Types of Blockchain Tokens and a Case Against Utility Tokens

Introduction

As we march steadily into 2018, the crypto craze shows no signs of slowing down. More and more blockchain projects appear every single day. Some look like they’ll change entire industries, some have a niche (but useful) application and some are outright scams.

Most of these projects use token issuance on the blockchain to raise funds through an initial coin offering (ICO). Now to get this out of the way, I think ICOs are great! They promise quick liquidity, immutable contract guarantees and most of all - they democratize access to investment capital (something that has always led to an increase in worldwide productivity).

However, not all ICOs are made equal. There is a trend currently,an unwise one, of forcibly tokenizing anything and everything. Since it’s much easier to gather significant sums of money via ICOs than it is to do the same with institutional investors, blockchain startups spend countless hours trying to find even a semi reasonable way of putting an ICO friendly token on their platform.

Rationalization - Why tokens?

Since blockchain applications are distributed and more often than not open source, it’s very difficult to come up with a model which will be profitable for platform developers.

Let’s say you have a network which receives ether or bitcoin in exchange for stabilizing a video file.

You put the network on the blockchain, people with powerful computers apply to stabilize and videographers apply to have their video stabilized. The network is growing and all is well.

But how do you earn money from it?

If you charge transaction fees, someone can simply fork your platform and remove the tx fee, without putting the effort of development in.

The solution, at least until now, has been to tie the network to tokens. In our example that would translate to:

On our platform, you can’t pay for video stabilization with anything other than our custom token Stable Video Coin (SVC)

The developers sell of a majority of SVC tokens in an ICO to earn ethers and bitcoins for development of the platform and keep a percentage for themselves to earn money from token appreciation in the future.

I think there are other (better) ways of doing this and we’ll discuss them in this article.

Types of tokens

There are a couple of key types of tokens currently used on the blockchain. They vary by their legal status and accessibility.

Note: I will not be using the standard protocol/utility/security division since I think it’s insufficient

1. The Consensus Token

The first type to appear, and used by Bitcoin and Ethereum is the “consensus token”. This token is given out as a reward for ensuring the network consensus either via PoW or PoS voting.

Their legality is usually the most discussed since Bitcoin and Ether alone make up more than 50% of the value in the blockchain world.

We refer to these types of tokens as cryptocurrencies (although other types of tokens might fit the name much better) and they’re what most people think of when you mention blockchain apps.

What to watch out for with consensus tokens?

Does the consensus network bring any tangible advantage to existing platforms?

Examples of tangible advantages are smart contracts, zero knowledge platforms, DAG(?) blockchains, better scalability, ASIC resistance, PoS (dPoS) blockchains etc…

The advantage isn’t always clear, but a good rule of thumb is that the alternative blockchain should at least try to do something Bitcoin and Ether can’t.

2. The Security/Equity Token

These types of tokens represent either a participatory role in decentralized platforms or shares in the ownership of a company.

DAO

When they represent participatory roles in decentralized platforms, they are called “DAO” (Decentralized Autonomous Organization) tokens.

A DAO (not to be confused with The DAO) is an organization which is governed by people voting through blockchain smart contracts.

Every participant owns a certain amount of tokens and has a voting power proportional to their holdings. They don’t have to vote, but certain DAOs reward proactive behavior with various incentives.

Shares

When the tokens represent ownership of the company, they are bound by various “real world” contracts which either map tokens to company shares or provide some sort of guarantee for the investor.

Sometimes these tokens represent shares in physical assets such as gold or oil. In these situations, the purpose of the blockchain platform is to provide simple trading environment for all participants

Utility tokens

Utility tokens are used for performing various activities on their platform of issuance. We’ve described them in the video stabilization example.

Why utility tokens?

Now with all this in mind, a question must be asked - why do utility tokens dominate the blockchain landscape?

Most newly created tokens are utility tokens. This always struck me as a weird thing until I started talking with various blockchain founders.

Some have found actual purpose in utility tokens, an actual utility. Most havent.

Why would all these various startups, which don’t have a proper use case for utility tokens, decide to make utility tokens instead of a DAO or a share structure?

The reason, more often than not, is… The Law!

See, when you issue any type of token which has significant value and when you decide to represent that token as a developer, you are legally responsible to your investors.

Over the past couple of centuries, all nations developed some ways of protecting investors and regulating the markets of various financial instruments. Enter…

The FindLaw website says:

The “Howey Test” is a test created by the Supreme Court for determining whether certain transactions qualify as “investment contracts.” If so, then under the Securities Act of 1933 and the Securities Exchange Act of 1934, those transactions are considered securities and therefore subject to certain disclosure and registration requirements.

It basically determines which value transactions are considered securities and which are not. If you are a security, you must go through a lengthy and uncertain process of registering.

This is the reason you’ll find many ICOs have KYC requirements that don’t allow you to be an American citizen. It’s also the reason most ICOs decide to be a utility token.

When you’re issuing a utility token, you fall under much much milder law structures in the EU and many other countries. This has the obvious advantage of making you spend much less money on starting the ICO.

It also allows various classes of investors who would otherwise be ineligible for investments, to invest in you hot disruptive up-and-coming blockchain startup.

Quick disclaimer - this is not the only reason companies do this. There used to be a time in the blockchain world when everyone thought utility tokens would be the “next big thing” in finance. Some companies from those times carry them as a legacy. Although they should also get rid of them

A case against utility tokens

So whats the problem with utility tokens? In theory, nothing. In practice? Everything.

Loads of new companies are bending their necks trying to find any even remotely reasonable way to incorporate utility tokens into their projects.

Even if these projects would thrive as DAOs or even classic companies with a normal shareholder structures, they implement barely useful tokens into their platforms to get a hold of ICO money.

As business plans get more and more convoluted, the potential user needs to wonder - why the hell would I want to use your XYZ token to pay for things? Why can’t I just pay with Bitcoin, Ether or some fiat-backed token?

So when I want to use your platform I first have to convert my money to your token and only then can I do anything? Why would I show such a high level of involvement for your platform?

If this is the future of payments, the future is worse than the present.

There are various structures which can be employed to develop reasonably governed blockchain platforms. The key aspect is to separate the user from the investor.

Let users decide with what they want to pay. Let investors buy tokens which represent ownership of either the protocol or the company.

Oh and… don’t rob your investor of voting rights. This is another interesting fact about most utility tokens - the holders get almost no voice on the future of the network you’re investing.

Imagine if you sold the shares in your company to someone and then ripped them of all of their shareholder rights? They have no rights to vote, no payouts as dividends, no legal assurances. All they have is an ICO token which they can hope appreciates in value.

Since I abide by the “live and let live” philosophy, I don’t think utility tokens should be banned nor punished. Sometimes they serve a legitimate purpose (In cases when the use case asks for a more specific type of currency), but mostly they’re used because they’re the simplest solutions.

To all the devs and CxOs - your investors deserve better

In the next article “Democratically Mutable DAOs”, we’ll discuss one way of monetizing a blockchain project which provides a more fair framework for the investors

Mislav Javor I'm an entrepreneur and a software developer. CEO of a blockchain startup aiming to simplify buying and selling of electricity. Actively participating in the proliferation of healthy (technology oriented) blockchain culture. Organizer of Blockchain Development Meetup Zagreb, lectured at HUB385 Academy and University of Osijek on topics of smart comtract development. In my free time, I'm a singer and a guitar/piano player. Contact at I'm an entrepreneur and a software developer. CEO of a blockchain startup aiming to simplify buying and selling of electricity. Actively participating in the proliferation of healthy (technology oriented) blockchain culture. Organizer of Blockchain Development Meetup Zagreb, lectured at HUB385 Academy and University of Osijek on topics of smart comtract development. In my free time, I'm a singer and a guitar/piano player. Contact at mislav@ampnet.io

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