Tales of ineffective token models

What’s the utility?

A lot has been said and written about utility tokens, especially during the ICO craze and record setting bull market in crypto assets which peaked in December of 2017. We saw Bitcoin reach a dizzying price peak of almost $20,000 USD. Since Bitcoin is the first cryptocurrency and the primary coin in crypto asset trading pairs, it has a strong correlation with every other crypto asset.

This means when Bitcoin moves in price, other crypto assets tend to move with it, sometimes with price action that matches Bitcoin’s volatility, or even amplifies it. When Bitcoin rises, some crypto assets tend to outperform it, and the same is true when its price declines as well. We saw traders capitalize on this legendary volatility, making fortunes overnight, and referring to the phenomenon as “altseason”.

This is especially true for the thousands of token sales which took place during this period, in a craze known as ICO madness. The way many of these tokens were crowdfunded and marketed resulted in a distribution model in which the earliest participants were able to make outsized returns. Each subsequent round offered participants the opportunity to buy in at a slightly higher price, allowing the earlier participants to lock in profits. This model created a craze among retail investors eager to 10x their gains. It simultaneously created a craze among startups which saw the ICO model as a way to sidestep strictly-regulated fundraising models such as IPOs.
Lost in the excitement of the bull run of 2017

Around the same time we saw literally thousands of ICOs and token offerings, we started hearing people talk about a shift in the near future, in the fundamental way the global economy will operate. This is when we first started hearing people talk about the token economy. The token economy is the idea that eventually blockchain will disintermediate most of the central planning and control of our global economy, replacing it with a multitude of trustless, permissionless, and decentralized blockchain alternatives.

The idea is that it would allow for a free and permissionless user experience putting users in power of their own finances again. This paradigm shift that was being predicted was often referred to as the internet of value. Each of these projected platforms would have its own blockchain token which would be used on the platform, allowing people to utilize these blockchains, in ways that cut out the middleman taking a rent-seeking percentage. It all sounds absolutely amazing, right?

Well, there are several serious problems with this vision, first of all, the sheer amount of market over-exuberance caused a lot of poorly thought out tokens to get massive amounts of funding in their token sale. Second, blockchain technology itself hasn’t matured to the point to facilitate mass adoption, yet. Third, the regulatory climate is unclear, causing a multitude of compliance issues for the companies behind these tokens. Lastly, there is the fact that many of these tokens were just outright cash grabs, with very misaligned incentives, and no real advantages for token holders themselves. We saw many startups create token sales to get a piece of all that cash flying around, and also because they might as well have a token, everyone else has a token. It became a trend, until the bubble popped at the end of 2017. Let’s take a look at what is wrong with some of these token models.
Token models and the flaws they have in their current iterations

The most important flaw, is one that is true for any token that is issued by a business, corporation, foundation, known group of developers, or other form of centralized entity where the participants identities are known. That is, the risk of prosecution, fines and jail time. Finance is strictly regulated, and many tokens aim to offer a service that is seen as illegal under the current regulatory regime. Disruption can actually be a crime in some cases. Governments and regulatory agencies around the globe are also busy trying to figure out how they can exert control over decentralized protocols.

Their only option to exert control and influence over open source software that anybody can download and use, is to apply regulatory pressure to the pain points of the businesses in the ecosystem. We’ve seen regulators outlaw ICOs, pursue regulatory action against decentralized exchanges and forcing them to implement AML/KYC, fine blockchain projects for operating as unlicensed securities, even dish out prison sentences, etc. To avoid legal issues, blockchains must be devised in a way that cannot be regulated or enforced, if they are going to be breaking the rules.

Another major aspect of creating a token, that is almost never considered, is why do you even need a token to do that in the first place? The majority of blockchain solutions are not actually an improvement over centralized alternatives. They are slow, inconvenient, computationally expensive and inefficient alternatives. Some argue that decentralization is only needed for use cases that require sovereign-grade censorship-resistance, and that for everything else it’s a waste of time and resources. This would mean in many cases, blockchain is the wrong tool for the job.

There are two major models for token distribution, fair distribution and unfair token distribution models.

A fair token distribution is usually referring to a Proof of Work blockchain token which was distributed to miners through block rewards. There is no founders reward, no allocation for developers, Advisors, or any other scammy free token handouts. Tokens are earned through mining and anyone can mine without permission and participate by verifying transactions.

An unfair token distribution model, would include a “premine” where a certain percentage or amount of the token supply is given to the team of the project, kept by a foundation, kept by developers, or kept by the business behind the token, the advisors, or other team members. These kinds of token distribution models were at the heart of almost every token crowdsale and ICO leading to many people calling them scams.

This is because of the way a small group of people was able to exercise a controlling influence over a significant supply of the tokens. In some projects a small amount of people control over 50% of the total supply of tokens. This is basically the opposite of the decentralized distribution of PoW mining fair distribution. Airdrops were partly devised to get around securities laws (we’re not selling it, we’re giving it away) and partly to mitigate allegations of unfair distribution models.

Currently, on Coinmarketcap there are 2144 listed tokens or crypto-assets. These tokens can be broken down further into various token “types”. Many of the utility tokens are similar in the functions they perform on their respective blockchains, and can be classified into several archetypes:

Utility Tokens — Tokens said to be integral to using a blockchain platform itself, usually depicted this way to avoid being classified as an unlicensed, unregulated security offering. Utility tokens often have little to no actual utility and only exist to avoid regulatory compliance.
Reward Tokens — These tokens are actually unlicensed, unregulated securities. They pay dividends similar to an equity, and people bought them with the expectation of future profits. They are different than staking tokens, because they do nothing to help secure the network. Reward tokens usually pay out a percentage of the platform’s fees/earnings to the token holder, and have no other use case. We have seen many reward tokens start to move into Security Token Offerings (STOs) because they are really just securities in the form of a token.
Staking tokens — These tokens are probably one of the only true types of utility token, because they have utility for staking, which helps strengthen consensus and secure the network. Staking tokens usually have another role as well, such as being the smart contract gas token, or native cryptocurrency of the platform they utilize. Staking tokens are flawed in they way they incentivize participants, and do not provide the same level of security or immutability that a proof of work consensus does.
Decentralized Exchange (DEX) Tokens — These tokens are actually useful and do have users using them as intended, if you’re a trader, but their usefulness depends on the DEX and the token’s execution. DEX tokens usually function as a placeholder token to facilitate trustless trading on decentralized exchanges. In some cases they also grant users of a DEX to save on the fees charged by the platform, or to distribute these fees to token holders similar to reward tokens. DEX tokens can be very vulnerable if the governance of the DEX itself is poorly set up, leaving the business behind the DEX vulnerable to pressure and pain points, like enforcement actions, fines, jail, etc.
Smart Contract Gas Tokens — These are tokens which are used to pay the computational costs of Smart Contracts. They are useful to pay for smart contracts on smart contracting platforms like Ethereum. The issue is that smart contracts themselves haven’t matured yet, they are very unreliable, insecure, limited in their use, and all of these limitations create severe limitations on the usefulness of the smart contract gas tokens themselves. The computational expenses created by smart contracts also limit the usability of the contracts.
Platform Specific Payment Tokens or Loyalty Program Tokens — These are the most flawed kinds of tokens in my opinion. Platform specific payment tokens are dumb because chances are it’s easier and cheaper to use fiat or an already established cryptocurrency like BTC instead of seeking a specific token to purchase a specific good/service. Loyalty Program tokens are even less innovative, loyalty programs have existed for a long time and simply don’t need the added inefficiencies of a blockchain.
Burnable or Buyback tokens — Some token models try to solve the lack of demand for their token by “burning” tokens or “buying-back” tokens similar to stock buybacks. The rationale is that destroying a percentage of tokens at regularly scheduled intervals will push up token price by limiting supply and increasing demand for existing supply. There are a number of flaws with this model. There is no guarantee they will follow through, or implement burns in a way that benefit token holders. Buybacks in the Stock Markets are also seen as borderline fraud and very controversial.

Another major flaw with many tokens is the fact that the incentives devised to encourage users to interact in a certain way, are often terribly misaligned. This creates a situation were the team behind a project has one set of motivations, which come directly at the cost of the token holders which often have a diametrically opposed set of motivations.

The businesses selling these tokens are selling them to people who don’t know what they are buying. Many tokens include language in the fine print that claims the token has no value or use or rights for the holder as a way to avoid prosecution for selling unregistered securities. The people buying these tokens are often unaware of this fact and believe purchasing a token grants them a say in governance, an ownership share of the platform or some other nonexistent benefit.

The teams behind these projects are not accountable to token holders in anyway, and are often legally accountable to shareholders, or investors putting them at odds with the incentives of the token holders. They often have a legal obligation to maximize the returns for their investors and they siphon off the revenues of the platform away from token holders in order to pay equity investors and shareholders. We have a problem where equity is stealing value from the token’s price. This is a brief overview of the problems surrounding this issue, if you’d like a more detailed summary, this article here, is an in-depth explanation of these kinds of systematically flawed-incentives common to many token projects.

Along with misaligned incentives, we have an additional issue with the token’s valuation, and how it is calculated. A token’s value depends not only on demand for the token, but also the demand for the underlying protocol the token was created for. With equities, a company creates X amount of value, and captures Y amount of that value, this is what Profit to Earnings Ratios are used to calculate. If shareholders are capturing this value instead of token holders, this must be taken into account when calculating the valuation for the token in question. Often this problem with valuation is overlooked giving token holders a skewed view of the value of the tokens they are holding, and also their future value.

A massive handicap to tokens, their valuations, and their usefulness is the lack of liquidity for most tokens with small market caps. A token with little to no liquidity can be controlled by an investor with enough capital to push the price around. These small cap coins often have very little market depth, making it easy for a whale to push smaller traders around. A major problem is that this (or a different flaw) makes them unattractive to new investors ensuring that the market cap will never grow to reach the necessary levels of liquidity.

Another flaw in many tokens we see around the ecosystem is that they have no intrinsic value. There have been many attempts at creating intrinsic value into a token’s design, but for the most part they have failed. Attempts at creating value include rewards/dividends payouts, participation in governance, making the token a utility necessary for the platform, etc. None have been very successful at driving value creation. Most attempts have been ineffective gimmicks, a tiny band-aid to cover up a gaping design flaw.

There is also an overall lack of adoption in general, many people simply aren’t using the tokens at all. The reasons for this are quite complex and should really be analyzed on a case by case basis. Some tokens are obviously more successfully executed than others.

However, most of the people who own tokens own them for speculative value, not to actually use them for their intended utility purpose.

This is immediately apparent to anyone actually trying to use a DEX, DApp, marketplace or decentralized p2p lending platform.

For example, almost nobody is using any of the tokens in the top 100 of Coinmarketcap for anything other than trading and speculation. I highly doubt anyone is planning to use Civic as a real-world identity verification option, or waste time watching ads on Brave browser to earn an almost worthless amount of BAT which you’ll need to submit AML/KYC to even withdraw, (a wonderful feature for a privacy-focused browser, by the way). This lack of adoption can be seen on sites like DAppRadar which show the remarkably low amount of actual daily users. This lack of adoption is a direct manifestation of poorly thought out token design and misaligned incentives. In fact, most DApp tokens are totally unnecessary.

Some tokens allow token holders to participate in the decision-making or governance process, but most do not. This means that token holders have no say in the roadmap, goals or direction of the project. This can also mean that the team behind the token may make a decision which compromises the core vision of the project’s stated goals.

An example of something like this, would be the EtherDelta DEX implementing AML/KYC on what was supposed to be a DEX which allowed for anonymous token trading. Another example would be Tezos implementing AML/KYC on crowdsale participants months after accepting their money with no verification process. This lack of say can really leave supporters of the project feeling jaded when a radically controversial change is made without their consent.

Tokenization also adds unneeded friction to the user experience. What is friction? Well, when you shop online, you want it to be as easy as possible, to quickly make your purchase in as few clicks as humanly possible. You just want to click the buy now button. You definitely don’t want to have to:

Create an exchange account
Doxx yourself with AML/KYC
Deposit money from your bank (which could take days/weeks)
Buy Bitcoin or Ether
Then have to put in an exchange order for an obscure & highly volatile small market cap token
Wait for your order to go through
Withdraw the token to your own compatible and secure wallet
Then use it to purchase a specific service/good.

In a token economy as envisioned above, all of us would have a never-ending personal hell of having to transact in this overly complicated manner in order to use any service or purchase any good. Imagine having to keep track of hundreds of different coupons and vouchers that could immediately lose all their value at any moment, just because you may want to buy a service, or purchase something, or make a trade on a dex in the future.

That is the reality of holding a bunch of platform specific utility tokens that are extremely volatile due to speculation. There is no sane reason for anyone to hold a multitude of platform specific tokens that can instantly become worthless. This friction puts a heavy slowdown on adoption by making things too expensive, too slow, and way too inconvenient.

Yet another major flaw many tokens have is in their token supply cap. Many tokens have astronomical amounts of tokens in existence into the billions and even 100’s of billions of tokens in some cases. Since the tokens themselves are extremely divisible (think 100 million Satoshis in a Bitcoin), there is no scarcity to drive-up price. This can be a problematic issue for a token that has no intrinsic value in and of itself. Many of these tokens with extremely high supply caps, simply create artificial scarcity buy locking up a sizeable amount of tokens, but you have to trust that the profit driven company behind the token won’t dump them if the price rises (they always dump them when the price rises). More problematic is that only a few wallets end up with the lion’s share of the token supply, creating centralization in what was supposed to be a decentralized project.

On top of there being way too many tokens out there, most of them have almost no use case or incentive to use them. They may have some sort of gimmicky incentive to “bootstrap” a user base but there is nobody actually using them when you take a closer look. Most people holding tokens are holding them because they believe in the future they will have a higher speculative value which they can cash out at a later date.

The final point I want to make is that having a compliant blockchain project, defeats the purpose of having a blockchain project. Blockchain is supposed to be useful for trustless, secure, permissionless, decentralized and censorship-resistant transfers of value. Introducing financial surveillance tools like AML/KYC, regulatory compliance, or any other control mechanism currently used by regulatory agencies defeats the whole purpose.

Blockchain projects need to be designed in such a way that it doesn’t matter what governments, regulators, law enforcement or anyone else in a position of authority says. Blockchains need to be self-regulating through the consensus rules of the protocols themselves to enforce the rules of the network. There should be no need for outside oversight, because the rules should be enforced by those operating nodes. Introducing pointless centralization vectors defeats the goal of decentralization in providing trustlessness and censorship-resistance which is the only truly demonstrable use case of blockchain in the first place.
In Conclusion

Blockchain has been touted to be completely disruptive to so many different industries, just fill out this AML/KYC form, upload your passport, and accredited investors only, please.

See how ridiculous that sounds? If you’re not planning on breaking rules made by sovereign-grade adversaries, then you should probably just work on a normal database, because chances are your token is useless/worthless, and your blockchain would be better served as a normal web app or database.

I’m reminded of a joke browser plugin that was released during the peak of blockchain hype & ICO craze during 2017’s bull run. It was a plugin designed to make every appearance of the word blockchain in news articles appear as “multiple copies of a giant excel spreadsheet” instead of blockchain. While humorous, it has a high degree of truth to it’s punchline.

The first round of tokenization efforts can be chalked up to too much exuberance, a general misunderstanding of the technical aspects of blockchain platforms, and a wide range of industries being sold a dream about blockchain and tokenization that isn’t really useful for their business model. Many released tokens because they thought they had to, they wanted to use blockchain as a marketing angle, or simply because everybody else was doing it. Others were just scammers trying to cash in.

The good news is that we’ve seen a lot of developers realize that the first round of blockchain tokens leave a lot to be desired. We’ve seen a lot of debate on how to improve token utility models, how to create value, and bootstrap users. We’ve seen a lot of people experimenting with how they align the incentives on a blockchain platform. We’ve seen people improving on the existing aspects of tokens that worked already. We have seen a flurry of development with DApps, layer 2 scaling solutions, and decentralized applications. We have also witnessed a huge amount of growing institutional infrastructure being created to support institutional involvement needed to jump start mass adoption, as well.

Overall, I have a high amount of positivity for tokenization in the future. I do believe eventually all forms of wealth will be tokenized. I do think there will be a form of token economy, I just see major flaws with the rudimentary first steps that have been pursued so far. Before Bitcoin there was B-Money, HashCash and BitGold, so I do expect us to see various iterations and implementations of unsuccessful token models as well. So, as much as I knocked tokens and tokenization in this article, I still see tokenization as the path forward, just not the way it’s being carried out currently.

Originally published at https://blog.hype.partners on June 13, 2019.