Economics of Entangled Tokens

Or Why You Should Start Paying Attention to How Investment in App Tokens Impacts Your Protocol Economy

A protocol economy comes into being when a network of miners contributes work to create a scarce resource and gets rewarded when said resource is used. For example, Ethereum is a network of miners providing computing power and consensus for smart contract execution. The Storj network does the same with storage, Mysterium provides VPN bandwidth, BAT for attention etc. This protocol economy is open and egalitarian: anyone can become a miner with the same rights and the only differentiating factor is the amount of work provided. In fact, in such basic economies, resource consumers are also miners and there is no fundamental distinction between those two roles.

As everybody knows, access to a scarce resource must be controlled so that it gets allocated to the most high value uses and doesn’t get depleted too quickly. In the protocol economy the mechanism by which we achieve this is called token. A token is both the reward miners get for contributing work and a “price” the consumer needs to pay in order to access the network and make use of its services. All tokens are created by miners, meaning that like every other proper economy, the pure protocol economy is entirely circular.

Working for a network: a modern miner’s mining rig for digital gold (or oil) (picture from: http://www.sohu.com/a/148055229_689761)

Protocol economies are curious, because the value produced within such an economy is the network itself. If the incentives are set up correctly, this economy grows organically via network effects. What’s more, there is no ownership in the classical sense; you cannot “own” the network without working for it in a process we call mining (which I explain later on in this post). You only “own” what you create in the form of tokens and if you want to transact with other network participants you need to work first. This is how a pure protocol economy works. In that way it is similar to Bitcoin in its early days where most people mined it themselves, there were no exchanges, and you could hardly buy a pizza for 10,000 of the basic tokens.

Such a pure protocol economy has certain limitations. Like every other form of economy it needs initial capital to bootstrap, since growing the network organically takes a lot of time. At the inception of any such network, the entry points for funds to flow in are virtually nonexistent making investments impossible. The answer we see the industry adopting currently is a token pre-sale or ICO — a clever way to fund protocol development via offering pre-mined tokens for sale to the general public. Another limitation is that if you want to use network resources you need a token to pay to mining nodes and the only way to get this token is to perform some work for the network; not everyone wants to be a miner. On the other hand miners must pay their bills and would gladly exchange their tokens for $$$ or other tokens. This is solved by establishing a secondary market for a token where parties buy and sell them freely.

Both the ICO mechanism (injection of capital) and the construction of secondary markets have huge implications for a protocol economy. Now the token not only regulates access to network resources, but also serves as an investment vehicle for those not interested in network usage. They instead speculate on network growth and overall increase in value. In other words: a token tradable on a secondary market entangles protocol usage with value coming from investment, which is why I call such tokens entangled tokens.

You can see this entanglement everywhere. The recent price explosion of Ethereum’s native token Ether cannot be explained by growing demand on network usage, smart contract execution becoming more costly, or due to other ways that computing power on the network becomes scarcer. Instead, it is caused by investors and speculators storing external value in the ether-tokens through secondary markets. Let’s be frank: for most young blockchain projects its token’s investment value is much higher than the resources it represents. It is hard to imagine someone buying millions of dollars worth of computing time of a not yet existing global super-computer just for the sake of using it in the future.

The current rise of protocol economies is very exciting, no doubt, and I’m sure some will be highly successful at approaching a network worth in the range of trillions. However, I see curious problems arising from entangling network usage and investment value in a single token.

Consider the following:

Do you invest in a car factory by buying a lot of cars for a price much above market value? If this idea sounds weird to you check again what are you buying when you invest in app tokens. You get a right to use a network — it’s like to get vouchers for cars instead of shares in a car production business. Do you really need those years of access to global super computer? Do you really need to make this millions of transactions over Ethereum network? Probably not so you will realize your investment by dumping your tokens on secondary market. In that case, however, you should ask yourself what happens to your car factory if you first massively drive up product price by hoarding cars it produces and then dump them on secondary market? When the price of token goes up too much due to investment and speculation, this stifles network usage. At the same time the value of the internal resource didn’t increase, so why should consumers pay more for it? A likely outcome is that they will decrease their usage or go and use an alternative network. Too high token prices may kill a network or make it grow — and therefore acquire value — more slowly. Thus, using entangled tokens limits network growth and decreases its potential value. (Side note: Ethereum has gas price mechanism that should deal with that, but it does not work correctly now. There were also proposals for coin abstraction where any token can be used to pay for smart contract execution. This would effectively disentangle ether from its speculative value.) Another effect of overpricing underlying resources is that token holders will start hoarding tokens instead of using them for the intended purpose. This may make the network cease operations and get replaced by an alternate network with lower value. This is a well known problem in economics called Copernicus/Gersham’s Law: “bad money” (e.g. impure gold) drives out “good money” (real gold) from circulation just because people will keep gold coins to themselves and spend their fake coins. An entangled token makes it very hard to further capitalize a network via secondary coin offerings. Imagine what happens to network usage if token supply is increased 3–4 times. The miners’ work would be worth ⅓ or ¼ of its original value from one day to another. This is likely to make them take their rigs and work for a competing network. On the other hand, later investment rounds are a norm off-chain and it is hard to imagine how you can grow a global enterprise purely organically in a form of autarky. Blockchain projects currently solve this by doing a single ICO much larger than a regular seed round, then sitting on piles of cash and entangled tokens with needlessly inflated prices. Entangled tokens create a conflict of interest between token holders. Investors want the price to go up. Other token holders want to use the network so prefer the price to be fair (so that the maximum number of resources can be produced and consumed). Think about financial markets speculating on food prices to inflate/deflate them and then sell their options with profit. Such price volatility is against the interests of the average consumer that needs food to survive. ‘Blockchain’ is seen by investors as one ‘thing’. If there is something they do not like (so called market sentiment is negative) they will sell their tokens regardless of particular network performance — and vice versa when sentiment is positive. This is likely to change when blockchain projects mature and the biggest networks stand on their own. But most of them will not. Take Central European currencies as an example: when there are bad news coming from the region, investors sell their Polish Zloty, Czech Korona, etc. regardless of how a particular country performs.

The issues above may sound like a case against speculation or investments that deflate or inflate prices, but actually it is not. Investment and speculation drives innovation and liquid secondary markets provide even more funds for new projects. VC investments were always like that and this will not change with the advent of ICOs. The question we need to address though is how to make the process safer for protocol economy.

The overall conclusion is that when you create your protocol economy or tokenize existing enterprise you should take into account that community of investors and speculators will make a huge impact on price of your token and indirectly on incentives that participants of your network have. You will have to deal with that. One of the solutions is of course disentangling the usage part of the token from its function as an investment vehicle by issuing two different tokens. One of the tokens reflects the value of the underlying resource created by the network, meaning its price is shaped by supply and demand created by consumers and miners. The other token solely functions as an investment vehicle and allows capital injections into the network. It operates similarly to equity in the off-chain word. Certainly those two tokens must interact: for example the network may share part of the fees and rewards with its investors via the “investment tokens”, but I will leave this topic for the next blog post.