Tokens & Cryptoeconomics

Cryptoeconomics refers to as the study of economic interaction in adversarial environments. The underlying challenge is that in decentralized P2P systems, that do not give control to any centralized party, one must assume that there will be bad actors looking to disrupt the system. Cryptoeconomic approaches combine cryptography and economics to create robust decentralized P2P networks that thrive over time despite adversaries attempting to disrupt the network. The cryptography underlying these systems is what makes the P2P communication within the networks secure, and the economics is what incentivizes all actors to contribute to the network so that it thrives over time.

Before the advent of Bitcoin it was commonly believed to be impossible to achieve fault tolerant and attack resistant consensus among nodes in a P2P network (Byzantine General’s Problem). Satoshi Nakamoto introduced economic incentives to a P2P Network to solved that problem in the Bitcoin White Paper published in 2008. While decentralized P2P systems based on cryptography were nothing new – see Kazaa and Bittorrent – what these P2P systems before Bitcoin lacked was economic incentive layer for coordination of the network of participants. Satoshi’s implementation of a proof of work (POW) consensus mechanism introduced a new field of economic coordination game, now referred to as cryptoeconomics.

In a crypto economic setup, economic incentives tied around a cryptographic token are considered to be the least common denominator for a multi stakeholder network like a (permissionless) Blockchain. Bitcoin is only the fist example for how token governance rulesets align stakeholder interests around economic incentives. While Satoshi tied Bitcoin’s token governance rulesets to POW incentive mechanisms, other Blockchains that followed have experimented with alternative consensus mechanisms like proof of stake (POS), proof of identity (POI), proof of burn (POB), etc.

 

Role of the Token

Native tokens of state of the art public & permissionless Blockchains like Bitcoin or Ethereum, are part of the incentive scheme to encourage a disparate group of people who do not know or trust each other organize themselves around the purpose of a specific blockchain. The native token of the Bitcoin Network, also referred to as Bitcoin, has token governance rulesets based on crypto economic inventive mechanisms that determine under which circumstances Bitcoin transactions are validated and new blocks are created.

These blockchain based cryptographic tokens enable “distributed Internet tribes” to emerge. As opposed to traditional companies that are structured in a top manner with many layers of management (bureaucratic coordination), blockchain disrupt classic top down governance structures with decentralized autonomous organizations (DAOs), where a group of people bound together not by a legal entity and formal contracts, but instead by cryptographic tokens (incentives) and fully transparent rules that are written into the software.

The Bitcoin Network can be seen as the first true DAO that provides an infrastructure for money without banks and bank managers, and has been attack resistant as well as fault tolerant since the first block was created in 2008. No central entity controls Bitcoin. In theory only a worldwide power outage could shut down Bitcoin.

With the advent of Ethereum however, tokens have moved up the technology stack and can now be issued on the application layer as dApp tokens or DAO tokens. Smart contracts on the Ethereum Blockchain enable the creation of tokens with complex behaviours attached to them. Today, the token concept is central to most social and economic innovations developed with blockchain technology. Something about tokens makes them an ideal proxy to understand the disruptive effects of blockchain technology.

Only permissionless ledgers (public Blockchains like Bitcoin or Ethereum), need some sort of incentive mechanism to guarantee that block validators to do their job according to the predefined rules. In permissioned(federated/consortium/private) distributed ledger systems, validators and block-creators may be doing their job for different reasons: ie if they are contractually obligated to do so. In permissioned environments, validators can only be members of the club and are manually and centrally controlled. Permissioned ledgers therefore don’t need a token. Also, please not that the term blockchain in the context of such ledgers is highly controversial.

 

Type of Tokens

There are different ways to differentiate between token. Some of them are outlined below. Please note that Crypto Economics is so new, that we are still in the early stages of exploring different roles and types of tokens. With every new Blockchain and every new application layer DAO  we will collectively learn by trial and error of what works and what not.

  • Usage tokens
    A token that is required to use a service. are based on services where ownership is required to use the service. Bitcoin and Ether are the best examples of usage tokens — token ownership does not give you any specialized rights within the network, but it does give you access to the service (the Bitcoin payment network and the Ethereum Virtual Machine in the case of BTC and ETH). Scarce tokens combined with a useful service can create massive value for token holders and entrepreneurs.
  • Work tokens
    A token that gives users the right to contribute work to a decentralized network or DAO (wether on blockchain level or smart contract level) and earn in exchange for their work. These tokens give individuals rights to contribute work to a DAO (and earn value) to help it function properly. That work can be serving as an oracle (in the case of Augur), being the backstop in a collateralized debt system (in the case of Maker), or securing the network (in the case of Ethereum when it switches to proof of stake).

These two types are not mutually exclusive and there are tokens that serve as both usage tokens and work tokens. An example of a token with both characteristics will be ETH when Ethereum transitions from proof of work to proof of stake.  Another way to differentiate between tokes is:

  • Intrinsic, native or built-in tokens
    of blockchains like bitcoin, ether, etc that serve as (a) Block validation incentives (‘miner rewards’), and (b) Transaction spam prevention. The logic behind this is that if all transactions cost some token, it limits the ability to spam.
  • Application Tokens
    With Ethereum, tokens can now easily be issued on the application layer through smart contracts on the Ethereum Blockchain as so called complex dApp tokens or complex DAO tokens.
  • Asset-backed tokens
    that are issued by a party onto a blockchain for later redemption. They are the digital equivalent to physical assets. They are claims on an underlying asset (like the gold), that you need to claim from a specific issuer (the goldsmith). The transactions as tokens get passed between people are recorded on the blockchains, and to claim the underlying asset, you send your token to the issuer, and the issuer sends you the underlying asset.

 

This section is quoted from Florian Glatz 2016:
A token is a socio-technological construct. It has a technological part, as an entry in a blockchain database and a social part — it’s raison d’être. The social component of a token is defined by an agreement between a group of people. In such an arrangement, tokens represent some aspect of the relationships between individual members of the group. Tokens derive value from faithfully reflecting the changes in those relationships over time. He distinguishes between four dimensions of a token:

  • Digital
    Tokens are the digital identity of something that can be owned by someone. Based on that premise, tokens can have a representational dimension, stretching into the physical, the virtual or the legal realm respectively. A token can be described as purely digital, if it has no such representational dimension. That’s the case for any blockchain’s base currency (i.e. bitcoin, ether, etc.) as well as for DAO-style tokens. The latter kind of tokens are used for different purposes within the organizational ruleset of a DAO. They can represent voting rights, ownership shares in the ‘company’, virtual stock options, and whatever else one might think of.
  • Physical
    Tokens can be bound to physical objects through a combination of software and hardware, or through contractual agreements respectively. Because physical objects are not always legally fungible, they may either be implemented with a list-based or a contract-based approach (v.s.). Tokens that are tied to physical objects through software + hardware, are referred to as smart property or smart objects. Smart objects are IoT devices that have an always-on connection to a network, through which they can communicate with (a subset of) the outside world. Additionally, they are capable of controlling their own usability through a combination of hardware and software features. A typical example for such an arrangement would be anything that can be controlled through an access mechanism such as a physical lock, as found in cars, buildings and many other kinds of physical infrastructure. For lack of a better position at which to place digital media files and software in general within the suggested token taxonomy, I am mentioning them under the category physical. Media files are controlled through access mechanisms as much as physical infrastructure, implemented, however, as ‘digital right management’ software, running on the appliances used to render digital media files consumable for human sensory organs. Tokens that are tied to physical objects merely through contractual agreements, rely on the legal system as the ultimate enforcement layer to sync on-chain and off-chain ownership of a given physical good. A good example would be many of the public services that may one day be offered on a blockchain-based infrastructure. Land registries are such an example, that is already being worked on. Since nation states are the ultimate regulators of physical space, they will have a tendency towards generic token manipulation rules, serving merely as simplistic functions to document the result of complex off-chain decision processes.
  • Virtual
    The virtual-reality dimension of a token is interesting because it reveals something fundamental. It is best explained with a comparison. Before the wide-spread diffusion of the PC and broadband internet access, the legal concept of copyright could be regulated through controlling physical media carriers as proxies (such as books, CDs, etc.). However, recent history taught us that intellectual goods such as films and books were only incidentally tied to physical objects. It turned out that the law, in a fundamentally phenomenological approach towards regulation, assumed that any intellectual good was at the same time an individual physical object that could be treated as such. Digitalization taught us that this assumption only holds true in a pre-digital world, which we have left forever behind. The Internet, for the first time since the invention of copyright, transformed intellectual property as a whole into its state of nature. Long before the zero marginal cost of reproduction became an economic reality, it was assumed that intellectual goods were at their core non-rivalrous, ubiquitous goods, i.e. something that cannot be localized in time or space, nor be exclusively ‘owned’ in the way physical goods are. However, because intellectual goods were tied to physical carrier objects by necessity, those properties were never actually realized in practice. Only when personal digital reproduction technology became ubiquitous, could intellectual goods become ubiquitous themselves.
    Virtual reality may, in case of a similar mass adoption as it happened with smartphones, disrupt another fundamental assumption in contemporary society. The assumption being, that the provision of digital infrastructure can be organized on today’s centralized techno-economic architecture of platform intermediaries. The reason why it cannot, is because private-access database silos are fundamentally incapable of mirroring our common notion of ownership and control. No prescription of “data portability” as envisioned in various regulatory models of platform intermediaries can sufficiently ensure the degrees of freedom physical space affords the human species, in the context of which our relevant notion of ownership originally evolved.
    It doesn’t actually need virtual reality as the ‘ultimate conclusion of digital’ to prove my point.[2] Already today the incompatibilities of our common notion of ownership in relation to digital resources is starting to show. One example is the use of artificial geo-fencing in the digital content market. Digital content providers create geographically-gated communities of users, each with their separate catalogue of available content. This creates friction when users travel across national boarders and are being served different content based on their geographical location. The European Commission now tries to control this phenomenon through a directive on the sale of digital goods and services. The suggested regulation would legally force service providers to more closely align themselves with their users’ understanding of ownership of digital resources.
    In that sense, virtual reality may become alongside IoT one of the fundamental driving forces of blockchain technology towards mainstream adoption. By tying virtual reality objects to blockchain-based tokens a realistic model of ownership with all the degrees of freedom available in physical space (and more) may be created.
  • Legal
    Lastly, tokens can represent property rights granted by law such as intellectual property rights, or contractually-defined rights established between two or more parties. In fact, those two kinds of tokens are closely linked when looking at e.g. intellectual property licensing databases, which are currently being built and popularized as a great match for blockchain technology. In their case, the same token represents a property right when resting with its creator and a contractual claim when resting with a licensee.
    Maybe the most relevant example though for tokens representing contractual claims are financial instruments implemented on a blockchain infrastructure. Currently, virtually every financial institute experimenting with blockchain technology is developing some form of a token contract. The only differences between them concern their permission rules and the types of transactions that can be performed on them.


A need for legal recognition!

The concept of blockchain tokens embodies the full potential of blockchain technology. Especially tokens that possess one of the representational dimensions laid out before, are closely linked to the traditional legal system. In order for blockchains to unfold their full potential with regard to reinventing ownership in the digital realm, the technology needs to be recognized de lege ferenda as a system capable of creating an objectively new ontological category. A new kind of thing, which deserves its own regulatory framework that reflects the unique affordances and constraints of blockchain technology.

 

On a more practical note…

Tokens can represent any asset:

  • An hours worth of rooftop solar energy
  • A currency such as dollar, euro, rupee, or gbp
  • A promise for a product in a crowdfund
  • A future download of a song from your favorite artist
  • An insurance policy
  • A ticket to an event

 

Tokens can be used as:

  • Token of ownership
  • Voucher to redeem for physical items on platforms that only permit the sale of digital goods.
  • Software license.
  • Stock certificates
  • Access rental cars or other vehicles
  • Ticket or access pass (party, concert, amusement park, ect. )
  • Automated road and bridge tolls
  • Access recording studio time, online game, a webcam, a wifi hotspot, toopen a locker or storage unit,  to access online storage
  • Customizable memberships or subscriptions
  • Pay per use exercise equipment
  • Crowd funding
  • Rewards program
  • Financial Instruments
  • Bond issuance
  • Derivatives
  • As a system of voting

 

Further Reading

A Blockchain Token Taxonomy, Florian Glatz
Thoughts on Tokens, Balaji S. Srinivasan
ICOs and VCs here, Fred Wilson
Fat Protocols, Joel Menegro 
Cryptoeconomics 101Nick Tomaino 
Tokens, Tokens and More Tokens, Nick Tomaino
Crypto Tokens and the Coming Age of Protocol Innovation, Albert Wenger
Crypto Tokens: A Breakthrough in Open Network Design, podcast with Vitalik Buterin, podcast with Olaf Carlson-Wee
Regulatory discussions , Coincenter
A gentle Introduction to Digital Tokens
Tokens on Ethereum, Consensys

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