After attending Token 2049 in Singapore, I spent a reasonable amount of time catching up with a few of the investors I met along the way. Two themes arose in our conversations. The first was what had happened with FTX (easy answer, fraud), and the second, which came from other investors with a traditional finance background, was rooted in determining the purpose behind Web3 tokens.

From an outsider's perspective, tokens are a way for Sam to take from you to give to Caroline. But under the hood, this question prompted curiosity: an approach to seeing tokens from a first-principles lens. Channeling my inner Ted Lasso, I thought it might be time for me to “be curious, not judgmental” regarding these cryptocurrencies.

When I started investing in the space, I did not have an insightful answer to this question. I viewed tokens as a mechanism of protocol ownership, as one would view public company shares. This knee-jerk understanding of tokens shifted over time, but few explicitly stated the “so-what” behind these now-demonized tools for decentralization.

Through the Scam Coin era of 2020–21, there’s been a proliferation of Web3 tokens for the sake of rug pulls, scams, and get-rich-quick-schemes. This has been bad for the industry: the original purpose of tokens in decentralized protocols diverged from its bull market use case. The hope is that this article provides a framework for investment scrutiny of tokens peddled or shilled to the public, or worse, Crypto Twitter.

This essay is my attempt at having a curious, open-minded understanding of a token’s role in Web3.

I. Introduction and Background

Cryptocurrencies, Explained

Cryptocurrencies, or tokens, are atomic digital currencies used as a medium of exchange through a decentralized computer network. Bitcoin and Ethereum are decentralized computer networks, meaning they are run as a collective rather than by a centralized entity or institution. Each network has the characteristic of being open and permissionless: anyone can download the software required to run an instance of each network and participate in validating transactions. This is the meaning behind the phrase “run by a collective” — the code verifies transactions, and the people running and maintaining the code (node operators, as they are called) come to a consensus on all valid transactions. Each network has its own digital currency, which acts as the atomic unit for that network; in this case, it’s BTC for Bitcoin and Ether for Ethereum.

As we’ve previously covered here, tokens are derived and built through a few lines of computer code called smart contracts, which are then executed and run on a decentralized network.

Computer networks like Ethereum allow users to build tokens atop its blockchain, whereas Bitcoin does not. Before Ethereum, individuals or projects had to create a separate and unique blockchain to issue a new cryptocurrency. The Ethereum ERC-20 standard enabled anyone with access to a computer to spin up their attempt at digital alchemy on Ethereum without reinventing a new blockchain network. This standard led to the Initial Coin Offering (ICO) boom of 2017.

To show you how easy it is to start an ERC-20 token, I decided to ask ChatGPT to write me the code to launch an ERC-20 token contract:

pragma solidity ^0.5.0;

import "https://github.com/OpenZeppelin/openzeppelin-solidity/contracts/token/ERC20/SafeERC20.sol";
contract MyToken is SafeERC20 {
    // Public variables of the token
    string public name;
    string public symbol;
    uint8 public decimals;
    uint public totalSupply;
    // This creates an array with all balances
    mapping (address => uint) public balanceOf;
    // This generates a public event on the blockchain that will notify clients
    event Transfer(address indexed from, address indexed to, uint value);
    // Constructor function
    constructor(uint initialSupply, string memory tokenName, string memory tokenSymbol, uint8 decimalUnits) public {
        balanceOf[msg.sender] = initialSupply;             
         // Give the creator all initial tokens
        totalSupply = initialSupply;                        
        // Update total supply
        name = tokenName;                                   
        // Set the name for display purposes
        symbol = tokenSymbol;                               
        // Set the symbol for display purposes
        decimals = decimalUnits;                            
        // Amount of decimals for display purposes
    }
    // Send coins function
    function transfer(address _to, uint _value) public {
        require(balanceOf[msg.sender] >= _value && _value > 0);
        balanceOf[msg.sender] -= _value;                    
        // Subtract from the sender
        balanceOf[_to] += _value;                           
        // Add the same to the recipient
        emit Transfer(msg.sender, _to, _value);             
        // Notify anyone listening that this transfer took place
    }
}

Impressive, huh?

Armed with these tokens, individuals can take partial ownership of a decentralized computer network. Because of the blockchain, all the nodes in the network maintain the same record of who owns which tokens and in what amount, along with the transfer record since inception. Hence the moniker, decentralized ledger. As you’ll recall, a node is a computer linked to a blockchain network that assists in producing, receiving, and moving data, which is what makes a blockchain stateful (e.g., able to record/remember transactions).

As you’ve seen from the code block, the smart contract defines the rights a token holder receives, such as the ability to send and receive tokens from and to their Web3 wallets.

Tokens and Their Analog Parallels

Tokens are not a new concept. Tokens in Web3 reflect many analog world counterparts: gift cards, ID cards, airline points, and club memberships. Even fiat money can be an extension of the token definition.

The main underlying difference has to do with issuance. For many of the aforementioned examples, the tokens’ allocation, distribution, and maintenance rely on a centralized intermediary to ensure validity and maintain the permissions they afford. Though not issued by a centralized institution, cryptographic tokens, by contrast, have their validity upheld through code, forming the basis of trust in code. Whereas confidence in a club membership “token” stems from that club’s financial stability and physical structure, assets, and quality therein, a cryptographic token’s validity is based on the code in its smart contract and maintains its records through the network’s distributed ledger and consensus mechanism.

To summarize, tokens are nothing new. What’s new is how the authenticity of those tokens is represented: through a decentralized computer network that records to a distributed ledger.

Cryptographic Tokens, Explored

Cryptographic tokens have all the qualities of general tokens (gift cards, ID cards, memberships, among others) people have interacted with before. They can provide access rights to property or public services (using the Bitcoin network to send payments to recipients abroad) or private (using an NFC-digital wallet card to enter into an Airbnb). The tokens' roles vary based on the specifications encoded in the smart contract.

As we’ve covered in What’s In Your (Web3) Wallet, tokens aren’t held in an individual’s crypto wallet. They are not digital files stored locally but entries on ledgers that map (point) to a particular blockchain address. The token holder’s identity is recorded through their wallet’s public key rather than physically possessing those tokens in their wallet.

To extend this example, if in this wallet we have a token that represents a ticket to a Broadway show, the owner of the owner would be able to sign a transaction with the private key transferring ownership to another individual if that capacity was encoded in the token’s smart contract. The functionality of the token, though owned by an individual, is dependent on the function the code enabled.

The example above illustrates a core component of tokens: a token's function depends on its code. This is significant because it opens the framework for assessing the function of other tokens. Take, for example, the Ethereum token standard ERC-721. These are non-fungible tokens or NFTs. Whereas ERC-20 tokens are infinitely tradable, as in the case of one dollar for another dollar or ten one-dollar bills for two five-dollar bills, NFTs are unique. While an ERC-20 token acts like a fungible good, an ERC-721 token acts like a non-divisible asset representing a finite and limited digital good.

Today, NFTs represent digital collectibles, cultures, and tribes. The ERC-721 standard implies that this code set can enable more complex digital assets ranging from representing identities to voting rights in elections. The extended use cases enabled by code take tokens beyond a means to incentive participation to secure a network or merely the exchange of value between two parties.

Tokens can represent non-tradable digital assets, known as soul-bound tokens or EIP-5484. These tokens would be a particular type of NFT that cannot be transferred. In other words, the ownership would be immutable. This is a unique improvement in tokens: we can now codify digital identity, reputation, and characteristics in an independently verified, non-transferable, and permanent manner. I cover a framework for building out a decentralized identity system here.

Tokens, Summarized

Thus far, we’ve covered the “what” behind tokens. We’ve analyzed how “easy” it can be to launch a token (thanks, ChatGPT ), which is why we have seen a proliferation of these internet coins over the last 36 months, many with the purpose of trading, speculating, and demonstrating the greater-fool-theory. We’ve covered the technological primitives behind these tokens, ranging from the fungibility of ERC-20 tokens, the non-fungibility and uniqueness inherent in ERC-721 tokens, and the potential for new identity systems and reputation to be captured through soul-bound tokens.

The next logical step of exploration is understanding the “why” behind these token features of a blockchain. Token usage as a means to safeguard and incentivize cooperation and maintenance of a decentralized network was covered earlier in Securing The Network with Proof of Work. The following section acts as an extension of that essay, seeking to clarify the usage of tokens for decentralized applications.

With that, let’s dive in.

II. The Purpose of Tokens in Decentralized Applications

History Of Open Source Systems and the Emergence of Read-Write-Own

Tokens represent a unique innovation for cultivating ownership and social coordination across software developers, contributors, and users. A protocol refers to the set of rules that computers of a network use to communicate with one another. A protocol is defined in the context of open-source systems; open-source refers to software that is free to use, study, modify, and distribute for any purpose. This is in contrast to closed-source or proprietary code, in which the code represents intangible, proprietary assets, as in the case of Tesla’s self-driving code or Google’s ranking algorithm.

For background, the modern internet was built and predicated on many open-source systems that govern standardization:

• HyperText Transfer Protocol (HTTP): used for accessing and receiving HTML files

• Simple Mail Transfer Protocol (SMTP): used for transferring e-mail between computers

• Transmission Control Protocol and Internet Protocol (TCP/IP): TCP ensures a reliable internet connection while checking for errors / IP tells information packets (collection of data) what their destination is and how to get there (through a web of links)

These open-source protocols created the foundation for the free and modern internet we experience today.

At the time the consumer-versions of the Internet came to fruition in the late 1980s/early 1990s, there was an array of competition between protocols jostling to become the “default,” similar to the proliferation of Layer 1 blockchains, each vying for developer and user attention.

When Web 2.0 began to take shape in the early to mid-2000s, many centralized intermediaries took advantage of what these protocols enabled to create winner-take-all platforms, as in the case of Google being the canonical search engine to the point where its name has emerged as a verb.

Web 1.0 became a prime target for rent extraction given its statelessness — its inability to keep a record of activities. The durability of business models didn’t emerge until Web 2.0 companies enabled “statefulness” for the internet built upon these free and open protocols. They took much of the value accrual for facilitating this innovation, as in the case of Meta being able to upload all your photos of your recent vacation or Shopify updating your shopping cart after you add an item.

In the axiom of Web 1.0 being read-only, Web 2.0 became read-write as producing, contributing, and distributing content reached a marginal cost of zero.

Web 3.0 is the next layer of innovation that will allow for a user to have a more thoughtful experience with the internet: one that isn’t defined or curated by a select few of legacy service providers. While Web 1.0 was oriented toward being free and open source, Web 3.0 ushers in a social coordination and incentive mechanism that is token-driven and open source. It creates a system of network ownership and shared incentives. This is one of the critical features of Web 3.0 that cultivates the read-write-own paradigm.

This is significant because tokens allow for a decentralized business model for protocols that weren’t possible prior. For the first time, software code was able to codify digital scarcity and authenticity. That was the core innovation that the Bitcoin Whitepaper introduced: the ability for a group of people to create digital scarcity in a socially-maintained and applied mechanism-design theory. In other words, safeguards were coded such that a participant could not double-spend tokens. Attempts at creating digital money with a centralized intermediary were attempted prior, but for the first time, a group of people could “trust in code” absent a centralized institution. If they tried to double-spend or alter the consensus-determined state of the record, punishments were so severe that the benefits of trying to lie/cheat even more punitive than it’s potential gain to discourage dishonest behavior.

Web 3.0 offers the potential for a renewed internet experience, just as the internet protocols of Web 1.0 faced when introduced to the developer community; there is always a cold-start problem in upstart marketplaces (e.g., how valuable is an Uber with no drivers or an eBay with no sellers)?

III. The Why Behind Tokens — An Answer to a Decentralized Cold-Start Problem

Cold start problems are the forces that make starting a competitor to Facebook or Uber complex and costly. It has to do with winner-take-all dynamics supported by Metcalfe’s law: “the value of a network is proportional to the square of the number of connected users of the system.” Therefore, the more people that use a network, the more valuable it becomes and the more challenging it is for a competitor to create a wedge and survive.

Web3 protocols are no different than the marketplaces (e.g., matching drivers and riders, writers and readers, buyers and sellers, etc.) we see in Web2, but they are run differently. While the Uber of today may charge drivers 30% of the ride cost and offer them no upside through stock ownership, a Web3 Uber could redefine who accrues the value of each ride, determined by all network users. The issue with developing a “decentralized Uber for X” today is that a protocol needs users. For consumers, the philosophical benefit of Web3 doesn’t outweigh the convenience and UI/UX of using entrenched, centralized incumbents — a barrier of convenient complacency.

A solution to start an initial community base is to give these early adopters ownership in the protocol, incentivizing adoption and their early contributions to the protocol. This ownership comes in the form of a digitally scarce good tied to the use of the network, which for Web3, is a cryptographic token or cryptocurrency. A token acts as a conduit for early adopters to be rewarded with something beyond the pride of being first: there may be price appreciation or rewards down the line. While this may sound farfetched, this is how Bitcoin incentivized early miners when there was no broad use case for BTC beyond a social experiment around a decentralized P2P payment network. Tokens, in this case, help address the cold-start problem inherent in new networks.

Therefore, the shift from Web2 to Web3 is fundamental and philosophical. Whereas a centralized intermediary would extract rent from creating, maintaining, and growing a marketplace or internet tool, a Web3 protocol replaces the centralized intermediary with transparent, user-driven coordination in which early contributors and builders benefit from a network’s use, popularity and utility through distributed token ownership. The network usage increases with this shift, and the network effects grow and deepen as users become owners of the network with potential value accrual: fee streams charged by these protocols are then redistributed or shared with their users. This is a fundamental shift from how the value is extracted today from Web 2.0 counterparts.

While there is a hint of speculation inherent in seeing a token appreciate for the sake of being early, there are additional features within a distributed system that aren’t possible in Web 2. One example is a hedge against the typical bait-and-switch policies seen through Web 2. When services like Facebook first started, the novelty and utility of staying connected created a meaningful experience for many first-time users, an actual utility. But once Facebook hit a critical mass of users, policies shifted to support ad-driven experiences. The goal became less of keeping people connected meaningfully and instead optimized for screen time (e.g., ad exposure) they could extract from a user’s day. These bait-and-switch tactics are at the core of concern regarding a lack of transparency and voice in how these policies may affect early and current users.

In Web3, the bait-and-switch tactics are less possible. A protocol’s token puts skin in the game for all stakeholders, aligning incentives through utility and the policies guiding a protocol’s evolution. However, the beauty of Web 3’s open architecture is that if users, in part or whole, disagree with a protocol’s direction, a group can “fork” (copy and paste) the code and recreate the protocol that best aligns with their values and expectations. I’ve written about protocol forks here.

The internet experience moves from a passive one to an active one in Web 3.

Decentralized Business Models

A common retort is that Web3 protocols, being that they are open-source, are easily forked and, therefore, can’t possess any business durability. No “trade secrets” or “IPs” protect a protocol from being copied and pasted.

This retort has validity a first glance. But the rebuttal is simple: marketplaces. An alternative to eBay or Uber would possess defensibility from network effects. Fee streams and delightful user experience in matching the goods and services of one group with the demands and preferences of another embed user lock-in. Conversely, with open source, there is a critical delineation between **open **source code libraries, which anyone with access to the internet to view, copy, and use, and the networks from which that code enables.

Only when the code is utilized, along with memes of production, is durability brought to life through a protocol and its community.

It’s important to note that the same components that make a traditional Web2 company durable, as in the case of Microsoft, are the same elements at play for open-source networks in Web3.

These features entrench existing players, building upon the network effects and generating defacto product lock-in. Take branding: Web3 protocols can share mind space as they establish a strong reputation, a loyal customer base assuming a delightful user experience and protocol utility, and offering services that would be hard to replicate. To expand on the last point, many of the services that make Web3 protocols useful are based on interoperability between services. These relationships are intangible, often cultivated offline, and consummated through code. These “integrations” with other services create their defensibility because a fork cannot simply copy over the “human element” to build a brand. Additionally, many of the protocols that have survived through bear cycles (e.g, post-2017 and post-2021) achieve early steps toward a Lindy Effect: the idea that the future life expectancy of some non-perishable is proportional to its current age, meaning that each additional period of survival implies longer remaining life expectancy. Assuming it is a decentralized protocol and not a centralized entity like FTX/Celsius/Voyager/BlockFi, the more time a protocol has been in the market, the longer you can expect it to be. The product ingredients entrench existing players, build upon the network effects, and generate switching costs.

Progressive Decentralization as a Framework

IV. Challenges and Straying Further From The Truth

The primary purpose of a token, primarily as it exists for a decentralized application (dApp), is to achieve progressive decentralization of that dApp. The goal of a token shouldn’t be to launch it to the public, with the expectation that insiders (founders, advisors, and early investors) sell token shares purchased at a significant discount to “dump on retail.” Unfortunately, that’s been the modus operandi for Web3, which offers validity to the distaste prudent, traditional investors have for the space.

The point of the token is progressive decentralization.

If we operate under the assumption that the “hero” of a protocol isn’t the code but rather the community, then building a framework that allows the protocol to be maintained, improved, and governed by the community serves to create and serve the “greater good.” This means that teams, initially, should be small and focused on building value-driven, delightful-to-use protocols while slowly and deliberately creating mechanisms to bring the community into the planning and execution process, from which the protocol’s tokens can be used to incentive these early adopters. Over these small iterations, the founding team is soon no longer the hero of the story but evolves into the role of the initial catalyst. Just as the Constitution allowed the US to operate in a framework of principles over the last 200 years, absent additional influence or changes from its writers, Web3 protocols can offer the same experience to early users and create long-term, principle-driven buy-in using tokens to decentralized ownership.

V. Conclusion

Tokens have diverged from their social coordination use-case and since evolved into unregistered securities, and quick pathways for insiders (teams, early investors, exchanges) to quickly market (pump) and sell (dump) to retail for the sake of making a quick buck. A terrible product, a horrendous user experience, and a solution in search of a problem became the expected norm. This became the prevalent outsider view. As a professional investor in the space, it was hard to watch and even harder to avoid participating in the cash grab that was the last bull market.

But returning to this hard-won, fundamental perspective in the why and how behind tokens provided the filter necessary not to be caught swimming naked when the tide went out.

Tokens are crucial in driving early adoption and achieving progressive decentralization on protocols that redefine how humans interact and experience the internet. Tokens are niche and controversial — they will be seen as a breakthrough in the proliferation of open networks, combining the social good of open protocols with the financial benefits of proprietary networks. They are the pathway towards a decentralized future and a tool that, if used correctly, can accelerate our ability to find more meaningful interactions with each other through the Internet.

Sources:

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