Tokens

In 2017 the primary method for incentivising investment in new decentralised platforms and protocols has been through token sales. Tokens are typically the currency used within a new protocol, and are specific to that protocol. For example, Filecoins are used within the Filecoin ecosystem, and so on. The process begins when a new protocol is detailed in a white paper, and people who believe it promises to deliver utility invest in it, thus funding its development. They invest by purchasing tokens in a token sale. Because there is usually a finite supply of these tokens, the value of these tokens is largely determined by speculation on future demand for the protocol. But when we dig deeper into the incentive mechanisms at play, it is clear that there are significant inefficiencies in this model.

The problem is that for almost all tokens, price is driven by two speculative factors. The first is that most of them are recycled rather than burned. So, for example, in the case of a decentralised storage system, users are supposed to buy tokens to then pay for the services of the storage providers. But when they do, the token is then resold by the storage provider to another user, or even the same user, or worse, hodled by the storage provider. This is a very strange mechanism, because if we play this out we need to ask what the users are paying for the tokens with — in this case it is almost definitely going to be ether. So, why then not just use ether to pay for storage? We will address this later, but a larger issue is that because tokens are recycled, the price of the token is driven by speculation on the demand for the token at a given point in time. This is an extremely inefficient pricing mechanism. What is likely to occur is that the price of a filecoin will increase with increasing demand for storage but the amount of storage purchasable per filecoin will not move with it. This begs the question, why not? The answer is that no one is using Filecoins as a unit of account, they are possibly using bitcoin or ether, but most likely they are actually using Euros or Dollars. Imagine a scenario where a user is comparing the price of S3 storage on AWS versus using filecoin. Do you think they are converting the price of AWS storage into filecoins? Of course not—they are going to convert the price of storage in filecoins into Dollars to do the comparison. Thus, as the price of Filecoins is driven up by speculation on future demand, the entire market has to re-price storage against the appreciating token price. So, again, why not just use ether?

At first glance, creating a new protocol token to be used within an ecosystem is not entirely necessary. For protocols built on Ethereum, which is most of them, they could use ether instead. Using ether as the medium of exchange in all the different ecosystems would at least provide some degree of inter-protocol exchange. And sure, ether is not particularly stable, but at least there would be a common unit of account that could be used to measure the value of one protocol in relation to others. The multiplicity of protocol tokens is almost certainly a barrier to entry for average users, even factoring in solutions such as the one proposed by the 0x team at Devcon: to abstract away the complexity of multiple tokens using a stablecoin. The many different forms of tokens make it difficult to accurately compare their respective value and purchasing power, especially when they fluctuate based on speculation on future demand rather than actual user demand.

Given the option of ether is readily available, it seems the primary reason creators of new protocols don’t use ether as their internal currency is that issuing a protocol token can be a highly lucrative funding mechanism. That profitability, for the most part, comes from speculators. Speculators recognise the value of the new protocol, see that demand for these tokens will grow once the protocol’s value becomes more widely known, and buy tokens not to use them but to sell them in the future at a profit. The money raised in an ICO, most of which comes from speculators, then funds the building of the protocol, plus an excess that mostly comes from the irrational exuberance of speculators. For one example, see Polkadot, who lost nearly $100m in funding through an software bug, yet their excess of funds was so high that they claimed this loss would not affect their development roadmap.

The problem with this form of speculation is that it incentivises holding tokens rather than spending them. This is a well documented problem for any deflationary currency and it limits the actual utility of the protocol, as those who wish to purchase tokens to actually use them are hindered by the inflated price, which has increased due to speculators who have no intention of using them, while if the price were kept low then users would feel more open to joining the new protocol. So, what’s wrong with this? After all, if the ICO is successful, the protocol creators are rewarded for their innovation. Plus, early adopters are rewarded for their ability to foresee and predict utility, and are incentivised to fund development. But one group who is not rewarded are users who actually want to participate in the new ecosystem. The speculators — and the high prices caused by their speculation — create a barrier to entry for the average user. In this way, they are like ticket scalpers, snapping up concert tickets when they are released in the hope of selling them back to fans at inflated prices.

The same principle applies to our current model for incentivising investment. Incentivising people to buy utility tokens in an ICO because they believe in the utility is a great method for raising lots of money quickly, but let’s keep in mind that the original vision of token sales was to create immediate network effects, as users would be created via this distribution of pre-purchased access to the system. It doesn’t make sense to create a system in which early adopters benefit from people not using the protocol, which is a result of the funding reward being the same thing the users are purchasing the service with. But it’s worth recognising why this is so common now. Previously the only model was Bitcoin. It was only possible to pay the miners in the thing itself rather since it was a closed system. It made sense with protocols such as Ethereum and Dash as well. But now, as blockchain technology matures and protocols with a variety of utilities are created on existing blockchains, it is worth recognising the limitations of this model. It only works so long as the protocol remains a hypothetical concept, whose existence is confined to a white paper and a website. But as soon as it is operational, and people realise that no one wants to use the protocol because these tokens have far more utility as a speculative instrument, the whole thing is likely to unravel. Bitcoin has avoided this by becoming a store of value rather than a medium of exchange, and Ethereum will likely be fine because users need to pay for gas to access the EVM, but it is worth pointing out that the vast majority of people holding Ether likely don’t even know what the EVM is or how it works.

What we need in order to address the inefficiency of this system is to find an alternative method of facilitating investment in new protocols. It could be argued that one reason we are rewarding those who fund the protocol with deflationary protocol tokens is to route around securities law, which restricts the most logical form of investment, the one that has worked since the invention of equities markets. Rewarding investors with the future profits of a system is a fairly efficient and well understood model, but an argument against this is that it is anti-egalitarian and will simply transfer the inequality in existing markets to nascent cryptoeconomic systems.

This is an extremely important point, and something we need to consider when we design incentive systems. Distributed consensus offers the potential for democratising aspects of the economy that previously would have been impossible to imagine not being controlled by multinational corporations or governments. In order to achieve the promise of this technology we need to understand the incentives at play and design them in such a way as to ensure that people are both funding and using these systems. While there is no obvious path forward in the pursuit of this goal there are some possible solutions.

The first such solution will involve decoupling the incentives of users and investors. If someone wants to perform both these roles they should not need to overcome perverse incentives to do so. The way to decouple these incentives is to continue creating tokens for new protocols, but rather than using them for the currency of the system we should use ether, or even better, viable stablecoins once they are available. We can then allow users and providers to price services in a transparent way, which will enable far greater adoption for the average user. These new protocol tokens will confer certain rights on holders. These could range from a portion of the fees being distributed to both service providers and token holders, to even allowing for some participation in governance. Furthermore, given that we have decoupled users from investors, we could now allow users to have a clear say in the governance of the protocol. It would allow them to vote with their feet and through direct governance rights scaled against usage. We could also allow service providers within the protocol to be granted tokens through some activity that supports the network, which would incentivise people to participate rather than to simply invest.

Unfortunately the law is not adequately designed to perform its duty at the moment. If the law rules out superior funding mechanisms in trying to protect something that it ultimately fails to protect, then it needs to be revised. This is simply a warning against the future consequences of a present imbalance. We are designing new protocols with inefficient payment systems, in which investors are incentivised to prevent people from using the protocol. We need to find a way to decouple investment and funding from actual usage. One of the major challenges in resolving this are existing securities laws, and there are multi-jurisdictional challenges that must be overcome. Ultimately we need a framework that allows anyone to invest in and use new protocols in a fair and transparent way, and finding a more efficient mechanism to implement this will benefit everyone in the long run. One thing is clear though, we need to keep experimenting.

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