When Token: The core thesis of tokenomics and when you should use a token in your protocol

Web3 projects are big on using tokens. With good reason. Beyond decentralization, adding ‘money’ to the internet is one of the big innovations crypto has brought to the table. But when do tokens make sense and when don’t they?

Why use a token?

Web3 is built around decentralized systems. That means that the core problem is around coordination: getting actors and stakeholders to coordinate around a common goal despite having different personal incentives. That is the purpose that tokens come to solve. Tokenomics serve to solve coordination problems in decentralized systems.

Tokenomics serve to solve coordination problems in decentralized systems.

The best use cases for tokens have been in this category. For example:

• Bitcoin (BTC) helps coordination of a decentralized system towards a peer to peer payment system and a store of value without any centralized party.
• Ethereum (ETH )helps coordination of a decentralized computing platform.
• Tellor (TRB) helps coordinate decentralized oracles.

In each of these use cases the tokens serve to coordinate action amongst a group of decentralized actors in order to achieve a common goal. The token aligns incentives towards the desired outcome.

This is the best use case for web3 tokens: aligning incentives and coordinating actions across decentralized parties to achieve a common goal.

Tokenomics: when does it make sense to use a token?

In the past, to coordinate this kind of action would have required either years of time to reach critical mass, a huge financing body to promote a specific standard and a large business development push. This is the way that earlier internet protocols came to become what they are today: SMTP, HTTP, IP etc. In non web3 protocols, the same dynamic is playing out as we speak with newer protocols. For example the automotive market has been arguing over whether to use DSRC or C-V2X for the past decade.

Tokens solve this. They align incentives and make it in everyone’s best interest to adopt the protocol earlier rather than later by creating financial, governmental or other forms of upside for early adopters.

But these kinds of situations aren’t as common as we’d like. As has become apparent over the past few years in the web3 ecosystem, it’s rare to find a token that actually ‘makes sense’. So when do these kinds of tokens make sense? What prerequisites should we look for?

Two factors to Wen Token

There are two factors to look at when evaluating whether a token will actually achieve success in aligning incentives across decentralized stakeholders:

1. The problem that’s being solved is large enough that participating in the system that solves it provides enough incentive. Incentives can be monetary, governance or control related or social. There just has to be enough to go around to be significant enough to influence behavior of the participants.
2. The incentive the solution offers fits the stake holders problems. As in, if participants have a monetary incentive, then the problem space has to generate enough monetary surplus to incentivize participation. If there isn’t enough value in the system, stakeholders won’t be interested in acting in the proper way.

Let’s look at two examples to make these factors clearer.

Bitcoin: Where tokens makes sense

Let’s use Bitcoin as an example and check the two factors.

1. Is the problem that’s being solved large enough? Yes — Bitcoin is solving a peer to peer payments system and digital store of value problem. The problem space has enough monetary TAM to provide significant fees for all participants. While there is a maximum cap to the TAM (which I analyze here: “The Bitcoin Maxi Price”), it’s still large.
2. Does the incentive the token supplies fit the motivation of the stakeholders? Yes — participants in the Bitcoin protocol are interested in monetary rewards nothing else. They are interested in a digital store of value or alternatively a digital cash system. The incentives line up.

Uniswap: A more nuanced case

Exploring Uniswap’s token drop shows a more nuanced picture. Firstly, UNI, Uniswap’s token doesn’t come to solve a pure decentralized system acting towards a common goal in the same sense as Bitcoin. UNI is the governance token of the Uniswap protocol. However significant portions of the Uniswap protocol are already deployed on the Ethereum blockchain and immutable: such as the common Uniswap liquidity pool smart contract. Thus the token isn’t here to align incentives among different active stakeholders. Rather it’s a governance token, more akin to a share in a corporation. It gives voting rights, but doesn’t promote active participation in the same way that Bitcoin promotes mining and running nodes. So already in the first key category UNI falls short.

Let’s take a look at the other two factors:

1. Is the problem that’s being solved large enough? Yes — Uniswap has seen massive success and volume crossing across its DEX’s. The liquidity problem has a large monetary TAM which means that governance has value. Should UNI holders decide that a small fee should accrue to the token, they could see financial upside (whether that’s a good idea or not is something I discuss here: “How to build a moat in web3”).
2. Does the incentive the token supplies fir the motivation of the stakeholders? Yes — Uniswap is a financial protocol, participants are looking for financial upside.

However, while the UNI token is meant to incentivize active participation in protocol governance to maintain decentralization, most token holders don’t receive enough financial incentive to promote this activity and therefore there is a slight mismatch between what the token was designed to do and how it actually plays out.

Summarizing when to use a token

Tokens make the most sense when you’re trying to build a decentralized system or protocol that relies on different, uncoordinated, stakeholders acting in a coordinated way to achieve a common goal. Tokens become the language of coordination to solve the decentralized coordination problem.

But even then, tokens don’t always work. You need two additional factors:

1. A problem that’s worth solving, so that the upside is significant enough to incentivize the desired action.
2. A problem where the incentive matches the motivation of the participants.

What about the use case of jumpstarting a network effect using tokens? Well, that’s a use case I’ll debunk in another post.

I design tokenomics for crypto protocols and am putting everything I’m learning into a super in depth course on Tokenomics. If you’re interested in my free email course on tokenomics, sign up here!