The Web3 Paradigm: Tokens (Part 1)
Cryptoassets have proliferated at an astonishing speed. At the time of writing, there are >12,000 different tokens that aggregate to approximately $1 trillion market capitalisation (source: Coingecko). Although Bitcoin and Ethereum still make up more than half of this figure, a long tail of tokens has emerged since Bitcoin’s zero to one moment in 2009.
Owing to its extreme volatility, the crypto market has been a seductive destination for retail traders. Many effectively regard it as an online casino. But as long-term investors who look for sustainable value accretion, we ask: what are tokens and what is their intrinsic value? This article and its sequel will address these basic but fundamental questions.
What are tokens?
Tokens are instruments that power cryptonetworks and decentralised applications. While tokens range in their design and purpose, one universal function is that they are used for capital formation. Capital raised from token sales provide the founding team start-up funds to develop and grow the product. Token sales can happen through an ICO (Initial Coin Offering) – during which retail investors contribute capital to the project, similar to a crowdfunding campaign – or privately to venture capital firms. The latter route has been gaining popularity due to regulatory concerns in many jurisdictions.
Broadly, tokens can be categorised into three types:
Cryptocurrency
A cryptocurrency is a native digital currency of a layer-1 blockchain. Cryptocurrencies are used to pay for transaction fees (also called “gas fees”) to miners/validators who provide their computing resource to maintain the blockchain in question.
Layer-1 blockchains are often likened to nations, and their native assets, to the nation’s legal tender. For example, just as USD is required to carry out financial transactions in the United States, ETH is required to carry out financial transactions on the Ethereum blockchain.
Successful cryptocurrencies may become de facto currency by serving the three major functions of money: medium of exchange, unit of account and store of value.
Application Tokens
Application tokens are digital assets associated with decentralised applications built on top of an existing blockchain. Application tokens vary greatly in use case and purpose. Most common types can be boiled down to three categories, namely utility tokens, non-fungible tokens (NFTs) and tokenised securities/funds.
Utility tokens: As the name suggests, utility tokens have intrinsic utility. We elaborate on the four types of utility: payment, collateral, governance and discount.
Payment: Payment tokens are proprietary currencies used to access a product or service within a crypto application. Think of it as credit for a specific online service which you can redeem in exchange for the service.
An example of a payment token is Filecoin’s FIL token. Filecoin, launched in 2017, is a peer-to-peer file storage network, through which people can lend their unused computer storage space to those needing it. Users pay suppliers in FIL for the storage service rendered. Filecoin is essentially a decentralised alternative to Amazon S3 and Google Cloud, with the theoretical benefit for users being a cheaper service (since the open network of storage providers competing against each other will drive down prices) and a passive income opportunity for the storage provider.
Collateral: Continuing with the Filecoin example, there is additional utility to the FIL token, which is that storage providers are required to hold and “stake” (pledge) FIL to join the network as a supplier. The staked tokens, which are essentially a form of collateral, are “slashed” (taken away) as penalty if the storage provider does not deliver the service according to the network’s standard – such as failing to retrieve the customer’s file with some minimum bandwidth guarantee. This provides additional assurance to the user that the provider has an incentive to adhere to the agreed-on terms.
From service providers’ perspective, collateral tokens give them the right to perform work for a crypto network and earn fees.
Governance: Governance tokens grant the holder voting rights on decisions that affect the crypto protocol’s roadmap. Developers usually publish improvement proposals and let the community vote by staking their governance tokens – the results from which are recorded on the blockchain and actioned. Depending on how far the project is on its decentralisation journey, topics for voting could range from product expansion plans to revenue model to the project’s capital allocation strategy.
One example of a governance token is Uniswap’s UNI token. Uniswap is a dominant decentralised exchange which enables “swaps” (i.e. buy/sell) between tokens for a fee. Since launching in 2018, the app has processed over $1.1 trillion of trading volumes and generated $2.7 billion in trading fees for its LPs (Liquidity Providers). Whilst UNI tokenholders currently do not have a claim on this cashflow, governance discussions are underway regarding a “fee switch”; if voted on by the UNI tokenholders and implemented, a proportion of fees to the LPs will be shared with the tokenholders. Uniswap’s proposals go through a life cycle, namely discussions on the forum and early temperature check votes to eventually proposal creation and voting.
Discount: Discount tokens work like a loyalty program in that holders qualify for discounts on products/services. Many tokens of centralised exchanges use this model.
Consider Binance – the world’s largest crypto exchange with >50% market share – and its BNB token. BNB is a payment token that is used to pay for transactions in the Binance ecosystem. But Binance also offers BNB holders a 25% discount on spot and margin trading fees and a 10% discount on futures trading fees. Details can be found here.
As implied above, a token’s utility features are not mutually-exclusive; a token can have more than one utility type.
A final remark on utility tokens is that layer-1 blockchain cryptocurrencies can technically be classified as utility tokens. ETH is used both as a payment and collateral token. Ethereum users pay validators in ETH as payment for their consensus and compute service. Meanwhile, validators must stake 32 ETH (~$50,000) as collateral to gain the right to participate and earn fees from the Ethereum network. The staked ETH creates an incentive for validators to act honestly, since malicious behaviour can result in the slashing of their collateral. ETH however doesn’t grant any governance rights to tokenholders, nor does it give any discounts on services. Ethereum follows soft-form governance where coordination between researchers and developers to improve the blockchain happens “off-chain.”
Non-Fungible Tokens (NFTs): NFTs are digital items that cannot be replicated. Blockchains provide digital proof of ownership, which means the provenance of the unique item is easily traceable. NFTs can be digital art, digital real estate or even any personal data such as one’s health data or credit scores.
In the last bull market of 2021, headlines in the NFT world primarily pertained to JPEGs that rose to prominence such as the Bored Ape collection (which currently trades at a floor price of 72 ETH or ~$114,000 in the secondary market!). The value of blue-chip NFTs are influenced by their scarcity and the human desire for status signalling, similar to physical luxury items.
Beyond digital luxury items, there are interesting NFT use cases that would allow users to have better control of their own data, and monetise it should they desire. A genomic sequencing start-up called Nebula Genomics is doing just this. With its partnership with a privacy-preserving blockchain called Oasis Network, Nebula Genomics is giving individuals the ability to safely store their genomic data and control who they give read-access to.
Tokenised Securities/Funds: Traditional securities or funds can be moved onto a blockchain from legacy systems for operational efficiencies such as faster settlement times. For instance, a private equity firm KKR has recently announced that it will tokenise its Health Care Strategic Growth Fund on the Avalanche blockchain.
Stablecoins
Stablecoins are digital assets pegged to government-backed fiat currencies such as the dollar or euro. They connect the real-world to the blockchain-based economies. There are multiple different ways for constructing Stablecoins, but the most popular is cash-backed. This is where a centralised entity (e.g. Circle) issues one unit of stablecoin (e.g. 1 USDC which is pegged to USD) and deposits a traditional asset (e.g. 1 USD) as a cash reserve in the traditional banking system. The risk of a stablecoin varies based on the extent of collateralisation and the quality of the reserve assets (100% reserve ratio in the same asset would be considered the safest, i.e. 1 USD backing 1 US stablecoin). After the failure of certain under-reserved stablecoins, stablecoin regulation has become a big area of interest for global regulators.
Stablecoins have been a hit product. At the time of writing, total supply exceeds $135 billion. The main players are Tether (USDT), Circle (USDC) and Binance (BUSD).
Source: The Block
Conclusion
A key takeaway from this post is intended to be that tokens are not monolithic. Different types of tokens possess different characteristics. They can have a combination of utility types as we saw with Ethereum’s ETH (payment + collateral), Filecoin’s FIL (payment + collateral) and Binance’s BNB (payment + discount).
The below chart shows a summary of the top 100 tokens by their utility. The most common function of a token is found to be for Payment, followed by Collateral, Governance then Discount. Excluding the 11 stablecoins in the top 100, tokens on average had 2 different utility types.
A careful examination of a token’s purpose and function is necessary before contemplating its intrinsic value. In the next article, The Web3 Paradigm: Tokens (Part 2), we will dive into some of the proposed valuation methodologies for tokens.