The Failure of Tokenisation Models

Blockchain has been often portrayed as revolutionary, mainly in terms of the tokenisation of all kinds of assets. This does not mean just tracking the ownership of stocks, commodities or other asset types on a new kind of ledger, rather the creation of new asset classes and tokens with their own economic models. Since 2017, the steep decline of the majority of tokenised assets suggests that most of these models are indeed flawed. In this note we ask, has tokenisation failed us?

In the 1990s, most of the people and companies developing the Internet’s building blocks had little monetary incentive to do so. The main reason for this was that most of the economic value was not captured on the protocol level. Because of this, it was difficult to monetise the development of protocols such as SMTP, HTTP or TCP/IP even though users of the Internet need them every single day. It was more profitable to build on SMTP and create applications that would operate on top of the underlying protocol, than the SMTP protocol itself. Gmail, Facebook, or YouTube are just a few examples of applications that benefited in this manner.

The widespread emergence of blockchain technology in the 2010s spurred on a new narrative. Bitcoin’s model of limited supply allowed for the introduction of digital scarcity in other protocols as well. This digital scarcity is expressed and represented by cryptographically secured units of account also known as tokens. These tokens may be viewed as native protocol currencies in which all transaction fees are paid. The idea of an open-source distributed ledger also provided a great fit for records related to the ownership of tokens because it removed central authorities and intermediaries typically involved in the process, and therefore eliminated the need to trust a single third party. Designing networks with an internal token that was transparently ruled and wrapped into a sound economic model appeared to be a tempting endeavour for both network creators and investors. Mastercoin (now Omni1), Ethereum2 and MaidSafe3 were just some instances of early projects took advantage of this novel medium to raise funds to build open-source protocols.

Figure 1: Paradigm change brought by tokenisation

Source: Union Square Ventures, Aaro Capital

A Paradigm Shift

This paradigm change came in the form of ICOs (Initial Coin Offerings). The first ICO happened in 2013, however it was only until early 2017 when ICOs really took off. During that year, start-ups around the globe were able to raise over $6 billion by selling tokens. The ICO frenzy was powered mainly by retail investors who took advantage of the opportunity to invest early in blockchain companies. For instance, the company behind Brave4 – a crypto and privacy-friendly browser – raised over $35 million in just a matter of seconds by selling their Basic Attention Token (BAT). However, in this case the token does not represent a stake in their company, neither voting rights, nor is it necessary for users who want to use Brave. Its main purpose is to tokenise the attention of Brave users who earn tokens for viewing advertisements, and tip web content producers for their work. Therefore, BAT is a utility, or application, token built on top of Ethereum, and an attempt to design an economic model around a token for which demand is not driven merely by using the protocol. While ICOs started first as tools to bootstrap and fund the “fat” protocols, they soon became increasingly more utilised for application layer projects that did not necessarily need a token and instead wanted to fundraise.

Figure 2: Diversification of ICO types

Source: Autonomous NEXT

However, each application that introduces a utility token to its ecosystem faces a great dilemma. Designing the system in a way that requires users to hold (and spend) the token when interacting with the application certainly has benefits from a token economics perspective, as it creates demand for the token and drives the price up. On the other hand, such a design creates also significant friction from the perspective of users and thus curtails adoption.

The Birth of Tokenomics

Nevertheless, tokenisation has been driving experiments with all kinds of economic token models and has eventually created its own subfield – tokenomics. In the past few years, we have witnessed a plethora of projects with different economic models around their tokens. In 2018 there were still thousands of projects doing ICOs, and even though the average amount raised per project decreased due to the bear market, the total volume amounted to almost $8 billion5. Since then, the price of Bitcoin bottomed at the beginning of 2019, which has indeed resulted in a steep decline in ICOs. This trend does not seem to be changing any time soon.

Figure 3: Amount of money raised via ICOs in 2019

Source: Icodata.io

This is a result of unmatched investor expectations, product development delays, outright project failures, and most infamously - scams.

Even though it may still be too soon to judge which token models make sense, there are definitely a few lessons we learned in the past years. Firstly, even though ICOs might be a good deal for project founders, as they receive a good chunk of money upfront, this is not necessarily the case for investors. This is especially applicable to application tokens with a forced utility which, out of all token types, are least likely to accrue value over time. Naturally, there are notable exceptions here such as Binance’s BNB token, which is one of a few that managed to not only maintain but increase its price through the bear market. While introducing utility tokens may not necessarily represent much friction in the case of cryptocurrency exchanges, with thousands or even millions of tech-savvy users working with them, the opposite seems to be the case for projects that aim to reach non-crypto audiences with their products. It is no wonder that many exchanges have been able to replicate a similar token model and maintain their token value, while many other projects have failed.

Value Accruing Assets

However, utility-driven token demand alone is not enough. It needs to be supplemented by scarcity as well. This is typically achieved through buyback or burn mechanisms that help to create an artificial shortage of the token supply. While projects usually incorporate these mechanisms into their token models from the beginning, we have witnessed cases when token burns were announced and executed at a later stage of the project. Perhaps the most recent instance of such a practice is the token burn announced by the Stellar Development Foundation just a few weeks ago, in which they burnt over 55 billion tokens worth almost $5 billion6.

Profit-sharing is another way to incentivize demand for tokens. This method was practiced more frequently in some of the early ICOs such as TaaS7 that shared a portion of their profit to token holders through dividends via smart contracts. As ICOs gained more traction and attention from regulators all over the world, this model has become less prevalent since such tokens often must comply with securities regulations. It is worth mentioning that STOs (Security Token Offerings) have evolved and branched off into a separate ecosystem.

Apart from these token models and protocol tokens with strong network effects, based on the empirical evidence, there are a few more models that are likely to accrue value for their tokens. Tokens that come with voting rights and allow for participation in decentralized governance models of projects like DAOs (Decentralised Autonomous Organisation) are one of the options, Maker DAO (MKR) and Decred (DCR) being great examples. While MKR holders may for instance vote on decisions related to DAI stablecoin, DCR holders decide upon various issues within their own protocol.

Figure 4: Unified Token Taxonomy

Source: Autonomous NEXT

The proliferation of Proof-of-Stake (PoS) among many cryptocurrencies is, apart from efforts to find eco-friendly and secure alternatives to Proof-of-Work, also related to the fact that staking provides more incentives for users to hold them. PoS-based tokens are indeed more attractive for investors as they can be viewed as yield producing assets. Even though the difficulty of staking varies across different protocols the point is the same – the more coins you have the more you earn. Some of the staking coins include PIVX, Cosmos, and soon also Ether.

Often staking comes with additional requirements such as running servers that participate in the underlying protocol infrastructure. This approach is applied e.g. in one of the most utilized smart contracts on the Ethereum network – decentralized exchange IDEX8 - which allows its holders who also run servers to support the infrastructure, to earn trading fees incurred by the platform.

Conclusion

Given that the cryptocurrency market is largely correlated to Bitcoin price and most of the networks are in their nascent stage with rather small userbases – it is difficult to evaluate properly which token models are failures and which are not. In the bear market, however, we could see that some models are better in maintaining their value relative to others. Those that have performed best usually combined multiple components from a spectrum of economic aspects such as network effects, burn and buyback mechanisms supporting supply shortage effect, yields in the form of newly minted coins or collected fees, or boosted token utility via voting rights. Which exact token models turn out to be the most successful ones remains to be seen in the future.

Bibliography

1 For more information on Omni, see: https://www.omnilayer.org/index.html

2 For more information on Ethereum, see: https://ethereum.org/

3 For more information on Maidsafe, see: https://maidsafe.net/

4 For more information on Brave, see: https://brave.com/

5 For more information on ICO statistics in 2018, see: https://www.icodata.io/stats/2018

6 For more information on Stellar burn, see: https://cointelegraph.com/news/stellar-burns-over-55-billion-tokens-worth-47-billion-usd

7 For more information on TaaS, see: https://taas.fund

8 For more information on IDEX, see: https://idex.market/eth/idex

Disclaimer

The material provided in this article is being provided for general informational purposes. Aaro Capital Limited does not provide, and does not hold itself out as providing, investment advice and the information provided in this article should not be relied upon or form the basis of any investment decision nor for the potential suitability of any particular investment. The figures shown in this article refer to the past or are provided as examples only. Past performance is not reliable indicator of future results.

This article may contain information about cryptoassets. Cryptoassets are at a developmental stage and anyone thinking about investing into these types of assets should be cautious and take appropriate advice in relation to the risks associated with these assets including (without limitation) volatility, total capital loss, and lack of regulation over certain market participants. While the directors of Aaro Capital Limited have used their reasonable endeavours to ensure the accuracy of the information contained in this article, neither Aaro Capital Limited nor its directors give any warranty or guarantee as to the accuracy and completeness of such information.

Please be sure to consult your own appropriately qualified financial advisor when making decisions regarding your own investments.

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