Token Value Creation
Token value accrual is critical. A valuable token enshrines the security of its blockchain. Validators require an economic incentive to honestly participate. They need to be rewarded in something that has tangible value. They will stop validating without an incentive. Defecting validators jeopardize the security of a blockchain.
There are over 2,500 tokens. The types of tokens has grown beyond native Layer 1 blockchain tokens. Native blockchain tokens are the tokens used to secure a blockchain network. BTC, ETH, SOL, AVAX and NEAR are examples of native blockchain tokens. Protocols and applications operating on blockchains also have their own tokens. Value creation and accrual in crypto is increasingly important and bifurcated. Native Layer 1 blockchain tokens have clear use cases for their tokens. They have value. The same cannot be said for protocol and application related tokens. And, in the case of all tokens, value accrual and distribution is muddled.
This article outlines the four avenues of token value. It details their shortcomings and how they pertain to different types of tokens. It opines on what will likely become the most important avenue of value creation.
There are four ways a token could be valuable:
Utility
Productive asset
Store-of-value asset
Governance rights
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Utility
An asset has utility value if it is consumed in an endeavor. Commodities and currencies are examples of utilities. They are often referred to as consumable or transformable assets. For example, gas is consumed when a car is driven. Euros are used when vacationing in Europe. They’re useful and have value because they provide a means to an end. Transport and holiday in the example given.
Tokens have utility value. Tokens are used as a means of exchange on a blockchain. A user buys blockspace using a blockchain’s native token. Validators are paid in the native token to ensure the transaction is correctly inputted on chain.
Layer 1 blockchains require a native token. Native tokens ensure decentralization and coordination amongst disparate parties. It prevents a blockchain from being beholden to a central authority. Imagine if Ethereum interactions were conducted in USD. The decentralized permissionless model would break down. A central actor, the US government, would control Ethereum. The central actor could censor transactions and reorganize blocks. It would defeat one of the purposes of blockchains.
The native token is crucial to designing a decentralized permissionless network. But that’s not the case with all token based projects. Beyond the Layer 1 level, there often are no validators to remunerate. Projects design gimmicks to manufacture some form of utility for their token. For example, their native token needs to be used to transact with their protocol. Token holders are incentivized to ‘stake,’ which is a misnomer. The ‘staking’ referred to has nothing to do with validating transactions. It’s a lockup to prevent token selling. It artificially buoys the token price.
Token gimmicks create a reflexive model. The more people interact with the protocol, the more buying demand there is. The more tokens are locked up. But as soon as the buying demand subsides, there’s nothing holding up the token price. It crashes.
The fabricated utility makes sense. The entrepreneurs, developers and communities that created these useful protocols design the tokenomics to be remunerated. As they should be. They developed useful technology. However, artificially creating token ‘utility’ for the sake of entrepreneurial compensation, creates sub-optimal tokenomics. Tokenomic design balancing developer remuneration and long term sustainability is necessary for the continued growth of the industry.
Token ‘utility’ can also be a guise. The tokens can’t directly represent equity-like stake in the protocol without potentially running into regulatory challenges. Tokens can serve a non-essential utility function for the protocol and trade as synthetic equity.
The crypto market has a smattering of different tokens. Layer 1 tokens have a clear and necessary utility. The utility of other tokens can be nebulous.
Productive asset
Productive assets generate returns. Real estate, shares in a company and bonds are productive assets. They are also referred to as capital assets. They produce something of value. They’re purchased on the expectation or contractual obligation of future rewards. Bonds are contractually obligated to pay their holders the disclosed interest rate. Real estate owners generate a return from rental income. Equity owners have rights to the company’s cash flow. Their return is driven by reinvesting the cash flow into the business or distributing it to owners.
Tokens have attributes of productive assets. They produce something of value that people are willing to pay for. They generate revenues and incur costs. The difference between the two are its profits. Layer 1 tokens typically redistribute the profits earned through burning tokens. Burning tokens removes them from circulation.
Beyond Layer 1s, the accrual and distribution of profits is ambiguous. Perhaps deliberately so due to regulatory uncertainty. A token could be construed as a security if it distributed profits to token holders.
The market is grappling with token value accrual. Some believe protocols that don’t charge fees or accrue token value are valueless. Others argue that they don’t charge fees in order to cement their leading market share. They’re staying clear of potential regulatory challenges. Reinvesting into business development is a higher return on capital than returning it to token holders.
Protocols are analogized to Amazon. Amazon was loss making for decades in order to solidify its dominant position. It only occasionally distributed capital to shareholders in the form of immaterial buybacks. The analogue is only partly accurate. Yes, protocols could be securing their market share and reinvesting like Amazon did. But, Amazon always had a choice of how to allocate its capital. It assessed reinvesting in its business versus returning capital to shareholders. Those alternatives are not as clear for protocols, at least not yet.
The key thing to understand today for a protocol is how it produces value, how that value is captured and how the value could be distributed in the future. The Amazon analogue is appropriate in this context. If the market believes that a protocol can create and capture value and responsibly steward the capital it creates, the market will be less concerned with distributions. The path to distribution is more pertinent if a protocol can’t actually capture the value it creates or engages in irresponsible capital allocation.
Protocol treasuries are increasingly accruing the economic value created. What the treasury does with the accrued capital will become top of mind. Does the treasury distribute the capital to token holders? If so, then how? Does it reinvest the capital? Who is making these decisions? How are alternatives assessed? All of a sudden the code that spawned the protocol now requires an organizational structure to determine what to do with the value it created.
Store of value asset
Store of value assets include fine art, collectibles and gold. They have value because of their rarity and social status. People believe they’re valuable and so they are. It’s memetic. Gold didn’t all of a sudden become a store of value asset. It became one over centuries. Leonardo da Vinci didn’t set out to create a store of value asset when he painted the Mona Lisa. It became one over time. Satoshi Nakamoto set out to develop a peer-to-peer version of electronic cash that allows online payments without a trusted third party. There is no mention of ‘store of value’ in the Bitcoin whitepaper.
Assets can’t set out to be a store of value. It’s a moniker that is bestowed over time due to certain attributes and social developments. As a result, store of value is irrelevant today for crypto assets outside of Bitcoin and Ethereum.
Governance
Governance rights only have economic value if the rights govern an asset that has economic value. The economic value can be in the form of a productive or commodity asset. My rights to vote on rules for my fantasy sports team have no economic value. The ability to vote on how a company or protocol distributes its capital is valuable. The ability to vote on how OPEC controls oil production is also valuable.
Governance in and of itself is not valuable in crypto. The governance needs to be tied to something with productive or utility value.
So what?
Utility and productive assets are the two most important avenues for crypto assets. A protocol needs a utility component for someone to buy the token in the first place. It needs a productive asset component for someone to continue to own it. Bitcoin and Ethereum are in a class of their own. Bitcoin and Ethereum both have utility and store-of-value attributes. Ethereum also has productive asset characteristics.
I suspect that the ‘utility’ aspect, with the exception of Layer 1s, will become less valuable over time.
Native tokens might not actually be needed other than for Layer 1 blockchains. Protocols don’t always need a native token. A liquid staking protocol can function with its liquid staking derivative and ETH or a stablecoin. It doesn’t actually need a native token. Same goes for decentralized exchanges.
The native token is sometimes created for understandable means of monetization. It’s quasi equity, without actually being equity. It’s wrapped in a ‘utility’ blanket for the sake of regulation.
Ironically, the ‘utility’ aspect of tokens can destroy value. Protocols grant tokens to users to spur their usefulness. For example, if users need to use the token to interact with the protocol, then the token needs to get into the users’ hands. Airdrops achieve that. The problem is as more tokens are granted, the future value of the protocol is divided by an increasing number of tokens, which reduces the value of each.
Regulatory clarity could remove the need for token utility. Protocols could then do away with unnecessary and costly issuances and reflexive token models. Users could simply interact with the protocol with the native Layer 1 token of the blockchain the protocol is built on or a stablecoin. The result would be a huge improvement in user experience. Crypto requires a different token for nearly everything. A blockchain’s native token is required to interact on each different Layer 1. Yet another token may be needed to use an application. All these tokens need to be owned in advance. If a user wants to use another blockchain, then assets need to be bridged to the target chain, which is prone to hacks. It’s a nightmare for users.
Imagine if customers had to use a different currency for each store they shopped at. It would be an inefficient mess. That’s the crypto experience.
There are 180 currencies globally, yet most global commerce is conducted in USD, Yuan and Euro. Simplicity improves functionality. The crypto economy will be the same. The majority of interactions will coalesce around a few utility assets. Under the hood, there may be lots of different tokens used to facilitate interactions, but the user will be oblivious to it.
If tokens didn’t need to mask in utility, they could be, what many are in hiding, quasi-equity.
Wait…isn’t that just recreating what we already have; securities?
Sort of. But better.
Tokens are a novel invention. They’re easy to create, track, exchange and settle. They’re superior to traditional securities. The blockchains on which tokens are used are more efficient and transparent than our archaic financial infrastructure. That’s why the likes of Larry Fink at BlackRock and Bank of America and touting the benefits of tokenizing assets.
I think tokens will come to represent blockchains, crypto protocols and off-chain assets mirrored on chain. Outside of Layer 1 blockchains, the source of a tokens value will be its productive attributes. Most tokens will be viewed as productive assets. As such, their value is derived by the quality of their product, the size of the market that wants the product and network effects. A select few crypto assets will espouse attributes of utility, productive and store of value assets.
Stay curious.
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Great piece Sam, really hit some key points and questions that need to be asked in the industry. Its this that I've been fascinated with, especially through the context of DAOs: "All of a sudden the code that spawned the protocol now requires an organizational structure to determine what to do with the value it created." I'm just not convinced that the DAO structure is the optimal and final form here.