Rise of the Token Hugger

Part 1: ICOs, Consensus & the Credulity Pandemic

Well, folks, wasn’t that spectacular? The fumes lately issuing from the incineration of hundreds of billions of dollars of crypto-capital is as good an excuse as any for a throat-clearing.

Crypto-fever has been an exercise in mass stupidity on an almost unprecedented scale. It has arisen at once from its accessibility and its mystique, led by Bitcoin and Ethereum and their smoky, beguiling detachment from mainstream economics.

Token Fever

The booming value of these early coins caught the attention of the masses — appealing not to their critical faculties, but to a base thirst for instant riches. Anything that quacked like Ethereum attracted tsunamis of cash — flowing in unquestioningly from the world’s burgeoning fellowship of Token Huggers.

Opportunists have of course piled in — sensing the fever, they’ve promptly issued thousands of so-called Utility Tokens, and sold them into this sudden well of credulity*.

For the few-dozen lines of code it takes to mint a Token, they’ve collectively raised billions of dollars.

How many will retire to Bermuda, unshackled by duties to investors, and leave their tech unbuilt?

Many protocols have raised tens of millions of dollars, leaving founders and hedge funds rich, but often with no explicit obligation to build the tech they promised

Echoes of 1999

It seems that ignorance and lunacy are now the dominant forces at play in the cryptocurrency markets, and the blockchain community needs urgently to regain its senses. This is a wonderful new technology but, perversely, it’s being threatened by its own evangelists.

To the casual observer, the blockchain project runs no deeper than Bitcoin, that underworld currency of the Silk Road — depraved by association.

Elsewhere, the headlines smack of gross opportunism. Hacks and hostage-taking. Celebrity endorsements reminiscent of the 1999 tech boom. Sackfuls of CryptoKitties clogging up Ethereum.

You can understand the conclusion of the sceptic: it’s just one noisy scam.

The Problem

I’m confident in making two broad-brush claims:

Cryptocurrency can have long-term sustainable value Most cryptocurrencies do not have long-term sustainable value

ICOs (Initial Coin Offerings) — that is, the issuance of new cryptocurrency — overwhelmingly fall into the second pot.

That’s the problem.

The typical ICO mints a Utility Token — for the duration of this first article, the Utility Token is in my crosshairs.

Later in this article I present a concrete ‘real-word’ example illustrating why.

But first —

What is a Utility Token?

In brief, it’s a digital coin, usually issued on the Ethereum network, to raise funds for a blockchain project.

The claim? That it will act as a payment token for the ‘ecosystem’ created by the business.

Compare & Contrast: The Consensus Token

To get some early clarity, to help divide this universe of tokens — let’s distinguish the Utility Token from the Consensus Token. My conviction is that the public’s inability to distinguish these items is highly damaging to the blockchain project.

A Consensus Token is the native token on its own blockchain. For example:

ETH is the Consensus Token on the Ethereum network

is the Consensus Token on the network BTC is the Consensus Token on the Bitcoin network

is the Consensus Token on the network ICX is the Consensus Token on the Icon network

And so forth — each a sovereign blockchain, each with its own native Consensus Token.

The Blockchain as a ‘Truth Universe’

One mental model of a blockchain is to think of it as a ‘truth universe’ of its own — cut off from the rest of the world’s data. It therefore requires a native token as a vehicle to deliver a unit of value on its network.

That’s why you need a Consensus Token: providing the value needed to forge dispassionate consensus — the economic force that welds all those distributed nodes into agreement.

Very roughly, the higher the aggregate value of those Consensus Tokens, the higher the cost of attacking the network — i.e. the stronger the blockchain.

I leave it to Part 2 to try to provide some intuition around these terms.

Spotlight: The Utility Token

For now, my claim is that the Utility Token is not a universal asset of this kind — and that, in its most basic form, it provides no utility at all.

In particular:

Utility Token investors may not benefit from the platform’s success It is private currency, creating a pool of dead capital It is damaging to the prospects of the very protocol it claims to serve

The premise is as follows: the founding team promises that, when their system is up-and-running, one or more of these Utility Tokens will be required to pay for use of its services. No other form of payment will be accepted.

Therefore, the theory goes — initial investors will see demand placed on the tokens they hold, by people who want to use the protocol in the future. That will cause the price to rise. And that will return value to the investors.

It has probably already occurred to you that receiving a return on your investment through possible second-order contingencies (with a hopeful nod to the velocity of money equation) is a daft proposition.

But the full absurdity of this proposal is best seen using a real-world example.

Thought Experiment: Utility Tokens on the High Street

A short story about a new store using ‘token finance’ to set up shop

It outlines how ICO protocols will find themselves stifled by their opportunistic binge on free money

Two Tesco Executives leave the company to start their own food retailer— first project, a new store.

The projected cost is £5m.

They quit their jobs after observing a new phenomenon: a prevailing craze over coloured plastic tokens. It seems an enticing opportunity to raise money — if they issued equity, they would give away future profit. And if they used debt, they would owe quarterly interest payments.

This way, they appear to give away no economics at all. Free cash!

So they go ahead and mint a treasury of red plastic tokens — 50 million little red discs, forged with guarantees that not another can be printed.

In exchange, they promise the circling clutch of ravenous Token Huggers that their store will only accept those little red tokens from their future customers, and nothing else — ‘we do not accept Sterling’ the signs will read.

The Executives have heard that keeping people out of the auction will help to amplify excitement. So they open a white-list application system, to signal high demand.

Applications for approval duly go through the roof.

The auction fills — £50m raised! The Token Huggers hug their tokens tightly for perhaps a week or so, until they break for trading.

Almost none of these ‘hodlers’ [sic] are future customers. And they are not in it to ‘hodl’ [sic], despite their self-righteous proclamations — they are there to flip their coins to the market. They congratulate themselves on the Reddit threads — what a steal! These tokens typically run capitalisations of billions — they got in for a cap of just £50m!

The investors are convinced this store is going to be the store to end all stores — the quality of the glass, there’s mahogany inlay on the tills, they say. ‘Rock star managers’. And the peerless stock — a land of milk and honey.

Before the foundations are even begun, the tokens begin trading. Buyers stung by the fury of exclusion from the whitelist now buy in at £2, £5, £10 — the token capitalisation soon crosses half a billion pounds.

Fast forward: Let’s generously suppose the store is completed, and that the executives, free of the formal duties that would normally attach to equity or debt, didn’t just run off with the money.

The store opens.

Freeze frame: and consider the following.

How many customers are there inside the store at any one time? 100 perhaps, to be very generous?

How much disposable cash will each customer carry? At the very most, perhaps £100?

So there will need to be at most 100 × £100 = £10k of little red tokens inside the store at any one time.

Notice — pounds remain the reference value. Why? Because that is how those shoppers measure their income, their expenditure, their worldly assets.

Now, there will need to be a liquidity pool outside — because those shoppers will need to trade into those tokens to do their weekly shop, and cash out for Sterling as they leave.

Probably this liquidity pool ought to be of a similar order of magnitude — let’s be generous, and say a further £15k.

So, except for continuing ‘store of value’ demand, the expected token supply should fall to c. £25k of value in the long run — that is, fall by 99.95% from the issue price, and 99.99% from the peak.

And look what their beloved customers suffer:

Transaction Costs: buying red tokens as they arrive, and selling out as they leave Currency Risk: the tokens might have tanked whilst they are doing their weekly shop Abject Confusion: The customers live their lives in Sterling. So do the proprietors, the suppliers, the staff. So the goods — to remain competitive but profitable — need to be stably-priced in pounds. Come the end of Day 1, the shop assistants are shattered, the day spent belting round the miles of shelves repricing items, as those little red tokens fluctuated violently against Sterling on the money markets outside the store. Worst of all, the customers lose track of cost of their groceries

The Fallout

It’s clear: the tokens were a mistake, strangulating an otherwise good business.

The shop owners would love to switch back to pricing in pounds, but can’t —after all, they promised their faithful Token Huggers that they never would.

— That was the price of giving away something for nothing.

A competitor opens its doors across the road — a perfect clone, except:

The shop accepts Sterling — a token-free zone The founders sold equity to finance themselves, yes. Took on debt, yes. But customers enjoy a vastly simpler, vastly cheaper shopping experience

The ICO store’s customers are fleeing — deterred by the chaos, the transaction costs, the currency risk.

The ICO store collapses.

And Now the Music’s Stopped?

Those still holding balances of worthless red tokens are left empty-handed.

Depending on your perspective, there is one silver lining — the founders can amply nurse their wounds from that £45m they pocketed before laying the first brick.

After reading this article, Nic Niedermowwe suggested using Uber as an alternative example. If you’re still feeling under-analogised-to: here it is.

ICO Appraisal: Two Criteria

I will argue for the inherent value in Consensus Tokens in Part 2.

But you don’t have to accept the premise that a Consensus Token can provide value, to accept that the Utility token carries next to none.

It should now be plain that the Utility Token is not just an unnecessary artifice — an economically illiterate excuse to raise cheap money. More than that, it’s actually a business-ruining gadget, providing no utility at all.

If in the meantime you find yourself appraising a non-security ICO investment — before you even bother weighing the credentials of the team, or the viability of the product, you should ask the following two questions:

Does the token provide consensus? Could the protocol be built without a token?

Unless the answer to the first is ‘yes’, and the second ‘no’, put down your pen.

Token Peddling 2.0: Virtue-Signalling

Some modicum of guilt has even begun to leak into the consciences of Utility Token issuers themselves. These days I’m inundated with cold calls from promoters on LinkedIn, praising themselves for ‘doing their best to find a real use for the token’. Perversely, the tone of these messages tends towards pride, not shame.

That Utility Token issuers are working quite so hard to retro-fit an excuse for printing a token is incredibly revealing. There’s free money washing about — how to grab it without inviting opprobrium?

Ask them why they really need a token, and they’ll direct you to their ‘white paper’, with its meek offerings of various gimmicks including voting powers and collateral lock-ups.

One almost ubiquitous ‘gift’ to the token buyer is the opportunity to vote on smart contract upgrades — that’s right: in exchange for your money, you’re generously invited to help to steer a system in which you have no direct economic interest.

Utility Token issuers and underwriters may want to steel themselves, and prepare for the SEC and other regulators to tap them on the shoulder.

The Public Securities Loophole

Which brings me to one final observation: a regulatory environment that’s so far been caught off-guard.

Suppose ICO issuers did attach real economics to their tokens — i.e. equity / revenue share. Then:

There are now metrics to help divine a value for the token They would almost certainly breach public securities law in most countries, for issuing a claim on future inflows

So in this weird world of the ICO, the solution to —

justifying an enormous inflow of money, and avoiding criminal prosecution

— it’s actually quite simple — don’t sell them something with demonstrable value. Sell them something that has no fundamental value at all.

Now there’s no metric at all to stop you dreaming, to tell you this much-hugged token of yours can’t be worth the earth — let alone that it’s worthless.

And there’s no claim on the future profits of the project— so you slip the leash of securities law.

After all, no regulator ever thought to ban a security secured on nothing.

This is perhaps one of the most improbable, illogical and outrageous quirks in financial history and regulators need to bring themselves up-to-speed on this mass creation of private currency, sold liberally and irresponsibly to an unquestioning public — with urgency.

Part 1 has sought to establish that ‘Utility Tokens’ hold no sustainable value. Part 2, to be published next week, makes a claim that there is long-term value in ‘Consensus Tokens’. Thanks to the many colleagues at EF who have proof-read the various iterations of this article.

* Nod to the late polemicist who coined this expression