Token Economy 101, or why Blockchain-powered decentralized networks are important
The “Token Economy” is currently booming, and strongly reminiscent of the Internet of the late 1990s. All Decentralized Applications (“Dapps”) combined, the total capitalization of this market is currently worth $100 billion, undergoing an extremely rapid growth (vs. less than $15b 6 months ago).
Despite the exuberance of markets, this dynamic is based on solid technological fundamentals, which could have a significant impact on the world.
Gabriel and myself had written the following Memo for internal use at Otium Capital, prior to upcoming investments in the field. Following several requests, we are now glad to share it.
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I. Blockchains unlock the creation of quasi-perfectly decentralized networks, a new type of organization that does not depend on a Central Operator, and allows its Users to benefit from the value they create
II. Decentralized applications (“Dapps”) that operate these networks are not companies and do not own shares, but it is still possible to invest in them by acquiring rights of use (“Tokens”)
III. The ecosystem is growing fast and increasingly connected with traditional investors, regulators and mainstream media
I. Blockchains unlock the creation of quasi-perfectly decentralized networks
a. Depending on the network, a wide variety of roles can be assigned to operators
A typical network can be divided into three entities, which are closely linked:
- Network Infrastructure, allowing exchanges between its members (the Internet protocol, the Uber application, railway infrastructures…)
- The network Users (web users, Uber and train drivers and clients…), who exchange with one another. The more active users there are in a network, the more its usefulness is important (this is referred to as the “network effect”)
- The network Operator (the ICANN, the Uber company and National Rail companies), rules on the use of the Infrastructure by Users, ensures its proper functioning (and provides computational power), and is responsible for the growth of the number of Active Users
The Operator can be assigned a more or less important role within the network:
- Minimum role: Merely defines the general exchange rules, just like ICANN with the Internet network. It is then known as a protocol
- Maximum role: It can go as far as building/maintaining the infrastructure, defining and enforcing strict rules, intermediating exchanges and levying commissions, such as the Uber company
The lower the role of the Operator, the greater the role of the Users, leaving an even more decentralized Network.
b. Blockchains unlock Operator-free networks, thus creating networks that are almost perfectly decentralized
Blockchains and Open Source undermine the role of the Operator:
- Rules enforcement control and computing power contribution: Helped by Users who provide it with computing power, the Infrastructure is able to enforce its own rules (the application code, which obeys only to itself, makes law and applies it), and therefore does not need an Operator for it. The Infrastructure then becomes an “Infrastructure+Application”, a Decentralized Application (called “Dapp”)
- Building the Infrastructure and defining Rules: All that remains is the role of rules definition and creation of the Dapp, which is supported by the application’s developers. The community of Developers (often gathered within one foundation) is thus all that remains of the Operator
Blockchain networks that are almost perfectly decentralized can therefore be broken down into three new entities:
- Dapp (see: typical Infrastructure model, with the specific added feature of rules enforcement control)
- Users, responsible for the supply and demand of goods and services, and for bringing computing power
- Developers (see: typical model Operator, limited to the role of rule definition and Infrastructure construction)
c. Tokens, the local currencies of decentralized applications
Blockchain applications are not compatible with traditional currencies like the euro or the dollar, and there is no Operator to take on the role of interface with the real world to cash them. Each Dapp consequently emits its own currency, called a “Token”. These Tokens are needed to trade via the Dapp.
They can be obtained in three ways:
- As a User of the Dapp, selling its services in exchange for Tokens
- By participating in “ICOs”, an equivalent to Dapp fund raising (see below)
- By purchasing on the secondary market (see below)
A great advantage of this system is that Tokens holders are encouraged to use the network to increase the value (and market price) of their Tokens, which solves the “chicken and egg” problem all networks are naturally confronted with.
In addition to serving as medium of exchange, Tokens are genuine, programmable assets, whose functioning is “coded” and which play a crucial role in Dapps mechanics. Here are some examples of Dapps that work with their own Tokens:
Storj behaves like a decentralized DropBox, whose Token is called the “Storjcoin”:
- “Suppliers” users provide the system with the data storage space at their disposal and are paid in “Storjcoins”
- “Demanders” of storage space users give the system files that they want to store
- The system encrypts files and manages their storage on Suppliers storage space, collects Storjcoins payments from Demanders, and redistributes them to Suppliers
Golem behaves like a decentralized form of Amazon Web Services, whose Token is called the “Golem”:
- “Suppliers” users provide the system with the computing power at their disposal
- “Demanders” users entrust the system with their calculations (training of an AI algorithm, execution of an application, etc.) and remunerate the “Suppliers” in Golem, once the calculations have been made
- The system connects Suppliers and Demanders according to the technical specifications of the calculations to be made, ensures the correctness of these calculations and transfers the Demanders Golem to the Suppliers
Augur is a decentralized Bookmaker, which allows to make mutual bets without then need for a central operator. Its Token is called the “REP”:
- All Users can place a new bet in the network, or take their chance on an existing bet
- Odds are created automatically, thanks to the mutual betting system
- When a bet ends, the Token bearer community is invited to vote to designate the winner, by an absolute majority
- Users who have voted correctly (= in the sense of the majority) receive a remuneration from the bet
- Users who have tried to cheat (=voted against the majority) are punished by seeing a portion of their Tokens confiscated
II. Dapps and their Tokens create a new economic paradigm
a. Tokens can be acquired at the time of their issuance, an event called “ICO”, standing for “Initial Coin Offering”
In the same way that Startups raise funds, Dapps hold ICOs. Unlike Startups that distribute shares in exchange for traditional currencies (Euro, Dollar…), Dapps distribute their internal Tokens in exchange for other Tokens that already have value (Bitcoin, Ethereum…). This mechanism has several advantages:
- Disseminate Tokens among many users (important for a network)
- Give the Tokens a market price, and thus incite networks suppliers to accept them in exchange for their Services
- Fund the development of Dapps
An ICO is structured as follows:
- ~80% of Tokens are auctioned to Users who pay in external cryptocurrencies (Bitcoin, Ethereum…). The funds thus collected are entrusted to the Foundation which federates the Developers. The funds raised (Bitcoin, Ethereum…) by the Foundation allow the remuneration of developers, and that of service providers (lawyers, lobbyists, communicators…)
[Note: The allocation of collected funds is ultimately decided by a few individuals. It is consequently not possible to speak of perfect decentralization, even if, as Tokens bearers, their interests are perfectly aligned with those of the other Tokens bearers. That’s why we refer to it as quasi-perfect Decentralization.]
- ~ 20% of the Tokens are retained by the Developers and the Foundation for their work. They have no interest in exceeding this order since in the case of abuse, the Users would refuse to participate in the ICO, and then to use the Dapp (or even copy the Dapp, which is easy in Open Source), and this would harm the value of their Tokens. Since Tokens are “programmable”, there can be a vesting period for developers (see Aragon’s ICO)
For the time being, no Dapp has ever needed to raise funds subsequently to its ICO (which would have constituted a “Non Initial Coin Offering”), thanks to the very large increase in the market price of all Tokens.
This will nevertheless be possible if the Token Dapp holders accept it (as with traditionnal companies).
The Foundation is the legal link between the Dapp, its developers and the “real world”. Its whole legal structure is still at its earliest stage, and we can expect it to undergo many developments, as it keeps up with those of technology.
The number and size of ICOs is rocketing up
The first ICO in history was that of the Ethereum network in July 2014, which had raised $13m (investors from back then now yield a multiple of 500x).
~ $ 300m have been raised in the past 12 months and the movement is accelerating very sharply. With regard to the number of projects currently in the making, it is fair to say that this is just the beginning.
In April 2017, $81m were raised during 11 ICOs (average of $7.3m/ICO).
There was a very high level of investor interest, with raises completed in less than a week, sometimes in just a few hours ($12m in 6 hours for iEx.ec, $5.6m in 24 hours or Matchpool, $4.7m in 5 days for Humaniq, and so on)
The quality of the projects is variable and some do not deserve the interest that is brought to them by the investors.
We must therefore expect, in parallel to these successes, some far-reaching failures. However:
- This can just as well be said about “traditional” startups
- Some projects are of very high quality, both among those who have already done their ICO (Augur, Golem) and in those who announced it for the coming weeks/months (Tezos, Filecoin, Truebit…)
- It should be borne in mind that the dilution experienced by contractors in these projects is c. 80% (vs. 25% in the conventional system):
- — An ICO like the project Aragon, which recently raised $25m for 70% of the Tokens, corresponds for example to a pre-money valuation of $11m, and a post-money valuation of $36m
- — In the end, investing $xm in an ICO amounts to owning 80% of a “shell” which contains $xm, entrepreneurs, and a vision
b. Once issued, Tokens are traded in the secondary markets
Secondary markets are the marketplaces where existing Tokens are bought and sold. The most important are Poloniex, Kraken, Bittrex and GDAX.
It is in these markets that the owners of Tokens bought in ICO can resell them, and possibly make profit.
Over the past 6 months, there has been an exponential increase in the price of exchanged Tokens: the market capitalization of all Tokens has increased more than fivefold over the past 4 months to $ 100b, and more than $3b are exchanged every day.
Market capitalization of the 3 Dapps presented above (May 22, 2017):
- Storjcoin: $ 315b (500,000,000 Storjcoins * $0.6)
- Golem: $ 300b (1,000,000,000 Golem * $0.3)
- Augur: $ 200b (11,000,000 * $18.4)
The 2013 increase was largely due to Bitcoin, but that of 2017 is mainly driven by the Ethereum ecosystem.
Market movements are very violent, especially in recent days (x3 in less than a month!), and a strong correction is of course very possible.
However, this is no different from the dynamics that can be observed in traditional markets, and says nothing on the underlying’s quality (see explosion of the Internet bubble during the 2000s).
c. As an asset class, Tokens are different to shares, albeit just as interesting
Dapps are not companies, but softwares that belong to themselves, so they have neither shares nor shareholders.
This being said, Dapp tokens are quite similar, in that they allow the use of the Dapp (= remunerate the Dapp’s service provider Users). Their value is therefore correlated with the intensity and quality of the network’s activity, as are the actions of a company.
More specifically, we can distinguish:
- The use value of Tokens, which can be calculated rather precisely by comparing it with the market price of similar services (AWS for Golem, DropBox for Storj…)
- The Net Asset Value of Tokens: the funds raised (in Bitcoin, Ethereum…) at the ICO “belong” to the network, they constitute a floor for its valuation. For example, Golem raised the equivalent of $9m in Ethereum during its ICO, so we can consider that the network (= the set of Tokens emitted) is worth “at least” $9m
- The market price, which can be seen on Token marketplaces such as Kraken or Poloniex, where the equivalent of several billions of dollars a day are exchanged. This price is derived from the use value, but can significantly deviate from it because of speculation, favoured by real-time quotation (in the same way as for stock exchange-listed shares!) Multiplying the market price of Tokens by the number of issued Tokens results in the network’s capitalization (its market valuation)
Purchasing Dapp Tokens, either at the ICO or on the secondary markets, therefore comes down to investing in the Dapp.
As with any investment, an investment in Tokens must pass through:
- An assessment of the team, the product and the proposal of value, the market, the Business Model …
- A confrontation of valuation at the current market price. Some ratios may then be useful:
- — Market Price/Net Asset Value: Allows to evaluate the Goodwill given to the team and the project by the market, if the Goodwill is zero the ratio is 1
- — Market Price/Value of Use
- — Market Price/Future value of use
- — …
III. The ecosystem is growing fast and increasingly connected with traditional investors, regulators and mainstream media
a. Many VCs show interest in the topic
Fred Wilson of Union Square Venture (whose investment thesis is based on network effects since 2011!) has written many articles on the subject, including:
- The Decentralized Startup : “There’s a new game in startup land. A new way to do things. And it is working for a lot of people who are playing that game right now”
- The Golden Age of Open Protocols : “So this new protocol-based business model feels like one of these “changes of venue”. And that smells like a big investable macro trend to me”
- Numerai and Polychain
- Online Publishing Should Look At Steem, Not Spotify, For Inspiration
Andreessen Horowitz has announced an investment of $10b in Polychain VC. Marc Andreessen is a notorious supporter of these technologies: “This is the distributed trust that the Internet always needed and never had”
OpenOcean has just started publishing an excellent series of Medium articles on the subject. The first being: The Rise of the Token Sale: “A future built on almost entirely new protocol stacks that put power back into the hands of the individual and present the possibility of up-ending entire companies, industries and governments”
Runa Capital also publishes a lot on this topic:
Boost.vc recently announced an investment in Tokens in Aragon, as well as its determination to continue in this path
b. The actors of the ecosystem are becoming more professional and are evolving towards more transparency, security, and links with regulators
Polychain is a new VC fund specializing in the Token Economy, managed by an industry pioneer. Since its $ 10m seed with Andreessen and USV early 2017, Polychain has $ 100m of AUM
The first edition of the Token Summit, the first conference devoted entirely to the Token Economy, just happened in New York. Numerous VCs were represented (including all of those cited above, with particularly strong support from USV) along with Dapps entrepreneurs
Filecoin is a very promising Dapp who has made the choice for his ICO to partner with Angellist to create the ICO marketplace Coinlist, and to make the maximum to satisfy the requirements of the regulator:
- Only “accredited investors” — in the sense of SECs — may invest
- The Tokens procurement mechanism (“SAFT”) was specially designed to be compatible with US law
Coinbase is a marketplace for “traditional” cryptocurrencies ($120m raised), which has set itself the objective of making the topic accessible to the general public. Product developments are therefore to be expected, proven by the excellent articles published by the team:
- A beginner’s guide to Ethereum tokens
- Blockchain Tokens and the dawn of the Decentralized Business Model
- Ethereum is the Forefront of Digital Currency
Smith + Crown is a “rating agency” intended for ICOs, which aims to be the equivalent of S&P for this new world
Coindesk.com is the ecosystem’s most popular media (just after Twitter!)
Switzerland, as a whole, and the Canton of Zug in particular (already famous for being the world centre of commodity trading) is pursuing a proactive policy of hosting companies and foundations linked to the Blockchain (Tezos, Melonport, Signal, Ethereum, Shapeshift, Xapo, etc.). This is achieved through the establishment of a suitable legal framework and by the multiplication of signs of goodwill by administrative authorities (for example, it is possible to pay local taxes in Bitcoin). This goes so far that the region has been nicknamed “Crypto Valley ” when referred to in the ecosystem.
c. Mainstream media is noticing the phenomenon
Fortune, May 2017: Why Startups Are Trading IPOs for ICOs
Financial Times, May 2017: Crypto ICOs are the new railway bonds
The Economist, April 2017: The market in Initial Coin Offerings risks becoming a bubble, But it may also spawn valuable innovations
Thanks to Blockchains and Tokens, quasi-perfectly decentralized networks are about to redefine the notion of enterprise and value sharing.
Entrepreneurs and investors alike, who can seize this opportunity, can expect extraordinary returns in exchange for the significant risks they take:
- Regulation: The SEC and its counterparts have not yet grasped the subject, but one can expect this to happen both in terms of the Token fundraising mechanism and the Dapp object (for example, developers and investors of Augur, which facilitates online gambling may be asked questions some day)
- Safety: Token theft is irremediable, because the judicial system has neither the mandate nor the capability to fight. It is therefore important to apply strict safety rules
- Volatility: Token markets are extremely variable, in both directions
The rapid structuring of the ecosystem continuously limits these risks, while its potential is getting everyday more obvious.