Centralized system are controlled and run by a single company, government, or individual where all decisions and control is based upon one group. Decentralized system however are run by a network of participants that no one is able control or shut down. When it comes to our financial system, three characteristics are very important: trustless, transparent, and unbiased.
When it comes to the financial system, it is important to understand how cryptocurrencies and tokens could play a role in decentralization. Thoroughly understanding the following points helps us understand them better:
- How cryptocurrencies and tokens are valued
- What cryptocurrencies and tokens serve in their underlying blockchain networks
- Why cryptocurrencies and tokens would be preferred over traditional financial instruments in the future
I will define cryptocurrencies and tokens first then explain these points as well as give example based off today’s most popular projects.
Cryptocurrencies are digital assets that have two main purposes, serving as a store of value and/or a medium of exchange. These are also general definitions of money or currency which is also why cryptocurrencies also thought of as a newer type of money. Bitcoin was what started the whole revolution of decentralized digital assets. Bitcoin can be used a form of money for purchasing any type of commodities, representing a medium of exchange, and a scarce digital asset which no one can produce similar to gold and silver, representing a store of value.
Tokens, although often confused with, are different than cryptocurrencies when it comes to their main purpose. They are digital assets whose main purpose is to provide some type of utility on the blockchain other than what cryptocurrencies do. Most tokens are used for purposes such as protocol governance, network access, and staking rewards. Following sections give a more in-depth analysis of their uses and functionalities.
It is important to note that the difference between them is not really that important as they are just terms to express two different types of their properties. Also, a lot of their properties overlap such as the way tokens can be used for a store of value or a medium of exchange and cryptocurrencies such as Bitcoin inherits token properties by rewarding its miners with Bitcoin. The main reason I got into their differences is to explain in the following sections the value and utility these digital assets bring to the financial industry that has not been seen before.
After establishing the definition of crypto assets it is important to dive deeper into their purpose and applications. Hence, we need to examine their roles, incentives and efficiency when it comes to applications and smart contracts built on decentralized blockchain networks.
Decentralized Blockchain Networks
One of the easiest ways to fully grasp the idea behind how decentralized blockchain networks work is to realize the differences between them and what we mainly have now. Furthermore, they are very similar to traditional businesses, however, very different at the same time.
As most of us know, businesses usually own their products or services under a license or some type of legal right. They are also responsible for making sure they are maximizing their profits and providing their shareholders the most that they are able to make out of their products or services. Most of these decisions are being carried out by a group of people, usually executives, who take control of every decision and action being done for the business. The two takeaways is traditional businesses are in charge of always generating as much profit as possible as well them being controlled by a set of users.
On the other side, decentralized networks are not businesses. Instead, they are a public open source, usually free, set of intangible assets which the product is maintained by a decentralized group of independent people. Despite being able to maintain and develop, these people do not have any type of advantage over the others nor do they own the product or service.
It is important to realize that they don’t act like traditional businesses, they are essentially self-dependent systems of logic that systematize exchanges done between operators (sellers) and consumers (buyers) of a service. They have no aim for or care about profitability. They aim to create as much value as possible while being minimally extractive. Carrying out the exchanges is the main goal as that is what keeps the system going and is also what determines its value. On the other side, businesses are induced to be maximally extractive and creating as much profit from the customers as possible since its evaluation is a factor of its profits. At the same time, both can be somewhat similar as you can think of decentralized networks as an Amazon that automatically processes exchanges between supply and demand, but in a trustless environment where everything can be verified and no one can alter.
I should mention that when I say minimal extraction I do not mean that they seize minimum value but instead they are designed to function for the lowest cost possible. When using decentralized blockchain networks such as Bitcoin or Ethereum, you only pay a minimum amount the transaction fee (sometimes refereed as Gas fee) requires you to pay to use the network. This fee is used to pay the validators who help keep the system running by validating each transaction performed. Thus, there is no central authority seeking to increase costs; businesses tend to increase costs as they form a monopoly or for example sell customer data which might be illegal.
Incentivizing Decentralization
Using blockchain technology, decentralized networks are capable of providing coordination services that are verifiable and secure same as centralized options do but instead keeping the control with the community rather than a single entity. However, in order for the system to work, there needs to be engagement from two main parties: operators and consumers. Given that if one is missing, it will fail. At the same time they are not free to use. This leads us to a problem about costs used to run the network.
Operator:
There are many ways that operators contribute to securing and validating the network protocol such as mining, staking, voting, or plotting — depending on the network’s consensus algorithm. These operators have to worry about profitability as they would shut down if they were losing money for too long. Therefore, it is important for the network protocol to be designed properly to maintain profitability for its operators. Else, it would be abandoned.
Consumer:
Consumers will always have to pay to use the network, one way or another. The most common ways are transaction fees, staking, or inflation. Some are better than the other for different types of uses. Consumers are required to pay fees to the operators that are serving the community by securing the network. Another group that is often paid, depending on the network, are the developers for providing the service being run on the network protocol. Ethereum users, for example, have to pay a transaction fee for each transaction done on it. Individual consumers are able to set a fee limit, however, the fee is technically set by the market as consumers bid higher to have their transaction done faster. Unlike traditional businesses which set the prices, in decentralized networks the market of consumers decide it therefore paying lower prices.
It is important to have incentives for anyone to maintain the network or else people would have to trust the generosity and goodwill others to to validate and secure the network which definitely does not work in a trillion dollar market like Bitcoin. Consumers also wouldn’t pay to use a network that isn’t valid or secure. Decentralized networks need to fuel up their growth first by generating funds.
Funding
VC Funding:
Centralized businesses usually rely on outside capital coming from venture capitalists to raise funds. This model can work very well when providing the initial capital used to fund the early development for a minimally extractive decentralized network, however, it gets really problematic when trying to get a decentralized network to become sustainable for long-term success. When networks rely on VC funding, they would need some type of value extraction from their users in order to repay their investors and shareholders. The network would also lack neutrality for the future of the network. Thus, this would challenge the whole idea of a minimally extractive system discussed earlier.
Usually when the network’s focus of being minimally extractive is shifted away, that will result in an impact on the users. By trying to extract as much value from the users that would make the network less competitive in comparison to others that do not use any VC funding. By increasing the network fee or creating bias towards their biggest investors, that would shift the network away from being community based. Instead, the other networks would be spending their time and resources back into their user community and making sure they pay the operators as high as possible to ensure security of their system.
Solution:
Instead of relying on VC funding and taking on debt, a better approach is to create a crypto token that is used throughout the network. This token would then be a required part of using the network protocol. In return, it helps raise funds and grow the network without taking on any debt from VCs and keeps the network minimally extractive for their users. By doing that, the value of the token on the market would then be linked to the value of the network itself. It is important for the token to have real financial value on the market in order for it to support the network’s growth.
Creating assets in the form of a token with inherit value through services allows decentralized networks to avoid taking on debt and creating bias, therefore remaining minimally extractive and decentralized.
There are many different ways in which the token benefits the network. They create a domino effect between the developers, users, and the investors. The developers of the network initially sell the token without taking on any debt using methods such as initial coin offerings. After selling some, the protocol also sets aside some of the tokens from the supply in order to reward the operators (e.g. miners) over time for securing and running the protocol. By keeping the network debt free, that also helps keep the network minimally extractive hence lowering costs for the users and paying the operators as high as possible.
As discussed earlier it is important for the token to have a case use, other than for raising funds, throughout the network in order for it to capture the value of its network. If the token lacks in capturing the value of the network, then it would have no intrinsic value other than just speculation or an expectation for a change. Also, if the token has no value that would hinder the fund raising and the operators would not be willing to run the network to get paid with it. All in all, that would affect the growth of the network in the long term.
As we’ve seen recently in the 2021 bull run, many meme tokens have gone 1million x or so although they have no real intrinsic value. These tokens are usually made just for quick pump and dumps cases and don’t last long. What separates tokens with real intrinsic value from these tokens is that they are able to maintain demand from the users when the token is constantly being used alongside its underlying network for reasons other than just trading. One great example is Chainlink’s token which is used by users for using their nodes, paying node operators, staking, and more. In return, this generates a growth cycle:
- A token is distributed by the development team using methods such as public selling, mining, and yield farming. An allocation of the token’s supply kept to be used for the network’s growth by rewarding the network operators and providers (e.g. miners and liquidity providers).
- Thereby, higher rewards for the operators results in a greater network service for the users(e.g. higher security, more liquid trades, etc). This in return leads to more services, released by the developers, as well higher user traffic meaning additional fees paid to the operators.
- With more network usage and higher user traffic that results in a higher demand for the token, therefore growing the network’s valuation and token’s market cap.
- Again, growth of the network’s valuation and its token consequently leads to more allocation for operators, resulting in more capital to fund and grow the network. It also attracts more investors and users therefore reenabling the cycle again.
The tokens economics and fundamentals are very important when trying to capture the value and drive demand for the network. I will now list a few of the most successful and effective methods some networks have implemented in the past.
Staking and Lockups
Staking is a method used by network protocols which incentivizes token holders to lock up their tokens in return for services or rewards. Staking mechanisms vary between different protocols however they all revolve around the idea of users using nodes to take tokens off the market and placing them in a state of illiquidity, reducing the circulating supply and ensuring the integrity, security and continuity of the network. When users provide tokens, they are rewarded dividends or network fees as a form of passive income.
There are many different consensus mechanisms that include staking but the most popular is the Proof-of-Stake which is currently used in networks such as Ethereum 2.0, Tezos, and Polkadot. When it comes to Ethereum 2.0, users are able to participate in staking by locking up 32 $ETH in a staking pool in order to validate transactions and produce blocks on the blockchain. However, stakers could possibly lose all their tokens and get kicked out of the system for actions such as malicious activities to corrupt the network, going offline, or failing to validate. Therefore this incentivizes honesty and integrity throughout the network. In return, Ethereum stakers are rewarded by block reward subsidies, new Ethereum getting minted each block, and network transaction fees.
Another form of staking is called insurance pools which is used to protect users from potential losses a protocol could suffer from due to attacks or bugs. One of the biggest insurance pools is Aave, a liquidity protocol, which incentivizes users to lock up their $AAVE tokens into a Smart Contract-based component called the Safety Module. The locked $AAVE is as a mitigation tool in case a deficit for the liquidity providers occurs within the money markets that belong to the Aave ecosystem. Stakers are incentivized to lock up their $AAVE tokens in return for rewards generated through inflation subsidies and fee distributions. Aave’s safety module covers a broad category of risks faced by the protocol and just like most protocols, it incentivizes its users to hold its tokens for the long term to ensure the network’s security.
A different form of staking you might experience in automated market makers such as SushiSwap or UniSwap is Liquidity Providing. That is a term used to describe users locking up their tokens in a pool in order to make trading on platforms easier, limiting slippage. When funding the pool, they are usually required to fund two different assets to enable traders to switch between one to the other by trading them in pairs. In return liquidity providers are given a portion of the transaction fee. It is important to note though that this does not play a direct role in giving tokens value by tying tokens to their network protocols, it is more of a method for facilitating token trades.
Token Payments for Network Protocol Access
One of the simplest but effective ways to tie token value to network protocols is by requiring payments for network services to be done using the token. This requires all users to acquire the tokens in order to interact with the network, increasing market demand. By driving up demand for the token using the network’s services, it forces that the demand for the tokens to flow through demand for the network’s services. At the same time, increasing the token’s value incentivizes security nodes to sustain the network’s security as its services depend on it and the node’s payments are also influenced by the token’s value.
One of the best examples of such a design is the Ethereum network and its native token, $ETH. Whenever users perform a transaction they are required to pay the validators for the network service with $ETH in what is called a ‘gas fee’ measured in Wei, equal to 10^-18 of an $ETH. The amount of ‘gas’ paid depends on the complexity of the transaction and how much power it needs to run. The current average gas fee by the time I wrote this is 33.6 Gwei. This makes the $ETH token the native token as anything from interacting with smart contracts to moving other tokens need a fee to be paid in $ETH.
Let’s take a look at the Bitcoin network. Bitcoin functions in a similar idea using its native token, $BTC. Bitcoin is well known for being the best store of value similar to its nickname, “digital gold” unlike Ethereum which is known for its smart contract ecosystem. For each block being created on the Bitcoin blockchain there are new bitcoins being minted in order to reward the miners this amount splits into half every four years, a process called halving, therefore as time goes on the miners make less. In order to keep the Bitcoin network secure over time, users are required to pay a fee using $BTC, similar to Ethereum’s.
If you realized, we only discussed the importance of maintaining an increasing demand for the native token for the users. However, it is also as equally important to maintain this demand throughout the operators (miners, stakers). Therefore, we need an additional way to incentivize the operators to hold on to their tokens rather than selling them. Ethereum, for example, is currently working on moving to a proof-of-stake system which will encourage the operators to stake their tokens rather than selling. Bitcoin on the other side, operating on the proof-of-work consensus mechanism, maintains a social agreement of being a great store of value across the community therefore discouraging operators to sell to other assets like fiat.
Governance Voting as Decentralized Autonomous Organizations
Decentralized Autonomous Organizations (DAO) are organizations represented by rules encoded as a computer program that is transparent, controlled by the organization members, and not influenced by a central government. As DAOs became more popular, there have been so many networks that create governance tokens. By holding governance tokens, network users are able to vote on certain proposals in order to make changes or improvements for the network. Most of the networks are designed that each token a user owns would count as a vote. Therefore, people are incentivized to hold on to their tokens in order to gain more power over the future of the network. One person or a small group having most of the votes could sometimes be bad, however most of the time the proposals being made are not destructive and often just variables such as fee percentages. At the same time, there have been different voting structures such as quadratic voting which fix the majority rule problem.
There are many types which networks build to implement token-based governance. Some use on-chain governance and others use off-chain. On-chain governance is when networks use hard-coded smart contracts that are built on the blockchain. These smart contracts handle the token-based voting on the blockchain then implement the changes by themselves based off the results. This method could be described as more decentralized compared to off-chain as you developers or operators cannot alter the results afterwards. On the other side, off-chain governance is when networks implement token-based voting however without binding rules based off the results. However, power is more centralized around the developers and miners in this system.
Based off past and current projects, I do not believe creating governance tokens to be the greatest way to incentivize demand for the networks protocol. Governance is really important when it comes to decentralization but it is usually just an additional feature for the network.
Fee Redistributions and Token Burns
The phrase “token burn” means algorithmically taking tokens out of market circulation by sending them to a locked address known as a “burn address”. Nobody owns the keys to this address therefore no one can retrieve these tokens and they will remain there forever. Therefore, some networks would use fees to purchase the tokens from the market and burn them. Most networks do that to accrue in token’s value and therefore to create additional incentives for traders and holders. As more tokens are burned, there will be fewer tokens available on the market therefore dragging the token’s price up. Some networks would use the fees generated from the users to pay them back directly to the holders of the token. Providing the users a form of passive income as dividends would incentivize users to keep holding the token as well as buy back more of the token with the fees paid in order to earn even more rewards.
A great example of a dividend paying token is SushiSwap’s $SUSHI. All trades on SushiSwap come with a 0.3% where 0.25% is provided to their liquidity providers and 0.05% being used to buy their own token in order to distribute them to $xSUSHI holders.
There is also a slight difference between burning tokens and issuing dividends. After a token burn, prices do not directly increase in value, however over time because of scarcity of the token through deflationary pressure and a hard-capped total supply, holders would begin to see the appreciation. When it comes to dividend payments, they are usually more obvious to holders as cash flow is more evident. In the end, it’s all about supply and demand. Decreasing the coin supply available or creating higher demand by paying dividends will generally result in the token becoming more valuable over time.
Decentralized networks and blockchains are on a verge to change everything about our society and disrupt any form of centralized model, therefore instead supporting information transparency, societal fairness, accessibility, and security. They aim to assist in creating a more trusted and inclusive digital environment across everyone. By removing a single centralized point of failure, decentralized systems are able to improve industries where any type of exchange or security are the primary problems. Replacing centralized institutions brings about the ability for anyone to be able to exchange value without being maximally extractive or monopolistic.
Through crypto assets, such as tokens, decentralized networks are able to do just that. Tokens on blockchain systems are built to providing a minimally extractive environment without any debt that will create bias. This yields to a self-sustainable community based environment that’s only goal is to serve the users of the network as efficiently as possible.
At the same time, current decentralized networks might come with disadvantages compared to centralized such as they could be more expensive or inefficient to work with or slower to develop and interact with. I do believe that centralization will still exist, however there are many industries that need to be trustless, censorship-free, and reliable such as our financial system, which is what decentralized networks do better.
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