Digital Tokens: Holding blockchain technology back?
In November, I shared my perspectives on the fallout of FTX. I argued that innovation is the result of the iteration of ideas by people and institutions over time. The collapse of FTX was an iteration of an idea that did not work as intended. Further, FTX was a material deviation from the original ideas that underpin blockchain technology, and more specifically, the bitcoin protocol - the longest running and most decentralized blockchain. As I have continued to reflect on the FTX situation, I’ve come to believe that FTX also highlights another poor iteration of an existing idea - the idea of every blockchain needing a token. In short, most tokens, except for bitcoin and maybe ether, in their current form represent unregulated digital securities with poor incentive mechanisms, relative to traditional equity securities. The unregulated nature and misalignment of incentives can lead to fraud and erode the long-term thinking that the industry needs to continue to scale infrastructure and increase adoption.
A token is a digital asset that can be transferred (not simply copied) between two parties over the internet without requiring the consent of the other party. bitcoin is the original token. Transfers of bitcoin and the issuance of new bitcoin are recorded in the Bitcoin blockchain. Fast forward 14 years, today, there are ~20K tokens connected to blockchains and other use cases. While digital tokens as part of blockchain based ecosystems are novel, the fundamental role that tokens play are not. Tokens are a digitally native tool that represent an iteration on three existing ideas. Digital tokens i) facilitate capital formation, ii) are a customer acquisition tool, and iii) can be digitally native commodities or digital resources that do not have an issuer.
Capital Formation
Tokens can act as a digitally native crowd-funding currency, serving as a digital currency. Tokens have a price; therefore, they can be issued and sold en masse at the inception of a new blockchain protocol to fund its development, similar to the way startups have used Kickstarter to fund project development. Every major token you have likely heard of, except for bitcoin, was started with some from of initial token offering. In a token offering individuals interested in the project typically exchange another token or traditional fiat in exchange for token ownership in the project. Tokens, like other alternative capital formation tools, are beneficial in that they can provide a way to fund previously undefinable shared infrastructure projects, like open source. In addition, tokens allow you to reach a lager network of potential investors. For example, US and non-US investors, individuals and institutions, are able to easily purchase tokens. In the US, while equities can only be sold to accredited investors (~3% of adults with >$1 million in net worth), tokens are currently able to be purchased by 100% of the American population, a 33x increase in the available US buyer base, relative to a traditional equity financing for a start up. Further, the US is only ~4-5% of the world population, therefore, international availability provides another 20-25x in the available buyer base. Lastly, tokens offer a significant improvement in the time to liquidity over traditional methods for startup finance, as they trade 24 hours, 7 days a week, globally, compared to up to 10 years to get liquid in a traditional equity investment.
Customer Acquisition
New protocols use tokens to bootstrap new user growth. Protocols offer digital tokens to new users in exchange for governance rights or a staking yield (like a bond coupon) for holding / locking up tokens for a set amount of time. Early adopters are attracted to purchasing tokens for the potential economic benefits in the form of price appreciation of the token and governance benefits of being able to potentially have decision making rights in the future trajectory of the protocol. As a customer acquisition tool, token issuances to early adaptors is analogous to the free products that Google and Facebook offer, with one exception, tokens allow early adopters to participate in the economic upside; whereas traditional customer acquisition tools only allow users to receive the free service or the one time cash referral bonus (e.g. PayPal usage of cash rewards at sign up during its early days).
Digital Commodities
bitcoin is currently the only token that is recognized by both the SEC and CFTC as a commodity. A commodity is a natural resource that has no issuer. Perhaps more important than what it is, in the case of bitcoin as a digital commodity, it’s important to note what it is note - a security. A security is legally defined as an investment of money in a common enterprise with a reasonable expectation of profit derived from the efforts of others - more on this below. As it relates to bitcoin, there is no issuer. Bitcoin is not issued by a corporation, a foundation, or a small group of people that can unilaterally make changes to the protocol. There is no leader of bitcoin, just like there is no leader of gold, copper, silver, or any other commodity.
My “hot take”
What does this have to do with FTX? While FTX was not a decentralized protocol, it’s rise and fall was primary catalyzed via the company’s ability to issue its own digital token, FTT. FTT represented nearly 90% of the equity value of FTX as the time of collapse. FTT was used by FTX as both a capital formation tool and a customer acquisition tool. As a capital formation tool, FTT was an unregulated security. As a reminder, a security is legally defined as an investment of money in a common enterprise with a reasonable expectation of profit derived from the efforts of others. Individuals and institutions purchased FTT as an investment in FTX in the hopes that they would benefit from the appreciation of the token as FTX saw greater adoption and revenue growth.
I don’t have an issue with digital securities. I think they are a great innovation, that will see widespread adoption, as they represent a digitally native investment contract that can be traded peer to peer, 24/7, globally on blockchain rails. The problem is the lack of regulation. Traditional securities are regulated by the SEC and are subject to disclosure rules that are designed to protect investors. Security issuers must disclose the team behind the issuance, compensation, holdings, related party transactions, risk factors, etc. FTT had no such disclosures. The lack of transparency about FTT is ultimately why it collapsed, once investors realized the largest holder of FTT was FTX and that FTX didn’t have any other acceptable collateral they quickly sold the token.
Another feature of traditional securities is transparent disclosure of the largest holders of the security. In addition, there is transparent disclosure of the buying and selling actions of the largest holders and the individuals responsible for the success of the enterprise that the security is an investment contract in. Further, traditional securities typically have lock-up periods or parameters around when insiders can sell. The benefit of lock up periods and selling schedules is that it incentivizes insiders to generally make decisions that are in the best interest of the enterprise and thus the value of the security. Traditional securities are structured to incentive longer term thinking.
Digital token ownership is not transparent. Digital tokens do not have lock ups or sell schedules. The opacity of ownership and non-existent lock up periods allow for and arguably incentives short term thinking. For example, in the current paradigm, I can create “Elliott Explains” coin. Proceed to distribute to my friends at a price of $.00001 and subsequently list it on a digital exchange and sell my ownership to retail buyers at a higher price. Once I liquidate my ownership, I am no longer economically incentivized to make Elliott Explains the best blockchain project. Further, new investors may have no idea that I am no longer a majority owner in the project, yet that is the reason they are investing. This is a crude, but directionally accurate example of investment activity of individuals and institutions into protocols that have digital tokens.
Put simply, digital tokens are unregulated digital securities that incentivize short-term thinking and facilitate fraudulent behavior due to lack of transparency and disclosures for potential investors. To be clear, I’m bet there are several protocols with digital tokens that have individuals and institutions with the best of intentions. However, the number of projects that fall into this category is significantly lower than 20K. Further, the old adage of “show me the incentives, and I’ll show you the outcome” applies here, just as in any other context.
To be clear, the conclusion of my position is not to get rid of digital tokens – that genie has been let out of the bottle and is not going back in. Instead, as allocators of capital, until there is a more robust regulatory framework that provides better transparency and incentive alignment it is best to take a cautious approach to tokens. When evaluating any cryptocurrency or adjacent project, if it has its own coin or token, we should ask, “does it really need a token?” Typically, I believe the answer is no. What history has demonstrated is that the reason why most projects have a token, is likely to benefit the creators/founders in terms of fast exit liquidity regardless of whether the underlying project offers any real value in the long run.
References:
1. https://news.earn.com/thoughts-on-tokens-436109aabcbe
2. https://nydig.com/research/through-the-looking-glass-the-ftx-and-alameda-saga
3. https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets
Who did what this month:
BNY Mellon’s CEO said that digital assets were the bank’s “longest-term play” on its latest earnings call. Link.
The SEC announced charges against Gemini and Genesis, alleging that Gemini Earn is an unregistered security that bypassed disclosure laws. Genesis held $900 million of Gemini Earn deposits and couldn’t meet liquidity demands after the collapse of FTX. Link. Link.
Crypto.com is cutting its workforce by 20%, citing the collapse of FTX causing the firm to cut more staff after announcing layoffs over the summer. Link. Link.
Crypto prime broker Genesis Global filed for bankruptcy and claimed $5.1 billion in liabilities, just days after the SEC filed charges against the company. Genesis, a subsidiary of DCG, has been struggling after suffering a $1.2 billion loss to crypto hedge fund 3AC. Link. Link. Bankruptcy proceeds are expected to begin Jan 23. Link.
Robinhood released its crypto wallet to 1 million waitlisted users. Robinhood Wallet is a mobile app that allows users to swap and transfer crypto using Polygon. Link.
Gemini, the Winklevii founded crypto company, conducted a 10% reduction in forcethis week.
Quicknode, a blockchain node infrastructure business, raised $60 millionin Series B financing from 10T, Tiger Global, Seven Seven Six and QED.