The token economy

Tip

Token economy: A system or marketplace where decisions are made driven by economic incentives of digital tokens.

Burrhus Frederic Skinner, or more commonly known as B.F. Skinner, was an American psychologist, behaviorist, and social philosopher who used the term "token economy" in 1972 in a video titled Token Economy: Behaviorism Applied" (https://www.youtube.com/watch?v=fyFzPgIy-0g). Skinner used this concept in the context of using physical tokens in a program of therapy for the treatment of criminals and the mentally ill. As a side note, the writer of the famous American animated sitcom The Simpsons, Jon Vitti, named the "Principal Skinner" character after B.F. Skinner (The Simpsons season 2 DVD commentary for the episode "Principal Charming" [DVD]. 20th Century Fox).

One of the major teaching techniques was using a token economy with the students. A token economy was very simply a structured learning situation, where tokens, or little plastic chips, were used so that students could earn tokens in a wide variety of ways. This always involved learning more appropriate behavior.

The meaning of a token economy or tokenized economy in 2018 contains the same concepts, but it is applied in a different context. Little plastic chips have now been digitized into tokens and instead of students earning tokens, anyone can earn them and the structured learning environment has now changed into a new digital world, where anyone can participate.

The underlying infrastructure that has allowed this new token economy to flourish is blockchains, which are the equivalent of an ad-hoc miniature economy. In this economy, you have a group of people, or entities, who are all interacting with each other, making decisions, co-operating, and even competing with each other. The driver is an underlying software that enforces the rules created by the original author(s) and it governs how the interactions will unfold.

What is interesting is that all these miniature economies are powered by their own specially created token. Why do these token projects do this? The answer is: because they can. The marginal cost of creating a new token on a platform designed for creating tokens is almost nothing; however, gaining adoption is a totally different challenge.

This leads to the concept of a minimum viable economy, where if traction or critical mass is achieved, the economy can self-sustain and self-govern. Otherwise, it collapses and new ones form very quickly, and it's the low barrier to entry that allows this to occur.

The token is interwoven throughout the business model, providing a way to reward and incentivize the network participants, customers, and stakeholders. This focuses innovation at the token level, as the blockchain infrastructure is already provided, along with other requirements, such as consensus algorithms and the creation of a network.

There are key questions to consider around the tokens with a token economy. For example, is the token tied exclusively to a product usage or a network? The current answer is almost always yes. Other key questions include: does the token provide the owner with special privileges or ownership? Is the token required to run a smart contract or is it used to pay for usage? The answers to these questions are all varied and unfortunately, they depend on the design and context.

The most important question, though, is whether having a token is an absolute necessity in solving the problem. In other words: if digital tokens and the blockchain technology had not been invented, could the problem still be solved?

A unique aspect of the token economy is around the distribution because the key is to get the tokens into the hands of as many users as possible, so they can be used. This is because in this miniature economy, your products or services can only be used or traded with that token, which means that if you provide a valued service or product, that token eventually comes back to you. This circulation between stakeholders is very important. The most successful token projects will be the ones that can solve this challenge or even gamify it.

Marc Andreessen, co-founder of Netscape and venture capitalist firm Andreessen Horowitz, famously stated, Software is eating the world. In his 2011 article, he outlined that the world's largest bookseller, Amazon, is a software company; the largest video service by subscriber, Netflix, is a software company; and music companies like iTunes, Spotify, and Pandora are also all software companies. The list keeps going, with the likes of Skype in telecommunications and Pixar for animated movie production and Andreessen added, Software is also eating much of the value chain of industries that are widely viewed as primarily existing in the physical world (https://a16z.com/2016/08/20/why-software-is-eating-the-world/).

Nearing a decade on, the manifestation of the physical world is slowly being recreated in the virtual world and the missing piece of the puzzle has been discovered: the ability to transfer value in this virtual world with trust. This is how and why the token economy will continue to grow and develop. The tokenized economy starts with the digitization of the physical world and ends with the realization of the virtual world.

What does the current tokenized economy look like?

A token economy may be hard to conceive because it is not really tangible, like physical assets or your local bazaar, but there are digital tokens being created every day for all sorts of uses. The following image shows only the top 10 out of the thousands available and these thousands will grow further in the coming years. The reason for the growth is because of the new network of markets that is being created.

Figure 6: A list of the top-10 tokens, out of thousands in a token economy, from CoinMarketCap.com

What is tokenization?

Tokenization is the process of converting the rights of real-world assets into a digital token, stored on a blockchain or decentralized ledger. The simplest analogy is democratizing ownership of real-world assets, where the value stored in some physical asset, such as real estate, is represented as a token. For example, if you had an apartment valued at $1,000,000, one million USD tokens could be created to represent the value of the apartment at $1 per token.

The one million token supply is totally arbitrary. The one million tokens could then be freely bought or sold on an exchange and if you bought 500,000 tokens, you would effective own 50% of the apartment, and the various rights and benefits associated.

This concept is not new, as anyone can create tokens and record the token history using a regular database, managed by a trusted third party, but the novelty now is that it can be done in a decentralized fashion and nobody can "erase" your ownership of these tokens. This is the key tenet of this blockchain technology.

Real-world assets, such as artwork, stocks, and gold, are just the first step because the same thing can be done with digital assets and intangible assets, such as carbon credits, patents, and copyrights. These tokens and their exchange are what creates this token economy. What's more, every brand, every artist, and every community can tokenize its economy with the ability to incentivize early adopters or reward loyal follows within this economy. This is the equivalent of being able to communicate value on a new level. Think of it as loyalty points on steroids.

The tokenization of everything

We've seen the ability to tokenize anything, from the physical and tangible to the intangible. The next logical question is why?

First of all, when assets are tokenized, they unlock liquidity. The value you have in your property is regarded as illiquid because there is no easy or quick way to access the capital stored there. Tokens representing the value of your property can be traded much more easily and hence they are more liquid.

The technology the tokens live on allows greater access to everyone. It may not be to the extent that all you need is a computer and internet connection, but it will be much more democratized than what we have at present.

This increased participation results in greater ease of trade, by bringing in more liquidity and efficiency to a market.

Tokenization enables new economic models, such as fractional ownership (investors can own a certain percentage of a certain asset), therefore users can purchase a smaller, more affordable portion, rather than an expensive whole portion.

Through fractional ownership, more diversification of risk can be obtained. If a valuable piece of artwork was destroyed in a fire, an investor would lose only the proportion of that which was invested.

Tokenization reduces administrative expenses and with smart contracts and an immutable audit trail, auditing and compliance become a lot easier and quicker for regulatory bodies.

It would be presumptuous to assume that tokenizing assets is without its challenges.

The most obvious one is trusting the issuer. Market participants need to be confident that they can redeem their real-world asset at any point in time. Whether it is the ability to redeem the five gold tokens for one ounce of gold, or the 2,000 tokens representing a fraction of a property for USD, if the token is not redeemable or exchangeable, then the token is worthless.

There is still a cloud of uncertainty over the regulations of tokenized assets. Governments and relevant regulatory bodies around the world are closely following developments and currently the default is to apply existing laws to these new scenarios.

Legal enforcement of token ownership and rights has yet to be tested in a court of law, particularly around the recovery of damages and liability. This will no doubt set a precedent if and when it occurs.

Digital identity and relevant Know Your Customer (KYC) requirements and anti-money laundering laws need to be met, and most probably integrated into the token platform, to satisfy the requirements of the various relevant regulators and financial market authorities.