference between these two types of functional tokens is dividing them into currency tokens and asset tokens, respectively. A currency allows me to pay for something of value (to access a service). An asset can be used in the production of value. Turning first to the question of design, I draw the following comparison. Imagine a store or website that required you to use a special currency to shop. Now consider a tool designed to allow you to build some sort of special craft or machine that you could then sell to people. Which of these makes more sense? Which are you more likely to encounter outside of the world of the blockchain? Personally, I have seen far more specialized tools than specialized currencies.

In my view, the oddity of tokens meant to function as single-use currencies signifies that their benefit is not to the design or overall function of the blockchain project employing them; rather, they are a fundraising tool. Often the most honest rationale for selling a currency token instead of using a “standard” cryptocurrency, such as ether or bitcoin, is that the development team needs to raise funds. None of this is to say that selling currency tokens should be scorned; there are many valuable projects that may have no other viable fundraising strategy. However, just as a store or website which chose to issue and then only accept its own currency would likely suffer, these projects start themselves with an unfortunate handicap. For this reason, I believe that token sales should, whenever possible, involve asset tokens instead of currency tokens.

How should I distribute my tokens?

Blockchain projects today are essentially startups. They’re highly-risky but potentially high-value endeavors that involve the use of a new technology. This should strike us as fortunate since startups have a well-established fundraising model: over time the founders give away more and more of their company at an ever-rising valuation until the startup has become a mature company with a broad set of owners. This isn’t to say that blockchain projects should operate identically to traditional startups; doing so would neglect many of the most valuable aspects of the technology. However, when we compare more standard fundraising models to what’s being done with token sales today, we can better recognize the relative strengths and weaknesses of each and discover the best way forward.

Today, teams launching blockchain projects commonly create and distribute all or nearly all their tokens in their initial token sale. Whether this decision is driven by simple herd mentality, devotion to ideals of decentralization and community inclusion, or pressure from token sale participants wanting to get as big of a slice as possible, the result is likely to be the same — a project incapable of delivering on its vision.

As entrepreneurs working with the blockchain space, we’re an idealistic bunch. We believe that our projects will change the world and that robust vibrant communities will quickly answer our call to grow and nurture our fledgling endeavors. Unfortunately, this is very rarely the case early on. Even after a token sale, it is still up to the founding team to complete technical development, refine the real-world use case, and acquire users. By distributing nearly all of their platform’s tokens on day one, the founding team is essentially giving away their ability to raise additional money and locking themselves into governance with those who participated in their sale (a group likely dominated by those looking to purely speculate on their token’s value). Some projects, such as Tezos, have implemented governance measures that would allow token holders to vote to fund additional development; however, this approach neglects that those who purchased tokens early may likely be speculators and therefore poor custodians of its future.

The simplest solution to this problem would be for the founding team (or the foundation they establish) to hold a majority of the tokens after the token sale, only distributing a small percent. While on the surface, this approach solves the issue of the founding team being able to effectively guide the project and continually fund progress, it does so by concentrating too much power into the hands of the founding team. This concentration leaves the door open for the founding team to manipulate the price of their tokens and even arbitrarily alter consensus (if the project operates its own chain). With these concerns in mind, I believe that the there are two properties of an ideal mechanism for token distribution:

Project organizers can raise additional capital to address the needs of the system as necessary without any need for a vote by token holders; Token ownership by pure speculators is discouraged and penalized.

1 is important because if project organizers can be confident in their ability to raise additional funds when necessary, they do not need to allocate and hoard potentially destabilizing amounts of tokens to fund development. The purpose of 2 is to encourage token ownership by the “right” community.

Conceptually, the implementation of such a mechanism is rather straightforward. First, our protocol must be able to track a specified usage metric such as the number of accounts or transaction volume. When certain milestones are reached, the protocol issues a predetermined number of tokens to the governing company or foundation, which can then be sold to fund the next stage of growth and development. Next, our protocol must be able to identify idle tokens, those which have not recently been used in a transaction or staked towards some function. Finally, accounts with only tokens that have been idle for more than a certain period of time have their holdings slashed and redistributed to active accounts.

Is my token a security?

Of all the regulatory and legal questions surrounding token sales, the question “Is my token a security?” is arguably the most difficult to answer, since the answer depends on the specifics of your token and its sale. This question is also incredibly important for project founders to answer correctly because the result determines who you can sell your tokens to (at least in the certain jurisdictions). For example, if your token is a security, it can be sold within the US only to accredited investors — those with either a net worth of at least $1,000,000 (excluding the value of their house) or annual income of at least $200,000 (or a total of $300,000 for married couples).

In order to determine whether or not your token is a security, the US government applies what is known as the Howey Test. Under the Howey Test, a token must meet three criteria to be considered a security:

The token must be obtained through an investment of money; The investment must be in a common enterprise; The investment is accompanied by an expectation of profit resulting solely from the efforts of others.

Last year, Coin Center released an in-depth framework for how the Howey Test might be applied to token sales as well as a decision matrix to guide analysis. For anyone serious about understanding this complex issue those are excellent places to start. Here I will limit myself to just a brief explanation of why the token and distribution models I’ve advocate for earlier in this post may help ensure that your token is not viewed as security. Earlier, I expressed my preference for asset tokens and for distribution mechanisms that redistribute idle tokens away from their holders. In addition to the benefits described when introducing these concepts, both of these design choices could potentially have an impact in ensuring that a token does not meet the third criterion of the Howey Test.

There is no denying that when people participate in a token sale they have an expectation of profit. They expect to benefit in some manner. The important point is how this is profit realized. In the case of asset tokens, there is profit to be earned by using the token for its intended function on the platform. When utilized, many asset tokens provide their holders with transaction or other fees from other network participants. It is through this utilization that a token holder expends their own effort in generating profit. Therefore, the expected profits of owning an asset token are derived not solely from the work of others. On the other hand, most currency tokens do not lead to the collection of any return or profit when utilized. Therefore, when purchasing a currency token, any expectation of profit is likely based on an expected increase in the value of the token, which is more likely to be deemed as coming solely from the work of others.

Moving on to consider the redistribution of idle tokens from inactive to active accounts, we should gain more confidence in our ability to avoid having our tokens classified as securities. If it is not possible to continually own tokens without utilizing them, then it is also impossible to realize a profit without utilizing them. With a setup such as this, any profit reasonably expected must involve some effort on the part of the token holder.