Token Economics: A rising knack for decentralized investments

By Jayashree R.

Introduction
The history of the Web has undergone tremendous evolution from Web1 (Information Economy) to Web2 (Platform Economy) and now at Web3 (Token Economy) as illustrated in Figure 1. The blockchain technology, often referred to as Web3, has therefore become a path-breaking force which is driving the next-generation of internet. According to CoinMarketCap (2021), the total market value of all cryptoassets i.e., both cryptocurrencies (which are more than 7800 in number as of January 2021, according to E-Crypto News, 2021) and stable coins, is more than a trillion US dollars.

Figure 1: History of the Web
Figure 1: History of the Web

This article begins by shedding light on decentralized investments and tokens, including the various types of tokens followed by a de-mystification of the actual word token economics. Explaining the economics of tokens using two frameworks, the article goes on to show how the correlation network between the top ten cryptoassets (by market value) for the period spanning from 18th September 2020 to 8th July 2021, also plays a role in the value of the tokens. Thereafter, the article is concluded.

Decentralized investments
Having understood the scale and the revolutionary aspect of cryptoassets, it raises the question of how they are different from traditional assets like stocks and bonds. This is where the concept of decentralization comes in. Decentralized investments refer to investments that take place in the absence of an intermediary or exchange. Simply put, digital values in the form of tokens can be sent on a peer-to-peer network, with a set of computers maintaining the unique data associated with all the transactions (referred to as ledger) that have taken place on that network. This mechanism ensures that the problem of double-spending¹ is avoided (Voshmgir, 2019).

Tokens
With the term decentralization out of the way, this brings the focus on the next term i.e., tokens. As noted by Mougayar (2017), “A token is a unit of value that an organization creates to self-govern its business model, and empower its users to interact with its products while facilitating the distribution and sharing of rewards and benefits to all of its stakeholders”. In simple terms, tokens act as a fuel for a decentralized economy. There are mainly four types of tokens; currency token, security token, utility token and asset token (Rijmenam, 2018).

1. Currency token
Currency token being the most well-known of them all, is a medium that facilitates exchange of value, where the value is determined by the forces of demand and supply. The only backing for it is the demand from the market. Examples: Bitcoin and Ethereum are currency tokens which were plagued by the chicken and egg problem² just like the other new currency tokens. (Rijmenam, 2018)

2. Security token
Security tokens are those that offer a future stake in the company to the owner of the token. This stake could be in the form of price appreciation, dividends or a share of the company’s revenue. The primary feature, therefore, is that security tokens constitute an investment contract.

3. Utility token
Utility tokens have a specific use-case and are not developed as investments. Examples of use cases include boosting certain sectors such as real estate and banking, solving challenges in the supply-chain, ensuring financial inclusion and so on (International Banker, 2020). However, utility tokens can still appreciate in value when there is increased demand for the good or service linked to it. Therefore, utility tokens provide future access to the concerned good or service, just like obtaining loyalty points or a gift card. Example: Ether is a utility token that is used on the Ethereum blockchain which helps to code and run the smart contracts. (Rijmenam, 2018)

4. Asset token
Asset token which as the name suggests, is a token that is backed by an asset (physical or digital). The possession of the asset token indicates that the person owns the asset backing the token. It can be owned by multiple people with a provision to even license it for certain durations so that the asset can be rented out.

Token Economics
The first person to introduce the idea of Token Economy was B.F. Skinner, a Harvard psychologist, in 1972 (101 Blockchains, 2021). He believed that the tokenomics model could control the behavior of people by offering incentives that held value in exchange for desirable actions and penalizing to discourage undesirable actions.
Token Economics, also known as Tokenomics, is therefore a branch of economics which deals with the study of policies, ethics and economic institutions for the production, distribution and consumption of all those goods and services which are tokenized. In other words, token economics³ involves the complete economics of how a token will work after launching it through a Token Generation Event, commonly referred to as Initial Coin Offering (ICO). Wandmache (2019) identifies thirteen parameters which are necessary to understand tokenomics.

Token utility, value and token economics framework
If tokens make people perform certain desirable actions, this indicates that they derive a certain value from the tokens which puts the forward the question ‘How are tokens valued and what is the utility obtained from them?’. According to Mougayar (2017), the utility from tokens is based on three tenets — Role, Purpose and Features. As shown in Figure 2, the roles include the right to own a token, creation of a transaction economy between the buyers and the sellers since tokens are an atomic unit of value exchange, tokens mimicking the role of ‘paying toll on the highway’ to get onto the blockchain network, the various functions of a token like being offered as incentive for joining a blockchain network, being used as a mode for payment in transactions and sharing of any earning among all stakeholders due to possession of the token.

Figure 2: Token Utility and Value
Figure 2: Token Utility and Value

Tan (2019) provides a complete framework for Token Economics (Refer to Figure 3). It comprises of three parts — Market Design (Overall design of the environment), Mechanism Design (Overall design of the gears guiding the tokenized ecosystem) and Token Design (Design specific to the token being used, governing actions of the people using incentives). Unlike in traditional economics where the user choices and behavior are predicted based on the “given markets”, token economics do not consider markets as “given”. They involve a combination of insights based on economic and game theory, common-sense and the existing empirical findings.

Figure 3: Token Economics Framework
Figure 3: Token Economics Framework

Market design is further broken into three parts — Thickness (Size of the network), No Congestion (To avoid damaging the market properties) and Safety (To make it safe for users to transact). Mechanism design is also broken into three parts — Governance (To organize the transactions well), NFI (To achieve the objectives by strengthening the incentive mechanism) and Structure (To resolve information asymmetry by using contract theory). Lastly, Token Design is also broken into three parts — Token Policy (To know how the tokens will be governed, similar to the concept of monetary policy), FI (To increase participation in the network) and Architecture (Structure of property rights and payoffs from it).

Correlation Network of Cryptoassets
Having understood the complete theory surrounding token economics and decentralized investments, this raises the question that ‘Is the value of cryptoassets affected by the prices of other cryptoassets?’. To check for this, a correlation network of the daily returns⁴ (%) of the cryptoassets is plotted. For this purpose, the top ten cryptoassets are considered based on market cap (Forbes Advisor, 2021) which are as follows: Bitcoin (BTC), Ethereum (ETH), Tether (USDT), Binance Coin (BNC), Cardano (ADC), Dogecoin (DOG), XRP, USD Coin (USDC), Polkadot (DOT) and Uniswap (UNI). The time period considered is from 18th September 2020 to 8th July 2021⁵. Figure 4 shows the plot of the correlation network.

Figure 4: Correlation Network plot of all ten cryptoassets
Figure 4: Correlation Network plot of all ten cryptoassets

There is a high correlation among all the cryptoassets especially that Bitcoin and Ethereum has with the rest of the cryptoassets, which is in line with Bitcoin.com (2019) and Binance Research (2019). This indicates that since the price of cryptoassets are highly correlated, therefore, the value of these tokens would also be influenced by the price of the other tokens among other factors. This is similar to the price function in economics where the price of products like tea would also be influenced by the price of its substitutes like coffee (Fort, 2018). In addition, this high correlation can be explained by the convenience yield factor, i.e., when an investor sees that the price of any cryptoasset is positive, it creates an impact similar to what dividends do and that holding the cryptoasset beyond its cash flows seems like a better option (Chicago Booth Review, 2018). Accumulating this effect for all the cryptoassets will invariably result in a high correlation among the cryptoasset returns.

Conclusion
This article explains decentralized investments and token economics including the various types of tokens, the valuation of tokens, the utility obtained from them and a complete framework for understanding token economics. Using a correlation network plot, it was observed that there is high correlation among all the ten cryptoassets during the period 18th September 2020 to 8th July 2021 which is in line with Bitcoin.com (2019) and Binance Research (2019). The convenience yield factor seems to explain the high correlation among the cryptoassets.
With a rising knack for decentralized investments where the adoption rate is almost equal to the number of Internet users that were there in 1997 (Nasdaq, 2021), the process of designing mechanisms and incentives to always produce desirable behavior from the users will only become an even more herculean task. In addition, the different protocols and designs for each project require the approach to the valuation of tokens to be changed accordingly, further complicating token economics. On the other hand, the rising interest in decentralized investments at least ensures that the field of token economics will progress in leaps and bounds as there would be better models for token valuation and the understanding of the economics of it.

Footnotes

  • [1] Since the record of each and every transaction on the peer-to-peer network is unique and each token is thoroughly verified, the value from it can be spent only once. If a copy of each transaction file could be created, then the same value could be spent multiple times.
  • [2] The chicken and egg problem refers to the fact that for a currency token to be used by many users, it requires a high value and high liquidity. However, high value and liquidity can only be achieved if the currency token is used by many users. Therefore, it takes a long time for a currency token to appreciate in value. Note: The chicken and egg problem won’t apply to cryptocurrencies which are backed by the government since governments can create demand by forcing everyone to use the currency token.
  • [3] Refer to Krueger (2018) for the complete list of laws that the economic models of any new token should follow.
  • [4] The data for the close prices of the cryptoassets was obtained from CoinMarketCap (2021) and the returns were calculated as the % change in the close prices of the cryptoassets.
  • [5] The choice of this time period is because Uniswap launched its UNI governance token only on 18th September 2020 (Decrypt, 2021) and therefore, the common time period for all the cryptoassets was from 18th September 2020 to 8th July 2021.
  • [6] Refer to CRAN (2021) for the complete documentation of the qgraph package.
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