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. Notes: This figure illustrates the various stages of evolution that the Web has undergone in the context of the blockchain technology (Voshmgir, 2019).

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.

Table 1: Tokenomics parameters, sample findings and research findings.
Notes: This table illustrates all the tokenomics parameters, along with a comparison of the sample findings and the research findings (findings from the literature), as analyzed by Wandmache (2019).

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. Notes: This figure illustrates the utility and value obtained from tokens based on the role, purpose and feature of the token (Mougayar, 2017).

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. Notes: This figure illustrates the complete framework for understanding Token Economics (Tan, 2019). NFI stands for Non-Financial Incentives and FI for Financial Incentives. In Mechanism Design and Token Design, the words to the left of the line are factors that enable user participation and the words to the right are the factors which are highly automated (governed by the code written). It is important to note that the relevance of these variables depends on the use-case, function and business model of the token. Another thing to note is that this framework only considers the endogenous variables and not external variables like the popularity of blockchain, the legislation surrounding it, and so on.

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. Notes: This figure shows the correlation network between all ten cryptoassets as mentioned above. Positive correlation is denoted by a green line and negative correlation is denoted by a red line. The thickness of the line indicates the strength of the correlation between the two cryptoassets in the nodes. The thicker the line, the higher the correlation. This image was plotted using the qgraph⁶ package in R programming.

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

References101 Blockchains. (2021, May 31). Tokenomics: The Beginner’s Guide. https://101blockchains.com/tokenomics/.Binance Research. (2019, March 20). Are Cryptoassets Highly Correlated? https://research.binance.com/en/analysis/correlations-q1-2019.Bitcoin.com. (2019, January 6). Report: Most Major Crypto Assets Show Close Price Correlation. https://news.bitcoin.com/report-most-major-crypto-assets-show-close-price-correlation/.Chicago Booth Review. (2018, February 7). The Bitcoin market isn’t irrational. https://review.chicagobooth.edu/finance/2018/article/bitcoin-market-isn-t-irrational.CoinMarketCap. (2021). Global Cryptocurrency Charts. https://coinmarketcap.com/charts/.CoinMarketCap. (2021, July 8). Today’s Cryptocurrency Prices by Market Cap. https://coinmarketcap.com/.CRAN. (2021, January 28). Package ‘qgraph’. https://cran.r-project.org/web/packages/qgraph/qgraph.pdf.Decrypt. (2021, June 17). Uniswap: Beginner’s Guide To the Leading DEX (2021). https://decrypt.co/resources/what-is-uniswap.E-Crypto News. (2021). How Many Cryptocurrencies Are There In 2021? https://e-cryptonews.com/how-many-cryptocurrencies-are-there-in-2021/.Forbes Advisor. (2021, June 25). Top 10 Cryptocurrencies In June 2021. https://www.forbes.com/advisor/investing/top-10-cryptocurrencies/.Fort, B. L. (2018, August 1). Economics 101: Demand. https://medium.com/impact-economics/economics-101-demand-301f79e90e51.International Banker. (2020, April 8). Token Economics: An Emerging Field. https://internationalbanker.com/brokerage/token-economics-an-emerging-field/.Krueger, F. (2018, February 12). How to think about Tokenomics. https://medium.com/workcoin/how-to-think-about-tokenomics-b3da509444e5.Mougayar, W. (2017, June 10). 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.Nasdaq. (2021, October 5). Everyone is early to Bitcoin. https://www.nasdaq.com/articles/everyone-is-early-to-bitcoin-2021-10-05.Rijmenam, M. v. (2018, April 10). Token Economics: Why and How Tokens Fuel the Decentralised Economy. https://www.linkedin.com/pulse/token-economics-why-how-tokens-fuel-decentralised-mark-van-rijmenam.Tan, L. (2019). Token Economics Framework. SSRN Electronic Journal, 1–17.Voshmgir, S. (2019). Chapter 1: What is the Token Economy? In S. Voshmgir, What is the Token Economy? O’ Reilly Media, Inc.Wandmache, R. (2019). Tokenomics. In S. Goutte, K. Guesmi, & S. Saadi, Cryptofinance and Mechanisms of Exchange: The Making of Virtual Currency (pp. 113–124). Springer Nature Switzerland AG.

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We are the IEEE BITS Goa student chapter. We are committed to enhancing the technical culture on campus and beyond.