Crypto Tokenomics: When you need to create a token

Jai Shri Ganesha

This post is a direct outcome of the question that was posted on Cardono forum. Here is a the approximate summary of the question:

Why do we have to create tokens with economic value that cannibalise the host blockchain and that you could buy with other currencies. The author wanted to clarify the following:

The “smart contract” is that you pay a certain amount as insurance in dollars and you get paid a fixed amount in case of an accident. But the amount is not in “insurance tokens”, it’s in dollars. Or another example Amazon gift cards are denominated in dollars as well, not in “Amazon tokens”.

So what the person was confused about, is that he is comparing the gift card or an insurance with a token issued on blockchain. Obviously there is a clear need to identify what a token is, and what it can do for the common societal use cases. More important question to answer is, when it is not needed.

This is the question we will explore in this brief article.

In principle imagine for a moment that we are now building web3.0 where value will be exchanged and we have information highway where such value transaction can happen. In this case it happens to be the decentralized blockchain of cardano. Here only ADA tokens would be a valid currency but in principle if there is an automated conversion ATM next to the entry to this highway i might as well be able to pay in my currency which gets converted to ADA in the backend. So in principle this is the easiest way for anyone to use this highway. Now question is why would anyone use this service ? The reason is that business now can interact with any other third party who are offering their services on this highway, and we might want to avail of such services. Say a petrol pump chain offers their payment services via cardano Blockchain. They provide an SDK(software development kit) that allows me to integrate it into my car recharge card (digital) and this costs me fraction of current complex payment systems via credit card / paypal etc.

Nowhere in this scenario should we be constrained to create our own tokens, because the gas recharge station is only interested in the end for getting its payment no matter in which currency. Thus from this standpoint, I think for each and every service creating a token is pretty useless exercise without any rationality. And if we can keep transaction as transparent as the above scenario, complexity of the system will be reduced and lesser friction for integration.

Now coming to the topic of how such services can be distinguished from one another in a universal open ledger and whether token is the only way to do that ? Let us explore that in bit more detail.

In the example of gas station above, it is service layer built on top of blockchain providing a specific value added service. And anyone who integrates it will have to pay for this service. The contract in the end will have some kind of unique identifier (TOKEN or Otherwise) which is kind of unique Domain/sub-domain for the blockchain that identifies the service provider. So every blockchain would need a system to uniquely identify transactions and these identifiers needs to be translated to real world use cases or objects.

For example we have now unique ID for the stakepools (and these are baked into the blockchain as metadata). That is all in my opinion that is needed. This identifier will be a proxy to the service being provided and the underlying unit of exchange that is provided via this identifier, can be be in ADA (native currency of Cardano in this case).

Tokens as tradable commodity: Why needed ?

Now let us take the concept of the unique identifier we have found in the earlier discussion a step forward…

We now have a unique identifier via which we can provide service and value exchange on the blockchain. Base currency for transaction is ADA (for Cardano chain) and till now we do not find the need of so called separate TOKEN requirement just the need of an unique identifier.

Now think of the following scenario. After a service is provided and a receipt about this transaction is provided to the client (also shows the payment done for getting this service). If the person is not happy and wants to return this object, he can use this receipt and a new cancellation transaction using this receipt identifier can be performed on the chain. All works till now.

Now replace this simple exchange with something like a share/Equity certificate or a Bond certificate (financial instruments). These kind of certificates have a time value as well. So if you buy a stock and sell it after 10 years the value might be entirely different. Same for bonds. In the earlier example, the receipt issued to the user is probably worthless in the few weeks even, as the return of the object is possible only within few weeks.

Also another reason a separate token may be needed to be created is to restrict the supply of a particular kind of token (max number to be issued). So when we create a particular token, which has a unique identifier, and we constrain the number of tokens issued, its utility value will increase if demand increases over time and inflation will be limited in the long term. Hence only for assets which increase in value, this becomes useful. So kind of putting money where the value is. Otherwise it will artificially lead to degeneration of this token. This scarcity needs to be embedded in the smart contract and would be bound by community voting rights if it needs to be modified.

So there is a stark difference between two kinds of receipt. One carries a time value with it (bond, stocks) and other does not (car insurance receipt).

So now given this differentiation where we have to take into account time value of the receipt/certificate how do we ensure such an instrument on blockchain ?

This is where precisely the concept of Smart Tokens kick in. We can now program a contract (Henceforth we call this Smart Contract) where multiple parties can collaborate with one another (trust relationships) and what comes out in the end is a contract / Token to represent this contract.

Does that mean for every sort of interaction this kind of contract is valuable or should be used ?

Answer is a clear no.

Why ?

Because whenever we commit data to the blockchain it costs money. Hence economically it will only make sense to execute a smart contract where multiple parties exchange value. And the value exchanged has to exceed the value of the cost of transaction incurred by the smart contract execution (probably by a large factor). Otherwise it makes little economic sense because this contract may change hands 100 of times and each time a transaction cost needs to be paid. So only if total transaction cost is lesser by a large factor of the underlying value, it will be a case for smart contract.

Examples of smart contracts:

Smart Bonds

For a value added service like a debt instrument on top of cardano (like a bond contract), we need to give the user a certificate of issuance of the bond. That bond instrument can be called a token, and can take up a different valuation which will be derived partly from the underlying instrument (ADA) or something else (time, etc.). So now in order to give the user something to hold in return for the money that they have deposited. we issue a CERTIFICATE or TOKEN. It is just a derived value and a representation of the same.

NFT (Non fungible tokens):

When we translate the existence of real world objects like painting, diamonds and other unique assets and want to issue a CERTIFICATE or TOKEN for this uniqueness, we use the immutability of the distributed ledger called blockchain for this purpose. We kind of execute a small contract that commits the object properties to the chain, and then issue a TOKEN to represent this transaction. In this case also the TOKEN represents some sort of value because it represents the real world object and people can now not easily fake the identity of the article (unless it is easy to form replica etc.), because the smart contract will not allow that.

Smart contract related TOKENS becoming their own currency:

One of the confusions people also face is, the association of tokens as a tradeable currency. In principle this should NOT be the defacto standard. It has become so on the last generation chains like Ethereum unfortunately, and has given a bad name to the Defi movement based on it, where many junk tokens are being created and traded (common people being caught up in this frenzy of quick money without truly understanding this concept of long term value creation).

What we see now is hundreds of tokens being accepted by the crypto exchanges which are built on various blockchains in the hope that people fall into the trap and invest in the hype surrounding these tokens. So basically this is nothing different than the internet dot com bubble where people started investing in junk IT companies which basically had zero value propositions. In this case, based on Ethereum many small projects have created tokens where the underlying value creation (long term) is zero.

One of the reason the cardano forum was discussing this question, was to avoid this same kind of behaviour on this third generation chain. So conceptual understanding of when a token is needed and when not, should to be very clear.

Now once a smart contract gets executed following things happen:

Simplified image of smart contract execution: Different parties agree on a certain set of rules and they pay their fees for the execution of a contract (normally ≥ 2 parties are needed for obvious reasons). They pay the fees, and a contract takes these inputs. It executes certain set of rules, and commits these rules to the blockchain by paying a transaction fees. As a proof of this execution, tokens are issued and given to the receiver (party 3). Here value transfer is from party 1 and party 2 to party 3. In exchange of the value party 3 pays party 1 and party 2, and receives a token as a guarantee for this exchange.

A token is spit out and the transaction committed to the chain (this is highly simplified view but explains the basics). The token holder may be one or many (organization for example).

In order to represent the separate value creation we need this holder of value or Token. Now in real world if we denote this so called value holder token as “TVAL” for example, it becomes a tradeable commodity itself provided exchanges host it and the community recognizes true value creation.

And hence can be exchanged on open market with anyone else using other value stores (including ADA). So once TVAL is created and traded, it will be hard to PREVENT IT FROM BEING EXCHANGED for anything else especially if the crypto exchanges allow such using underlying technology such as uniswap where we can exchange one token for another seamlessly.

Tokens: When not needed ?

There was still some doubts in the mind of the person who started this discussion, regarding the need for tokens when he registers his car on the chain (for example a car dealer). It was not yet clear to him.

Here is the exact quote from the question:

The “smart contract” is that you pay a certain amount as insurance in dollars and you get paid a fixed amount in case of an accident. But the amount is not in “insurance tokens”, it’s in dollars. Or another example Amazon gift cards are denominated in dollars as well, not in “Amazon tokens”.

Again we see how much confusion is there in the minds of people regarding utilization of the blockchain and tokens on them. He tries to compare a insurance product / amazon gift card with a token. Neither increase in value over time, and hence no value build up means, no token. So would it mean that we cannot denominate the gift card or a car on a blockchain. Certainly we can.

That brings us to the topic of another sort of identifier which is now becoming a standard. It is called DID (Decentralised identity). They are not smart contracts but proxy identifiers to real world objects.

For insurance it is just a fixed payout and the insurance certificate can be just a DID document on blockchain (decentralized identifier). There is no need of a token for this, because an insurance contract value does not change over time.

A separate article has been written on this topic.

Final recap and takeaway:

• Smart contract is a layer on top of the base blockchain which is basically an immutable ledger. In this article we have just used Cardano ADA as the reference chain, as we are 3–4 months away from Plutus smart contract being deployed on mainnet, and hence a lot of discussions happening about need of tokens and when ?
• Smart contract and their tokens are needed as a representation of value creation on the blockchain. Tokens are a placeholder of unit of value creation for the purpose it is used for.
• Not every use case requires a token. Only when an extra identifiable value (like financial instruments like bonds, stocks, rare jewels, antique items) whose value changes over time(best weather scenario should increase), & they are scarce , can be best associated with token issuance.
• When an items has no extra value generation but only an unique identifier is needed, it is best to think in terms of DIDs (Decentralized identifiers). They create utility in enhancing value exchange across different geography and B2B use cases (like supply chain, insurance, etc.).

Welcome to the brighter future with third generation block chains like Cardano. We will get there where freedom from the centralized power centers we have created can be done away with…it will take time …but we do see the light at the end of the tunnel…(which we ourselves have created).