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Token Economics for Lawyers (2): the value of tokens

May 15, 2023 Manuel Lamiroy Leave a comment

This is the second part of a two-part article. In the first part we explained what tokens and token economics are. We also discussed some legal issues and the relevance for lawyers. In this second part, we look at the value of tokens. Tokens are digital assets. Assets have a value. How is that value assessed? What are the factors in determining the value of tokens? And what are the most common value models for digital tokens?

Factors determining the value of tokens

The value of tokens is determined by a variety of factors, including supply and demand, market sentiment, and the underlying technology. Let’s have a look at those.

Supply and Demand: Like any other asset, the value of tokens is determined by the balance of supply and demand. If there is a high demand for a particular token and a limited supply, the price of the token will go up. Conversely, if there is a low demand and a high supply, the price of the token will go down.

Market Sentiment: The value of tokens is also influenced by market sentiment. If investors believe that a particular token has a strong future, they will be more likely to buy it, increasing its value. Conversely, if there are concerns about the future of a token, investors may sell their holdings, causing the value to drop.

Underlying Technology: The underlying technology of a token can also influence its value. If a token is built on a strong, reliable blockchain network, it may be seen as more valuable than a token built on a less secure network. Similarly, if a new technology is more environmentally friendly than its competitors, it will be considered more valuable.

Terminology

The value of a token is largely determined by the token model. The term token model refers to the design and structure of a token, and how these aim to create a self-sustaining ecosystem that incentivizes network participation and rewards valuable contributions. These models typically include elements such as token distribution, inflation rate, governance mechanisms, and utility functions, among others.

There are several different value models of tokens, each with its own unique characteristics and potential benefits. But before we explain those, it is good to first familiarize ourselves with some of the terminology regarding these characteristics.

A hard cap is the maximum amount of funds that a token sale or initial coin offering (ICO) can raise. Once this cap is reached, no more tokens will be sold or created. A soft cap, on the other hand, is a lower funding threshold that must be met for the project to proceed. If the soft cap is not met, the project may be cancelled or delayed, and investors may receive a refund.

The total token supply is the total number of tokens that will ever be created for a given project. This includes both tokens that have already been distributed and tokens that have not yet been released. The circulating supply, on the other hand, is the number of tokens that are currently in circulation and available for trading. This excludes tokens that are locked up or held by the project team, for example.

The market cap, short for market capitalization, is the total value of all tokens in circulation. It is calculated by multiplying the current price of a token by the circulating supply of tokens. Market cap can be used as an indicator of the overall size and success of a project and is often used to compare different projects within the same industry or sector.

Token value models

There are basically four common types of token value models:

Deflationary tokens

Deflationary tokens are designed to decrease in supply over time, either through burning tokens or reducing the rate of token issuance. In other words, there is a hard cap on the number of tokens created. which acts as a deflationary mechanism as demand increases over time, but supply does not. This creates scarcity and can lead to a rise in the value of the token as demand outstrips supply. The goal is to incentivize long-term holding of the token and discourage short-term speculation. However, there is a risk that the decreasing supply may make the token less attractive for use in transactions, reducing its utility. Examples of deflationary tokens are Bitcoin (BTC), Litecoin (LTC), and Bitcoin Cash (BCH).

Inflationary tokens

Inflationary tokens are the opposite of deflationary tokens. They are designed to increase in supply over time, either through regular token issuance or through other mechanisms such as staking rewards. The goal is to encourage spending and discourage hoarding, as the value of the token may decrease over time due to increased supply. This can also incentivize network participation and development, as new tokens are issued to those who contribute to the network. In this model, there is no hard cap on the number of tokens created. Instead, there are various iterations of the tokens being issued. Some token issuers limit token creation to a yearly basis, while others stick to a set schedule. And some adjust the supply, based on demand data. Examples of inflationary tokens are Ethereum (ETH), Polkadot (DOT), and Solana (SOL).

Dual-tokens model

In a dual-tokens model, there are two tokens: one that serves as a utility token for network access or use, and another that serves as a store of value or governance token. This can help separate the utility and speculative aspects of the token, and potentially provide more stable value for both. The utility token can be inflationary or deflationary depending on the specific model, while the store of value/governance token is typically designed to be more stable. Examples of this are VeChain (VET), VeChain Thor Energy (VTHO), NEO, GAS, Ontology Coin (ONT), Ontology Gas (ONG)

Asset-backed tokens

Asset-backed tokens are tokens that are backed by a physical asset or reserve, such as gold or fiat currency. This provides a degree of stability and confidence in the token’s value, as it is tied to a tangible asset. However, the value of the token may be limited by the value of the underlying asset, and there may be challenges in ensuring the proper reserve ratio and maintaining transparency. Examples are Pax Gold (PAXG), which is linked to the price of gold, as well as Tether (USDT) and USD Coin (USDC), which are both linked to the US Dollar.

Additional considerations

It’s worth noting that these different value models are not mutually exclusive, and hybrid models may also be used to achieve specific goals. Ultimately, the choice of value model depends on the specific use case and goals of the token and its associated network. Overall, the deflationary utility token model is the most popular, with the inflationary token model in second place.

The design of token models plays a crucial role in determining the value of tokens within a given ecosystem. A well-designed token model can create a strong network effect and incentivize various stakeholders to participate in the network. This, in turn, can increase the demand for tokens.

For example, a token with a deflationary supply mechanism may see an increase in its value as the supply decreases over time. Similarly, a token with strong governance mechanisms that allow token holders to have a say in the network’s decision-making process may be more attractive to investors and users, increasing the demand for tokens.

On the other hand, poorly designed token models may lead to a lack of adoption, low network activity, and a decrease in the token’s value. For example, a token with excessive inflation or high transaction fees may discourage users from participating in the network, leading to a decrease in demand and a corresponding decrease in the token’s value.

The value of tokens: conclusion

The value of tokens is determined by a variety of factors, including supply and demand, market sentiment, and the underlying technology. Overall, the value of tokens is closely tied to the token model’s ability to incentivize network participation, promote adoption, and balance the supply and demand dynamics within the network. The success of a token model depends on its ability to provide clear value propositions, promote adoption and usage, and maintain a healthy balance between supply and demand dynamics.

Sources:

Legal IT

Token Economics for Lawyers – part 1

April 19, 2023 Manuel Lamiroy Leave a comment

In this article as well as the next, we have a look at token economics. Now, the expression “token economics” can mean different things depending on the context. What these two articles are about is tokens as digital assets. It is not about token economics in the context of behavioural therapy. (Which is what the entry in the Wikipedia entry is about. So, that may be confusing). In this article, we will discuss definitions of tokens and token economics. We will answer the question “what are digital tokens used for?”. We will also talk about some of the legal issues of token economics, and finally look at the relevance of token economics for lawyers. In the follow-up article, we will focus on the values of tokens as digital assets.

Definitions of tokens and token economics

In today’s digital world, tokens have become a buzzword among investors, entrepreneurs, and businesses. From cryptocurrencies to utility tokens, the rise of tokens has created a new economy where the value of tokens is determined by a complex interplay of supply and demand.

So, what are we talking about? Let’s start with tokens and give an example that everybody probably is familiar with. If you go to a casino, you don’t play with real money. Instead, you exchange real money for tokens, and each token has a specific monetary value. While you are playing, you are using tokens. When you leave, you can exchange the tokens again for real money. A token therefore is something that symbolizes or represents something else.

In the context of token economics, tokens are digital assets, and they are typically created and managed through blockchain technology. They are unique assets that can represent a wide range of things, from cryptocurrencies to loyalty points to real-world assets like stocks and commodities. The key feature of tokens is their ability to store value and be traded freely on digital marketplaces. This means that tokens can be bought and sold like any other asset, allowing investors to benefit from price movements and businesses to raise funds through initial coin offerings (ICOs).

The article on the ESPEO Blockchain website defines token economics as “the study of a new type of economy that can be defined as the design of a particular ecosystem in a blockchain environment. There are as many ecosystems as startups and projects in the blockchain industry, where tokenization is a popular process.” In this context, the expression “token economics” is often shortened to tokenomics.

What are digital tokens used for?

Digital tokens can be used in a variety of ways, depending on the type of token. Some common uses include:

Currency: Cryptocurrencies like Bitcoin and Ethereum are tokens that are used as a medium of exchange. They can be used to purchase goods and services or traded for other currencies.
Utility Tokens: Utility tokens are tokens that are used to access a particular product or service. For example, a company may create a token that can be used to access their platform or to pay for a specific service.
Security Tokens: Security tokens represent ownership of an asset, like stocks, bonds, or real estate. They are governed by securities regulations and offer investors the opportunity to earn dividends or other forms of income.
Fungible and non-fungible tokens:
- Fungible tokens are interchangeable with other tokens of the same type, meaning that each token has the same value and can be exchanged for another token without any loss of value. For example, a 5€ bill is a fungible token, because any two 5€ bills have the same value and can be exchanged for one another without any loss of value.
- Non-fungible tokens, NFTs, on the other hand, are unique and cannot be exchanged for another token without a loss of value. Each token represents a specific asset, such as a piece of artwork or a collectible item and has its own unique value. For example, a unique piece of digital art might be represented as a non-fungible token. (We talked about non-fungible tokens in a previous article).

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Legal issues of token economics

As tokens are assets, there are several legal challenges and issues regarding token economics that one should be aware of.

One of the main challenges is the regulatory uncertainty surrounding tokens. In our article on NFTs, e.g., we mentioned the issues about whether or when NFTs become securities. Depending on their economic characteristics, tokens may be subject to various regulatory regimes, including securities laws, commodities laws, or money transmission laws. This can make it difficult for issuers and investors to navigate the legal landscape and comply with applicable regulations.

Another issue is the potential for fraudulent or abusive practices in token offerings or trading. Due to the lack of regulation and oversight in some token markets, there have been cases of fraud, market manipulation, and other forms of misconduct. Lawyers may need to advise clients on how to comply with anti-fraud laws and regulations, as well as how to mitigate legal risks associated with token-based transactions.

Additionally, there are intellectual property issues related to token economics, particularly with respect to the ownership and licensing of the underlying technology and protocols that support token ecosystems. Lawyers may need to advise clients on patent, copyright, and trademark issues related to token-related technologies, as well as on licensing and commercialization strategies.

Finally, there are data privacy and cybersecurity concerns associated with token transactions, which can be particularly acute in decentralized networks where personal data is stored and transmitted across multiple nodes. Lawyers may need to advise clients on how to comply with data protection.

Relevance for lawyers

So, how are token economics relevant to lawyers?

As mentioned above, token economics can impact the regulatory treatment of tokens. For example, if a token is classified as a security, it may be subject to more stringent regulations than if it is classified as a utility token. Lawyers may need to be familiar with the various factors that determine the classification of a token, such as its economic purpose, distribution, and governance.

Secondly, lawyers may need to understand token economics to advise clients on the legal implications of launching a token-based project or participating in a token sale. This could include drafting legal documents such as token purchase agreements, whitepapers, or terms of service that incorporate the economic features of the token.

Thirdly, token economics can affect the way that tokens are valued and traded in the market. Lawyers may need to understand the mechanics of token supply, demand, and circulation to advise clients on issues such as token pricing, market manipulation, or insider trading. We will discuss those in our next article.

Finally, token economics is a rapidly evolving field that requires interdisciplinary knowledge and collaboration between legal and technical experts. Lawyers who are familiar with token economics may be better positioned to engage with clients in emerging sectors such as decentralized finance (DeFi) or non-fungible tokens (NFTs), where the legal implications of token economics are still being defined.

Conclusion

Tokens are digital assets that are typically created and managed through blockchain technology. They are assets that can represent a wide range of things, from cryptocurrencies to loyalty points to real-world assets like stocks and commodities. They can be used in a variety of ways, including as currency, utility tokens, and security tokens. As the digital world continues to evolve, the importance of tokens in the economy is likely to grow. By understanding token economics and the value of tokens, lawyers can assist their clients in making informed decisions and navigating this new landscape with confidence.