The weird economics of utility tokens

(This is a copy of a post i made on Medium: https://medium.com/@tkktkk/the-weird-economics-of-utility-tokens-23721e5e671d)

Preface

There is a number of different use cases for tokens in the future blockchain ecosystem. Now, when I say “tokens”, I basically mean anything that provides some sort of means to identify ownership or custody, including Bitcoin, Ether and so on. I’ll try to refrain from using concrete names of projects where possible, but I consider Bitcoin and Ethereum to be fair game. For the purpose of this post, most tokens can be considered a utility token to some degree. For example, Ether powers the Ethereum network, with all its smart contracts and token transfers. In that sense, it is a utility token. But apart from that, if intentional or not, it is also a store of value, which, as we will see, is a good thing.
Also, let’s make a clear distinction between speculators and users here. Users buy a token to use it. Speculators buy a token in the hope that it gets more valuable in the future, often by assuming that users are going to use it. Of course, those two groups, as well as the different types of use cases (general usage versus speculation) can overlap.

How utility tokens work: the dumbed down version

The easiest way to think of utility tokens is to think of them as coupons: Generally speaking, a utility token is a means of payment for specific services. Other than money, they are not supposed to be used for — well, anything money can buy, but for a range of services defined by the issuer. That doesn’t mean that they can’t turn into a type of money. Stamps did become a means of payment in a lot of cases, as a non-blockchain example. Ether was supposed to be a utility token, but turned into a store of value and a means of transfer value and has at this point definitely money-like features. But the main assumption is this: a customer wants to use a service or buy a good, but instead of paying with it through regular means, they do so by using a dedicated token. If we ignore the underlying dynamics of a purely speculation-driven market, speculators assume that at some point, mass usage will set in, which will drive up the price.

First and foremost, a lot of utility tokens make the downright stupid assumption that users are actually willing to jump through all the hoops necessary to aquire these tokens, then use them to pay for the service. And even if we were to assume that at some point, these token transfers would be automated by an app and the user wouldn’t need to bother with all the hoopla, I’m sure that when a dedicated token is technically not needed, the project will be copied (yay, open source!) and more broadly used payment methods (e.g. ETH) will be implemented. At that point, dedicated utility tokens will be a means of getting a discount at best: to stay competitive, the token-based version needs to be cheaper to use.

But let’s assume that at least some utility tokens gain a status of regular usage. there’s three possible ways to determine the price of a service:

1.: The number of tokens per unit is fixed.

2.: The number of tokens per unit is determined by classic supply and demand.

3.: A mixture between the above.

The first way is problematic, because it gives speculators too much power over the prices of the service provided. Instead of being driven simply by people wanting to use the service and providers willing to provide the service to certain conditions, a third party manipulates the price.

Flexible token prices are good for users, but dangerous for speculators

For the provider and the user, the second way is preferred. In the overall sope of things, a user doesn’t care whether they have to pay 100 tokens today and 10,000 tomorrow, as long as the amount of factual money they spent remains roughly the same. At the same time, this means that neither the user nor the provider have an incentive to hold the tokens for future use. Both of them want to have some sort of predictability. Buying them in advance would pose the risk of being unable to use them as effectively, should the number of tokens needed go up significantly, keeping the tokens would become speculation.
This also means that the actual price of the token has close to zero impact on its usability, as long as there are enough tokens available. So, usability-wise, liquidity becomes the deciding factor. Users, as well as providers, who buy and sell tokens if needed, don’t need to care whether a single entity holds 90 percent of the token and might completely crush the market, as long as the remaining ten percent, or whatever the actual openly available amount is, is enough to power the system, which, with big numbers of tokens, as well as possible fractions often going down to the sixteenth degree, should be possible in just about any case. You could almost say that a token which is almost infinitely divisible, both in a practical and in a market sense, has almost infinite supply from a users point of view. Considering trhis factor alone, it seemingly has no applicable value in the direct sense.

On the other hand, this means for speculators that there actually is not the slightest incentive to favor one token over another, from a purely usage based analysis. From a speculators perspective, all those tokens, as well as their usage-based price projections are absolutely interchangeable. Instead, the only metrics remaining are in fact market dynamics, rich lists, market based sentiments and so on.
This doesn’t mean that sentiments about the usefulness of a given token doesn’t influence the price, but for the most part, these sentiments are pretty much fake and not more than action triggers, something the crypto market as a whole is very prone to do: a few years back, rebranding was all the rage and projects with no technical improvements whatsoever significantly moved up in price, just by changing their name.
I’d expect sentiments like that to still have influence on the price, but not because it makes sense in a hard economic way (as in “more usage = higher price”), but because speculators are playing a game, whether they are aware of it or not. In this game, outside influence pretty much triggers dynamics without having a factual effect on them.

Why all this stuff is stupid and nothing works like that

This all sounds like it makes a lot of sense, right? Well, not exactly. Obviously, other factors will still have impact on the price and other, smarter people than me figured out the same thing as well and are actively trying to give tokens a value by giving them other use cases, in addition to the fundamental use case of paying for a specific service. Providing collateral to be able to actively participate in the system is something I’ve seen, as well as passive income means. It is a dangerous thing to build in these means without having any other use case than positively influencing the price for a number of reasons. Catering to speculators to initially sell the token can harm the project in the long run, if done in a less than optimal way.
My main takeaway is this: actual usage of a token has almost no influence in the determination of the value of a token from a speculators point of view.