Value of the token model

https://fehrsam.xyz/blog/value-of-the-token-model

Fred Ehrsam, Jan 2017

Since my prior post on app coins (I think the more appropriate term is now tokens or blockchain tokens) we’ve seen more and more projects use this model. The tide is turning. While over $1bn of venture capital was invested in Bitcoin and blockchain based startups up through 2015, 2016 saw over $100m of crowdsourced, non-venture money fund 60+ projects.

As momentum has increased, there have been some intelligent critiques of the model which help to hone in on the value a token really provides. I especially enjoyed these two, where the author argues it’d be more efficient to port the smart contracts of a token to use Ether directly, eliminating the token. He argues this will happen because 1) it eliminates the cost to convert between Ether and tokens, and 2) Ether will be a “better money” than any token because it will be more broadly used, thus more stable, so people will prefer to just use Ether. I want to succinctly describe the core value of the token model and address some of the common critiques below.

Governance People will want to have governance over their own communities separate from the global governance of Ethereum (or any other base blockchain). A token is necessary for this sub-governance. Not having sub-governance would be like anyone who owns USD being able to walk into a Google shareholder meeting and voting without owning Google stock just because Google shares happen to be denominated in USD. Or like everyone in the US being able to vote on the bylaws of a social club in San Francisco, just because it happens to exist in the US.

A token offers security to community governance. While anyone can buy a token with Ether, in order to meaningfully influence the governance of that token community they’d have to buy a lot, increasing the price drastically while doing so. Finally, if they voted on something bad for the community, they would be destroying the value of what they own.

It may be that the rules around some communities and their protocols can be static and thus don’t need governance — but I imagine most will want the option to evolve.

Monetary policy Ethereum may make monetary policy decisions like “let’s do 1% inflation to support the ongoing development of the Ethereum protocol.” A token built on Ethereum might want to do the same. And you’d want each to be able to do that independently. This is similar to what we are seeing with the Euro: you don’t necessarily want monetary union without fiscal union.

Aligning incentives Tokens align incentives between developers, contributors, users, and investors. They allow everyone who wants to contribute to a project early the opportunity to get in on the ground floor. This overcomes the classic chicken and the egg problem for systems based on network effects.

Addressing the original critiques “Just using Ether is more efficient because it eliminates the cost to convert between Ether and tokens”

The marginal cost argument for why it’s cheaper to do a contract on ETH is weak in my opinion. The cost of exchanging a token for ETH is already low at ~0.25% and will approach 0.

The more interesting economic force, in my opinion, is that Ether holders have a strong economic incentive to take any token protocol that works and port it directly to Ether. Let’s say Filecoin gets 30% of the Ethereum market cap. If Ether holders successfully port it — a simple matter of copying the code of the smart contracts — they absorb that value, and the value of their Ether goes up. So it seems like it will be tried. The question is whether or not it will work. In cases where a token is really needed for the reasons described above, I think the answer is no.

Separately, I wonder what happens here if/when tokens start to span multiple base blockchains. For example: what if Filecoin is its own virtualized blockchain, where its ledger state is maintained across blockchains. If that is possible, you can imagine a token not being dependent on any one blockchain.

“People will prefer use Ether instead of tokens because it will be more stable in value”

Holding/pricing in Ether instead of a token can be both a benefit and a drawback. On the benefit side, Ether may be more stable. On the drawback side, these communities may not want to be subject to changes in the price of Ether. This becomes especially true if tokens can start living across multiple base blockchains. In any case, I think this point is least important since holding tokens is not required because they can instantly be converted in/out of Ether.

Conclusion As with early internet startups, some token models don’t make sense. For every 1 huge hit there will be 3 minor successes and 100 failures, so we shouldn’t be surprised when some fail. However, the fundamentals of the token model are valuable and powerful. They allow communities to govern themselves, their economics, and rally a community in powerful ways that will allow open systems to flourish in a way that was previously impossible.

Thanks to Linda Xie.