Token Economics 101 How to Create and Accumulate Real Value?

Token Economics 101 Creating & Accumulating Real Value

Tokens are a novel invention that are easy to create, track, exchange, and settle, and they are far superior to traditional securities.

Original title: “Token Value Creation”

Author: SAM ANDREW

The accumulation of token value is crucial. Valuable tokens ensure the security of their blockchain. Validators need economic incentives to participate honestly. They need to be rewarded in a tangible way. Without incentives, they will stop validating. The absence of validators threatens the security of the blockchain.

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There are currently more than 2,500 types of tokens. The types of tokens have exceeded the scope of L1. Blockchain tokens are tokens used to secure blockchain networks. Examples of native blockchain tokens include Bitcoin (BTC), Ethereum (ETH), SOL, AVAX, and NEAR. Protocols and applications running on the blockchain have their own tokens. In cryptocurrencies, the creation and accumulation of value have become increasingly important. Native blockchain tokens have a clear purpose for their tokens, and they have value. However, this is not the case for tokens related to protocols and applications. Furthermore, in the case of all tokens, the accumulation and distribution of value have become confusing.

This article outlines the four ways in which tokens create value and explains in detail their drawbacks and their relationship with different types of tokens.

Tokens can gain value through four approaches:

• Utility

• Productive Assets

• Store of Value Assets

• Governance Rights

Utility

If an asset consumes labor or material in an endeavor, it has utility value. Goods and currencies are examples of utility. They are often referred to as consumable or convertible assets. For example, cars consume gasoline when driven, and euros are used when vacationing in Europe. They are useful and valuable because they provide means to achieve goals, such as transportation and vacationing in the examples.

Tokens have utility value. Tokens are used as a medium of exchange on the blockchain. Users use the native tokens of the blockchain to purchase block space. Validators are rewarded with native tokens to ensure that transactions are correctly inputted onto the chain.

L1 blockchains require native tokens. Native tokens ensure decentralization and coordination among different parties. It prevents the blockchain from being subject to central authority. Imagine if interactions on Ethereum were conducted in US dollars, the decentralized permissionless model would collapse. A central role, namely the US government, would control Ethereum. This central role could review transactions and reorganize blocks. This would contradict one of the purposes of blockchain.

Native tokens are crucial for designing decentralized permissionless networks. However, not all token-based projects are the same. Outside of L1, there are usually no validators that can be rewarded. Projects create various demand points to create some form of utility for their tokens. For example, their native tokens need to be used for transactions with their protocols. Token holders are incentivized to “stake,” which is a misconception. The so-called “staking” has nothing to do with validating transactions, but rather to prevent token sales. This artificially increases the token price.

The tokenomics created a reflexive model. The more people interact with the protocol, the greater the purchasing demand. The more tokens are locked up. However, once the purchasing demand decreases, there is nothing to support the token price. The price will collapse.

The artificially created utility makes sense. Entrepreneurs, developers, and community designers who create these useful protocols have designed token economic models to receive rewards, which is reasonable. They have developed useful technologies. However, the “utility” created artificially for the sake of entrepreneur rewards can lead to suboptimal token economic models. Balancing token economic design between developer rewards and long-term sustainability is necessary for the industry’s continued growth.

The “utility” of tokens can also be a kind of disguise. Tokens cannot directly represent equity-like interests in the protocol, otherwise, regulatory challenges may arise. Tokens can provide non-essential utility functions to the protocol and be traded as synthetic equity.

There are various tokens in the cryptocurrency market. L1 tokens have clear and necessary utility. The utility of other tokens may be unclear.

Productive Assets

Productive assets can generate returns. Real estate, company stocks, and bonds are all productive assets. They are also known as capital assets. They produce valuable things. Their purchase is based on expectations of future returns or contractual obligations. Bonds have contractual obligations to pay disclosed interest rates to holders. Real estate owners earn returns through rental income. Equity holders have cash flow rights in the company. Their returns come from reinvesting cash flow into the business or distributing it to shareholders.

Tokens have the characteristics of productive assets. They generate valuable things that people are willing to pay for. They generate income and incur costs. The difference between the two is profit. L1 tokens typically reallocate the earned profit by burning tokens. Burning tokens removes them from circulation.

Outside of L1, the accumulation and distribution of profits are unclear. This may be due to regulatory uncertainty. If tokens distribute profits to holders, they may be considered securities.

The market is working to solve the problem of token value accumulation. Some believe that protocols that do not charge fees or accumulate token value are worthless. Others believe that not charging fees is to consolidate their market share and avoid potential regulatory challenges. Reinvesting funds into business development has a higher capital return than returning it to token holders.

Many Web3 protocols are likened to Amazon. Amazon has been losing money for decades in order to consolidate its dominant position. It only occasionally distributes capital to shareholders in the form of insignificant buybacks. This analogy is only partially accurate. Yes, protocols may be consolidating their market share and reinvesting like Amazon. However, Amazon always has the choice of how to allocate its capital. It evaluates the pros and cons of reinvesting funds into the business versus returning it to shareholders. For protocols, these alternative solutions are not so clear, at least not yet.

For a protocol, the key to understanding today is how it creates value, how it captures that value, and how that value is distributed in the future. In this context, the analogy to Amazon is appropriate. If the market believes that a protocol can create and capture value, and responsibly manage the capital it creates, the market will pay less attention to distribution issues. If a protocol is unable to capture the value it creates or engages in irresponsible capital allocation, then the path of distribution becomes more important.

The protocol’s treasury is accumulating more and more of the economic value it creates. How the treasury handles the accumulated capital becomes a primary concern. Will the treasury distribute capital to token holders? If so, how will it be distributed? Will it reinvest the capital? Who makes these decisions? How are alternative proposals evaluated? Suddenly, the code of a protocol incubating now needs an organizational structure to determine how the created value is handled.

Store of Value Assets

Store of value assets include art, collectibles, and gold. They have value because of their scarcity and social status. People believe they have value, so they do. This is a memetic effect. Gold did not suddenly become a store of value asset. It became one over centuries. When Leonardo da Vinci painted the Mona Lisa, he did not intend to create a store of value asset. It became one over time. Satoshi Nakamoto aimed to develop a peer-to-peer electronic cash system that allows online payments without relying on trusted third parties. The concept of “store of value” was not mentioned in the Bitcoin whitepaper.

Assets cannot be designated as a means of storing value. This is a nickname bestowed over time due to certain attributes and social developments. Therefore, store of value is now irrelevant for crypto assets other than Bitcoin and Ethereum.

Governance

Governance rights only have economic value when they involve assets with economic value. This economic value can be manifested in productive or commodity assets. Just as voting rights on how a company or protocol allocates capital have value, voting rights on how the Organization of the Petroleum Exporting Countries (OPEC) controls oil production also have value.

In the cryptocurrency field, governance itself does not have value. Governance needs to be combined with something that has productive or utility value.

Summary

Utility and productive assets are the two most important paths for crypto assets. A protocol needs a utility component to get someone to buy the token for the first time. It needs a productive asset component to get someone to continue holding it. Bitcoin and Ethereum are unique in this regard. Both Bitcoin and Ethereum have utility and store of value properties. Additionally, Ethereum also has productive asset characteristics.

I suspect that the value of “utility” aspects (excluding L1 protocols) will decrease over time.

Except for L1 blockchains, other applications/protocols may not necessarily require native tokens. Liquidity staking protocols can operate using their liquidity staking derivatives and ETH or stablecoins. They actually do not need native tokens, and the same goes for decentralized exchanges.

Native tokens are sometimes created as a means of understandable profitability. It is quasi-equity, but not actually equity. To comply with regulatory requirements, it is wrapped in the guise of “utility”.

Ironically, the “utility” aspect of tokens may undermine their value. Protocols grant tokens to users to promote their usefulness. For example, if users need to interact with the protocol using tokens, then the tokens need to reach the users’ hands. Airdrops are a way to achieve this purpose. The problem is that as more and more tokens are granted, the future value of the protocol will be gradually divided into more and more tokens, thereby reducing the value of each token.

The clarity of regulation may eliminate the need for token utility. Then, protocols can eliminate unnecessary and costly issuance and reflexive token models. Users can simply use the blockchain-native L1 tokens or stablecoins built by the protocol to interact with the protocol. The result will be a huge improvement in user experience. Cryptocurrencies almost need to use different tokens for each transaction. Interacting with each different L1 requires the use of the blockchain’s native tokens. Using an application may also require another token. All of these tokens need to be held in advance. If a user wants to use another blockchain, the assets need to be bridged to the target chain, which is prone to hacking attacks. This is a nightmare for users.

Imagine if customers had to use different currencies for each store they shopped at. That would be an inefficient mess. This is the experience of cryptocurrencies.

There are 180 currencies globally, but most global trade is conducted in US dollars, Chinese yuan, and euros. The same will be true for the crypto economy. Most interactions will revolve around a few utility assets. Behind the scenes, many different tokens may be used to facilitate interactions, but users are completely unaware of this.

If tokens do not need to hide behind utility, they can become quasi-equity hidden by many people.

Wait… Isn’t this just recreating the securities we already have?

It’s kind of like that, but better.

Tokens are a novel invention. They are easy to create, track, exchange, and settle. They are much superior to traditional securities. Blockchains that use tokens are more efficient and transparent than our outdated financial infrastructure.

I believe that tokens will represent blockchain, encrypted protocols, and mapping of off-chain assets. Except for L1 blockchains, the source of token value will be their productive attributes. Most tokens will be seen as productive assets. Therefore, their value depends on the quality of their products, the scale of market demand, and network effects. Only a few cryptographic assets will have the attributes of utility, productivity, and store of value.

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