Key Takeaways
The token economy is a system that incentivizes individuals to contribute to a common goal without the influence of a centralized authority
Token enterprises begin with an initial coin offering and grow from perceived value of their service which incentivizes people to work for the service (to get tokens), thus further improving the value and creating a positive feedback loop
The token economy is growing rapidly and has the potential to make disruptive changes in many markets
What is the Token Economy?
The term “token economy”, originating in applied psychology, refers to a system of incentives that reinforce and build desirable behaviors; targeted behaviors are reinforced with tokens and later exchanged for rewards. Today, “token economics” more commonly refers to the study, design, and implementation of economic systems based on cryptocurrencies. In crypto markets, a token economy is implemented using digital assets as tokens and a framework of rules outlining the desirable behavior is implemented using smart contracts. Tokenization is the process of converting some asset into a token unit that is recorded on a distributed ledger technology. Anything of economic value, such as real estate, commodities, currencies, can be tokenized, leading to a variety of potential token economies.
Note that a token is not a digital file. The distributed ledger provides a public infrastructure in the form of a distributed record of transactions. This distributed ledger is then stored on multiple computers in the network, and it keeps track of which wallet address is the owner of which token.
Token markets are decentralized and rely on built-in incentives to improve the functioning of the market. In contrast, the prevailing model in today’s internet is the “platform economy”. In the platform economy, companies (Google, Facebook, etc.) build their platforms atop the internet and serve as the governing authority for the service. The companies decide what features to develop and users pay for the service by subscription or having their data monetized. Platform companies are driven by profit, not by the users of the service. What is fundamentally different about token economies is that they create a framework in which participants mutualize their interests and have strong incentives to continually improve the functioning of the economy.
How does a token economy enterprise get started?
A new token system often comes to market through an ICO (initial coin offering) which allows the founding team to distribute tokens to raise capital for funding the enterprise. A lot of initial demand for the new token is dependent upon the team’s vision and the soundness of the token economy. As the market’s perceived value of the token increases, participants, customers and speculators take note and invest in the token, thus increasing its demand. Typically in token economies, since the token supply has a ceiling, increasing token demand leads to increasing value, which attracts even more participants, customers and speculators. The increasing number of participants in the network strengthens the network in two ways: it makes it more decentralized and secure by adding more nodes to the blockchain, and participants work to improve the network and develop services on the platform to attract even more users (because they will receive more tokens as a reward for the work). This increases the utility of the system, which attracts more customers, and further strengthens the feedback loop. Usually, the tokens of a network also work as “shares” of the network and can be used to vote whether or not to add the contributions of an open source developer, this is the main way of preventing sabotage on the network.
These same mechanisms can work in reverse, leading to the token economy’s demise if there is a perceived loss of value in the token economy.
Let’s look at a case study of a successful token economy, Bitcoin. The service of the Bitcoin network is to create and verify transactions using cryptography algorithms without centralized authority. The work to be done (mining and verification) on the Bitcoin network is incentivized by crypto token rewards for miners. The reward for completing a block of verified transactions (which involves solving extremely complex computational math problems) started at 50 Bitcoins per block and is cut in half every four years. Currently, the reward per block is 12.5 Bitcoins. As the perceived value of the Bitcoin token increased, the incentive to mine on the network became more attractive and more people started doing work on the network. As more miners are working to verify blocks, the network becomes more secure and the original service (secure decentralized transactions) is improved, thus attracting more customers and again increasing the value of the token. The feedback loop begins.
The Bitcoin network is incentivizing an autonomous group of people to individually contribute to a collective goal. The Bitcoin token allows for transparent, efficient, and fair interactions between market participants, at a low cost.
In summary, token economics is the key to keeping the Bitcoin system sustainable in the long term; blockchain technology is the skeleton of the network, but token economics is the muscle and veins that bring the technology to life.
Why the token economy is set to grow
The size of the Bitcoin blockchain has grown to 344 gigabytes from 197 gigabytes at the start of 2019. As of January 2021, there are more than 4,000 (up from 2,200 in 2019) cryptocurrencies in existence and more than 350,000 (up from 175,00 in 2019) Ethereum token contracts on the Ethereum main network. In June 2019, social media giant Facebook announced it was working on its own token, the Libra token, showing that the trend is not only an underground movement.
Tokens can lower the cost of many current markets. A big part of the lower cost results from the fact that the transaction validity of the business process itself is enforced dynamically by the distributed ledger. This is very different from traditional settings, in which the validation of financial operations consists of labor-heavy auditing systems to avoid “misbehavior.” Replacing human resource–heavy tasks that require domain expertise with automated real-time cryptographic proof of oversight can reduce costs of bureaucracy by orders of magnitude.
Security tokens are a type of token that are increasing in popularity. Security tokens are essentially digital, liquid contracts for fractions of any asset that already has value, like real estate or corporate stock. Security tokens ensure investors that their ownership stake is preserved on the blockchain ledger. With their ability to demonstrate value, security tokens could disrupt traditional finance markets in favor of newer blockchain models.
The truth is that this field is young; experts are still working to define parts of the token economy, and best practices are far from set in stone. Sure, many of the new token economies beginning today will die out, but many of the ones that survive will reshape the digital enterprise landscape.