The discussion about the inefficiency of app tokens as investment vehicle has been unfolding over the past few months, resulting in a general conclusion that such tokens are not a good way to fund new or existing projects, both for regulatory and economic modelling reasons. In a recent post Fabian Vogelsteller, lead Ethereum developer and ERC20 token standard co-author, hints at the problem:
“(…) actual equity investments using blockchain. — Something many of the current ICOs actually want, but rather invent some dodgy token, which shouldn’t be there in the first place.”
Many app token projects today have little economic sense and do not represent any network value. Sometimes they are just flawed business models designed with a good intention, and sometimes they are outward scams. However, the problems with the app tokens go much deeper, to the very core of the concept. There are strong arguments that by buying app tokens you may actually be killing the project you want to support — even a project with a perfect token economy behind.
Investors become manipulators of the token price
The app token inefficiency discussion has so far been developing in the shadows of the classification of app/utility /protocol tokens debate. This debate hovers primarily around the regulatory topics, and has picked up after the SEC report about theDAO from July, essentially becoming a discussion on how to avoid legal responsibility when launching an ICO. The result of this has been that the legal stuff dominated the economic modelling debate, and fuelled the emergence of the whole cast of Blockchain lawyers, preoccupied with inventing (often doubtful and sometimes fantastic) legal workarounds for ICOs.
Until recently Vitalik Buterin, Ethereum chief scientist and also ERC20 standard co-author, published “On Medium-of-Exchange Token Valuations”, discussing the economics of network tokens in terms of equilibrium seeking between developers (supply side), and users (demand side). In the process of equilibrium seeking, the token looks to establish the optimal price of service or good produced by the network. This is a standard economic situation where the value of goods produced is maximised by the competing forces — users wanting to drive the price down, and developers (service providers in this case) wanting the price up.
However, Vitalik argues, the above economic equilibrium is destroyed when the third party appears in the equation — the investor, or, as Vitalik says, the manipulator — whose economic gain is best achieved by destabilising the equilibrium of the economy of the network.
“This leads to increased opportunities for market manipulation, as a manipulator would not just be wasting their money fighting against a single equilibrium, but may in fact successfully nudge a given currency from one equilibrium into another, and profit from successfully “predicting” (ie. causing) this shift. It also means there is a large amount of path dependency, and established brands matter a lot; witness the epic battles over which fork of the bitcoin blockchain can be called Bitcoin for one particular high-profile example.”
Investors unwillingly crush the token price of the project that they want to support
“A [network]token is both the reward miners get for contributing work and a “price” the consumer needs to pay in order to access the network and make use of its services.”
It’s the same argument as Vitalik’s, just differently phrased. Originally the price of the token should be set based on the supply and demand on the free market, between the user and the producer. The involvement of a third party — an investor, entirely changes token economy dynamics, eventually destabilising the price of the token and putting the entire token economy at risk. The investors are not aligned with other network participants — they will either pump and dump tokens for a short term gain, or look for a large increase of token value long term, which also poses significant problems. Quoting “Entangled Tokens”:
“When the price of token goes up too much due to investment and speculation, this stifles network usage. At the same time the value of the internal resource didn’t increase, so why should consumers pay more for it? A likely outcome is that they will decrease their usage or go and use an alternative network. Too high token prices may kill a network or make it grow — and therefore acquire value — more slowly. Thus, using entangled tokens limits network growth and decreases its potential value.”
In most (or all?) app token economies today, even the good willing investors become the manipulators of the token price, slowly crushing the token price of the project they invest in, and bringing the token price and the network value to zero. So what’s the solution?
Equity — a great economic invention with a bad reputation
“Do you invest in a car factory by buying a lot of cars for a price much above market value?”
When stripped of its negative connotations, liaisons with banks, greed, the crises of 2001 and 2008, and in general the pre-Blockchain finance industry, the concept of equity appears as one of humanity’s greatest economic inventions. It could be thought of as an abstract, general token standard, that could represent any business model and allow for investment to be made without interfering with economic models of the project being funded. The concept of a share is actually not so old — it starts in 1602 with East India Company issuing first shares tradeable on Amsterdam Stock Exchange. This innovation made a great deal of Europe’s economic growth following the Middle Ages. In today’s Blockchain economies shares could be thought of as equity tokens, put on-chain as an abstraction above app tokens.
Equity tokens could represent a stake in governance, economic output and information of the network. The equity token holders would be aligned with other network participants— their gain would be maximised by putting the underlying network in equilibrium state, rather than by destabilising it. This would align investors with users and developers, who ideally should also own equity of the network. They are not only thought of as a sound investment vehicle based on a proven concept — they also give more control to investors in terms of ownership and liquidity. Again, and to finish, quoting Fabian:
“[…] because there is the legal soundness and because there is the smart contract structure and this, the core thing why you want to have a blockchain token is that you have control, you have ownership, you’re able to transfer it — you’re really owning […] The beauty is the ownership, the beauty is the control everybody has, and bringing this together with real-world equity where people can actually invest in real companies.”