Tokenomics

Chapter 1. Once Upon a Token

Note

The future is decentralized and the future is tokenized.

Out of all the technological advancements that humans have achieved throughout history, the creation of a simple token on a simple digital distributed ledger has the potential to redefine the very meaning of value. This is because the underlying technology, which will be discussed throughout this book, will open up new markets, and these new markets will enable everyone to connect, participate, and exchange value in ways we never thought possible.

We are already seeing snippets of this, such as being able to send value around the world in seconds at a fraction of the normal cost; crypto and token markets trading 24/7 instead of having to close at the end of each business day and all weekend, and, of course, accessing permissionless markets with just a computer and an internet connection.

In this chapter, we start off the journey by introducing some high-level concepts. We will talk about the exciting technology in more detail in subsequent chapters. This first chapter looks at the idea of a network of markets, explains what tokenomics is and paints a picture of a tokenized economy.

These concepts should become clearer as you progress through the book and hopefully, by the end, you can join the network of dots and make your own connections.

We may be surrounded by fancy words, such as "tokenomics" or "blockchain technologies", but beneath it all we are humans trying to connect. We must connect in order to communicate, produce, create, and exchange, all within a market.

A network of markets

Markets have existed for as long as humans have engaged in trade and markets have emerged as a natural process of social coordination. The evolution of markets is constant, through a series of technological discoveries that help these markets to become more efficient.

Money has helped to facilitate trade and make markets much more efficient than bartering. In fact, it was around 5,000 BC that scripts first appeared and then around 2,500 BC when the first coinage appeared. With the onset of the agricultural revolution, and the rise of cities and kingdoms, an economy of favor and obligation didn't work. Therefore, money was invented as a much-needed solution.

Money allows participants within a community to compare quickly and easily the value of different commodities, and to easily exchange one thing for another. Cowry shells were a very popular representation of money used for thousands of years in Africa, South Asia, East Asia, and Oceania (Sapiens: A Brief History of Humankind, Yuval Noah Harari). Fast-forward a few thousand years and computers have made updating stock prices much more efficient than using chalk and blackboards, but how have networks and markets developed?

Naval Ravikant, the CEO and founder of AngelList, a website for startups, angel investors, and job-seekers, wrote a very insightful 36-tweet tweetstorm in June 2017 about a network of markets. Here is a summary of Naval's key points:

Blockchains will replace networks with markets. Humans are the networked species. The first to network across genetic boundaries and thus seize the world. Networks allow humans to co-operate and to allocate the fruits of our co-operation. It is this overlapping network that helps to create and organize society. Physical, digital, and mental roads connected us all together. Money is a network, religion is a network, a corporation is a network, roads are networks, electricity is a network, and all these networks must be organized according to rules. They require rulers to enforce these rules against cheaters. (https://twitter.com/naval/status/877467629308395521).

Ravikant further explained the different types of networks, such as social networks, the search network, the telecommunications network, and networks run by the elite, such as the university network, the medical network, and the banking network. The most exciting network mentioned was the blockchain network:

"Blockchains are a new invention that allows meritorious participants in an open network to govern without a ruler and without money. They are a merit-based, tamper-proof, open voting system where the meritorious are those who work to advance the network. As society gives you money for giving society what it wants, blockchains give you coins for giving the network what it wants".

The tweetstorm contained some very deep concepts (you may want to refer back to this when you reach the end of this book) that can be encapsulated by the very first tweet:

Blockchains will replace networks with markets.

Without having to understand what a blockchain is, but accepting that it is some technology that can enable the transfer of value without involving an intermediary, this statement conveys the idea that there is a technology that has come along and, for the very first time, allowed the creation of a network of markets, which is profoundly more powerful than the network of information.

These networks are essentially Open, Random, and Supportive (ORS)®, which is a concept expanded on in Chapter 9, Social Media and Influencers. Open and random mean permissionless because anyone can join the network at any time. Supportive means that these networks are neutral, censorship-resistant, and democratized.

This network of networks will also have to be interconnected because, as we've seen time and time again, the world will never agree on a single ledger or a single platform, as long as each provider wants to own the network.

Consider this: the largest taxi company in the world (Uber) owns no cars, the largest media company (Facebook) creates no content, the largest accommodation provider (Airbnb) owns no hotels, the largest e-commerce companies (such as Alibaba) own no inventory, and a $130 billion USD currency (bitcoin) has no CEO, no bank branches, and no customer support. What do they all have in common? They all have a network, be it of cars, rooms, suppliers, or trust (https://techcrunch.com/2015/03/03/in-theage-of-disintermediation-the-battle-is-all-for-thecustomer-interface/).

The Internet of information

The internet has allowed access to vast amounts of information and the ability to communicate with anyone in the world from a device in the palm of our hands. It has been a mammoth effort from contributors around the world putting all this information online. Need to know how to cook your better half's favorite dish? The chances are that the recipe will be online and there will probably be a video showing you step-by-step the process of cooking it too. In fact, it was reported that "how to" video searches have surged 70%, with over 100 million hours watched in 2015. (https://searchengineland.com/youtube-how-to-searches-up-70-yoy-with-over-100m-hours-of-how-to-videos-watched-in-2015-220773).

Near instant access to any kind of information was a scene from science fiction movies only several decades ago, but this has now become a reality. The ability to access this information and knowledge, and to communicate, has transformed multiple industries, such as media, telecommunications, and health, and the list goes on. What this information didn't change, though, was how value was transferred because intermediaries were still required.

Take the action of purchasing a pair of shoes online. The payment from the consumer to the producer was not a straight line between two parties but often a zigzag, with multiple intermediaries involved. This was necessary because there was no other way.

Another example is the political system, where when we vote for a representative, we are transferring the rights of our political value to the representative, so that he or she can represent our views for a certain period of time. We have always used intermediation as a tool to scale our society and this was required because there was no better technology to do anything differently.

We have since discovered, or perhaps, more appropriately, we knew all along, that this intermediation is not perfect. Look at financial institutions as an example: it could be argued that banks are the reason that more than half of the world's population has been excluded from basic financial services.

Then comes the predicament where these intermediaries or representatives, once they get big enough and the value they accumulate is large enough, have more incentives to service their own interest than those that they represent.

This leads us to the question: why is the internet that we know and love, that has changed so many aspects of human society, not managed to enable us to transfer value? The reason is relatively simple: information can be almost infinitely replicated without cost. The same music file can be downloaded millions of times, or a digital image can be replicated, shared, and used many times over, all for almost zero cost. This problem didn't have an answer in the decentralized world, until the invention of bitcoin.

Bitcoin, a digital asset, was really a blockchain technology that presented itself as bitcoin. Many people then incorrectly thought that bitcoin was the first application of the blockchain technology. More on this in Chapter 2, A Bit of Coin Theory. This is analogous to the development of other technologies, where there was some product that embodied the technology, but as the technology matured, there were different designs aimed at different use cases.

Take, for example, automobile technology, where the goal was to get from point A to point B quicker than on foot or horseback. This technology then developed to getting from point A to point B with a heavy load (a truck), or with a group of people (bus), or even with renewable energy (electric cars). This design-driven approach is focused on one specific use case, rather than a generic design that fits every use case.

Blockchain is similar because there are thousands of token projects searching to find the right use case to focus on and be successful at. The challenge, though, is to look beyond bitcoin because the modus operandi is that we only see what we already know. Many thought PCs were just powerful typewriters and the internet just a place where computer nerds hung out. In fact, Keynesian economist Paul Krugman, who was awarded the Nobel Prize in Economic Sciences in 2008, wrote an article in 1998 on the topic:

"The growth of the internet will slow drastically, as the flaw in 'Metcalfe's law'—which states that the number of potential connections in a network is proportional to the square of the number of participants—becomes apparent: most people have nothing to say to each other! By 2005 or so, it will become clear that the internet's impact on the economy has been no greater than the fax machine's. (http://web.archive.org/web/19980610100009/www.redherring.com/mag/issue55/economics.html)."

We all know now that the internet's impact on the economy is much greater than the fax machine, but it was Krugman's most recent article, in July 2018 in The New York Times, that had many critics up in arms:

"In other words, cryptocurrency enthusiasts are effectively celebrating the use of cutting-edge technology to set the monetary system back 300 years. Why would you want to do that? What problem does it solve? I have yet to see a clear answer to that question" (https://www.nytimes.com/2018/07/31/opinion/transaction-costs-and-tethers-why-im-a-crypto-skeptic.html).

It is almost impossible to see the full potential of any technology from the beginning. Bitcoin may be that powerful typewriter but we must wait for its true potential to reveal itself in the next decade or so. This is because bitcoin is the first network of networks for the transfer of value without requiring an intermediary.

The Internet of value

The Internet of value allows important things in an economy or market to be transferred, instead of just information. The difference between information and value is the scarcity: if you give information to someone you still own it, but if you transfer value to someone, you do not own it anymore. Examples include stocks, intellectual property, art, music, votes, identity, and, of course, money. The Internet of value provides the ability to move value as easily as we move information.

Being able to send the same $1,000 to more than one recipient is not a good idea and this is known as the "double spend problem," which is explained in Chapter 2, A Bit of Coin Theory. The problem has previously been managed through intermediaries, such as banks, governments, and numerous other third parties, to establish trust in our economy. They provide the service of identifying people, verifying, clearing, and settling the transaction, and keeping records, so that you cannot spend the same $1,000 twice.

The result, over time, is an increase in cost, a reduction in value, and the exclusion of a large number of people from the global economy. These intermediaries also capture our all-important data. With this new technology called "blockchains", or more accurately "distributed ledger technology", there is a decentralized network where trust is native to the medium. Value can be created, transferred, or exchanged and participants trust the network and the mathematics (believe it or not, the world we live in is governed by the laws of mathematics).

In this Internet of value world, value is represented by none other than a token and the value it represents is governed by the various laws of economics, where the simplest is supply and demand. This has given rise to the concept of tokenomics.

What is tokenomics?

The word "tokenomics" is a portmanteau, or combination, of the words "token" and "economics" and it is a relatively new term that rose to popularity in the middle of 2017. As with anything new, the meaning has yet to be standardized, with many industry leaders attempting to provide their own definition. This is similar to attempting to define blockchains or the internet in the early days, as there are a range of ideas that are encapsulated within the idea of tokenomics.

Tokenomics, however, encompasses the concept of the study, design, and implementation of an economic system to incentivize specific behaviors in a community, using tokens to create a self-sustaining ad hoc mini economy. It includes game theory, mechanism design, and monetary economics.

If we think back to the loyalty points we get from our local supermarket or an airline, when we collect or redeem them some of us analyze the economics. For example, I need to purchase another $50 worth of groceries in order to receive a $15 gift voucher because it only gets paid out after 200 points have been collected, and I'm on 195 points ($10 of spending for one point). Another example is asking how many flights do I need this year to achieve gold status and how many flights do I need to maintain gold status? Anyone who has gone through these scenarios could argue that they were analyzing the tokenomics of the loyalty points system.

Tokenomics was selected as the title of this book because with all the ICOs in the last few years, and this new tokenized economy that is emerging, token supply, inflation rate, and even the various incentive schemes can all be encapsulated into this word.

Micro and macro

In economics there are two major fields: microeconomics and macroeconomics. Microeconomics focuses on individuals or companies, which could mean studying the supply and demand for a specific product or the production that an individual or business can produce. Macroeconomics focuses on the aggregate issues that affect the overall economy, such as the gross domestic product of an economy or the effects of imports or exports.

Tokenomics is similar. Microtokenomics can be considered as features that drive the functions of individual participants within a blockchain economy. Examples include mining rewards and how they change over time, and the mechanics needed to adjust the token supply, demand, and velocity, such as vesting periods, the mining difficulty, and the inflation rate.

Macrotokenomics consists features that relate to the interaction with the wider blockchain economy and they tend to include governance (such as who decides what the next new feature is), the participant interaction within the ecosystem, and also the external factors of the token growth and volatility (such as the utility of the token and the liquidity on exchanges). It is the interaction of all these variables that produces what is known as a 'token economy.'

First occurrence of the word

One of the earliest occurrences of the word was in a tweet with the hashtag #TOKEnomics, in March 2012, from DJ Hustlenomics, an American rapper:

Figure 1: One of the earliest uses of the word "tokenomics" by an American rapper. (https://twitter.com/DjHustlenomics/status/185205191480582144)

'Hustlenomics' was the second studio album by American rapper Jasiel Amon Robinson, who is better known for his stage name 'Yung Joc.' Needless to say, this was probably nothing to do with blockchains or the new decentralized economy.

The next occurrence was from someone on Twitter with the handle @thewayoftheid. Again, we can probably safely assume that Jamie is not talking about blockchains to @Mami_LongLegz:

Figure 2: Another use of the word "tokenomics" on Twitter in December 2013. (https://twitter.com/thewayoftheid/status/416599434097463296)

Almost a year later, in August 2014, there was a more relevant tweet from Dave Feuling, or @GoodForOneDrink, who tweeted Enjoying Tokenomics at the good ol Hammond Hotel. Feuling explained where he heard the word from:

"A local bar (no longer in business) held Tokenomics on Wednesday nights for a certain length of time. It was called this bc (sic) every drink you bought awarded you a drink token that was good for one free drink of equal or lesser value. It was basically a special happy hour" (https://twitter.com/seandotau/status/1024041929158221824).

This tweet may not be directly referencing blockchains or ICOs, but we are getting closer because there is a token involved that can be redeemed for a drink at the Hammond hotel in Wisconsin, USA:

Figure 3: The earliest mention of the word "tokenomics" that has reference to an actual token (https://twitter.com/GoodForOneDrink/status/497159085721391104)

Fast forward to March 2015 and the word "tokenomics" was mentioned again in a tweet by @mmoblogosphere, who was actually referencing @casualnoob blog post titled Tokenomics. @casualnoob is a female blogger with the pseudonym "Da Cheng", who is a mage (a magician) character in the computer game World of Warcraft (WoW).

Figure 4: A blog post on tokenomics, analyzing the WoW token

The tokenomics blog was in reference to a WoW token released by Blizzard Entertainment and "Da Cheng" analyzed the economics of the token. Essentially, Blizzard created two in-game tokens. One token could be bought from Blizzard for an initial price of $20 per token and another could be sold to Blizzard to add 30 days of game time to your account. The final tokenomics recommendation from "Da Cheng" was:

"Recommendation: buy Gold WoW tokens on day 1. Buy all you can afford. There will never again be such a concentrated glut of sellers. The price will never drop to 40 000g again. Don't buy $teel WoW tokens before week 5, once the upward price momentum of gold tokens is obvious."

The final occurrence before the floodgates opened wasn't until June 2017 (https://twitter.com/search?l=&q=%22tokenomics%22%20since%3A2014-07-03%20until%3A2017-07-04&src=typd&lang=en) by William Mougayar, a thought leader in tokenomics, who wrote an article titled Tokenomics — A Business Guide to Token Usage, Utility and Value. (https://medium.com/@wmougayar/tokenomics-a-business-guide-to-token-usage-utility-and-value-b19242053416). Mougayar provided a detailed analysis, where he defined a "token" as just another term for a type of privately issued currency.

Figure 5: The tweet that opened the floodgates on the word "tokenomics." (https://twitter.com/wmougayar/status/873912937676779522)

The token economy

Note

Token economy: A system or marketplace where decisions are made driven by economic incentives of digital tokens.

Burrhus Frederic Skinner, or more commonly known as B.F. Skinner, was an American psychologist, behaviorist, and social philosopher who used the term "token economy" in 1972 in a video titled Token Economy: Behaviorism Applied" (https://www.youtube.com/watch?v=fyFzPgIy-0g). Skinner used this concept in the context of using physical tokens in a program of therapy for the treatment of criminals and the mentally ill. As a side note, the writer of the famous American animated sitcom The Simpsons, Jon Vitti, named the "Principal Skinner" character after B.F. Skinner (The Simpsons season 2 DVD commentary for the episode "Principal Charming" [DVD]. 20th Century Fox).

One of the major teaching techniques was using a token economy with the students. A token economy was very simply a structured learning situation, where tokens, or little plastic chips, were used so that students could earn tokens in a wide variety of ways. This always involved learning more appropriate behavior.

The meaning of a token economy or tokenized economy in 2018 contains the same concepts, but it is applied in a different context. Little plastic chips have now been digitized into tokens and instead of students earning tokens, anyone can earn them and the structured learning environment has now changed into a new digital world, where anyone can participate.

The underlying infrastructure that has allowed this new token economy to flourish is blockchains, which are the equivalent of an ad-hoc miniature economy. In this economy, you have a group of people, or entities, who are all interacting with each other, making decisions, co-operating, and even competing with each other. The driver is an underlying software that enforces the rules created by the original author(s) and it governs how the interactions will unfold.

What is interesting is that all these miniature economies are powered by their own specially created token. Why do these token projects do this? The answer is: because they can. The marginal cost of creating a new token on a platform designed for creating tokens is almost nothing; however, gaining adoption is a totally different challenge.

This leads to the concept of a minimum viable economy, where if traction or critical mass is achieved, the economy can self-sustain and self-govern. Otherwise, it collapses and new ones form very quickly, and it's the low barrier to entry that allows this to occur.

The token is interwoven throughout the business model, providing a way to reward and incentivize the network participants, customers, and stakeholders. This focuses innovation at the token level, as the blockchain infrastructure is already provided, along with other requirements, such as consensus algorithms and the creation of a network.

There are key questions to consider around the tokens with a token economy. For example, is the token tied exclusively to a product usage or a network? The current answer is almost always yes. Other key questions include: does the token provide the owner with special privileges or ownership? Is the token required to run a smart contract or is it used to pay for usage? The answers to these questions are all varied and unfortunately, they depend on the design and context.

The most important question, though, is whether having a token is an absolute necessity in solving the problem. In other words: if digital tokens and the blockchain technology had not been invented, could the problem still be solved?

A unique aspect of the token economy is around the distribution because the key is to get the tokens into the hands of as many users as possible, so they can be used. This is because in this miniature economy, your products or services can only be used or traded with that token, which means that if you provide a valued service or product, that token eventually comes back to you. This circulation between stakeholders is very important. The most successful token projects will be the ones that can solve this challenge or even gamify it.

Marc Andreessen, co-founder of Netscape and venture capitalist firm Andreessen Horowitz, famously stated, Software is eating the world. In his 2011 article, he outlined that the world's largest bookseller, Amazon, is a software company; the largest video service by subscriber, Netflix, is a software company; and music companies like iTunes, Spotify, and Pandora are also all software companies. The list keeps going, with the likes of Skype in telecommunications and Pixar for animated movie production and Andreessen added, Software is also eating much of the value chain of industries that are widely viewed as primarily existing in the physical world (https://a16z.com/2016/08/20/why-software-is-eating-the-world/).

Nearing a decade on, the manifestation of the physical world is slowly being recreated in the virtual world and the missing piece of the puzzle has been discovered: the ability to transfer value in this virtual world with trust. This is how and why the token economy will continue to grow and develop. The tokenized economy starts with the digitization of the physical world and ends with the realization of the virtual world.

What does the current tokenized economy look like?

A token economy may be hard to conceive because it is not really tangible, like physical assets or your local bazaar, but there are digital tokens being created every day for all sorts of uses. The following image shows only the top 10 out of the thousands available and these thousands will grow further in the coming years. The reason for the growth is because of the new network of markets that is being created.

Figure 6: A list of the top-10 tokens, out of thousands in a token economy, from CoinMarketCap.com

What is tokenization?

Tokenization is the process of converting the rights of real-world assets into a digital token, stored on a blockchain or decentralized ledger. The simplest analogy is democratizing ownership of real-world assets, where the value stored in some physical asset, such as real estate, is represented as a token. For example, if you had an apartment valued at $1,000,000, one million USD tokens could be created to represent the value of the apartment at $1 per token.

The one million token supply is totally arbitrary. The one million tokens could then be freely bought or sold on an exchange and if you bought 500,000 tokens, you would effective own 50% of the apartment, and the various rights and benefits associated.

This concept is not new, as anyone can create tokens and record the token history using a regular database, managed by a trusted third party, but the novelty now is that it can be done in a decentralized fashion and nobody can "erase" your ownership of these tokens. This is the key tenet of this blockchain technology.

Real-world assets, such as artwork, stocks, and gold, are just the first step because the same thing can be done with digital assets and intangible assets, such as carbon credits, patents, and copyrights. These tokens and their exchange are what creates this token economy. What's more, every brand, every artist, and every community can tokenize its economy with the ability to incentivize early adopters or reward loyal follows within this economy. This is the equivalent of being able to communicate value on a new level. Think of it as loyalty points on steroids.

The tokenization of everything

We've seen the ability to tokenize anything, from the physical and tangible to the intangible. The next logical question is why?

First of all, when assets are tokenized, they unlock liquidity. The value you have in your property is regarded as illiquid because there is no easy or quick way to access the capital stored there. Tokens representing the value of your property can be traded much more easily and hence they are more liquid.

The technology the tokens live on allows greater access to everyone. It may not be to the extent that all you need is a computer and internet connection, but it will be much more democratized than what we have at present.

This increased participation results in greater ease of trade, by bringing in more liquidity and efficiency to a market.

Tokenization enables new economic models, such as fractional ownership (investors can own a certain percentage of a certain asset), therefore users can purchase a smaller, more affordable portion, rather than an expensive whole portion.

Through fractional ownership, more diversification of risk can be obtained. If a valuable piece of artwork was destroyed in a fire, an investor would lose only the proportion of that which was invested.

Tokenization reduces administrative expenses and with smart contracts and an immutable audit trail, auditing and compliance become a lot easier and quicker for regulatory bodies.

It would be presumptuous to assume that tokenizing assets is without its challenges.

The most obvious one is trusting the issuer. Market participants need to be confident that they can redeem their real-world asset at any point in time. Whether it is the ability to redeem the five gold tokens for one ounce of gold, or the 2,000 tokens representing a fraction of a property for USD, if the token is not redeemable or exchangeable, then the token is worthless.

There is still a cloud of uncertainty over the regulations of tokenized assets. Governments and relevant regulatory bodies around the world are closely following developments and currently the default is to apply existing laws to these new scenarios.

Legal enforcement of token ownership and rights has yet to be tested in a court of law, particularly around the recovery of damages and liability. This will no doubt set a precedent if and when it occurs.

Digital identity and relevant Know Your Customer (KYC) requirements and anti-money laundering laws need to be met, and most probably integrated into the token platform, to satisfy the requirements of the various relevant regulators and financial market authorities.