- Token-based incentive systems have unique potentials and constraints; they can attract and organize value adding contributors in unprecedented ways, yet typically require a “level playing field” created by an immutable or distributedly governed ruleset.
- Host platforms—base protocols, seperate networks, dApps—can incentivize value-adding community collaboration through token function design and compensation mechanisms.
- A rich understanding of token functions and the tradeoffs they present is crucial for effective cryptoeconomic design. Token functions have implications for everything from design, use case, the business model of the underlying organization, and valuation methodologies. They present tradeoffs that projects must manage.
Tokens: A Crucial Element in a Powerful New Incentive System
Bitcoin evidences token-based incentive structure’s potential: the historic capital investment in mining bitcoin is likely north of $12 billion USD, yet “Bitcoin” or entity purporting to operate on its behalf did not hire miners, form mining companies, or even fund the ecosystem of services built around the core network and its mining. Rather, such large-scale economic activity emerged in part as a product of a novel incentive system: bitcoin, the “token,” along with its supply and PoW compensation mechanisms, helped motivate impromptu contributors to perform critical services securing the distributed economic system.
Bitcoin demonstrates that cryptoeconomic design works. Its potential as an incentive system helps explain why projects and companies hoping to replicate its success devote resources to understanding cryptoeconomic design.
Token function is a key component of cryptoeconomic design; examining token function is to study how tokens accrue or confer different forms of value to those who hold it, so as to anticipate how the token will motivate different communities of end-users and contributors to acquire, hold, use, or trade the token. Token functions have implications for everything from design, use case, the business model of the underlying organization, and valuation methodologies. They present tradeoffs that projects must manage.
A Simple Framework for Understanding Token Functions and their Tradeoffs
Smith + Crown has tracked, analyzed, advised on and built token models since 2013, and has found that tokens serve a wide variety of functions on the protocol, platform, or app that hosts them—their ‘host platform.’ Though widely used, the term ‘utility’ token belies the plurality of methods host platform have devised for tokens to accrue or confer value. This memo shares the framework Smith + Crown developed to classify tokens by function and understand how host platforms pursuing specific designs are benefited or challenged through that choice.
The chart below represents an introduction to what can be a more nuanced and intricate subject. Future discussions will examine each token function in greater detail, highlight notable variants, and consider the effects place in stack or business model can make to the advantages or challenges presented by a function design choice. The chart’s categories are non-exhaustive, in that new token functions will be developed, and non-exclusive, in that many tokens confer multiple rights. Likewise, there are important edge cases in tokens that could warrant further categorization. Nonetheless, this high-level categorization is a step toward better understanding these crypto-economic primitives in a way projects can build on and long-term investors can learn from.
The Melon protocol, which is a decentralized platform for hedge fund management, requires all protocol fees to be paid in MLN.
The DASH protocol, a general purpose cryptocurrency network with native privacy features, utilizes a consensus method that enables those holding 1000 DASH to serve as Masternodes, which can send special transactions and share in block rewards along with DASH miners.
Sweetbridge, who is developing a platform for collateralizing stablecoin loans using crypto-assets and eventually off-chain assets, will give those who stake or ‘activate’ SWC discounts on platform fees, priority access when lending activity or trading activity is restricted, and other benefits.
The Dfinity Network, a planned next-generation smart contract platform, intends to implement on-chain governance mechanisms in which token holders can vote to change all basic parameters of the protocol.
The Decred protocol, a general-purpose cryptocurrency, has an on-chain voting system in which 75% of proof-of-stake nodes need to approve network hard forks.
ChronoBank, which aimed to create an ecosystem of stablecoins to pay employment industry workers instead of relying on short-term loans from banks, issued a TIME token that entitles holders to a portion of fees.
DigixDAO, which is launching a platform to issue tokens backed by precious metals, has a DGX token that confers to holders a portion of fees generated through the sale and trading of its gold- and silver-backed tokens and collected via smart contract.
Quadrant Biosciences offered Ethereum tokens via a reverse dutch auction that legally represent equity in the company.
Cryptokitties is an ecosystem of provably unique collectible and breedable cats, similar in spirit to Pokemon.
Some qualifying remarks warrant making. This memo does not discuss any hard differences between ‘utility tokens’ and other types of tokens—it is not clear this is a straightforward distinction. Likewise, the more widely recognized term ‘Security Token’ can be used to suggest a legal categorization that ‘Revenue-Sharing’ is strictly neutral on. In general, token function does not appear to be a determinant in their legal classification.
Similarly, while blockchain tokens are sometimes compared to equities, such comparisons can ultimately be misleading: equities represent financial instruments with legal rights to dividends and Board-level input. While the underlying companies may vary immensely, the relationship between a company and its equity is fairly standard.
Could assist with accounting.
It seems to establish a relationship between value and usage.
It is not clear anyone wants to hold the token.
Easily forked away or abandoned.
Enables decentralization of key components of the system.
The function on its own requires that only a portion of the network use the token, mitigating usability concerns.
Perceived value should track growth of system, aligning incentives among workers.
The token can make the network more resilient to 51% attacks.
Threat of cartel behavior and the influence of ‘whales’.
It is unclear whether token balance is always the best form of ‘license’ to perform work.
Can build user engagement.
Access to premium features can give token value without requiring it for platform adoption.
Provides an objective way to verify membership and allocate benefits.
Host platforms often need to rethink their business model.
Need to balance perceived benefit of the feature with the token price.
Token holders should have an incentive to make good decisions.
Can be a thoughtful way of gathering feedback if well designed.
Generally not enough of a benefit on its own to justify a token.
Easy to implement.
Blockchain does offer a means of rapid and micro-distributions.
Need legal enforcement mechanisms.
Token is rent-seeking and risks being forked away.
Benefits from existing market infrastructure.
Can help combat fraud and counterfeiting.
Need to acquire or create the asset in the first place.
May introduce a single point of failure as a result of custody infrastructure.
Finally, while token function is a vital component of cryptoeconomic design, a more perfect grasp requires understanding other interacting elements, such as supply, circulation, governance and management. Important questions in these domains include:
- How does the token supply change over time, and under what conditions?
- How does this match expected usage of the network?
- What is the organizational structure built around the token?
- What is the business model? Can the token change over time – and if so, how?
- How do the benefits or functions of the token get enforced?
Conclusion: More Token Types to Come and More to Understand
Like coupons, loyalty programs, or 'gamification', tokens and their economies may further prove a powerful tool for influencing and organizing contributor behavior, albeit through an incentive system with its own distinct set of constraints. Indeed, the large-scale economic activity prompted by the Bitcoin protocol emerged in response to a set of incentives that no one entity can arbitrarily change, and incentives in cryptoeconomic design are instantiated in a set of rules built around a provably scarce, tradable instrument of value—a cryptographic token.
Among Signals projects, value-transfer, unsurprisingly, is the most commonly implemented token function. This category includes both cryptocurrencies and so-called 'payment tokens'; many tokens in this category are supplemented with additional functions. Few Signals projects currently offer dividend or asset-backing functionality: while the designs offer notable benefits, the requisite custody and legal infrastructure required to fully support such offerings is relatively nascent and projects may be greater subject to regulatory uncertainties.
The industry has not yet seen the full range of tokens, their limitations, or their potential to incentivize new behaviors or develop new structures. With some exceptions, the products that depend on tokens are not yet mature enough to enter the mainstream, which has prevented wider appreciation of the diverse potential of thoughtfully designed tokens. Markets are growing and greater participation is still expected, and this will likely bring increased interest in the unique ways in which innovative token architecture can catalyze the emergence of new corporate and organizational structures. Smith + Crown expects that a variety of new primitives, templates, and standards will emerge to create a continuously evolving array of token features and community expectations.