Tokenomics 101 — Understanding Token Sales and other New Models of Blockchain-based Financing for the New Economy

First, there was gold and physical money and money equivalents. Then there was debt. After that, there was equity. Now, there are tokens. These are the fourth, and newest, asset class.

This article is the start of a series that introduces some of the fundamental concepts of what I call Tokenomics, which is a framework for how digital tokens are used by blockchain projects and other innovative organizations. This includes broad uses such as a novel form of community fundraising, a store of utility value, and a medium of exchange. Tokenomics covers governance in terms of organizational and legal structures, token allocation and treasury management, economic incentives using tokens, business models around utility tokens, as well as the mechanisms of token sales.

First, let’s look at when and how tokens originated from the cash-equivalent cryptocurrencies. But you, like many others, may be wondering even what cryptocurrencies are, so part 1 of this article deals with the digital coins, part 2 talks about Ethereum, and part 3 deals with the tokens themselves.

Part 1 — Blockchain 1.0 and Bitcoin

 If the 18th century made an inquiry into the nature and causes of the wealth of nations, and the 19th century critiqued capital and the political economy, the 20th century might be defined by the morality and correctness of capitalism under the philosophies of Ayn Rand and the Tea Party on the one side and socialism with Chinese characteristics on the other. To paraphrase a famous quote from Atlas Shrugged, I believe the first two decades of the 21st century will be defined in retrospect by the question, «Who is Satoshi Nakamoto?»

For those of you who don’t know already, in the world of cryptocurrencies Satoshi Nakamoto is nobody and everybody. Depending on what theory you believe, he’s either an Australian future patent troll; or «he» is actually a collective of four (or, perhaps, more, or less) people; he’s a government agency or an agent of a government! Or, after all, and against all odds, he is simply Satoshi Nakamoto.

No matter the case, his now-famous whitepaper was the seed that created Bitcoin, the world’s first widely used digital cryptocurrency based on what we now call blockchain. From the abstract, Nakamoto wrote:

A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution. Digital signatures provide part of the solution, but the main benefits are lost if a trusted third party is still required to prevent double-spending. We propose a solution to the double-spending problem using a peer-to-peer network.

Bitcoin and other early cryptocurrencies are what I call blockchain 1.0, generally based on the same idea described in Satoshi’s whitepaper: A peer-to-peer network exchanging digital coins that are recognized by members of the community as having value and therefore meriting use as a medium of exchange and similar to fiat (real-world) currency.

I’m going to assume that you are familiar with Bitcoin and we’re mostly concerned with how the Bitcoins were used for fundraising rather than for speculation, anyway. So to skip to the chase, out of these early cryptocurrency communities came the concept of an initial coin offering — an ICO, sort of a shout-out / up yours to the traditional finance world’s model of fundraising, the IPO — wherein a group of Bitcoin enthusiasts might support a blockchain project by essentially donating Bitcoins or other cryptocurrencies to it, in return for some new cryptocurrency under a different name, or for some vague promise of future benefit or even just for the hell of it.

Why would you do that? Early holders of Bitcoins didn’t have much to spend them on: a pair of pizzas here, a flight on airBaltic there. The new digital coins weren’t all that useful. This was especially true after the collapse of the main Bitcoin exchange Mt. Gox and the arrest and conviction of Ross «Dread Pirate Roberts» Ulbricht and the takedown of Silk Road, the darknet’s most trafficked market for illicit goods (I’m at risk of losing you with all these links, but after finishing this article check out the links at the bottom for more reading).

Despite these inauspicious beginnings, Bitcoins have appreciated about six times since the days of Mt. Gox and Silk Road. And those two pizzas from the very early days? They are now worth about US$30 million, each! Definitely, the most expensive pizzas ever, at least until Elon Musk builds his wood-fired pizza oven on Mars.

If Bitcoin was the mother coin, the output of an ICO was usually a new ‘baby’ coin (sometimes called an alternative coin or altcoin) that you would get in return for your contribution of cash or Bitcoin. These new altcoins were usually built with the same code that runs Bitcoin and, therefore, are considered forks from the Bitcoin blockchain. One of my favorites is Dogecoin, the Shiba-Inu-inspired coin which started as a joke and ended up becoming one of the most widely used cryptocurrencies out there, perhaps because of its photogenic mascot.

This article is not meant to be a history of Bitcoin and the blockchain 1.0 era here (but I can cover more about this in future articles in the series). Instead, I want to focus on the next generation, what I call blockchain 2.0, which was created when the Ethereum blockchain made it possible to issue tokens. This capability, in turn, has created the newer funding model of token sales called (you guessed it…) ITOs!

Part 2 — Blockchain 2.0 and Ethereum

 Before I start to talk about initial token offerings and how they are different from ICOs, what exactly is a token and how is it different from an altcoin?

First, we need to understand that Ethereum in some ways is not unlike Bitcoin and altcoins. Ethereum’s cryptocurrency is called Ether (i.e., ETH) and it powers the Ethereum Virtual Machine, a kind of computer built using blockchain. But it is not the Bitcoin blockchain or a fork of that chain but rather, an entirely new chain that is basically built from the ground up.

Why would you want a computer on a blockchain? Well, smart contracts, of course! What are those, you say? They are Ethereum’s killer app at the moment, allowing basic agreements to be executed based on certain conditions being met. One such condition might be, «If you send ETH (as a proxy for cash) to this address, we will send you XYZ tokens (as a proxy for …something) in return. And if for some reason, the contract execution fails (such as because not enough people subscribed to the token issuance event), you will get your ETH back.» All this happens automatically.

I’m simplifying that process a bit, but think about it for a moment. Today we need lawyers to draft agreements, notaries to certify them, courts to enforce them, banks to transfer funds, stock brokerages to hold stock certificates in trust, and more, just to execute something like a real-world share offering. Ethereum and its smart contracts did all that, entirely digitally, at a low relative cost, and without any trusted institutions in between the subscriber and the issuer (aside from the Ethereum blockchain itself, which is a decentralized organization managed by a foundation in Switzerland, but we’ll come back to that in one of the future articles of this series on organizational structures).

In other words, Ethereum (and other blockchains) have created a trustless environment. Untrusted, you read? No, trustless, as in, you don’t need to trust the other party because the Ethereum Virtual Machine blockchain will do everything according to the smart contract without fail (NB: Ehtereum is not perfect, and people programming the contracts still make mistakes in coding, so ‘without fail’ and ‘trustless’ are figures of speech, but you get the idea, I’m sure).

Part 3 — Digital Tokens

 So, now we’re finally at the main point of this entire article. What are those digital tokens, anyway?

First, they are not cryptocurrencies. The main difference, as described above, is that cryptocurrencies, whether Bitcoins or any of the altcoins including Ethereum and its ether, have their own blockchains. Establishing a blockchain is technically difficult so there are only a few dozen main ones and really less than ten in significant volumes of usage.

Second, a digital token is kind of analogous to the real-world tokens. Are there any people reading who went to Chuck E. Cheese as kids, or take their kids there today? You know how you can’t put money directly into the machines but you have to buy those little metal discs? And you don’t get money out of the games of chance and skill (because that would be gambling at a pizza house!) but instead, you get long chains of paper tickets?

Those discs and tickets are both kinds of tokens. Therefore, a token in this context is an in-house representation of some amount of real money (such as a quarter, $0.25) that now only has some utility value. At Chuck E. Cheese, the utility value of its tokens is the ability to play a video game or exchange for a stuffed animal. But just try paying your library fines with these tokens and see what happens: National news, that’s what happens. I’ll save you a click and tell you that the library doesn’t consider Chuck E. Cheese tokens legal tender. And before you think, that was a stupid question, of course they weren’t legal tender, keep in mind that sometimes not even all the pretty papers and coins your country’s mint creates are usable as circulating legal tender, either, despite having a clear face value on them.

So then those Bitcoins and similar cryptocurrencies and tokens are definitely not legal tender, right? Well, not if you live in Japan, where Bitcoins are increasingly used across the retail landscape, and the government is moving to regulate and allow its usage in a number of significant ways. But we are still a long way from cryptocurrencies being totally equivalent to other forms of money, legally accepted in all usages.

Tokens’ worth and legal status, at the moment, exist in an area between ‘none’ and ‘similar to Bitcoin’ at the two extremes, and something called ‘utility’ in the middle. Utility is an economics concept roughly meaning the level of satisfaction derived from usage over another alternative: the degree to which choice A outweighs choice B. Or, more generally, the usefulness or ability to do something. A utility token, therefore, is an object (or digital representation) that allows the bearer to do something of value to them.

In the world of the blockchain, utility tokens are issued in exchange for some other form of value (cryptocurrencies, real money, goodwill and other types of consideration) given by the subscriber to the blockchain organization. That organization might be creating an application that will use the utility tokens to redeem for service.

Strictly speaking, that’s all they are supposed to be for, but in reality, utility tokens are often seen as investments, typically by the subscribers who buy them in the hopes that their price appreciates in value and may be sold for profit, or issue some kind of other benefits.

The issuer, for the most part, disclaims any right to profits or other forms of dividends, voting rights,equity ownership shares or options to an underlying asset of the blockchain organization. In other words, the organization is not issuing securities or another instrument that would likely fail the Howey Test. Blockchain-based digital utility tokens may only be exchanged for a service provided by the organization and may not be used to pay your library fines (unless, perhaps, you happen to be doing a blockchain library, of some sort).

Finally, as a technical matter, the digital tokens which I am describing above typically do not have their own blockchains. Rather, they are built upon another blockchain. The vast majority of such tokens today are created on the Ethereum blockchain but other platforms, such as Waves, exist for a similar purpose.